Monthly Archives: September 2009

SEC Proposes Flash Order Ban, Announces Market Structure Review

This post comes is based on a Davis Polk & Wardwell LLP client memorandum by Annette L. Nazareth, Lanny A. Schwartz, Gerard Citera, and Robert Colby.


In response to an outcry of criticism voiced by the public, Congress and regulators, on September 18, 2009, the Securities and Exchange Commission (the “SEC”) proposed to ban the use of “flash orders” on equities and options exchanges and large alternative trading systems (Exchange Act Release No. 34-60684 (September 18, 2009)).

The term “flash orders” refers to a practice whereby a trading center will for a few milliseconds show subscribers of the trading center’s data feed customer buy orders priced at the national best offer, or customer sell orders priced at the national best bid. Market participants with fast electronic connections can then execute the orders at the flash price. If the order is not immediately executed, it is withdrawn without exposure to the entire marketplace, or is routed to other exchanges.

The SEC is concerned that although flash orders provide customers with better prices, they harm the markets for long-term investors by undermining public quotes and creating a two-tier market. Under the proposal, flash orders would be impermissible “locking quotes”, i.e., quotes that “lock the market” by matching the quote on the opposite side of the best bid and offer. The SEC states in the release that certain market mechanisms and order types, such as price improvement auctions and immediate or cancel orders (“IOCs”), that bear some functional similarities to flash orders will not be affected by the proposal.

Perhaps more significant than the proposed ban of flash orders is the signal that the SEC is once again preparing to intervene in the equities and options markets. The SEC stated its intention to consider in the near future additional market structure topics, including dark pools, Regulation ATS thresholds, alternative trading systems (“ATSs”) post-trade transparency, direct market access, high frequency trading, and co-location, either through proposals or concept releases.

Brief Description and History of Flash Orders

Flash orders are commonly used to send customer buy orders priced at the national best offer, or sell orders priced at the national best bid, to trading centers that may not be displaying the national best quote. The flash order offers the potential for the order to trade on the preferred trading venue immediately at the best price publicly quoted in the market without having the order routed to another market, and for market participants receiving the flashed order information to trade against the order without having to publicly quote the best price.

Because exchanges and other trading centers benefit from maximizing the number of orders that are executed on their markets, they are often willing to pay rebates to brokers who send flash orders that are executed on their markets. The brokers might otherwise have to pay fees to a destination market if the flash orders are routed away and executed there.


Negotiating with Labor under Financial Distress

This post is by Effi Benmelech of the Harvard University Department of Economics.

In my paper, Negotiating with Labor under Financial Distress, which I recently presented at the Law, Economics and Organizations Seminar here at Harvard Law School, my co-authors, Nittai Bergman and Ricardo Enriquez, and I analyze how firms strategically renegotiate labor contracts to extract concessions from labor. While anecdotal evidence suggests that firms tend to renegotiate down wages in times of financial distress, there is no empirical evidence that documents such renegotiation, its determinants, and its magnitude. This paper attempts to fill this gap. More specifically, we use a unique data set of airlines that includes detailed information on wages, benefits and pension plans, to document an empirical link between airline financial distress, pension underfunding, and wage concessions.

We first show that airlines in financial distress obtain wage concession from employees whose pension plans are underfunded. An underfunded plan is one in which plan assets are insufficient to cover outstanding benefit obligations. Employees with underfunded pension plans can in some situations bear a higher cost when firms default if the benefits promised to them exceed the benefit limits set by the Pension Benefit Guaranty Corporation (PBGC), the federal corporation which protects the pensions of nearly 44 million American workers. The maximum annual guarantee is determined by employee age and was $30,978 for a 60 year-old employee in 2006.

Since highly-paid employees with promised pensions that exceed the PBGC guarantee stand to lose more when their pension is transferred to the PBGC, we hypothesize that they will be more likely to make concessions during labor bargaining. Our identification strategy thus relies on a triple-difference, or DDD, specification, with three levels of differences: (i) financially distressed vs. non-distressed airlines, (ii) underfunded pension plans vs. funded plans, and (iii) wages exceeding vs. those that are below the PBGC limit.

We find that airlines that are financially distressed can negotiate down the wages of their employees whose pensions are underfunded and are not fully covered by the PBGC guarantee. The magnitude of the triple difference estimator suggests that in such renegotiation annual wages are reduced by between 9.3% and 11.2%. Analyzing levels instead of the percentage change shows that in renegotiation financially constrained airlines with underfunded pension plans extract between $12,252 and $17,360 in annual wages from employees not fully covered by the PBGC guarantee. Our results are robust to the inclusion of year, airline, plan and airline by-year fixed effects in addition to airline and employee controls.

