Monthly Archives: November 2009

Is Delaware’s Antitakeover Statute Unconstitutional?

Editor’s Note: 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.

Steven Herscovici, Brian Barbetta, and I have a new article entitled Is Delaware’s Antitakeover Statute Unconstitutional? Evidence from 1998-2008. The working paper is available here. The article will be published in the Business Lawyer in May 2010, along with commentaries from academics, judges, and practitioners.

The article makes three simple points. First, three federal district courts held in 1988 that Delaware’s antitakeover statute must give bidders a “meaningful opportunity for success” in order to be valid under the Supremacy Clause of the U.S. Constitution. Second, these three courts upheld Section 203 because the empirical evidence available at the time showed that bidders were able to achieve an 85% tender in hostile offers reasonably often, but all three courts left open the possibility that future empirical evidence could change this constitutional conclusion. Third, no bidder in the past nineteen years has been able to achieve 85% in a hostile tender offer against a Delaware target. We conclude from these points that:

“[T]he empirical claim that the federal courts have relied upon to uphold Section 203’s constitutionality is no longer valid. It seems possible that the federal courts would uphold the constitutionality of Section 203 on different grounds. But at the very least the constitutionality of Section 203 would seem to be up for grabs.”

The Wall Street Journal and The Deal have written about our findings, and Wachtell, Lipton has issued a memorandum to clients criticizing our article. We respond to the Wachtell critique at pp. 47-48 and footnote 166 of the current draft, available above.

I am currently trying to collect data on practitioner perceptions about the viability of the 85% out. For any readers of this blog who are willing to fill out the very short poll available here, I will e-mail a synthesis of the findings to you in a few weeks. Thank you in advance for your help.

Taxing Unreasonable Compensation

This post comes to us from Aaron Zelinsky.

In my paper, Taxing Unreasonable Compensation: §162(a)(1) and Managerial Power, which is forthcoming in the Yale Law Journal, I argue that IRS should disallow tax deductions for unreasonable compensation paid by publicly held corporations.

Section 162(a)(1) of the Internal Revenue Code allows companies to deduct “a reasonable allowance for salaries or other compensation.” The IRS has systematically interpreted “reasonable allowance” to apply only to closely held corporations, effectively concluding any amount of compensation paid by a publicly held corporation is “reasonable.” The IRS bases this interpretation on the presumed arms-length nature of the board-CEO relationship, which sets compensation at a “reasonable” level.

I argue that, in light of the managerial power hypothesis, executives may exercise undue influence over the board in setting their compensation. Therefore, publicly traded corporations may lack the appropriate oversight and incentive infrastructure to set executive compensation reasonably. Thus, the IRS should examine the compensation of both publicly and privately held corporations.

I suggest two methods for achieving this result: first, the IRS could employ the same multi-factor test to evaluate compensation paid by publicly traded corporations as it does for the compensation paid by their privately traded brethren. Second, the IRS could assess the objective traits of the corporations CEO-board relationship to determine the propensity for management influence in the setting executive compensation.

The full paper is available for download here.

Merrill Bonuses Raised Issues in Merger with Bank of America

This post comes is based on an article that first appeared in the New York Law Journal.

On Jan. 1, 2009, Merrill Lynch & Co. Inc. (“Merrill”) merged with Bank of America Corporation (“BofA”). [1] At the end of 2008, prior to the close of the merger, Merrill awarded approximately $3.6 billion in bonuses to its employees. The payment of these bonuses has been the subject of numerous investigations and lawsuits. This column discusses (i) the background to the payment of these bonuses and (ii) a pending lawsuit charging BofA with not furnishing adequate information to its shareholders in connection with their vote on Dec. 5, 2008, in which they approved the merger. [2]


In the one-week period beginning Sept. 13 and ending Sept. 19, 2008, crises erupted at a number of major financial firms. The investment firm of Lehman Brothers filed for bankruptcy. The insurance conglomerate AIG received a pre-TARP bailout of $85 billion (giving the Federal Reserve a 79.9 percent stockholder position; additional amounts subsequently were provided with the total bailout amounting to approximately $170 billion). A third firm facing a financial crisis was Merrill. [3]

On Saturday, Sept. 13, 2008, Kenneth Lewis, the chief executive officer of BofA, met with John Thain, the chief executive officer of Merrill. They discussed the possible acquisition by BofA of Merrill. Merrill’s losses were turning out to be significantly greater than anticipated earlier in the year. Merrill’s losses, the deepening crisis on Wall Street and the precipitous drop in Merrill’s stock price threatened its survival.


Should Bondholders be Bailed Out?

