Monthly Archives: November 2009

CEO Equity Incentives and Accounting Irregularities

David F. Larcker is the Director of the Corporate Governance Research Program at the Stanford Graduate School of Business.

In our forthcoming Journal of Accounting Research paper, Chief Executive Officer Equity Incentives and Accounting Irregularities, we examine the relationship between chief executive officer (CEO) equity incentives and accounting irregularities (e.g., restatements, Securities and Exchange Commission Accounting and Auditing Enforcement Releases, and shareholder class action lawsuits). Although equity holdings may alleviate certain agency problems between executives and shareholders, concerns have arisen among researchers, regulators, and the business press that “high-powered” equity incentives might also motivate executives to manipulate accounting information for personal gain. This view assumes that stock price is a function of reported earnings and that executives manipulate accounting earnings to increase the value of their personal equity holdings. If this allegation is true and the economic cost of accounting manipulation is large, this idea has important implications for executive-compensation contract design and corporate monitoring by both internal and external parties.


Reviewing the 2009 Proxy Season And Looking Ahead to 2010

David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz. This post is based on an article by Mr. Katz and Laura A. McIntosh, consulting attorney for Wachtell, Lipton, Rosen & Katz. The article first appeared in the New York Law Journal.

Although 2009 was more notable for legislative and regulatory corporate governance initiatives than for shareholder activism, the recently concluded proxy season produced several potentially significant results. As might be expected, executive compensation issues attracted a large number of shareholder proposals and a significant degree of shareholder support. In the general category of corporate governance, a few topics appeared to be increasingly popular with shareholders: the right to call special meetings, the majority election of directors and independent board chairmanship. Overall, shareholders focused on many of the same issues as did Congress and the Securities and Exchange Commission (SEC) over the last year. In light of the fact that the majority of legislative and regulatory initiatives proposed in 2009 will be pending through the beginning of 2010, a number of important variables remain unknown for next year’s proxy season.


Deal Protection — One Size Does Not Fit All

This post is based on a Kirkland & Ellis LLP client memorandum by David Fox and Daniel E. Wolf. Mr. Fox and Mr. Wolf are both partners at Kirkland & Ellis LLP specializing in corporate and mergers and acquisitions law.

As noticeable as it is for its size, the recent Berkshire Hathaway/Burlington Northern transaction is also conspicuous as an apparent example of the parties taking a thoughtful approach to the issue of deal protection in crafting a package of terms that could be viewed as “off-market” individually, but more middle-of-the-road when taken as a whole.

In almost every public company merger, “deal protection” provisions are among the most heavily negotiated terms of the transaction agreement. Deal protection describes a suite of merger agreement terms designed to protect the buyer’s deal from being jumped by a competing bidder. Of course, many a seller would like to leave open the possibility of a superior bid emerging for reasons both practical (obtaining a better price) and legal (under Delaware law, a target board may not agree to a combination of deal protection mechanisms that are so onerous as to be preclusive of a higher bid emerging). Since the collapse of the credit markets in 2007 and with the emerging recovery, we have seen a noticeable trend toward ever tighter deal protection terms favoring buyers in many public merger agreements. While this trend is certainly not without exception, it does reflect a shift in perceived “market terms” on many of these negotiated issues. Much as we argued in our recent M&A Update entitled “Deal Certainty: The Fallacy of a New Market,” we suggest that market participants and their advisers avoid arguments based on recent precedent and instead engage in the “nuanced, fact-intensive inquiry” deemed necessary by VC Strine in his 2005 decision in the Toys “R” Us litigation with the goal of ensuring that the right balance is struck in light of the particular circumstances in question.


Testimony Concerning the Discussion Draft of The Financial Stability Improvement Act

Editor’s Note: Elisse Walter is a Commissioner of the Securities and Exchange Commission. This post is the written copy of her testimony before the Committee on Agriculture, United States House of Representatives, omitting introductory and concluding remarks. The complete written testimony is available here.

I am pleased to have the opportunity to testify concerning the Discussion Draft of the Financial Stability Improvement Act (Discussion Draft). [1] This legislation, currently being marked-up by the House Financial Services Committee, [2] would make significant changes to the regulation and resolution of large, interconnected financial firms whose disorderly failure might put the financial system at risk.

