Monthly Archives: October 2009

Bailouts, Bonuses, And The Return Of Unjust Gains

(Editor’s Note: This post comes to us from Tracy A. Thomas of the University of Akron, and is based on a comment in the Washington University Law Review.)

In March 2009, ailing insurance giant American International Group (AIG) triggered a national outcry when it paid out $165 million in government bailout funds for employee bonus incentives. [1] President Obama called the bonus payments an “outrage” and promised that his administration would “pursue every single legal avenue to block these bonuses and make the taxpayers whole.” [2] He chastised the firm for its audacity of using borrowed taxpayer monies to reward financial recklessness and greed. This was the same company, of course, who within days of receiving its first infusion of government cash in September 2008, sent its executives on a half-million dollar boondoggle retreat at a fancy desert spa. [3] And just several months after the initial fiasco, AIG tried to award $265 million in further bonuses, [4] adding to performance bonuses of $454 million paid to employees and executives in 2008. [5] It was just over a year ago when AIG turned to the government for its survival. The government stepped in to assist AIG when the company faced imminent death from its risky financial derivative products that were backed by precarious mortgages. [6] Fearful that the toppling giant would trigger a cataclysmic domino effect, the government authorized the bailout funds to keep AIG, and the entire U.S. financial sector, afloat. [7] The government agreed to loan AIG the money, now totaling over $173 billion, collateralized with AIG’s assets and an 80% equity ownership of the company. [8] The first infusion of cash to AIG was authorized by the Federal Reserve in September 2008, supplemented with funds authorized in October by Congress in the $700 billion bailout bill, the Emergency Economic Stabilization Act (EESA), which established the Troubled Assets Relief Program (TARP).

As a result of the AIG bonus debacle, the President and Congress took several steps to try and avoid these problems in the future. In the EESA, Congress gave the Treasury Secretary the power to require these troubled financial institutions to meet appropriate standards for executive compensation, but did not directly prohibit the type of employee bonuses at AIG. [9] The subsequent American Recovery and Reinvestment Act (Recovery Act), passed in February 2009 after the transition to the Obama administration, added significant new restrictions for highly-paid executives of financial institutions that receive TARP assistance, including prohibitions against paying bonuses, retention awards, or incentive compensation, except as payments of long-term restricted stock. [10] President Obama also installed Kenneth Feinberg, former special master of the 9/11 Fund, as the pay czar to oversee all employee bonuses and payments for companies receiving large amounts of bailout funds, including AIG. [11]


SOX and Insider Trades

This post comes from Francois Brochet of Harvard Business School.

In my paper, Information Content of Insider Trades before and after the Sarbanes-Oxley Act, which was recently accepted for publication in the Accounting Review, I examine whether Section 403 of SOX has resulted in the provision of more timely and relevant information to market participants in the United States. SOX Section 403 addresses the issue of insider trading disclosure, by requiring insiders to report their trades to the Securities and Exchange Commission (SEC) on a Form 4 within two business days. Until August 2002, the requirement had only been to file Form 4 with the SEC within ten days after the close of the calendar month in which the transaction had occurred.

Using stock returns adjusted for book-to-market and size and abnormal trading volumes as proxies for information content, I find evidence that filings of insider purchases are significantly more informative after SOX. Over a three-day window beginning with the receipt of the form by the SEC, the pre- and post-SOX mean cumulative abnormal returns are 0.59 percent and 1.89 percent, respectively, while the pre- and post-SOX average daily trading volumes are 1.03 percent and 12.03 percent higher than normal, respectively. These differences are all statistically significant. In the case of insider sales, mean daily trading volumes around post-SOX filings are significantly higher than normal (1.15 percent over a three-day window) and greater than they were pre-SOX. In contrast, mean abnormal returns are more negative around pre-SOX filings than around post-SOX filings (-0.28 percent and -0.11 percent, respectively, over a three-day window). All results except for stock returns around filings of insider sales suggest that SOX has increased the information content of Form 4’s. However, additional findings indicate that, after controlling for confounding factors such as preplanned trades and litigation risk, stock returns around filings of sales are also significantly more negative after SOX.

