Monthly Archives: December 2009

Supreme Court to Consider Extraterritorial Application of Securities Laws

Margaret E. Tahyar is a partner and member of the New York Financial Institutions Group at Davis Polk & Wardwell LLP. This post is based on a Davis Polk & Wardwell client memorandum by Joel M. Cohen, Edmund Polubinski III, Lawrence Portnoy, Brian S. Weinstein, James H.R. Windels, and Robert F. Wise, Jr.

In recent years, securities fraud lawsuits in the United States have increasingly been brought against non-U.S. companies. In October 2008, the United States Court of Appeals for the Second Circuit issued an important decision concerning the extraterritorial application of the U.S. securities laws, Morrison v. National Australia Bank, 547 F.3d 167 (2d Cir. 2008). On November 30, 2009, the U.S. Supreme Court decided to hear an appeal from the Second Circuit’s decision. Non-U.S. issuers with businesses in the U.S. should follow the Morrison case closely, along with legislation that is currently making its way through Congress concerning the extraterritorial application of the U.S. securities laws. These developments may determine the circumstances under which non-U.S. companies can be exposed to private securities fraud suits or regulatory enforcement actions in the U.S.

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SEC’s Guidance Facilitates Lock-Ups in Exchange Offers

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 update.

On November 16, 2009, the Staff of the Securities and Exchange Commission’s Division of Corporation Finance (the “Staff”) issued a new Compliance and Disclosure Interpretation (Interpretation #139.29) facilitating the ability of an issuer to enter into lock-up agreements (i.e., agreements to tender) with holders of its debt securities in connection with a registered exchange offer under the Securities Act of 1933, as amended (the “Securities Act”), for the issuer’s outstanding debt securities (the “Lock-Up Interpretation”). [1]

As noted in our previous Update, “Debt–for-Debt Exchanges and Other Debt Modification Strategies in the Current Environment” (April 13, 2009), many corporate debt issuers are focused on the restructuring of their outstanding debt securities. One tool available to issuers in restructuring their outstanding debt securities is a registered debt exchange offer. However, many issuers have viewed registered exchange offers as not being attractive, relative to other available options, because of the need to register the transactions under the Securities Act and comply with tender offer rules under the Securities Exchange of 1934, as amended (the “Exchange Act”). The need to register under the Securities Act and comply with the tender offer rules under the Exchange Act (particularly in the case of exchange offers for convertible debt and other equity securities) can limit transaction structuring options and increase transaction execution risk. [2]

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Credit Market Competition and Capital Regulation

This post comes to us from Franklin Allen, Professor of Finance and Economics at the The Wharton School of the University of Pennsylvania, Elena Carletti, Professor of Economics at the European University Institute, and Robert Marquez, Associate Professor of Finance and Economics at the Boston University School of Management.

In our paper, Credit Market Competition and Capital Regulation, which was recently accepted for publication in the Review of Financial Studies, we present a theory that demonstrates that inducements for banks to hold capital can also come from the asset side. We show that when credit markets are competitive, market discipline coming from the asset side induces banks to hold positive levels of capital as a way to commit to monitor and attract borrowers.

We develop a simple one-period model of bank lending, where firms need external financing to make productive investments. Banks grant loans to firms and monitor them, which helps improve firms’ expected payoff. Given that monitoring is costly and banks have limited liability, banks are subject to a moral hazard problem in the choice of monitoring effort. One way of providing them with greater incentives for monitoring is through the use of equity capital. This forces banks to internalize the costs of their default, thus ameliorating the limited liability problem banks face due to their extensive reliance on deposit-based financing. A second instrument to improve banks’ incentives is embodied in the loan rate. A marginal increase in the loan rate gives banks a greater incentive to monitor in order to receive the higher payoff if the project succeeds and the loan is repaid. Thus, capital and loan rates are alternative ways to improve banks’ monitoring incentives, but entail different costs. Holding capital implies a direct private cost for the banks, whereas increasing the loan rate has a negative impact only for borrowers in terms of a lower return from the investment. We consider both the case where there is and isn’t deposit insurance.

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Division on the Buy-Side: The Structure Of Acquisitions By Private Equity Firms

Recently, in the Mergers and Acquisitions course at Harvard Law School, three preeminent mergers and acquisitions practitioners discussed private equity transactions with Vice Chancellor Leo Strine, Jr., who teaches the class.

The panel consisted of Eileen T. Nugent, a mergers and acquisitions partner and Co-Head, Private Equity Group at Skadden, Arp, Slate, Meagher & Flom LLP; Robert B. Schumer, the chair of the Corporate Department at Paul, Weiss, Rifkind, Wharton & Garrison LLP and co-head of the firm’s Mergers and Acquisitions Group; and John G. Finley, a senior partner in the mergers and acquisitions group of Simpson Thacher & Bartlett LLP. Eileen and John are also members of the Advisory Board of the Program on Corporate Governance.

