Monthly Archives: December 2009

SEC Adopts Final Rules on Enhanced Proxy Statement Disclosures

Editor’s Note: Eduardo Gallardo is a partner focusing on mergers and acquisitions at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson, Dunn & Crutcher client memorandum by Ron Mueller, Amy Goodman, Gillian McPhee, Dina Bernstein, and Anthony Shoemaker.

At an open meeting held on December 16, 2009, the Securities and Exchange Commission (“SEC”) approved a set of proposed rules to enhance the information provided to shareholders in company proxy statements regarding a number of risk oversight, compensation, board leadership and composition and other corporate governance matters.  The SEC approved the final rules by a 4-to-1 vote, with Commissioner Kathleen Casey dissenting.  The SEC released the text of the final rules on the same date they were adopted, with the 129 page adopting release available here.

The new rules have an effective date of February 28, 2010, except that a rule change on how equity awards are reported in the Summary Compensation Table applies to all companies with fiscal years ending after December 20, 2009.  Because all of the rule changes other than the equity reporting rule call for enhanced disclosures, companies presumably could, but would not be required to, voluntarily comply with all of the new rules even if they file their definitive proxy statements before February 28, 2010.


Did Fair-Value Accounting Contribute to the Financial Crisis?

Christian Leuz is the Joseph Sondheimer Professor of International Economics, Finance and Accounting at the University of Chicago Booth School of Business.

In a recently released working paper co-authored with Christian Laux entitled Did Fair-Value Accounting Contribute to the Financial Crisis? we investigate whether there is merit to the claim that fair-value accounting exacerbated the severity of the 2008 financial crisis. The main allegations are that fair-value accounting contributes to excessive leverage in boom periods and leads to excessive write-downs in busts. The write-downs deplete bank capital and can set off a downward spiral, as banks are forced to sell assets at “fire sale” prices, which in turn can lead to contagion as prices from asset-fire sales become relevant for other banks.

We begin our analysis by explaining in more detail how pure mark-to-market accounting can cause problems in a crisis. We then outline extant accounting rules for banks’ key assets, which is different from pure mark-to-market accounting. Extant rules allow banks to deviate from market prices under certain circumstances. In addition, not all fair value changes enter the computation of banks’ regulatory capital. We then examine possible mechanisms through which fair-value accounting could have contributed to the financial crisis, and conclude that it is unlikely that fair-value accounting added to the severity of the financial crisis.


Director Engagement With Shareholders Without Fearing Regulation FD

Francis H. Byrd is Managing Director and Corporate Governance Advisory Practice Co-Leader at The Altman Group. This post is based on an Altman Group Governance and Proxy Review by Mr. Byrd.

Over the course of several forums on governance, director leadership and engaging with shareholders, a number of board advisors have intoned mightily against the notion of having corporate directors involved in a company’s shareholder engagement efforts. The foremost rationale offered for holding directors apart from discussions with investors is that Regulation FD creates insurmountable problems for companies whose directors could potentially be involved in engagement and outreach to shareholders. While there are legitimate concerns about the shareholder engagement process for company officers and directors, fear of Regulation FD need not be among them – if due diligence and care are properly undertaken.

To be clear, Regulation FD requirement can create difficulties for companies in communicating with investors, but engagement with shareholders can be much different than the relationships companies maintain with equity and credit analysts. Whether you need to have your board members involved depends on the answer to four questions: 1) who is the shareholder making the request, 2) what are the circumstances surrounding the engagement request (or need), 3) a determination as to whether director involvement will add value; and 4) which director or directors need to be involved.


SEC Approves Amendments to NYSE Corporate Governance Listing Standards

John Olson is a founding partner of Gibson, Dunn & Crutcher LLP and a visiting professor at the Georgetown Law Center. The following post is based on a Gibson, Dunn & Crutcher client memorandum by Mr. Olson, Brian J. Lane, Ronald O. Mueller, Amy L. Goodman, Gillian McPhee, and Elizabeth Ising.

On November 25, 2009, the Securities and Exchange Commission (“SEC”) approved amendments to the corporate governance listing standards of the New York Stock Exchange (“NYSE”). The changes will take effect on January 1, 2010.

