Monthly Archives: September 2009

25 Professors Submit Amicus Brief in Supreme Court Investment Advisory Case

Editor’s Note: This post is by John Coates of Harvard Law School.

On September 3, 2009, twenty-five corporate law and finance professors and scholars – including several contributors to this blog – filed an amici curiae brief in the case of Jones et al. v. Harris Associate L.P. The case is now pending before the United States Supreme Court. The brief is available here, and the names of those joining the brief are listed at the bottom of this post. The Supreme Court is currently scheduled to hear the case on November 2, 2009.

The Harris case is an appeal of the Seventh Circuit, in an opinion written by Judge Frank Easterbrook, noted previously on this blog here and here. That decision upheld the trial court’s dismissal of the case against Harris Associates, a mutual fund advisor, on the ground that as long as a mutual fund adviser does not breach the fiduciary duty owed to shareholders by failing to disclose all pertinent facts or otherwise hindering the fund’s directors from negotiating a favorable price, no judicial review of the reasonableness of the adviser’s fee is required to dismiss a claim under Section 36(b) of the Investment Company Act (ICA).

Judge Easterbrook’s opinion rejected the long-followed Second Circuit decision in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982). Gartenberg, while respecting deliberations of independent directors, required courts to consider those deliberations in light of multiple factors in determining whether investment adviser fees were excessive and, in dicta, suggested that evidence of comparable fees and competition among advisors should not be given much weight. A decision by the Seventh Circuit declining to rehear the case en banc generated a dissent from Judge Richard Posner.


Motives and Consequences Of Financial Regulation

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

The motives and consequences of financial regulation are once again being hotly debated in the current global financial crisis. However, this debate is hardly new. In my paper The Political Economy of Financial Regulation: Evidence from U.S. State Usury Laws in the 19th Century, which was co-written with Tobias Moskowitz of the University of Chicago and which was recently accepted for publication in the Journal of Finance, we look to the past and study the political economy of financial regulation and its consequences through the lens of usury laws in 19th century America. Usury laws are arguably the oldest form of financial regulation. Moreover, the rich political and economic landscape of the 19th century United States provides a useful laboratory to investigate the motives and impact of financial regulation during a critical point of U.S. economic development. Our investigation into the causes and consequences of financial regulation entails answering who and what determines regulation and who benefits and loses from it.

We first argue that usury laws had financial and economic impact. We show that binding rate ceilings constrain some borrowers at certain times and that usury laws significantly affect lending activity in the state. We further show that changes in these laws are associated with future economic growth and, importantly, that the impact on growth is concentrated exclusively among the smallest borrowers in the economy.

We then investigate the determinants of financial regulation. Like everything, use of regulation varies with its cost. States impose tighter usury laws (lower maximum rates and stiffer penalties) when it is less costly to do so. When current market interest rates exceed the rate ceiling or during financial crises, states relax restrictions by raising the rate ceiling. When market rates fall or the crisis abates, ceilings are re-imposed or tightened. States hit hardest by financial crises are even more likely to follow this pattern. We also show that usury laws respond to neighboring state competition for capital flows (particularly foreign at this time). These results suggest that usury laws have real (or at least perceived) impact, otherwise why bother to change them?

To distinguish between the private and public interest motives for regulation we measure the extent of incumbent political power in a state and its relation to usury laws. State suffrage laws that restrict who can vote based on land ownership and tax payments (not race or gender) keep political power in the hands of wealthy incumbents. We find that such wealth-based voting restrictions are highly correlated with financial restrictions. We find that wealth-based suffrage laws are not affected by financial crises. We also find that after a financial crisis abates, states with stronger wealth-based voting restrictions are even more likely to re-impose tighter usury laws.

As further corroboration of private interests, we find a positive relation between wealth-based suffrage restrictions and other forms of economic regulation designed to exclude certain groups, such as general incorporation laws that permit free entry of firms. In addition, we find that usury laws are tighter when incorporation restrictions are also tight, which seems to conflict with the public-interest motivation, which is supposed to include or help underserved or disadvantaged groups rather than limit access. We also consider whose private interests, the financial or non-financial sector, are best being served by these policies and find that the combination of policies most correlated with usury laws fits non-financial incumbent interests best.