John took the class through the pre-2005 “traditional” structure of private equity transactions. The panel expressed their view that there was very little optionality in this structure, because of “corporate veil piercing” concerns that the sponsor may be liable, and also because of reputational factors in an environment in which neither sponsors nor banks tried to escape from transactions.

John explained how the situation changed with the SunGard transaction in 2005, with the advent of reverse termination fees, though there was also a reduction in the prevalence of financing outs. The panel then discussed how these changes in deal structure played out when the debt market crashed. The panel also made some comments about how deal terms have chnaged in strategic transactions since then, including the increasing use of reverse termination fees or liquidated damages in strategic transactions.

Vice Chancellor Strine provoked a spirited argument among the panel on the question of whether over-leveraging from private equity trends helped or damaged companies involved in those transactions.

The video of this discussion is available here. (.mov format – click here to get the latest version of Quicktime) (video no longer available)

SEC Amends Rules Related to Credit Rating Agencies

James Morphy is a partner at Sullivan & Cromwell LLP specializing in mergers & acquisitions and corporate governance. This post is based on a Sullivan & Cromwell publication by Robert E. Buckholz, Jr., David B. Harms, Frederick Wertheim, Eric J. Kadel, Jr., and Robert S. Risoleo.  Since the date of that publication, the SEC has issued the proposal described in the final section of the post; it is available here.

The SEC has adopted and proposed a number of changes to its rules and forms relating to the use of credit ratings in public offerings, references to ratings in SEC rules and forms, and the oversight of registered credit rating agencies.

First, a group of proposed amendments would require issuers to disclose credit ratings and specific, potentially extensive related information when those ratings are used in connection with a registered offering. Registrants would also be required to disclose on Form 8-K any subsequent changes to a previously-disclosed credit rating.

Second, the SEC has issued a concept release on whether it should rescind Securities Act Rule 436(g), which currently exempts NRSROs (but not other credit rating agencies) from liability as “experts” under Section 11 of that Act.

Third, the SEC has adopted amendments to remove references to ratings of NRSROs from a few SEC rules and forms, and it has reopened the comment period with respect to similar proposals for other rules and forms. For a discussion of the amendments specifically affecting registered investment companies, see our companion publication, also issued today, titled Use of Credit Ratings Under the Investment Company Act of 1940.

Finally, the SEC has voted to take action on a number of amendments to its rules governing NRSRO oversight which are intended to increase ratings transparency generally and also to facilitate greater competition in the ratings of structured finance products. The SEC also voted to propose further changes that would increase NRSRO reporting and disclosure requirements, with a principal focus on perceived conflicts of interest.

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The Blue Sky Laws and Corporate Policy

This post comes to us from Ashwini Agrawal, Assistant Professor of Finance at NYU.

A number of recent studies debate the impact of investor protection law on corporate policy and performance. On one hand, many papers identify cross-country differences in firm characteristics and attribute these differences to variation in legal protection of investors from insider expropriation (which in turn is attributed to heterogeneity in countries’ legal origins). On the other hand, a number of studies find within-country evidence that changes in investor protection laws have little impact on corporate decisions.

I address this debate in a new working paper entitled The Impact of Investor Protection Law on Corporate Policy: Evidence from the Blue Sky Laws which I recently presented at the CELS 2009 4th Annual Conference on Empirical Legal Studies. More specifically, I exploit the staggered passage of state investor protection statutes (“blue sky laws”) in the U.S. in the early 20th century to estimate the effects of investor protection law on firm financing decisions and investment activity.

Regression estimates indicate that the introduction of investor protection law, keeping legal origin fixed, causes firms to pay out greater dividends, issue more equity, grow in size, and experience improvements in operating performance and market valuations. Additional analysis suggests that alternative hypotheses for the measured changes in corporate policy and performance – such as political economy considerations, changes in unobservable investment opportunities, and firm location decisions – have limited explanatory power.

Overall, the evidence is strongly supportive of theoretical models which predict that investor protection laws have a significant impact on firm financing and investment policy. The findings further suggest that proper design of legal institutions can have important implications for the functioning of capital markets.

The full paper is available here.

Bruce Wasserstein

Editor’s Note: 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 remarks delivered by Mr. Lipton at the memorial service for Bruce Wasserstein earlier this week.

Sometime after leaving the Cravath law firm to join First Boston in 1977 and before co-founding Wasserstein Perella in 1988, Bruce Wasserstein moved from being a phenomenal investment banker to an investment banking legend. If I had to place the time of the transformation, I would choose 1981. It was when Bruce advised DuPont on the takeover of Conoco, which at that time was the largest takeover in corporate history. Conoco was a classic case of the complexity and tactical maneuvering that were features of the takeover battles that caught the attention of the Nation for most of the decade of the 80’s. First having been attacked by Dome Petroleum, then having negotiated a merger with Cities Service, Conoco was again attacked, this time by Seagrams, just as it was about to sign a merger agreement with Cities Service. In desperation, Conoco turned to DuPont to rescue it. Bruce structured a deal that outmaneuvered Seagrams, was successful despite a higher offer from Mobil, and resulted in DuPont acquiring all of Conoco. The investment banking world recognized that DuPont’s success was the result of the brilliant strategy and tactics of Bruce Wasserstein. The legend was born.