As discussed in more detail below, the amendments, which the SEC approved in the form proposed in the NYSE’s original release: (1) codify certain staff interpretations, (2) clarify various disclosure requirements, and (3) incorporate applicable SEC disclosure requirements into the NYSE listing standards. Because most of the amendments conform the NYSE listing standards to existing SEC rules, or are of a clarifying or updating nature, they should necessitate only minimal changes to a listed company’s governance practices and disclosures. The most significant change is the new requirement that companies notify the NYSE in writing after any executive officer becomes aware of “any” non-compliance with the corporate governance listing standards, rather than any “material” non-compliance, as currently required.

The SEC release approving the NYSE amendments can be found here. The NYSE filing outlining the proposed amendments includes a mark-up showing the proposed changes to the text of the corporate governance listing standards.


The Risks to Private Enterprise from Federal Preemption of State Corporate Law

Peter Atkins is a Partner for Corporate and Securities Law Matters at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a Skadden client memorandum, and follows up on matters raised by Mr. Atkins in this post on the Forum regarding his article entitled Raising the Bar.

The current multi-pronged effort for U.S. federal preemption of state corporate law, particularly in the area of corporate governance, is largely predicated on the view that it is necessary to forestall excessive risk-taking in the private sector. However, the federal preemption “cure” is a carrier of its own systemic disease. Before imposing this “cure,” it is essential to make a responsible assessment of its need and consequences.

State Regulation of Public Business Corporations: A Cornerstone of Capitalism

The modern U.S economic system — variously called capitalism, free enterprise or private enterprise — is centered around the publicly traded business corporation organized under state law. It is the principal vehicle for gathering non-government capital, investing it and managing the businesses in which it is invested. Historically, the governance of these companies has been regulated by their states of incorporation, with limited exceptions. And, in general, the state law-based corporate governance model has been very respectful — indeed protective — of the core concepts of the U.S. private enterprise system: freedom, capital raising, risk-taking, experimentation, innovation and value maximization. The model recognizes that publicly traded business corporations, as key enablers of the U.S. capitalist system, should be regulated in a manner which permits these core private enterprise concepts to operate with minimal interference.


Risk Management and the Board of Directors

Martin Lipton, is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisition and matters affecting corporate policy and strategy. This post is based on a Wachtell, Lipton, Rosen & Katz client memorandum by Mr. Lipton, Daniel A. Neff, Andrew R. Brownstein, Steven A. Rosenblum, Adam O. Emmerich, Sabastian V. Niles, and Brian M. Walker, excluding Appendix A, which describes areas of risk. The complete memorandum, including the Appendix, is available here.

Balancing risk and reward has never been more challenging than it is today. Companies face risks that are more complex, interconnected and potentially devastating than ever before. Over the past two years, a perfect storm of economic conditions has triggered an extraordinary downward spiral from which we are only recently beginning to emerge: the subprime meltdown, liquidity crises, extreme market volatility, controversial government bailouts, consolidations of major banking institutions and widespread economic turmoil both in the U.S. and around the world. Against the background of the global financial crisis and the still uncertain global economy, companies are re-assessing their strategies for responding to the challenges and pressures of the new environment. Risk—and in particular the risk oversight function of the board of directors—has taken center stage in this re-assessment, and expectations for board engagement with risk are at all-time highs. Risk from the financial services sector has contributed to large-scale bankruptcies, bank failures, government intervention and rapid consolidation. And the repercussions have spread to the broader economy, as companies in nearly every industry have suffered from the effects of a global constriction of the credit markets, sharply reduced consumer demand and volatile commodity prices, currencies and stock prices.


Derivatives’ Bankruptcy Priorities

Editor’s Note: Mark Roe is a professor at Harvard Law School, where he teaches bankruptcy and corporate law. This post is based on an op-ed article from today’s Financial Times.

A lot is happening in the financial regulatory overhaul bill that moved swiftly from committee through the US House of Representatives this week. But one vital reform is not locked in yet, although it is reportedly percolating in the Senate and a stripped-down version made it into the House bill passed last Friday.

Derivatives, repos and financial swaps – the huge financial market in protection against foreign exchange and interest rate fluctuations, in liquidity-enhancing transactions, and in guarantees against loan defaults – are treated extremely favourably in bankruptcy law. It has been a successful lobbying effort for this part of the American financial industry: priority treatment is important for the industry, but not well enough understood to engage much public attention beyond the financial press.