I also find that, after SOX, insiders are less likely to sell shares immediately prior to negative stock returns and ahead of earnings news that falls short of analyst forecasts. This finding suggests that there is a decrease in informed insider selling around SOX. In the remainder of the paper, I use a variety of supplemental tests to provide further support to my causal attribution of the increase in information content of Form 4 filings to Section 403 of SOX.

The full paper is available for download here.

Delaware Decision Defers to Retention of Directors Under a “Majority Vote Resignation Policy”

Editor’s Note: This post is based on an article by Professor Hamermesh in the Widener Institute of Delaware Corporate and Business 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 a very interesting opinion on a matter of first impression, Vice Chancellor John Noble has indicated that the refusal of a board of directors to accept the resignation of a director who fails to obtain a majority vote under a “Pfizer-style” majority vote resignation policy is largely immune from judicial review.

The case – City of Westland Police & Fire Retirement System v. Axcelis Technologies, Inc., decided September 29, 2009 – involved something of a collateral issue: namely, whether to permit inspection of documents relating to the board’s decision to reject the proffered resignations of three directors.  In rejecting that demand, however, the court suggested that such a rejection would not ultimately be tested under standards of judicial review more demanding than the business judgment rule.  For reasons explained below, I question whether that degree of deference should prevail as a general rule, especially in the situation where the majority voting rule exists as a requirement in the bylaws, rather than only as a matter of board policy.

The three directors in question, while elected by the required plurality vote as specified in Axcelis’ bylaws, did not receive a majority of votes cast at Axcelis’ 2008 annual meeting.  (The opinion suggests that this shortfall resulted from an ISS recommendation based on the 7-member board’s refusal to support a proposal to dismantle the board’s classified structure).  As a result, and as mandated by a governance policy adopted by the board of directors (a so-called Pfizer type policy), those three individuals were required to submit their resignations.  Under the policy, however, the board of directors had the discretion to reject the resignations.  In announcing the board’s rejection of the three directors’ policy-mandated resignations, Axcelis referred to the experience of the directors, their membership on key committees, and the anticipated need to supervise negotiations with a potential bidder for the company.

Over six months after the annual meeting, and after a very disappointing outcome of the bidding negotiations, the stockholder plaintiff made a formal demand to inspect documents, mostly relating to the board’s dealings with and evaluation of a potential bidder’s acquisition proposals.  The demand also included the following two categories:

6. All minutes of agendas for meetings (including all draft minutes and exhibits to such minutes and agendas) of the Board at which the Board discussed, considered or was presented with information concerning or related to the Board’s decision not to accept the resignations of Directors Stephen R. Hardis, R. John Fletcher, and H. Brian Thompson.

7. All documents reviewed considered, or produced by the Board in connection with the Board’s decision not to accept the resignations of Directors Stephen R. Hardis, R. John Fletcher, and H. Brian Thompson.

The stated purpose for this inspection was apparently to investigate possible waste or mismanagement, a traditionally accepted basis for inspection under Section 220 of the Delaware General Corporation Law.  Under settled Delaware law, all the plaintiff had to proffer to become entitled to the inspection demanded was “some evidence to suggest a credible basis from which [this Court] can infer that mismanagement, waste, or wrongdoing may have occurred.” And as the Vice Chancellor acknowledged, this evidentiary requirement has accurately been described as “‘the lowest possible burden of proof’ in Delaware jurisprudence.”


Survey of Governance Practices for IPO Companies

This post is based on a Davis Polk & Wardwell LLP client memorandum; the primary authors of the memorandum are Ning Chiu, William M. Kelly and Richard J. Sandler.