We also control for the share of the airline wage expense in two ways. First, we control throughout our analysis for the ratio between the wage of an employee group and overall firm wage expenses and find that our results are always robust to the inclusion of the wage share variable. Second, we employ a placebo test to analyze the effect of the PBGC guarantee. Specifically, we compare wage renegotiation in airlines with deeply underfunded plans (the treatment group) to wage renegotiation in similar employee groups in airlines with no defined-benefits plans (the placebo group). We find that amongst highly paid employee groups with wages not fully covered by the PBGC guarantee, only those with a pension plan, and in particular one that is underfunded, agree to accept wage reductions in renegotiation. In contrast, identical highly paid employee groups employed in airlines without defined benefit plans do not accept wage cuts in renegotiation. Thus, our results are not likely driven simply by some employee groups making wage concessions for reasons unrelated to pension underfunding.

The full paper is available for download here.

Financial Crisis Inquiry Commission to Begin Investigations

This post from John F. Olson is based on a Gibson, Dunn & Crutcher LLP client memorandum by Michael Bopp and Aditi Prabhu.

This update focuses on the launching of the Financial Crisis Inquiry Commission (“FCIC” or “Commission”), which was created by Congress as section 5 of the Fraud Enforcement and Recovery Act, which became law on May 20, 2009. The bipartisan Commission is charged with examining the domestic and global causes of the current U.S. financial and economic crisis. In addition to discussing the Commission’s first meeting, which took place today, this alert summarizes the Commission’s broad investigatory mandate, its subpoena and other coercive powers, and its charge to gather information from private and public entities.

FCIC Holds First Meeting; Sets Course for Rigorous Investigations

The FCIC held its first public meeting today in order to outline for the public its mission and approach.  The majority of the meeting consisted of prepared statements by the Commissioners and concluded with a timeline for the investigation.  The Commissioners highlighted the importance of the FCIC’s work and their commitment to the daunting task of determining the causes of the economic crisis.  While the remarks were mostly broad in nature, the Commissioners repeatedly pointed to failures on the part of both the financial system and government regulators as contributing to the crisis.

Chairman Phil Angelides

Chairman Angelides related that while this is the FCIC’s first public meeting, it has held several working sessions.  The Commission has adopted rules and procedures and, most notably, has created whistleblower protections for those who convey information to the Commission.

Angelides introduced Thomas Greene as the newly-appointed Executive Director the Commission.  Greene previously served as Chief Assistant Attorney General of the Public Rights Division in the Office of the Attorney General of California.

Angelides noted that the purpose of the Commission is to determine the causes of the crisis, not to offer “prescriptions for the future,” although the Commission is permitted to do so.  He compared the FCIC to the 9/11 Commission, which conducted over 1200 interviews, reviewed 2.5 million pages of documents, and held 12 days of public hearings.  Angelides expressed the view that the FCIC should be “similarly thorough” and should “leave no financial stone unturned.”  He also compared the FCIC’s work to the Pecora hearings in the 1930s in terms of its aspired impact.

He noted that the Commission’s final report is due in 15 months.  To carry out its mission, the Commission will seek records from government agencies and financial institutions, and hold hearings.  Angelides mentioned that the FCIC will use its subpoena power if necessary.

Vice Chairman Bill Thomas

Vice Chairman Thomas distinguished the FCIC from congressional committees which are also working on similar issues by stating that the Commission need not respect any boundaries.  Rather, its real constraint is time.


The Effect of SOX Section 404

(Editor’s note: This post comes to us from Peter Iliev of Pennsylvania State University.)

In my paper, The Effect of SOX Section 404: Costs, Earnings Quality and Stock Prices, which was recently accepted for publication in the Journal of Finance, I investigate the costs, the benefits, and the overall value impact of SOX Section 404. This provision requires that managers report on the effectiveness of the controls that monitor the internal financial reporting systems, and an outside auditor attests to the management’s assessment of company controls.

Section 404 and its practical application have been under intense attack from business groups and lawmakers who generally view compliance as overly burdensome. Despite calls for a small company exemption, the SEC only gave a five month extension to small companies’ compliance. This exemption provides an ideal quasi-experiment for this study. Specifically, I use a regression discontinuity design that compares the companies that were just above the rule cutoff and had to file the report to companies that were just below the cutoff and did not have to file the report. This is a good quasi-natural experiment because the exact cutoff is not related to firm fundamentals. In addition, one must consider whether firms actively manipulated their public float to escape compliance. This paper uses the public float rule in 2002 to predict (instrument) the actual compliance in 2004. Firms with a public float over $75 million in 2002 had to comply with Section 404 in 2004. However, in 2002 firms had no information about the way Section 404 would be implemented. Therefore, companies did not know that this threshold would be used to define 2004 compliance and were less likely to actively avoid having a public float above $75 million.