Overall, the evidence we uncover appears most consistent with financial regulation being used by incumbents with political power for their own private interests—controlling entry and competition while lowering their own cost of capital.

The full paper is available for download here.

Delaware Dominant in Choice of Law for Merger Agreements

This post is by Steven Davidoff of the University of Connecticut School of Law. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In our paper “Delaware’s Competitive Reach:  An Empirical Analysis of Public Company Merger Agreements” recently posted to the SSRN (and available here) my co-author Matthew Cain of the Notre Dame Mendoza College of Business and I evaluate the selection of governing law and forum clauses in merger agreements between public firms from 2004-2008.

In contrast to prior research, we find that Delaware is the dominant choice among merging parties. During the sample period approximately 66.4% of agreements select Delaware for their governing law and 60% of agreements select Delaware as their choice of forum. This compares to 61.8% of targets during this time that are incorporated in Delaware, and 54.8% of acquirers that are similarly incorporated.

We find that Delaware’s attractiveness has increased in recent years in response to exogenous events, namely the financial crisis and the Second Circuit’s decision in Consolidated Edison, Inc. v. Northeast Utilities.  The latter court ruling was perceived by practitioners as creating an unfriendly merger precedent under New York law.  We find that the opinion made the Delaware forum a more attractive one vis-à-vis New York.

Delaware’s attractiveness is also evidenced by the fact that top-tier legal advisors, foreign acquirers, transactions surrounded by greater financial uncertainty, and larger transactions tend to select Delaware’s forum over other venues.  Our results are robust to controls for simultaneity and endogeneity.

Our results also provide support for the theory that Delaware competes by providing quality governing law, and particularly, adjudicative services. They also highlight the contestability of Delaware’s dominance; parties adjust their choices of law and forum during our sample time period in response to legal and other events.

Prior empirical work on the race-to-the-bottom/race-to-the-top debate has focused on Delaware’s primary product, the public company charter.  We posit that Delaware is more than a single-product provider but rather a supermarket offering complementary and differentiated products beyond the public company charter.  For example, the law governing, and adjudication of, merger agreements is one such complementary product while the law governing real estate investment trusts is a differentiated one (and one where Delaware does not compete).   By studying this former product we hope to further inform the debate over how and when Delaware competes.

Our results ultimately support the conclusion that Delaware competes strongly in other legal products beyond its primary one, the public company charter.  They also show that attorneys and their clients are responsive to unfavorable legal rulings and the quality of adjudication.

CFOs, CEOs and Earnings Management

This post comes from John (Xuefeng) Jiang, Kathy Petroni, and Isabel Wang of the Eli Broad College of Business, Michigan State University.


In our paper, CFOs and CEOs: Who Have the Most Influence on Earnings Management?, which was recently accepted for publication in the Journal of Financial Economics, we investigate whether Chief Financial Officer (CFO) equity incentives are associated with earnings management. Extant research has primarily focused on how chief executive officer (CEO) equity incentives affect earnings management (Bergstresser and Philippon 2006; Cheng and Warfield 2005). However, both commentators and policymakers have expressed a concern that CFO equity-based compensation might also contribute to earnings management. As described by Katz (2006), during testimony before the Senate Finance Committee IRS Commissioner Mark Everson expressed that the temptations of stock appreciation demand “heroic” virtue to keep managers from wrongdoing. He suggested that CFOs who are in charge of “minding the cookie jars” should not be paid by stock options, but by “generous but fixed compensation for specified contract periods.” Echoing concerns over CFO compensation, the SEC recently amended its disclosure rules on executive compensation by requiring that firms report their CFO pay. One analyst claims that the mandatory disclosure of CFO compensation is “a major benefit” of the amended SEC disclosure rule (Harris 2007).