The U.S. IPO market, which has been in the doldrums since 2007, has recently been showing signs of life. We have recently completed several large transactions, and our pipeline of deals in process is more robust than at any time in recent memory. With more companies working on and considering IPOs, this is a good time to release our survey of corporate governance practices for IPO companies. Our survey focused on corporate governance at the time of IPO for the largest 50 U.S. company IPOs in 2007 and 2008. The results are presented separately excluding controlled companies in recognition of their different governance characteristics.


The Future of Financial Regulation

(Editor’s Note: The post below by Chairman Mary Schapiro is a transcript of her remarks at the University of Rochester’s Presidential Symposium on the Future of Financial Regulation, omitting introductory and conclusory comments; the complete transcript is available here. The views expressed in this post are those of Chairman Schapiro and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners or members of the staff.)

The financial events of the last two years have had an impact on every American, and the repercussions have been felt throughout our society and the world. Importantly for regulators and for our discussion today, the crisis has laid bare significant limitations in our financial regulatory structure and exposed gaps in the regulation of products and market participants that truly must be filled.

I believe in the coming months this Congress will enact new legislation regarding the way we regulate our financial markets. And, I believe this because there is such a tremendous need to reform the system.

The shape of that legislation is still subject to the rough and tumble of Washington, but I believe that many of the legislative proposals working their way through Congress — though perhaps not perfect — represent a significant step forward. And, I am personally committed to helping to turn the hope of regulatory reform into a reality.

I thought I’d take a few moments to lay out briefly:

  • First, the gaps that need to be addressed.
  • Second, the most constructive way to approach systemic risk.
  • Third, the steps we are taking at the SEC apart from the legislative process to achieve reform.

    Assessing the Chrysler Bankruptcy

    In a recent working paper Assessing the Chrysler Bankruptcy, which I presented at the Law and Economics seminar here at Harvard Law School, David Skeel and I evaluate the Chrysler bankruptcy. Chrysler entered bankruptcy as a company widely thought to be ripe for liquidation if left on its own, obtained massive funding from the United States Treasury, and exited via a transaction that transferred its auto business and most of its preexisting creditors to a new company principally owned by some of Chrysler’s old creditors.

    The transaction proved controversial in capital markets, as some lenders — those left behind with claims on the shell company that had owned the auto business — complained that their entitlement to priority wasn’t honored. Warren Buffett wondered out loud that there would be “a whole lot of consequences” if the transaction was approved, as it was, because it could “disrupt lending practices in the future.”

    Our overall conclusions are not favorable to the process and results. The Chrysler bankruptcy process used undesirable mechanisms that federal courts and Congress struggled for decades to suppress at the end of the 19th and first half of the 20th centuries, ultimately successfully. If the mechanisms are not firmly rejected, either explicitly or via judicial (or legislative) distinction or via a collective forgetting of the event among bankruptcy institutions, then future reorganizations in chapter 11 will be at risk, in ways that could potentially affect capital markets.


    CFPA Legislation Goes Too Far on Some Issues, Not Far Enough on Others

    (Editor’s Note: This post is based on a letter sent by Hal S. Scott, R. Glenn Hubbard and John L. Thornton of the Committee on Capital Markets Regulation, an independent and nonpartisan research organization dedicated to improving the regulation and enhancing the competitiveness of the U.S. financial system, to the Chairmen and Members of the House Financial Services Committee and the Senate Banking, Housing and Urban Development Committee.)