The big advantage of the regression discontinuity design is that it can isolate the effects of SOX Section 404 compliance from the effects of the changing business climate (and any contemporaneous event) that would have affected all firms. The disadvantage of this approach is that it can look at small firms only. It is possible that the effect of Section 404 compliance is different for larger firms and hence the results do not to generalize to, for example, Fortune 500 type firms. However, small firms are interesting in themselves. First, there are, of course, more small firms than large firms. Second, the big complaint about Section 404 (and SOX compliance in general) has been that small firms pay disproportionately high costs because of the fixed cost nature of compliance. Third, small firms are likely to suffer more from asymmetric information and low reporting quality, and they could benefit most from the new regulation.

I investigate the audit fees as a direct measure of the costs of Section 404, the changes in reporting behavior proxied by firm accruals, and the stock returns around SOX related announcements as a measure of the net benefits of compliance. I find that the attestation of the management’s report (MR) by outside auditors imposed significant costs for small firms. Filing an MR in 2004 increased audit fees by 98%, or $697,890. With a median firm market size of $110.9 million in 2004 and negative average earnings, this is not a small amount. I show that the increase in audit fees was not driven by the general increase in auditing costs, but was SOX specific. Section 404 also led to more conservative reporting. MR filers had significantly lower accruals and discretionary accruals in 2004. The effect is economically significant, with MR filers booking an estimated $15.1 million less in discretionary accruals than non-filers. For small firms, this change is substantial. The mean and median earnings of my sample are negative $4.8 million and $1.4 million with a standard deviation of $23.3 million. Finally, MR filers had higher event study returns around announcements of delays in Section 404 implementation. The buy-and-hold returns of MR filers was 17% lower than non-filers over the two year period starting with the announcement of the rule and ending after the filing of the 2004 annual reports. These results are confirmed with a sample of foreign firms that were near the 2006 implementation cutoff of $700 million. Foreign firms that did not provide audit reports had 30% lower audit fees and 2.3% lower discretionary accruals. Event study evidence of foreign firm returns further indicates that the costs outweigh the benefits. Some firms might have manipulated their public float in 2004 to avoid filing an MR.

The full paper is available for download here.

NYSE and NASDAQ Propose Rule Changes

This post from Eduardo Gallardo is based on a Gibson, Dunn & Crutcher LLP client memorandum by Amy Goodman, Gillian McPhee and Joelle Khoury.

On August 26, 2009, the New York Stock Exchange (“NYSE”) filed proposed amendments to its corporate governance listing standards with the Securities and Exchange Commission (“SEC”). The NYSE has proposed that they take effect on January 1, 2010. The proposals must be approved by the SEC before they become final, and will be the subject of a 21-day comment period following publication in the Federal Register.

The NYSE proposals would amend the corporate governance listing standards to: (1) codify certain staff interpretations; (2) clarify various disclosure requirements; and (3) incorporate applicable SEC disclosure requirements into the listing standards. Because most of the proposed changes would conform the NYSE listing standards to existing SEC rules, or are of a clarifying or updating nature, they should necessitate only minimal changes to listed company governance practices and disclosures. [1]

Below is an overview of the proposals in the NYSE filing, which includes a mark-up showing the proposed changes to the text of the corporate governance listing standards.

In addition, in August 2009, the NASDAQ Listing and Hearing Review Council sent a paper to companies listed on The NASDAQ Stock Market LLC (“NASDAQ”) seeking comment on whether NASDAQ should adopt a “comply or disclose” approach with respect to certain corporate governance practices. The paper is discussed in more detail below.

NYSE – The Proposed Amendments – A Brief Overview

A primary purpose of the proposed amendments is to update the NYSE’s corporate governance listing standards in light of the SEC’s 2006 adoption of Item 407 of Regulation S-K, which requires disclosure about director independence and certain other aspects of a company’s corporate governance practices. In this regard, the proposals would eliminate each disclosure requirement currently included in the NYSE corporate governance listing standards that also is required by Item 407 and reference the SEC requirements. Although the NYSE acknowledges in the proposing release that this approach may appear redundant, it will permit the NYSE to take action (including delisting) against companies with deficient Item 407 disclosure, as these companies also will be deemed out of compliance with NYSE rules. In addition, as discussed below, the changes would permit companies to make disclosures about certain matters on their websites instead of in their proxy statements.