(Editor’s Note: This post is Lucian Bebchuk’s most recent column in his series of monthly commentaries titled “The Rules of the Game” for the international association of newspapers Project Syndicate, which are available here.)

A year after the United States government allowed the investment bank Lehman Brothers to fail but then bailed out AIG, and after governments around the world bailed out many other banks, key question remains: when and how should authorities rescue financial institutions?

It is now widely expected that, when a financial institution is deemed “too big to fail,” governments will intervene if it gets into trouble. But how far should such interventions go? In contrast to the recent rash of bailouts, future government bailouts should protect only some creditors of a bailed-out institution. In particular, the government’s safety net should never be extended to include the bondholders of such institutions.

In the past, government bailouts have typically protected all contributors of capital of a rescued bank other than shareholders. Shareholders were often required to suffer losses or were even wiped out, but bondholders were generally saved by the government’s infusion of cash.


Practical Solutions To Improve The Proxy Voting System

On October 21, 2009 The Altman Group submitted a proposal to the SEC titled Practical Solutions To Improve The Proxy Voting System (available here).

Effective January 1, 2010 brokerage firms will no longer be able to vote for non-responding clients with regard to uncontested elections of directors as a result of the SEC’s recent approval of Amended NYSE Rule 452. Also, for many years corporations have complained about a lack of access to the names of all of their beneficial owners. Finding ways to deal effectively with these issues is now of significant importance to public companies of all sizes.

Our proposal to the SEC suggests certain reforms to the proxy voting system. Among the key issues which we propose the SEC take action on are the following 5 points:

  • 1. First and foremost, a new methodology called ABO (i.e., All Beneficial Owners) should replace the current NOBO/OBO mechanism which has existed for 25 years, at least with regard to record dates for annual or special meetings.
  • 2. The SEC should seek to authorize the establishment of a second mail and tabulation methodology, one that would give companies the ability (using the names available under ABO) to choose a different vendor to take responsibility for the mailing and tabulation process, while retaining the option to use the current Broadridge system. This new option would be akin to the way most companies currently use their transfer agent to mail and tabulate the votes of registered owners.
  • 3. The SEC should require the NYSE to implement as quickly as possible a robust investor education program to try and ameliorate at least some of the impact resulting from the loss of broker voting on non-contested director elections under Amended NYSE Rule 452.
  • 4. The SEC should amend Rule 13(f) so that information reported by institutions reflects both shares owned and also voting rights after taking into account loans and other transactions that alter such rights. We also suggest shortening the reporting period for 13(f) information to 15 days from 45 days after the end of a calendar quarter and reducing from 20 to 10 business days the pre-notification of a company’s annual meeting record date.
  • 5. The SEC should establish new procedures to deal with issues like “empty voting” and the use of derivative positions to alter voting rights.

Opinions as Incentives

This post comes to us from Yeon-Koo Che of Columbia University and Yonsei University and Navin Kartik of Columbia University.


Difference of opinion would be obviously valuable if it inherently entails a productive advantage in the sense of bringing new ideas or insights that would otherwise be unavailable. But could it be valuable even when it brings no direct productive advantage? Moreover, are there any costs of people having differing opinions? In our forthcoming Journal of Political Economy paper entitled Opinions as Incentives, we explore these questions by examining the incentive implications of difference of opinion.

We employ a framework that captures common themes encountered by many organizations.  More specifically, we study a setting in which a decision maker, or DM for short, consults an adviser before making a decision. Both individuals’ payoff from the decision depends on some exogenous state of the world. We model the decision and the state as real numbers, where the DM’s payoff-maximizing decision is equal to the state. At the outset, however, neither the DM nor the adviser knows the state; they only hold some prior views about it. The adviser can exert costly effort to try and discover an informative signal about the state; the probability of observing such a signal is increasing in his effort. Effort is unverifiable, however, and higher effort imposes a greater cost on the adviser. After the adviser privately observes the information, he strategically communicates with the DM. Communication takes the form of verifiable disclosure: sending a message is costless, but the adviser cannot falsify information, or equivalently, the DM can judge objectively what a signal means. The adviser’s strategic choice therefore is whether or not to reveal any information he has acquired. Finally, the DM makes her decision given her updated beliefs after communication with the adviser.