    The Committee on Capital Markets Regulation (“Committee”) has, since its establishment in 2005, provided empirical, independent research dedicated to improving the regulation of U.S. capital markets. In May 2009, the Committee published its report entitled, The Global Financial Crisis: A Plan for Regulatory Reform, setting out 57 recommendations for enhancing the soundness and effectiveness of the U.S. financial regulatory framework. [1] As part of its recommendations, the report sets out the Committee’s proposals for reforming the U.S. regulatory architecture to make it more robust and better designed to address the needs of investors and consumers of financial services. In this context, we felt that it would be useful to set out our position on the Administration’s proposal— presently embodied in H.R. 3126, the Consumer Financial Protection Agency Act of 2009 (Act)—that would establish the Consumer Financial Protection Agency (CFPA) as a dedicated agency for regulating and overseeing consumer protection issues in the provision of financial services. Where appropriate, we also make reference to the revised discussion draft of H.R. 3126 (revised discussion draft), proposing changes in the CFPA bill, circulated by Chairman Frank to the House Committee on Financial Services on September 22, 2009. [2]

    From the outset, the Committee wishes to emphasize that establishing an independent regulatory agency for consumer and investor protection is one option the Committee believes deserves serious consideration; the other option, in our view, would be to incorporate this function as a division of a new consolidated regulatory agency. The Committee’s position on the Administration’s proposal, outlined below, is premised on the understanding that an independent agency would be created along the lines of H.R. 3126.


    Proxy Solicitation Through the Internet

    This post is based on a Sullivan & Cromwell LLP client memorandum.

    The SEC has proposed to amend the Internet proxy delivery rules in order to increase retail shareholder participation in the proxy voting process and to improve the notice and access model. The proposed amendments would:

    • provide flexibility regarding the format and content of the Notice of Internet Availability of Proxy Materials;
    • permit issuers and other soliciting persons to accompany the Notice of Internet Availability of Proxy Materials with an explanation of the process of receiving and reviewing proxy materials and voting; and
    • permit a soliciting person other than the issuer to use the notice and access model and send its Notice of Internet Availability for Proxy Materials by the later of
      • 40 days before the shareholders meeting, or
      • the date on which the soliciting person files its definitive proxy statement if the soliciting person’s preliminary proxy statement is filed within 10 days of the issuer’s filing of its definitive proxy statement.

    The SEC is providing an abbreviated comment period with comments due by November 20, 2009.


    Corporate Governance, Firm Valuation & Stock Returns

    In our paper, “Thirty Years of Corporate Governance: Firm Valuation & Stock Returns”, which we recently presented at the Seminar in Law, Economics, and Organization here at Harvard Law School, we introduce a comprehensive corporate governance database starting in 1978 and ending in 1989, which tracks for a sample of approximately 1,000 unique firms whether these firms had any of the 24 corporate governance variables that constitute the G-Index of Gompers, Ishii and Metrick (2003). The computation of this index for the 1990-2006 period is based on data compiled by the IRRC (Investor Responsibility Research Center). The G-Index is a composite of the twenty-four variables, adding one point if any of the provisions is present, where a higher score indicates more restrictions on shareholder rights or a greater number of anti-takeover measures. The E-Index of Bebchuk, Cohen, and Ferrell (2009) is based on six of the twenty-four G-Index provisions. By combining our dataset with the IRRC database which covers the 1990-2006 time period, we obtain comprehensive corporate governance data for the 1978-2006 time period. The importance of having data for the 1978 – 1989 period is underscored by the fact that this period is characterized by widespread corporate governance changes, while after 1990 such changes largely cease. Further, four out of the six E-Index provisions (supermajority merger, classified board, poison pill and golden parachute) experienced dramatic increases in their incidence during the 1978-1989 period, with their incidences remaining relatively stable thereafter. In addition to the introduction of our database, our paper addresses two questions: what is the relationship between governance and firm valuation and what is the relationship between governance and abnormal stock returns over the 1978-2006 time period.