The following provides a brief overview of the most significant amendments that the NYSE has proposed:

Director Independence Disclosure: The NYSE is proposing to replace its current director independence disclosure requirements with a requirement that listed companies provide the disclosures required by Item 407, which require that companies describe, for each director, by specific category or type, any transactions, relationships or arrangements that the board considered in determining that the director is independent. Current NYSE listing standards permit boards to adopt and disclose categorical standards to assist them in assessing independence, and allow companies to make a general disclosure that their independent directors meet these standards. Accordingly, if adopted, the proposals would eliminate the concept of categorical standards from the NYSE listing standards. However, we expect that the boards of many companies will continue to maintain these standards, because they provide a useful tool for assessing director independence.

Executive Sessions of Non-Management Directors: The NYSE listing standards require that non-management directors hold regular executive sessions. Because some companies have expressed a preference for holding regular executive sessions of only the independent directors, the proposals would clarify that this satisfies the NYSE requirement.

Communications with Directors: The NYSE listing standards require companies to provide “interested parties” with a method to communicate with the presiding director, or the non-management or independent directors as a group. The NYSE proposes clarifying that “interested parties” is not limited to shareholders.

Requirements for Audit Committees: Under current NYSE listing standards, if a member of a listed company audit committee simultaneously serves on the audit committees of more than three public companies, “and the listed company does not limit the number of audit committees on which its audit committee members serve to three or less,” then the board must determine that this service would not impair the member’s ability to serve on the listed company’s audit committee, and the company must disclose this determination in its proxy statement. According to the proposing release, the wording of this provision has led to uncertainty about whether the determination and related disclosure are necessary if a listed company does not limit outside audit committee service to three public company audit committees. The proposals would clarify that both the determination and disclosure are required whether or not a company limits the number of audit committees on which its directors may serve to three or less.

Codes of Conduct: The NYSE listing standards require that companies “promptly” disclose any waivers of their codes of conduct granted to executive officers and directors. The proposals would clarify that companies must disclose waivers within four business days, consistent with SEC requirements governing Form 8-K disclosure of waivers from a company’s code of ethics applicable to its CEO and senior financial officers. The proposals also would specify that companies can make the disclosure through a press release, on their websites or on a Form 8-K. The NYSE notes in the proposing release that this timing varies slightly from the guidance in the staff’s Frequently Asked Questions, which state that companies may make the disclosure using one of these alternatives within two to three business days.

Notification of Non-Compliance with Corporate Governance Listing Standards: The NYSE listing standards currently require that companies notify the NYSE in writing after any executive offer becomes aware of a “material” non-compliance with the corporate governance listing standards. The proposals would amend this provision to require notification when an executive officer becomes aware of any non-compliance.

Certification Requirements: Under the current NYSE listing standards, listed company CEOs annually must certify to the NYSE that they are not aware of any violation of the NYSE corporate governance listing standards, qualifying the certification to the extent necessary. The certification is due within 30 days of a company’s annual shareholder meeting. In addition, in their annual reports to shareholders, companies must disclose that they filed the previous year’s CEO certification and any certifications required by SEC rules. According to the proposing release, this requirement has caused significant confusion because it relates to filings that were made in the previous year, and the NYSE believes it is no longer necessary in light of the SEC rules requiring Form 8-K disclosure of any material non-compliance with exchange rules. In view of these considerations, the NYSE is proposing to eliminate the disclosure requirement relating to these certifications, but is retaining the certification requirement.

Website Discussion of NYSE-Mandated Corporate Governance Disclosures: The NYSE is proposing to give companies the option to make specific corporate governance disclosures required only under the NYSE’s rules on their websites, instead of in the proxy statement. However, if they choose to make such disclosures on their website, that fact and the company’s website address must be provided in the proxy statement. These disclosures would include information about:

• contributions made by the company to any non-profit organization where an independent director is an executive officer, if the contributions exceeded the greater of $1 million or 2% of the organization’s revenues in any single fiscal year during the past three years;• the identity of the director chosen to preside at executive sessions;

• the method for interested parties to communicate directly with the presiding director or the non-management or independent directors as a group; and

• the board’s determination that an audit committee member’s service on more than three public company audit committees does not impair the member’s ability to serve effectively on the company’s audit committee (discussed above).

Website Requirements: The NYSE has proposed minor changes to various aspects of its rules on website disclosure, including:

• Creating new subsections on web posting and disclosure within each of the provisions governing audit, compensation and nominating/governance committee charters, corporate governance guidelines and codes of conduct. These provisions would set forth existing NYSE requirements that companies post these documents on their websites, disclose in the proxy statement that the documents are available on the website, and provide the website address.

• Eliminating the requirement that companies make hard copies of their governance documents available in print on request in light of fact that the documents are available on company websites.

