Yearly Archives: 2009

SEC and CFTC Release Joint Report on Harmonization of Regulation

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Friday, October 23, 2009
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This post is based on a client memorandum from Davis Polk & Wardwell LLP by Daniel N. Budofsky, Robert L.D. Colby, Annette L. Nazareth and Lanny A. Schwartz.

The Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) (collectively, the “Commissions”) released a joint report on October 16, 2009 (the “Report”) reviewing the key elements of the Commissions’ regulatory schemes and providing recommendations for regulatory harmonization. The Report was produced in response to a request in Treasury’s White Paper on Financial Regulatory Reform.

The Report contains a number of recommendations to strengthen the agencies’ oversight and enforcement, enhance market efficiency and investor protection and improve inter-agency coordination and cooperation. Indicating a belief that these goals cannot be met completely under current law, a number of the recommendations ask for Congress to enact new legislation. No recommendations are provided in a number of areas explored by the Report, presumably due either to disagreements between the two Commissions or a belief that any differences in the regulatory schemes are warranted by the differences between securities and futures.

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How Law Affects Lending

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, October 23, 2009
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This post comes to us from Vikrant Vig of London Business School, Rainer Haselmann of the University of Mainz, and Katharina Pistor of Columbia University School of Law.

 

In our paper, How Law Affects Lending, which was recently accepted for publication in the Review of Financial Studies, we exploit variation in legal institutions of twelve transition economies to investigate the effect of legal change on the supply of credit.

Our study focuses on twelve Central Eastern European (CEE) transition economies. We assemble a unique matched database comprising bank-level information, ownership information, and time series information of legal changes for these countries. There are several advantages of using this set of countries as a laboratory: (i) these countries have undergone major legal reforms in the 1990s; (ii) these countries form a fairly homogeneous group; (iii) there is a considerable inter-temporal variation in the timing of these reforms; (iv) the reforms are motivated by pressures from outside governing bodies such as the European Union (EU), European Bank for Reconstruction and Development (EBRD), and USAID; and (v) these are all bank-based economies; therefore, creditor rights should play an important role in these countries.

We find that banks increase the supply of credit subsequent to legal change. The economic impact of a legal change on bank lending is considerable; an improvement of our legal indicator by one implies an increase in loan supply by 13.66%. Further, we differentiate between legal rules designed to protect individual creditors’ claims outside bankruptcy (Collateral) and the collective enforcement regime bankruptcy establishes (Bankruptcy). We find Collateral to be more important than Bankruptcy. This result is in contrast to previous articles, in which measures related to collective enforcement/reorganization (LLSV index) were used to proxy for creditor rights. Further, the effectiveness of a bankruptcy regime is conditional on the existing collateral regime, i.e., the existence of a strong collateral regime is critical for the efficacy of the bankruptcy regime.

Finally, our data suggest that entrants to the market, and in particular foreign banks, respond more strongly to legal change than incumbents by increasing their lending volume. The same is true when comparing greenfield banks with incumbents. We also find that improvements in collateral law result in an increase in individual and household lending, while lending to the government remains unaffected. Finally, legal improvements also affect firms’ level of external debt and their capital structure.

The full paper is available for download here.

Considerations for Public Company Directors in the Current Environment

Posted by Eduardo Gallardo, Gibson, Dunn & Crutcher LLP, on
Thursday, October 22, 2009
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This post is based on a Gibson, Dunn & Crutcher LLP memorandum by Amy Goodman and Gillian McPhee.

The current economic and regulatory landscape poses unprecedented challenges for public companies and their boards of directors.  They are facing scrutiny from shareholders, Congress, regulators and the public, and new proposals to address the causes of the financial crisis have been emerging on almost a daily basis for over a year now.

Many of these proposals remain under consideration at a time when calendar-year companies are beginning preparations for the 2010 proxy season, complicating the planning process.  The uncertainty of the current environment means that, with respect to many issues–such as the SEC’s proxy access proposals–companies and their boards find themselves in a “wait and see” mode.  Directors should remain informed during this time as new developments occur, and they should be prepared to respond at an accelerated pace.  To assist boards in addressing the potential changes that lie ahead, this memorandum outlines key issues for directors to consider over the coming months.