    Turning to the central issue of the relationship between governance and firm valuation, we find a robust statistically significant negative association between poor governance and firm valuation over the 1978-2006 period. In particular, the inclusion of firm fixed effects in pooled panel regressions mitigates the endogeneity of firms adopting governance provisions depending on their heterogeneous circumstances. Using both firm and year fixed effects, we document a robust negative and economically meaningful association between the G-Index and Tobin’s Q. This finding survives various robustness checks. The economic magnitude of the association seems meaningful. For example, over the full time period and using firm and year fixed effects, the coefficient of the G-Index equals -0.011 implies that a one standard deviation increase of the G-Index (3.0) is associated with a decrease in firm value of about 3.3%. We find, however, no evidence in support of the “reverse causation” explanation for this negative association in the 1978-1989 period, i.e. that firms with lower firm value tended to adopt more G- and E-Index provisions. In fact, we find that the higher valued firms tended to adopt more provisions, although this relationship disappears once firm and year fixed effects are included. The “reverse causation” may play a (economically very minor) role in explaining changes in firms’ corporate governance in the 1990-2006 time period.

    Turning to the relationship between firm valuation and abnormal stock returns, Gompers, Ishii and Metrick (2003) document that firms with higher (lower) G-Index scores have lower (higher) subsequent stock returns. Our longer time period, and the time variation in corporate governance arrangements, enables us to make a number of findings that bear on the literature that developed from this finding. We document that for the full 1978-2007 time period, whether using value-weighted or equally-weighted portfolios, that there are positive, strongly statistically significant positive abnormal returns (using the Fama-French-Cahart four-factor model) associated with going long good corporate governance firms and shorting those with poor governance (whether proxying the quality of corporate governance by the G- or E-Index). Second, we find that abnormal returns for equally-weighted portfolios over the 1978-2007 period is robust to industry-adjusting. However, the abnormal returns of the value-weighted portfolios are not robust to industry-adjusting. Third, our analysis of returns suggest that governance seems to matter most for smaller capitalization stocks and that the association between governance and abnormal returns generally appears to decline over our time period. We interpret our governance-related abnormal return findings as consistent with ‘learning,’ i.e., investors learned gradually over time the importance of good governance, which is reflected in the fact that abnormal returns were largest in the beginning of our time period and then generally declined thereafter.

    The full paper is available for download here.

    Merger Arbitrage, Beneficial Ownership Reporting and Proxy Contests: The SEC’s Perry Order

    This post is based on a Latham & Watkins LLP client memorandum.

    Earlier this year, on July 21, 2009, the US Securities and Exchange Commission issued a cease-and-desist order charging investment adviser Perry Corp. (Perry) with securities law violations for its failure to report timely under Section 13(d) of the Securities Exchange Act of 1934 its beneficial ownership of more than 5 percent of the outstanding common stock of Mylan Laboratories Inc. (Mylan). [1] In the Perry Order, the Commission determined that Perry was not entitled to avail itself of the annual short-form reporting provisions of Rule 13d-1(b) (the so-called 45-day 13G provision) because it did not satisfy the “ordinary course of business” requirement under that provision.

    The Perry Order illustrates the Commission’s aggressive enforcement of the Section 13(d) beneficial ownership reporting requirements in the context of complex merger arbitrage practices using derivatives products. The Perry Order is notable for the breadth of its legal conclusions and their potential implications for requiring a broad array of investors to switch their reporting status from the 45-day 13G regime to either a Schedule 13G filed within 10 days of additional acquisitions or to a full-scale Schedule 13D filing status.

    Background on Merger Risk Arbitrage and Beneficial Ownership Reporting

    Merger risk arbitrage loosely refers to practices that investors use to profit from arbitrage spread opportunities typically created by cash or stock acquisitions of publicly traded companies. In a stock-for-stock merger, the pre-merger arbitrage spread opportunity exists because the number of shares (and/or fractional shares) of acquirer stock to be received in exchange for one share of target stock often trades at a higher market price than a share of target stock, reflecting market uncertainty about whether the merger will be completed (the “risk” in merger risk arbitrage) and the time it will take to complete the merger (which results in a financing cost to carry the arbitrage position until merger completion). The pre-merger spread decreases if the merger appears likely to be completed and as the time for completion approaches, and increases if the merger seems less likely to be completed or its completion is delayed.


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