• Moving the requirement that listed companies maintain a publicly accessible website out of the corporate governance listing standards and into a stand-alone section (Section 307.00) of the Listed Company Manual. This is intended to clarify that the requirement applies to companies that are subject to web posting requirements under any part of the Listed Company Manual (and not just the corporate governance listing standards).

• Specifying that, to the extent any provision of the Listed Company Manual requires a company to make documents available on its website, the website must be accessible from the United States, must clearly indicate, in the English language, the location of the documents and must include a printable version of the documents in English.

Provisions Applicable to Specific Circumstances: The NYSE also is proposing certain changes and clarifications to the transition periods applicable to companies listed in conjunction with an initial public offering, spin-off or carve-out with regard to timing for compliance with its corporate governance requirements. In addition, the NYSE is proposing to add sections detailing the compliance requirements applicable to companies when they list upon emergence from bankruptcy, transfer from another market, cease to be controlled companies or cease to be foreign private issuers (as discussed below).

Foreign Private Issuer Disclosure: The NYSE also has proposed changes applicable only to foreign private issuers:

• The NYSE rules currently require that foreign private issuers disclose significant differences between their home country corporate governance practices and NYSE requirements applicable to U.S. companies. Foreign private issuers may make these disclosures in their annual shareholder report or on their websites. However, as a result of a rule change effective for filings relating to fiscal years ending on or after December 15, 2008, SEC rules now require this disclosure in the Form 20-F. Accordingly, the NYSE is proposing to require foreign private issuers that file annual reports on Form 20-F to include a statement of significant differences in the Form 20-F. All other foreign private issuers will continue to have the option of disclosing this statement either in their annual reports or on their websites.• The NYSE is proposing to set forth specific timing requirements for compliance with its corporate governance listing standards for companies that cease to be foreign private issuers. Under the proposals, companies generally would have to comply with the corporate governance listing standards within six months of the date they fail to qualify for foreign private issuer status under applicable SEC rules, which enable foreign private issuers to test their status annually at the end of the most recently completed second fiscal quarter (“determination date”).

• The NYSE is proposing to add a transition period on shareholder approval of equity compensation plans for companies that cease to qualify as foreign private issuers. Under the proposals, these companies will have a limited transition period with respect to certain equity compensation plans that were not shareholder-approved, so that companies can make additional grants under the plans without shareholder approval after they cease to qualify as foreign private issuers. Subject to certain exceptions, the transition period generally would end on the later of six months after the date a company ceases to qualify as a foreign private issuer or the first annual meeting after that date, but in no event later than one year after the determination date.

NASDAQ Request for Comment on “Comply or Disclose” Approach

On August 3, 2009, the NASDAQ Listing and Hearing Review Council sent a paper to NASDAQ companies seeking comment on whether it should adopt a “comply or disclose” approach for certain corporate governance practices as an alternative to additional, substantive requirements, noting that some non-U.S. markets follow a “comply or disclose” model and that it “offers flexibility to companies and transparency to investors and allows practices to evolve in a logical manner.” Accordingly, the NASDAQ paper solicits comment about a range of practices, including board leadership, resignation policies for directors that fail to receive majority votes, annual director elections, and shareholder ratification of a company’s outside auditor. Any required disclosures would appear either in a company’s proxy, in the case of most U.S. companies, or in its annual report filed with the SEC for all other companies. Comments are due by October 30, 2009.

What Companies Should Do Now

For NYSE companies, most of the amendments conform the listing standards to existing SEC rules or are of a clarifying or updating nature. Accordingly, if the amendments are adopted, they should necessitate only minimal changes to companies’ corporate governance practices and disclosures. The most significant potential amendment is the proposal to require that companies notify the NYSE in writing after any executive officer becomes aware of any non-compliance, as opposed to a “material” non-compliance, with the corporate governance listing standards. Companies may wish to comment on this aspect of the proposal.

In addition, NYSE companies will need to review their proxy disclosures and governance documents (including committee charters and D&O questionnaires), to determine whether any section references to the NYSE listing standards need updating. We expect that companies will need to update their D&O questionnaires this fall in any event, in light of pending SEC proposals to require enhanced proxy disclosure about compensation and corporate governance matters. [2] Companies also should consider whether they will eliminate disclosures about the filing of CEO certifications and the undertaking to provide hard copies of governance documents upon request, although companies may want to continue this latter offer as a matter of good investor relations.

NASDAQ companies should consider whether to comment on the NASDAQ paper. If NASDAQ decides to move forward with additional corporate governance requirements, companies may find a “comply or disclose” approach preferable because it would preserve flexibility and allow them to adopt the practices that work best for them. Accordingly, it may be useful for companies to provide input to NASDAQ as it moves forward with this process.