I recount the DuPont-Conoco deal not just to mark the beginning of the legend, but to introduce Bruce’s philosophy of investment banking and mergers and acquisitions. When a few years ago he was asked what makes a great banker, Bruce re-plied:

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Private Ordering and the Proxy Access Debate

Lucian Bebchuk is the Director of Harvard Law School’s Program on Corporate Governance. Scott Hirst is the Co-Executive Director of the Program and Co-Editor of the Harvard Law School Forum on Corporate Governance and Financial Regulation.

The Harvard Law School Program on Corporate Governance recently issued our paper, Private Ordering and the Proxy Access Debate. The paper can be downloaded here.

The paper addresses key objections raised against the SEC’s proposal to provide shareholders with rights to include shareholder nominees for election as directors on the company’s proxy statement. Opponents have argued that a preference for private ordering and a recognition that “one size does not fit all” support retention of the current default rule that prevents shareholder nominees from being included on the company’s proxy. We show that this is not the case.

First, opponents argue that, even assuming proxy access is desirable in many circumstances, the existing no-access default should be retained and the adoption of proxy access arrangements should be left to opting-out of this default on a company-by-company basis. Our article identifies strong reasons against retaining no-access as the default. There is substantial empirical evidence indicating that insulating directors from removal is associated with lower firm value and inferior performance. Furthermore, when opting-out from a default arrangement serves shareholder interests, a switch is more likely to occur when it is favored by the board than when disfavored by the board. We analyze the impediments to shareholders’ obtaining opt-outs that are favored by shareholders but not the board, and we present empirical evidence indicating that such impediments are substantial. The asymmetry in the reversibility of defaults highlighted in this article should play an important role in default selection.

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Cashing in Before the Music Stopped

Editor’s Note: This post is based on an op-ed article from the print edition of today’s Financial Times by Lucian Bebchuk, Alma Cohen, and Holger Spamann. The op-ed article is based on their study, “The Wages of Failure: Executive pay at Bear Stearns and Lehman 2000-2008,” which is available here. Although Lucian Bebchuk is a consultant to the US Treasury’s office of the special master for TARP executive compensation, the views expressed in the post should not be attributed to that office.

According to the standard narrative, the meltdown of Bear Stearns and Lehman Brothers largely wiped out the wealth of their top executives. Many – in the media, academia and the financial sector – have used this account to dismiss the view that pay structures caused excessive risk-taking and that reforming such structures is important. That standard narrative, however, turns out to be incorrect.

It is true that the top executives at both banks suffered significant losses on shares they held when their companies collapsed. But our analysis, using data from Securities and Exchange Commission filings, shows the banks’ top five executives had cashed out such large amounts since the beginning of this decade that, even after the losses, their net pay-offs during this period were substantially positive.

In 2000-07, the top five executives at Bear and Lehman pocketed cash bonuses exceeding $300m and $150m respectively (adjusted to 2009 dollars). Although the financial results on which bonus payments were based were sharply reversed in 2008, pay arrangements allowed executives to keep past bonuses.

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Implications of the Incorporation Transparency Act

J.W. Verret is an Assistant Professor at George Mason University School of Law and a Senior Scholar at the Mercatus Center’s Financial Markets Working Group. This post is based on a legal backgrounder by Professor Verret published by the Washington Legal Foundation, which is available here.

The Incorporation Transparency and Law Enforcement Assistance Act, introduced by Senators Levin, Grassley, and McCaskill and currently pending before the Senate Homeland Security Committee, is being sold as an anti-terrorism and anti-money laundering provision. The bill requires that states maintain an accurate and updated list of all beneficial owners of corporations and limited liability companies they create and make that list available to law enforcement and others by subpoena and likely as part of a state’s public records, just as they do for other entities’ formation documents. Publicly traded companies are exempt from the current text of the bill, but privately held companies are directly targeted.

New business entities, including corporations, limited liability companies (LLCs), limited liability partnerships (LLPs), non-profit organizations, and other entities file formation documents with a state’s Secretary of State.  Competition among states for business creation is fought in part through the crafting of innovative business entity laws. State laws require business entities to maintain updated contact information for an agent who can receive service of process for the purpose of litigation.  But owing to the complexities of business ownership, states have not undertaken the impossible task of keeping an up-to-date list of all current owners of all business entities organized under a particular jurisdiction’s laws.  The Levin bill would require that the states collect and maintain beneficial ownership information on corporations and LLCs, but not LLPs, non-profit organizations, or other business entities.  As such, it would be ineffective at hindering use of those entities for the crimes that the bill is intended to stop.  Even if terrorists were to comply with the self-reporting requirements of the bill, they would nevertheless merely switch to using these alternative business entity types for their illegal activities.

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