1.  Executive Summary

As discussed in more detail below, as boards prepare for the potential changes that lie ahead, there are a number of key areas to consider.  These include:

a. Director Elections.  Boards and companies should take a holistic approach to the director election process, considering the potential impact that the loss of broker discretionary votes will have on director elections at the upcoming annual meeting, as well as the effect of majority voting, “notice and access” (also known as “e-proxy”), and expected voting recommendations of the major proxy advisory firms.

b. Executive Compensation Practices and Disclosures.  Boards and compensation committees should evaluate their companies’ compensation practices and policies in light of the current environment, including the strong possibility of federal legislation requiring an advisory vote on executive compensation, or “say on pay.”  For the 2010 proxy season, new required disclosures are anticipated relating to the risks created by employee compensation plans and the use of compensation consultants.  In view of these considerations, companies should assess their compensation disclosures, with particular focus on the Compensation Discussion & Analysis.  In addition, boards and compensation committees should be aware of executive compensation practices that institutional investors and proxy advisory firms frown upon (such as tax gross-ups) and those that they advocate, such as “hold-through-retirement” provisions and “clawback” policies.

c. Board Leadership.  Boards and companies should expect a continued spotlight on the issue of board leadership in the coming months.  In anticipation of new required proxy disclosures about board leadership structure, boards should consider why their current leadership structure is appropriate.  At companies that combine the positions of chair and CEO, consideration should be given to what, if any, steps should be taken to enhance the independent leadership of the board.  In addition, the board should consider this issue as part of the succession planning process.

d. Risk Oversight.  Boards and companies should consider whether the board has the appropriate structure and processes in place for overseeing the major risks facing the company.  The board should be comfortable that it understands these risks and how the risks relate to the company’s business and strategy.  Boards, and those who advise them, should think carefully about how the board is spending its time and see that the board has adequate time to address critical issues such as strategy and risk.
e. Shareholder Engagement.  Boards should be attentive to what their companies are doing to engage shareholders and recognize that, more than in the past, directors may need to play a greater role in reaching out to shareholders.  Initiating a dialogue before a major issue arises helps build a relationship so that the company is not approaching a major shareholder for the first time to talk about a critical subject.

f. Shareholder Proposals for the 2010 Proxy Season.  For the 2010 proxy season, we expect that shareholder proposals seeking the appointment of an independent chair and proposals seeking an advisory vote on executive compensation will continue to be popular.  In addition, executive compensation in general is likely to be a frequent subject of shareholder proposals.  Finally, shareholders’ ability to call special meetings and supermajority voting provisions also are likely to be focal points in the next proxy season.

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Regulation of OTC Derivatives and the Proposed OTC Derivatives Markets Act

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, October 22, 2009
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(Editor’s Note: The post below is a transcript of Mr. Gensler’s recent testimony to the House Committee on Financial Services, omitting introductory and conclusory comments. Mr. Gensler’s complete written testimony can be found here.)

I would like to address much-needed regulatory reform of OTC derivatives in the context of two principal goals: lowering risk to the American public and promoting transparency of the markets.

We embark upon this reform effort as the financial industry has become ever more concentrated. Given the events of the last decade, there are fewer providers of financial services today. There may be 15 to 20 large complex financial institutions that are at the center of today’s global derivatives marketplace. Five to ten years from now, it is quite possible that the financial system will become even more concentrated. With fewer actors on the stage, it is especially important that we lower the risk of these participants and bring sunshine to the activities in which they are involved.

One year ago, the financial system failed the American public. The financial regulatory system failed the American public. Exhibit A of these twin failures was the collapse of AIG. Every single taxpayer in this room – both the members of this Committee and the audience – put money into a company that most Americans had never even heard of. Approximately $180 billion of our tax dollars went into AIG – that is nearly $414 million per each of your Congressional districts. While a year has passed and the system appears to have stabilized, we cannot relent in our mission to vigorously address weaknesses and gaps in our regulatory structure.

Lowering Risk

To lower risk to the American public, the Administration proposed four essential components of reform.

First, those financial institutions that deal in derivatives should be required to have sufficient capital. Capital requirements reduce the risk that losses incurred by one particular dealer or the insolvency of one of its customers will threaten the financial stability of other institutions in the system. While many of these dealers, being financial institutions, are currently regulated for capital, I believe that we should explicitly – both in statute and by rule – require capital for their derivatives exposure. This is particularly important for nonbank dealers who are not currently regulated or subject to capital requirements.

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Combining More Effective Banking Regulation with Market Discipline

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, October 21, 2009
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(Editor’s Note: The post below by Commissioner Sheila Bair is a transcript of her remarks to the International Institute of Finance Annual Meeting in Istanbul earlier this month, omitting introductory and conclusory comments; the complete transcript is available here.)