[1] The NYSE originally filed an earlier version of these proposals with the SEC in 2005, and later amended the proposals following the SEC’s comprehensive changes to its proxy disclosure rules in 2006, but no SEC action was taken on these proposals.
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[2] Proxy Disclosure and Solicitation Enhancements, SEC Release No. 33-9052, 34-60280, 74 Fed. Reg. 35,076 (July 17, 2009).
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Corporate Governance and the U.S. Senate

This post by Stanley Keller of Edwards Angell Palmer & Dodge LLP is based on an article in the Massachusetts Lawyers’ Weekly.

Classified boards, where directors serve staggered terms (typically for three years with one-third of the directors elected each year), has been a recognized corporate governance alternative for a long time. The laws of every state permit corporations to structure their boards in this way. In fact, it is the default rule in Massachusetts for publicly traded companies unless the board of directors or the shareholders elects to opt out.

This should sound familiar because it is the way members of the United States Senate are elected, with Senators serving six-year terms and one third elected in each two-year election cycle. The Constitution’s Framers understood the stabilizing effect of this arrangement, which they believed would ensure continuity and allow Senators to take responsibility for measures over time and make them independent of rapid swings in public opinion. For more than 200 years, this policy has served the nation well. It is a policy that also has served corporations and their investors well when they have chosen to use it.

Yet undoing this corporate governance system is precisely what is now being proposed – ironically, by two Senators. They want to prohibit for stock exchange traded companies the very governance system under which they serve. They claim that classified boards of directors are part of what they call a “widespread failure of corporate governance” that was one of the “central causes of the financial and economic crises that the United States faces.”

Such a claim ought to be accompanied by hard evidence – but it is not, and with good reason. There is no evidence suggesting that classified boards were in any way a contributing factor to the ongoing economic crisis. To the contrary, companies involved in recent financial meltdowns whose boards were not classified include AIG, Washington Mutual, Bear Stearns, Citigroup, Bank of America, Lehman Brothers and General Motors. Going back to the 2001-era financial frauds, Enron, WorldCom, Tyco and HealthSouth all had unclassified boards. If anything, then, good policy and common sense suggest that we would want to retain the alternative of classified boards, not prohibit them.

As is the case with the U.S. Senate, too-frequent elections, rather than staggered terms of office, are what can undermine desired continuity and the ability to govern for the long term.

The key point is that we should not have a one-size fits all mandate for corporate governance. Rather, investor choice ought to be retained, not discarded. Certainly, corporations and their shareholders should be free to decide whether or not they want a classified board and whether the governance structure that is fine for the United States Senate works for them. Indeed, the current system is working as we would want it to, with individual choice at individual companies exercised freely – less than 40% of the S&P 500 companies have classified boards and, during the last six years, more than 200 companies have successfully put to a shareholder vote proposals to declassify their boards of directors.

In short, there is simply no evidence that classified boards bear any of the blame for the recent economic crisis. The laws of all states allow for classified boards, with Massachusetts mandating it, and there is the ability for investors to make a choice on the matter. In these circumstances, the current legislative proposal to preempt state laws and do away with classified boards is an inadvisable step back from investor choice, and toward the imposition of an unjustified one size fits all federal governance rule that will do nothing to prevent future financial breakdowns.

Perspectives from the Boardroom—2009

This post is by Jay Lorsch of the Harvard Business School.

Chief executives and regulators have been blamed for the current economic crisis, but in some ways what is surprising is that boards have generally escaped notice. Clearly the experience of corporate boards in the downturn has not been explored. To understand what transpired in the boardrooms of complex companies, and to offer a prescription to improve board effectiveness, eight senior faculty members of the HBS Corporate Governance Initiative talked with 45 prominent directors about what has happened to their companies and why. These directors, who serve on the boards of financial institutions and other complex companies, were asked two broad questions: How well did their boards function before the recession? And, what do they believe should be improved as they look to the future?

This white paper first explains how the interviewees characterize the strengths of their boards, then examines in depth six areas in which they identified shortcomings or needs for improvement:
1) clarifying the board’s role;
2) acquiring better information and deeper knowledge of the company;
3) maintaining a sound relationship with management;
4) providing oversight of company strategy;
5) assuring management development and succession;
6) improving risk management.

Finally, the paper discusses two issues that appeared not to trouble the interviewees but that the public feels are important: executive compensation and the relationship between the board and shareholders.

The key concepts highlighted include:

· Regulations and laws offer little guidance about what specifically boards should do, and, given this lack of specificity, most boards have gradually developed an implicit understanding of what their job should be.