Because CFOs’ primary responsibility is financial reporting, we argue that CFO equity incentives should play a stronger role than those of the CEO in earnings management. We separately and jointly examine the association between CFO and CEO equity incentives and earnings management. We consider two settings (accrual management and the likelihood of beating analysts’ expectations) and utilize methodologies similar to those used in prior research that has documented an association between CEO equity incentives and earnings management. We find that the magnitude of accruals and the likelihood of beating analyst forecasts are more sensitive to CFO equity incentives than to those of the CEO. For example, our results suggest that if a CFO equity incentive moves from the first quartile to the third quartile of the distribution of our sample CFO equity incentives, the absolute total accruals as a percent of total assets would increase almost 75 percent more than the increase associated with a similar move of CEO equity incentives. Similarly, the change in odds ratio of beating analysts’ expectation is 5 percent more when CFO’ equity incentives increase from the first quartile to the third quartile than when CEO’ equity incentives have a similar move.

Our results suggest future research should consider compensation of CFOs when investigating incentives for earnings management. More importantly, our results confirm policymakers’ concerns over CFO compensation and thus provide indirect support for the SEC’s new requirement for disclosures of CFO compensation. The disclosure of CFO compensation should be useful for investors and analysts to assess the quality of firms’ financial reporting.

The full paper is available here.

Treasury Proposes Comprehensive Supervision of OTC Derivatives

This post by James Morphy comes to us from David J. Gilberg, Kenneth M. Raisler and Dennis C. Sullivan of Sullivan & Cromwell LLP.

On August 11, the Treasury Department released the Over-the-Counter Derivatives Markets Act of 2009 (“OCDMA”), its legislative proposal to regulate the over-the-counter (OTC) derivatives industry. The proposed legislation provides an approach to comprehensively regulating OTC derivative transactions and the entities that enter into OTC derivatives transactions. Through its proposal, the Treasury Department is recommending the repeal of many provisions of the Commodity Futures Modernization Act (“CFMA”), which was adopted in 2000.


On August 11, the Treasury Department released the Over-the-Counter Derivatives Markets Act of 2009 (“OCDMA”), its legislative proposal to regulate the over-the-counter (“OTC”) derivatives industry.[1] The proposed legislation closely follows the proposals offered by Treasury Secretary Timothy Geithner [2] and Commodity Futures Trading Commission (“CFTC”) Chairman Gary Gensler [3] earlier this year. Treasury’s proposed legislation shares similar themes with the joint principles [4] offered by House Agriculture Committee Chairman Colin Peterson and House Financial Services Committee Chairman Barney Frank, whose Committees have jurisdiction over the federal banking regulators, the Securities and Exchange Commission (“SEC”) and the CFTC. Given the full legislative agenda of the Senate in the fall, it is expected that the House of Representatives will move first on drafting OTC derivatives legislation, likely using the Administration legislative proposal as a template for its own legislation. It remains unclear if Congress will pass OTC derivatives legislation in the remaining Congressional legislative session.

However, should the climate change/energy legislation and healthcare reform efforts stall, lawmakers will turn their attention to financial reform, including regulation of OTC derivatives.

Framework of the Legislation

The OCDMA effectively divides regulatory authority over OTC derivatives between the CFTC and the SEC, reflecting the current division of jurisdiction between the agencies in the futures markets. Specifically, under the OCDMA, security-based swaps and credit derivatives based on a single security or issuer, or a narrow based group of securities, will be regulated by the SEC and swaps and credit derivatives based on broad-based indices will be regulated by the CFTC. The same division will also apply to swaps based on corporate debt and event-based contracts. All other OTC products, including interest rate, currency and commodity swaps, will fall under the control of the CFTC. However, federal banking regulators will maintain their jurisdiction over identified banking products (as defined by the Commodity Futures Modernization Act of 2000), unless the appropriate federal banking agency, in consultation with the CFTC and/or SEC, determines that the banking product has been structured in such a way that it performs the same function as a swap or was structured in a way to avoid regulation. If the regulators make that determination, the banking product will be regulated by the CFTC or the SEC.

The bill sets an aggressive timeline – 6 months to 1 year, for the agencies to implement the required rulemakings. Swap transactions entered into before the enactment of OCDMA must be reported to a regulated repository within 6 months of the effective date of the regulation.


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