It’s been a year since we faced down the biggest financial crisis to hit the world economy in modern times. Thanks to extraordinary action by monetary and regulatory authorities, we’re now in a period of relative stability. Credit markets are slowly getting back to normal. Liquidity is improving. Equity markets are staging a comeback.

But this is no time to sit back and relax simply because the worst of the storm appears to be over. Storms and hurricanes like this financial crisis can be very unpredictable. They have a nasty habit of regrouping and coming back with a fury. There’s now an active (and I hope ultimately productive) debate in the United States and around the globe about how to repair the financial system.

It’s truly a global debate. Virtually no economy went untouched by the financial crisis.

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Do Buyouts (Still) Create Value?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, October 21, 2009
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This post comes to us from Shourun Guo of Duke Energy Corporation, Edith S. Hotchkiss at Boston College, and Weihong Song at the University of Cincinnati.

 

The leveraged buyout (LBO) wave of the 1980s was an important phenomenon well studied by academics and practitioners. However, given the rise of the private equity industry, changes in the characteristics of firms targeted for buyouts, and changes in the structure of the transactions themselves, the mechanisms through which buyouts can create value have likely changed. Despite this, there is little (or no) evidence from the more recent wave of buyouts which documents whether and how these transactions create value. In our forthcoming Journal of Finance paper, Do Buyouts (Still) Create Value?, we seek to fill this gap by studying a sample of 192 LBOs completed between 1990 and 2006.

We first show that the firms in our sample on average experience large increases in total value from the time of the buyout to their subsequent exit from a private equity firm’s portfolio, producing large returns to invested debt and equity capital. We find that returns to either pre- or post-buyout capital are positive and significant for all outcome groups except deals ending in a distressed restructuring. Median market and risk adjusted returns to pre- (post-) buyout capital are estimated at 72.5% (40.9%), even including the cases of distress.

There are three potential explanations for the realized returns we document. First, firm value will increase if there are firm specific improvements in operating performance. Second, even if there are no changes in the cash flows of the firm subsequent to the buyout, firm values may benefit from rising market or industry sector valuation multiples while the firm is private. Third, substantial increases in leverage produce larger tax shields, boosting returns by increasing the cash flows available to the providers of capital. We directly quantify the impact on returns of changes on each of these explanations.

Comparing the realized returns to what they hypothetically would have been if profitability (relative to firms matched on industry and pre-buyout characteristics) had remained at its pre-buyout level, for the full sample we show that improvements in performance account for 23% (18.5%) of the pre- (post-) buyout return. Changes in industry valuations also have a large effect on returns; changes in the industry total capital/EBITDA ratio account for 18% of the return to pre-buyout capital for the full sample, and 26% of the return for firms exiting through an IPO. The magnitude of the impact of increasing tax shields depends on our assumptions as to whether leverage will be maintained after the exit from the private equity firm’s portfolio; for firms sold in a secondary LBO, the increased tax benefits account for 29% of the return to pre-buyout capital.

We also use cross sectional regressions to provide further evidence on the relative importance of the factors explaining returns. These regressions account for the fact that there may be some overlap in the sources of these gains; for example, an increase in leverage may affect the firm both through increasing cash flows as a result of the discipline of debt, as well as through the cash flow benefits of reducing taxes. Consistent with our prior results, the regressions show that the impact of changes in industry valuation multiples and realized tax benefits from increased leverage are each as important as operating gains in explaining returns. The regressions also show that in addition to our cash flow measures of operating changes, firms which restructure via asset sales while private are associated with significantly lower returns.

The full paper is available for download here.

Regulate OTC Derivatives by Deregulating Them

Posted by Lynn A. Stout, Cornell Law School, on
Tuesday, October 20, 2009
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As a result of the current financial crisis, there have been multiple calls for strict new regulation of over-the-counter (OTC) financial derivatives. In a new article entitled Regulate OTC Derivatives by Deregulating Them, I propose instead that we consider returning to the common law approach to “off-exchange” derivatives—“deregulate” them by refusing to allow traders who use OTC derivatives contracts only to speculate, and not to fulfill a bona fide hedging purpose, to enforce their contracts in the courts. After all, there is no cheaper form of government intervention than refusing to intervene at all, even to enforce a deal.