Professor Bebchuk Intervenes in Israel’s Largest Reorganization

At the request of one of Israel’s largest institutional investors, Professor Lucian Bebchuk submitted a report on whether the reorganization proposal of Africa-Israel Investments Ltd. would adequately protect the interests and contractual rights of public bondholders. Africa-Israel Investment Ltd., a conglomerate with business operations around the world (including the US where one of its subsidiaries owns the New York Times building), is the largest business firm to have undergone a reorganization process in Israel’s history. Given the importance of the reorganization of Africa-Israel Investments for investors, and the possibility that this reorganization might affect the structure of other reorganizations of financially distressed firms in Israel, Bebchuk carried out his review and analysis on a pro bono basis. Bebchuk’s report concluded that the proposal made by the company failed to provide adequate protection for the bondholders’ rights and interests and discussed ways in which the plan should be revised to provide bondholders with adequate protection.

Bebchuk’s report is available here. An article focusing on the report published by Haaretz, one of Israel’s main newspapers, is available here (in Hebrew).

Risk Management Lessons from the Global Banking Crisis

The following post comes to us from William L. Rutledge, executive vice president in charge of the Bank Supervision Group at the Federal Reserve Bank of New York, and Chairman of the Senior Supervisors Group.

The events of 2008 clearly exposed the vulnerabilities of financial firms whose business models depended too heavily on uninterrupted access to secured financing markets, often at excessively high leverage levels. This dependence reflected an unrealistic assessment of liquidity risks of concentrated positions and an inability to anticipate a dramatic reduction in the availability of secured funding to support these assets under stressed conditions. A major failure that contributed to the development of these business models was weakness in funds transfer pricing practices for assets that were illiquid or significantly concentrated when the firm took on the exposure. Some improvements have been made, but instituting further necessary improvements in liquidity risk management must remain a key priority for financial services firms.

The Senior Supervisors Group (SSG), a group of senior financial supervisors from seven countries of which I am Chairman, recently forwarded a report to the Financial Stability Board entitled Risk Management Lessons from the Global Banking Crisis of 2008. The report reviews in depth the funding and liquidity issues central to the recent crisis and explores critical areas of risk management practice warranting improvement across the financial services industry. The report is a companion and successor to the SSG’s first report, Observations on Risk Management Practices during the Recent Market Turbulence, issued in March 2008.


Fed Proposes Incentive Compensation Policies for Banking Organizations

This post is based on a Sullivan & Cromwell LLP client memorandum. The approach followed by the Federal Reserve was advocated in Regulating Bankers’ Pay, a discussion paper by Lucian Bebchuk and Holger Spamann issued by the Program on Corporate Governance last spring, which was described in a post on the Forum here.

On October 22, 2009, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a comprehensive proposal (the “Proposal”) on incentive compensation policies that is intended to ensure that these policies do not undermine the safety and soundness of banking organizations by encouraging excessive risk-taking. The Proposal applies to all banking organizations supervised by the Federal Reserve (U.S. bank holding companies, state member banks, Edge and agreement corporations, and the U.S. operations (including securities subsidiaries) of foreign banks with a branch, agency, or “commercial lending company” subsidiary in the United States (each a “banking organization”)). It covers executive and non-executive employees who receive any current or potential compensation that is tied to achievement of one or more performance metrics, as well as “golden parachute” and “golden handshake” arrangements.

The Proposal is based on three key principles that are designed to govern incentive compensation arrangements. There are no prescriptive requirements, such as “caps” or “claw backs”, but there is extensive guidance as to the development, implementation and relevant considerations for these arrangements.


Creating Reform That Is Sustainable for Investors

(Editor’s Note: The post below by Commissioner Aguilar is a transcript of his remarks at the Hofstra Investment Management Conference, omitting introductory and conclusory remarks; the complete transcript is available here. The views expressed in this post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission or the other Commissioners.)

Right now there are many voices clamoring to be heard regarding financial reform. This clamor is composed of some recommendations that are intuitive and others that are not. There are those calling for reforms that are limited to the factors that contributed to the crisis and others who see the possibility of broader legislative and administrative action as an opportunity. Some see it as an opportunity to advance their existing commercial interests, and others, like me, see it as an opportunity to reestablish a comprehensive, but flexible, capital markets regulatory framework that can better react to current and future events.

I think it is important to step back and think through the principles that should motivate any proposed reforms. As a regulator standing on the precipice of legislative and administrative action, I think it is important to focus on how things should be rather than how they are. Rahm Emmanuel’s oft-quoted remark that we should not waste a good crisis is absolutely right. I firmly hope that the opportunity will not be wasted. Unfortunately, it is clear that some transformational changes are no longer on the table — such as a merger of the SEC and CFTC. In addition, there are robust efforts underway to scale back the Obama Administration’s effort to regulate the multi-trillion dollar over-the-counter derivatives industry.

My goal for today’s remarks is to discuss an appropriate construct for financial reform and to consider examples from the current debate that exemplify these principles.


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