· Directors expressed strong consensus that the key to improving boards’ performance is not government action but action on the part of each board.

· To improve board effectiveness, each board should achieve clarity about its role in relation to that of management: the extent and nature of the board’s involvement in strategy, management succession, risk oversight, and compliance.

· If, as interviewees insisted, each board’s effectiveness is directly attributable to its activities, it follows that boards have a responsibility to define their own roles with clarity, and to decide how to perform those roles in light of the nature of the firm, its industry, and its particular challenges.

· If boards are to decide on their goals and activities, they must expect to invest extended time in hard-headed discussions of both, leading to concrete and actionable conclusions.

· Boards need to maintain a delicate balance in their relationship with management. They must be challenging and critical on the one hand and supportive on the other. They have to sustain an open and candid flow of communication in both directions. And they must seek sources of understanding their company beyond just management without offending management.

· Issues of executive compensation and the relationship between boards and shareholders cannot be ignored, if only because they affect public perceptions of business and therefore its social legitimacy.

The full paper is available for download here.

Proposed Money Market Reforms Fail to Address Key Issues

This post is by Jeffrey N. Gordon of Columbia Law School.

Despite last year’s near-miss of a Money Market Fund catastrophe, the SEC’s current Money Market Reform proposal asks for only modest reforms that fail to address the key issues of this $3.8 trillion financial intermediary; indeed, that may well aggravate systemic risk.   First, the proposal does not appreciate that there are really two separate MMF types, retail MMFs and institutional MMFs, with different regulatory needs.  Retail MMF investors are looking for a bank account that combines safety with a higher rate of interest.  For them there is no substitute for fixed NAV, “safety and soundness” portfolio constraints and deposit insurance paid for with risk-adjusted premiums. Institutional MMFs, which now account for approximately 60% of MMF assets, function as low-cost providers of a corporate treasury function for large business entities.  This outsourcing saves these entities (corporations, life insurers, pension funds) the need to assemble individual portfolios of money market instruments the value of which would of course fluctuate.  Institutional MMFs thus should not carry a fixed NAV or the associated portfolio constraints.   Second, the SEC proposal fails to appreciate how MMF regulation creates systemic risk by artificially increasingly the supply of short term finance.  The consequence is to shift maturity transformation away from banks to short term credit markets, which, as last fall demonstrated, may seize-up in times of financial distress.  As suggested by the Group of 30’s report in February 2009, whether money market funds are a desirable innovation needs full scale examination.

These ideas are developed in a comment letter I submitted to the SEC on its Money Market Reform Proposal.   Here’s the text of the letter:

This letter is submitted by me personally in response to the SEC’s request for comments on its proposed Money  Market Reform Rule announced in Release No. IC-28807.   This letter proposes a different direction to reform, one that begins with the division between retail and institutional money market funds and that takes account of the different motives and needs of the investors in each.

“Reform” is of course timely in light of the fragility of Money Market Funds (“MMFs” ) revealed in the financial distress that followed the failure of Lehman Brothers.  As the Commission describes quite well in the Release, Lehman’s failure unexpectedly led to the “busting of the buck” by the Reserve Fund, which held a large amount of Lehman’s commercial paper in its portfolio.  The problems at the Reserve Fund in turn triggered a “run” especially by institutional investors on non-Treasury MMFs that was staunched only by an extraordinary MMF guarantee program provided by Treasury and by the creation of a special MMF liquidity facility by the Federal Reserve.  It is also widely believed that FDIC decisions in addressing bank failures – whether or not to protect bank creditors – were influenced by concerns about the solvency of MMFs that held bank paper.   Various MMFs undertook their own safeguards against the risk of runs, principally by selling off commercial paper (that is, making use of the Fed’s facility) and by shifting their portfolio composition towards Treasury instruments (Federal agency debt for the adventurous) and   by shortening maturities.  These measures had their own consequence, namely a sharp contraction in the demand for commercial paper and other short term credit instruments that industrial and financial firms had come to rely upon in their corporate finance plans.  The Federal Reserve responded with another special liquidity facility in which the Fed’s became a buyer of last resort of commercial paper.


Do Analysts Understand Street Earnings?

This post comes to us from Chih-Ying Chen of Singapore Management University.


In my forthcoming Review of Accounting Studies paper entitled Do analysts and investors fully understand the persistence of the items excluded from Street earnings?, I investigate whether analysts and investors fully understand the persistence of the items excluded from Street earnings and whether their ability to understand it has improved since the adoption of Reg G. In the past, companies commonly presented their earnings on the basis of methodologies other than Generally Accepted Accounting Principles (GAAP) in their earnings releases. These non-GAAP earnings numbers, often referred to as pro forma earnings or core earnings, exclude certain items that managers claim to be nonrecurring. Analyst-tracking services also exclude nonrecurring items when they report analyst earnings forecasts and the actual earnings of firms (often referred to as Street earnings).