The common law treated purely speculative derivative transactions in which neither party was hedging against a preexisting economic risk as legally unenforceable “gambling” contracts. This rule, a version of which still survives today in the form of insurance law’s requirement of “insurable interest,” forced would-be derivatives speculators to either investigate whether their counterparty was truly hedging, or to trade on an organized exchange where the rule of unenforceability did not apply. Exchange trading, however, was subject to member-imposed margin requirements, netting requirements, and disclosure rules that kept excessive speculation in check. As a result, the common law rule kept derivatives speculation from contributing excessively to systemic risk.

The common law rule against “off-exchange” derivatives speculation eventually morphed into elements of the Commodities Exchange Act which were repealed by the Commodity Futures Modernization Act of 2000. This change in the law was directly responsible for the subsequent explosion in OTC derivatives trading and dramatic increase in systemic risk. Logic and history accordingly both suggest that a return to the common law approach might be an effective policy response to the problem of systemic risk.

The full article is available for download here. The article is followed by comments from Jean Helwege, Peter Wallison, and Craig Pirrong, as well as my response to these comments.

Delaware Decision Clarifies Standards for Third-Party Transactions with Controlled Companies

Posted by William Savitt, Wachtell, Lipton, Rosen & Katz, on
Tuesday, October 20, 2009
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This post is based on a Wachtell, Lipton, Rosen & Katz client memorandum by William Savitt and Ryan A. McLeod. 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.

The Delaware Court of Chancery has suggested certain rules of the road when a third party acquires a company with a controlling stockholder. In re John Q. Hammons Inc., S’holder Litig., C.A. No. 758-CC (Del. Ch. Oct. 2, 2009).

The case arose from the sale of John Q. Hammons Hotels, Inc., a publicly traded hotel chain controlled by John Hammons. In late 2004, a special committee of the company’s board explored potential third-party mergers. Hammons informed the committee that, in view of his particular tax and business interests, he would consider a transaction only if he retained an interest in the surviving entity and received a line of credit to continue developing new hotels. The committee ultimately recommended that the board approve a transaction in which public shareholders were cashed out at a substantial premium. Hammons separately bargained for a participating preferred interest in the surviving company and lines of credit totaling $300 million. The transaction was conditioned on the approval of a majority of the minority shares actually voting, and was approved and closed in 2005.

Certain shareholders challenged the transaction, alleging that Hammons dominated the negotiation process and received an undue proportion of the merger consideration. Ruling on crossmotions for summary judgment, the Court rejected the argument that the transaction was presumptively subject to the plaintiff-friendly “entire fairness” standard of review. Because Hammons was not himself cashing out the shareholders or otherwise “standing on both sides of the transaction,” but was instead dealing with a third party, the Chancellor concluded that all defendants would be protected by the business judgment rule “if the transaction were (1) recommended by a disinterested and independent special committee, and (2) approved by stockholders in a [fully informed and] non-waivable vote of the majority of all the minority stockholders.”

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Shareholders’ Say on Pay: Does it Create Value?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, October 19, 2009
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This post comes to us from Jie Cai and Ralph Walkling of Drexel University.

 

In our forthcoming Journal of Financial and Quantitative Analysis paper, Shareholders’ Say on Pay: Does it Create Value?, we investigate whether allowing shareholder votes on executive compensation increases shareholder wealth. We perform three experiments to examine this issue. In our primary experiment, we examine the market reaction to the passage of the House of Representatives “Say on Pay Bill”, which was passed on April 20, 2007 by a 2-1 margin. In our second experiment, we examine the shareholder sponsored say-on-pay proposals targeting individual companies. In our third experiment, we ask whether shareholder votes are related to excess CEO compensation when they are asked to approve equity-based compensation plans.

Our primary experiment examines the stock price reaction of 1,270 of the largest corporations in the United States on the day the bill passed the House. The passage of the Say-on-Pay Bill might not be surprising to the market since Democrats were in control of the House. However, its 2-1 margin (269 positive votes vs. 134 votes against) was a surprise, as well as the fact that 55 Republican Congressmen also supported the Bill. We find a more favorable market reaction to the bill for firms that overpay their CEOs and for firms that have low pay-for-performance. Additionally, we find that the positive stock price reaction is more pronounced for firms with relatively weak, but not the weakest governance. These firms are likely to benefit from better compensation design if they implement such improvements under shareholder pressure. Conversely, firms with the weakest governance may not respond to advisory shareholder votes at all. Finally, market reaction is more favorable for firms that have higher activist shareholder ownership as well as firms that have previously responded to shareholder dissatisfaction as expressed in director elections.