But derivatives, repos and swaps should not be so favoured. Yes, they are valuable in managing risk and enhancing liquidity: a derivative allows a company that is sensitive to interest rate changes to trade a fluctuating interest rate for a fixed one, while a repo allows a financial institution with a fixed, illiquid asset to sell it for cash today, by promising to buy it back a week later, thereby getting cash for that week. But they are favoured so much that financial players can set up deals so that they beat all other creditors if the other side of the deal goes bankrupt.


Crisis Resolution and Bank Liquidity

Editor’s Note: This post comes to us from Viral Acharya, Professor of Finance at New York University, Hyun Song Shin, Professor of Economics at Princeton University, and Tanju Yorulmazer, a Senior Economist at the Federal Reserve Bank of New York.

A central difficulty during banking crises is one of finding ready buyers of distressed assets. If a bank needs to restructure its balance sheet during a crisis or be sold as a going concern, the potential buyers are generally other banks, but they may have also been severely affected and thus be financially constrained and unable to purchase the bank or its assets. This leads to especially severe problems in a banking crisis given the relative opacity of bank balance sheets and the high sensitivity of banking assets to macroeconomic shocks. Surviving banks with enough liquidity during adverse states of the world stand to make windfall profits from purchasing assets at fire-sale prices. Even if crises arrive infrequently, the potential gains from acquisitions at fire sales could be large. This gives banks incentives to hold liquid assets so that in the event that they survive a crisis, they will have resources to take advantage of fire sales. In our recent working paper Crisis Resolution and Bank Liquidity, we present a model of banks’ choice of ex-ante liquidity that is driven by these strategic considerations.


RiskMetrics Issues Policy Updates for 2010 Proxy Season

Holly Gregory is a Corporate Partner specializing in corporate governance at Weil, Gotshal & Manges LLP. This post is based on a Weil, Gotshal & Manges client memorandum.

On November 19, 2009, RiskMetrics Group issued updates to its proxy voting policy that will be applicable to shareholder meetings held on or after February 1, 2010. The policy updates that are applicable to US companies are available at here. This briefing summarizes those policy updates that affect US companies and discusses implications for voting recommendations and results in uncontested elections of directors. [1] Notably, RiskMetrics’ updated policy expands the circumstances that will lead it to recommend that its clients vote against or withhold votes for directors who are up for re-election in 2010. As outlined in Appendix A, there will now be more than 40 categories of practices that could lead to a negative vote recommendation.

RiskMetrics voting recommendations are influential: The voting results at Russell 3000 companies for the 2009 proxy season indicate that the vast majority of directors who received a majority “against” or “withhold” vote also received an adverse RiskMetrics vote recommendation. The impact of negative vote recommendations is likely to be even greater for the 2010 proxy season because of the increase in companies adopting majority voting for the election of directors and/or director resignation policies, coupled with the elimination of brokers’ ability to vote in director elections in the absence of customer instructions.

In preparing for their companies’ 2010 annual meetings, corporate counsel, corporate secretaries and directors (particularly those serving on compensation or nominating and governance committees) should review the updated policy and consider areas of potential vulnerability.


Optimal CEO Compensation when Managers are Loss Averse

This post comes to us from Ingolf Dittmann of the Erasmus University Rotterdam, Ernst Maug of the University of Mannheim, and Oliver Spalt of Tilburg University.

In our paper Sticks or Carrots? Optimal CEO Compensation when Managers are Loss Averse, which was recently accepted for publication in the Journal of Finance, we analyze a simple contracting model where the manager is loss averse and explore to what extent its predictions are consistent with salient features of observed compensation contracts. In particular, we suggest a new approach to explaining the almost universal presence of stock options by assuming that manager’s preferences exhibit loss aversion as described by Kahneman and Tversky. More specifically, on the basis of experimental evidence they argue that choices under risk exhibit three features: (i) reference dependence, where agents do not value their final wealth levels, but evaluate outcomes relative to some benchmark or reference level; (ii) loss aversion, which adds the notion that losses (measured relative to the reference level)loom larger than gains; (iii) diminishing sensitivity, so that individuals become progressively less sensitive to incremental gains and incremental losses.

We develop a stylized principal-agent model with a loss-averse agent and show how it can be calibrated to individual CEO data. In the first part of the paper, we consider piecewise linear contracts that consist of fixed salary, stock and one option grant. We find that the loss aversion model can explain observed contracts very well if the manager’s reference wage is low, i.e. not much higher than last year’s fixed salary and bonus. The model then predicts realistic option holdings and salaries.


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