Lessons from the Recent Financial Crisis

There are many lessons we can learn from the recent financial crisis and events of last fall. In particular, these events demonstrated the need to watch for, warn about, and eliminate conditions that could cause a sudden shock to lead to a market seizure or cascade of failures that put the entire financial system at risk. While traditional financial oversight and regulation can help prevent systemic risks from developing, it is clear that this regulatory structure failed to identify and address systemic risks that were developing over recent years. The current structure was hampered by regulatory gaps that permitted regulatory arbitrage and failed to ensure adequate transparency. This contributed to excessive risk-taking by market participants, insufficient oversight by regulators, and uninformed decisions by investors.


Internal Governance of Firms

Raghuram Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business.

In The Internal Governance of Firms, which was co-written with Viral Acharya and Stewart Myers, and which I recently presented at the Finance Seminar at Harvard Business School, we argue that there are important stakeholders in the firm, particularly its junior managers, who care about its future even if the CEO acts in his or her short-term self interest and shareholders are dispersed and powerless. These stakeholders, because of their power to withdraw their contributions to the firm, can force the CEO to act in a more public-spirited and far-sighted way. We call this process internal governance.

The basic intuition behind the model is as follows. Think of a partnership run by an old CEO who is about to retire. The CEO has a young manager working under him who will be the future CEO. Three ingredients go into producing the firm’s cash flow: the firm’s capital stock; the CEO’s ability to manage the firm, based on his skill and firm specific knowledge, and the young manager’s effort, which allows her to learn and prepare for promotion. We assume the CEO can commit to a pre-determined amount of investment. The CEO will leave the investment behind as the firm’s capital stock. The CEO can appropriate everything else: he can tunnel cash out of the firm, consume perks, or convert cash to leisure by shirking. Because the CEO has a short horizon, he could simply decide to take all of the cash flow, investing nothing for the future. But he needs the young manager’s effort in order to generate the cash flow. If the manager sees that the CEO will leave nothing behind, she has scant incentive to exert effort, and cash flow falls significantly. To forestall this, the CEO commits to investing some fraction of current cash flow, building or enhancing the firm’s capital stock in order to create a future for his young employee, thereby motivating her. This allows the firm to build substantial value, despite being led by a sequence of myopic and rapacious CEOs.


The Dodd Bill’s Effect on Corporate Governance and Executive Compensation Processes

Margaret Tahyar is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP. This post is based on a Davis Polk & Wardwell LLP client memorandum by Ning Chiu, Francis S. Currie, William M. Kelly, and Barbara Nims. Davis Polk & Wardwell LLP have also prepared a summary of the draft Restoring American Financial Stability Act, which is available here.

The project of federalizing major elements of our corporate governance and executive compensation processes continues apace. The 1,136-page Restoring American Financial Stability Act of 2009, introduced last week by Senate Banking Committee Chairman Christopher Dodd, has principally attracted attention for its proposed radical overhaul of the regulation of financial institutions. But the Dodd bill also contains corporate governance and executive compensation provisions that would be applicable to all US public companies. The governance elements function as a somewhat more modest Version 2.0 of the universal governance mandates that had earlier been proposed in Senator Charles Schumer’s Shareholder Bill of Rights. The compensation elements are to a great extent lifted from legislation already passed by the House of Representatives this summer under the Corporate and Financial Institution Compensation Fairness Act of 2009.


The Limits of Private Ordering

Beth Young is a lecturer at Harvard Law School and a senior research fellow at The Corporate Library. This post is based on a paper prepared for the Council of Institutional Investors and the Shareowner Education Network; the paper is available here. The views and opinions expressed in the paper are those of Ms. Young and do not necessarily represent views or opinions of Council members, board of directors, or staff.

In June 2009, the Securities and Exchange Commission proposed to require public companies, under certain circumstances, to include in the company proxy statement and proxy card the names of director nominees submitted by substantial long-term shareholders (generally referred to as “access to the proxy” or “proxy access”). At the same time, the SEC proposed to amend Rule 14a-8(i)(8), the shareholder proposal rule’s “Election Exclusion”, to reverse a 2007 amendment and allow shareholders to submit proposals seeking the adoption of a proxy access regime. The comment period for the rulemaking expired on August 17, 2009, and the SEC received hundreds of comment letters.