In our second experiment, we use a sample of 113 say-on-pay shareholder proposals between 2006 and 2008 to examine shareholder-sponsored say-on-pay proposals targeting individual companies. We find that the companies targeted are not ones likely to benefit from say-on-pay. On average, the CEOs of these firms are not overpaid. Moreover, targeted firms have similar performance and governance as typical firms. Activist shareholders appear to target large firms. In addition, most of these proposals are sponsored by labor unions with very small stock holdings in the companies targeted. The stock prices of targeted firms react negatively to the announcement of union-initiated proposals and these proposals receive lower support from other shareholders. Finally, when shareholders vote down these proposals, the stock prices of targeted firms react positively, and the reaction is higher when more shareholders vote against the proposals.

In our third experiment, we examine shareholder votes concerning management proposals for approval of incentive compensation (mostly equity-based compensation plans). Using a sample of 2,511 management-sponsored compensation proposals voted on at 1,853 shareholder meetings during the 2003-2008 period, we find that shareholder support for such proposals is lower when abnormal CEO compensation is high and CEO pay-for-performance sensitivity is low.

Taken together, our evidence suggests that say-on-pay may benefit firms with questionable compensation practices but can hurt firms targeted by special interests. Thus, with say-on-pay it is not the case that one size fits all. The full paper is available for download here.

Deal Certainty – The Fallacy of a New Market

Posted by David Fox, Kirkland & Ellis LLP, on
Sunday, October 18, 2009
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This post is based on a memo by David Fox and Daniel E. Wolf of Kirkland & Ellis LLP.

In the aftermath of the economic crisis that began in mid-2007, much ink has been spilled on the lessons learned by buyers and sellers regarding the pitfalls of deal certainty and the development of new paradigms for both financial and strategic buyers. Many assert that in the post-crash M&A market there has been substantial crosspollination between the traditional deal structures used by those two categories of buyers in the pre-2007 period, with financial buyers being forced to accept deal terms that were once only demanded of strategic buyers and with strategic buyers demanding some of the looser deal commitment terms that previously benefited only financial buyers.

We argue that any attempt to identify a simplified new paradigm or market for basic deal certainty terms is an overly simplistic view of the deal market in these early days of recovery — rather, we believe that the perceived departures from traditional deal structures are largely a reflection of a complex equation of a dozen or so contractual variables that interact with overall deal dynamics, including company-specific and secular market conditions, to produce a deal-specific outcome in the relevant post-crash transactions.

Before outlining this proposition in greater detail, it is useful to briefly trace the history of divergence between deal terms in cash deals for strategic buyers and financial, or private equity, buyers.

Before 2005

Historically, there was a wide divergence between deal models for strategic and financial categories of buyers. Strategic buyers, with the backing of their balance sheets, were expected to commit fully to the completion of an announced cash acquisition backed by a provision providing for a specific performance remedy of the buyer’s obligation to close. Sellers were comfortable relying on the potential to obtain such an order of specific performance to force a closing combined with an assumption that alternatively they would be able to collect lost premium in a damages action against a reneging buyer (noting that the validity of this assumption, at least under New York law, proved somewhat tenuous with the 2005 decision in the Northeast Utilities case).

By contrast, financial buyers were able to proceed with much looser legal commitment to the completion of a cash buyout. Financial sponsors, whose business model depended on borrowing a significant portion of the purchase price in order to leverage their equity investment, often benefited from the inclusion of a “financing condition” in their purchase agreements, meaning they were able, as a theoretical contractual matter, to walk-away from closing, usually without consequence, in the event debt financing was not available. At the time of signing, the financial buyer often delivered a negotiated debt term sheet and/or a “highly confident” letter from debt
financing sources, with such documents providing little if any legal assurance that the debt in fact would be funded. A shell entity created by the financial buyer was the only party to the contract with the seller, meaning that, absent veil-piercing, any specific performance remedy would be largely ineffective.

Sellers accepted the financial buyer’s argument that, as a repeat acquiror, the reputational damage associated with it walking away from any deal were so great that the optionality inherent in the deal terms was a negligible risk. With the very low incidence of failed deals, mostly a function of rational deal terms and levels of leverage and available liquidity in the debt markets, the effectiveness of reputational concerns as a constraint on financial buyers was never really tested.

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