Due to the lack of an authoritative definition, pro forma or Street earnings could be measured in different ways at different times. Previous research has produced results that are consistent with the claim that items excluded from pro forma or Street earnings are recurring. Concerned that pro forma financial information may obscure GAAP results and mislead investors under certain circumstances, the U.S. Securities and Exchange Commission (SEC) introduced a new disclosure regulation, Regulation G (hereafter, Reg G), which came into effect on March 28, 2003. Reg G requires public companies that disclose non-GAAP earnings to also present GAAP earnings and a reconciliation of the two. Since the adoption of Reg G, there is some evidence that the probability of disclosing non-GAAP earnings and using non-GAAP earnings exclusions to meet or beat analyst forecasts has decreased.

Since my focus is on analyst and investor understanding, I begin by comparing the association between Street exclusions and future Street earnings with analyst and investor expectations of this association. Analyst expectations are measured by the association between Street exclusions and subsequent analyst earnings forecasts, and investor expectations are inferred from stock returns around the time of the subsequent earnings announcements. Street exclusions are classified into MBF exclusions and non-MBF exclusions, where MBF exclusions are those that allow a firm to meet or beat analyst earnings forecasts (that is, the GAAP earnings number is below the consensus forecast of analysts, but the Street earnings number is not).

My empirical results show that the difference in the levels of persistence between MBF and non-MBF exclusions declined after the adoption of Reg G. Analysts underestimate the persistence of non-MBF exclusions, but the degree of this underestimation is lower in the post-Reg G period. In contrast, there is little evidence to indicate that analysts underestimate the persistence of MBF exclusions in either time period. I also find strong (weak) evidence that investors underestimate the persistence of Street exclusions in the pre- (post-) Reg G period. As it is not possible for firms with excluded gains or without Street exclusions to meet or beat analyst forecasts using Street exclusions, I also analyze a restricted sample that comprises only the observations with excluded expenses. In this sample, I find that both MBF and non-MBF exclusions are less persistent and that analysts and investors are better able to understand these exclusions in the post-Reg G period. Further analyses show that only firms that had highly persistent Street exclusions in the pre-Reg G period had substantial declines in this persistence and improvements in the ability of analysts to understand it in the post-Reg G period.

Overall, my results suggest that Reg G constrained the practice of excluding recurring expenses from Street earnings to meet or beat analyst forecasts and helps analysts and investors to understand the persistence of Street exclusions.

The full paper is available for download here.

Shareholder Opportunism in a World of Risky Debt

This post comes to us from Richard Squire of the Fordham University School of Law.


According to the Treasury Department’s June 2009 report on the financial crisis, the collapse of AIG is Exhibit One in the case for more aggressive federal regulation of derivative contracts. Contrary, however, to the view adopted by Treasury, AIG did not fail merely because it sold credit default swaps linked to subprime mortgages. Rather, it failed because it also bought up mortgage-backed securities for its own investment portfolio. This meant that the risks borne by the company were correlated: its assets were likely to evaporate just as large-scale liability on its swap contracts was triggered. When the housing market collapsed, it was the combined damage to both sides of AIG’s balance sheet that brought down the company.

In a forthcoming article in the Harvard Law Review (available here), I demonstrate that seemingly reckless conduct of this type is in fact fully rational from the perspective of a firm’s shareholders. Such conduct reflects an opportunism hazard created by contingent debt, a hazard I term “correlation-seeking”. If a contingent liability is especially likely to be triggered when the liable firm is insolvent, the contract that creates the liability (such as a credit default swap) transfers expected wealth from the firm’s unsecured creditors to its shareholders. That transfer gives managers an incentive to sell contingent claims against their firm that correlate with the firm’s insolvency risk, even when doing so generates large social costs such as overinvestment and possible systemic risk. The capacity for correlation-seeking to destroy wealth is vast given the widespread current use of contingent debt contracts, which include not only derivatives such as default swaps and options, but also more traditional arrangements such as loan guaranties.

Despite the pervasiveness of the hazard, lawmakers and scholars have overlooked correlation-seeking. As a result, legal rules that aim to prevent opportunism toward creditors regulate contingent liabilities under principles designed for “fixed” liabilities—that is, debts that are certain to come due on a specified future date. Accordingly, contingent debt is treated as less of an opportunism hazard precisely because it is (by definition) less likely than fixed debt to come due. On this view, a contingent liability is like a fixed liability, only less so.


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