Among commenters opposed to the adoption of Rule 14a-11, a common theme was that the SEC should refrain from imposing a uniform federal access procedure. Instead, these commenters urged, the SEC should facilitate private ordering to permit shareholders at each individual company to decide whether proxy access is desirable and to establish its precise contours. To that end, these commenters generally supported the SEC’s proposal to amend the Election Exclusion.


Do Envious CEOs Cause Merger Waves?

This post comes to us from Anand Goel, Assistant Professor of Finance at DePaul University, and Anjan Thakor, the John E. Simon Professor of Finance and a Senior Associate Dean at Washington University in St. Louis.

In our paper, Do Envious CEOs Cause Merger Waves?, which was recently accepted for publication in the Review of Financial Studies, we develop a theory which shows that merger waves can arise even when the shocks that precipitated the initial mergers in the wave are idiosyncratic.

We start with a simple premise: CEOs have preferences defined over both absolute and relative consumption, with relative-consumption preferences characterized by envy. Whenever we refer to a CEO, we mean the CEO of a bidding firm, and by envy, we mean that an individual’s utility is increasing in the difference between his consumption and that of the person he envies. There is now a large literature on the biological, sociological, and economic foundations for envy-based preferences, and substantial empirical evidence that preferences display envy. Assuming envy-based preferences generates a simple yet powerful intuition for why mergers come in waves. If CEOs envy each other based on relative compensation and CEOs of bigger firms get paid more, then a merger in the industry that increases firm size for one CEO will cause other envious CEOs to be tempted to undertake value-dissipating but size-enhancing acquisitions, thereby starting a merger wave.


How Recent Proxy Changes Will Affect the Corporate Landscape

This post is an interview conducted by Francis H. Byrd, Managing Director and Corporate Governance Advisory Practice Co-Leader at the Altman Group, with Holly Gregory, Corporate Partner specializing in corporate governance at Weil, Gotshal & Manges, LLP. It is based on articles from the Altman Group’s “Governance & Proxy Review”, available here and here.

This week we bring you the second interview our “The Altman Interview” series where we speak with top experts and thought-leaders having an impact on corporate governance. Our interview with attorney Holly J. Gregory covers 10 questions on hot button issues for 2010.

Ms. Gregory is a well-known and highly respected figure in the world of corporate governance. As a partner at Weil, Gotshal & Manges, Ms. Gregory counsels corporate directors, executives and investors on the full range of governance issues and best practices. She played a key role in drafting the OECD Principles of Corporate Governance and advised the Internal Market Directorate of the European Commission on corporate governance regulation. Ms. Gregory has also served as an advisor to the World Bank and the joint OECD/World Bank Global Corporate Governance Forum on governance policy for developing and emerging markets.

In addition to her legal practice, Ms. Gregory has helped organize governance-related programs for the SEC, OECD, World Bank, Yale’s Millstein Center for Corporate Governance and Performance, Transparency International and Columbia University School of Law’s Institutional Investor Project.


Communications with Financial Analysts and Related Disclosure Issues

This post is an abridged version of a Cleary Gottlieb Steen & Hamilton LLP client memorandum, excluding footnotes; the complete memorandum is available here.)

Securities analysts play a key role in securities markets, and publicly held companies as a matter of market practice regularly brief them to help them understand company results and business trends. There have been some unfortunate instances, however, in which analysts have received nonpublic information on which their clients have acted before the information was disclosed to the general public. In the wake of these cases, as well as Enron and the unanticipated and significant decline in the financial position of other public companies, the role of the securities analyst was scrutinized by Congress, the Securities and Exchange Commission (the “SEC”), state regulators and various self-regulatory organizations. The result was a heightened campaign against selective disclosure, facilitated by the SEC’s adoption of Regulation FD (Fair Disclosure) in 2000.

Although the number of Regulation FD cases has diminished in recent years, this is perhaps because compliance has become deeply ingrained in market participants. Nonetheless, given the potential for SEC enforcement action, as well as insider trading litigation, ongoing vigilance in this domain is certainly warranted. A memorandum prepared by Cleary, Gottlieb, Steen & Hamilton LLP (available here) sets out guidelines for communications between management and securities analysts in light of applicable case law and the SEC’s Regulation FD. A summary of the guidelines is included below.


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