Yearly Archives: 2009

Paying for Performance at Goldman

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, July 24, 2009
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Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published today on Wall Street Journal online and available here.

Last week, after reporting stellar second-quarter profit of $3.4 billion, Goldman announced the setting aside of $11.4 billion for compensation – which, broken down per employee, is similar to what Goldman set aside in the first half of the boom year of 2007.

Goldman’s CFO argued that its pay decisions reflect the firm’s “pay for performance culture.” However, if Goldman proceeds to pay record cash bonuses this year, as many now expect, these payments would reflect a return to flawed pay structures, as well as a failure to implement effectively the compensation principles Goldman recently put forward.

The setting aside of $11.4 billion for compensation, it should be stressed, doesn’t yet commit Goldman to any amounts of cash bonuses. Goldman still has time to determine the magnitude and structure of its 2009 compensation. In doing so, it should give substantial weight to lessons drawn from the financial crisis.

The crisis has highlighted a substantial flaw in compensation structures that provide rewards for short-term performance – which is what Goldman’s paying super cash bonuses for 2009 would do. Such rewards can over-compensate executives as well as produce excessive incentives to take risks.

Rewards for short-term results can produce over-compensation by enabling executives to cash out large amounts of compensation on account of results that are subsequently reversed. In many financial firms whose aggregate earnings over the past several years are negative, executives have still been able to cash out large amounts of bonus compensation during the first part of this period – and they kept these amounts despite the large losses subsequently borne by the firms.

In addition, and perhaps most importantly, bonuses for short-term results provide incentives to seek improvements in short-term results even at the expense of excessive taking of risks of an implosion later on. The short-term distortion caused by standard compensation structures, which Jesse Fried and I first highlighted in our “Pay without Performance” book, has recently become widely accepted. Treasury Secretary Geithner stated last month that “[s]ome of the decisions that contributed to this crisis occurred when people were able to earn immediate gains without their compensation reflecting the long-term risks they were taking for their companies and their shareholders.”

Indeed, the flaws in the standard compensation structures of financial firms have been explicitly recognized by Goldman’s own leaders. Last April, in a widely praised speech before the Council of Institutional Investors, Goldman’s CEO Lloyd Blankfein called for compensation reform, stating that “[financial firms’] decisions on compensation … look self-serving and greedy in hindsight.” Evaluation of employees’ performance, Blankfein stressed, “must be made on a multi-year basis to get a fuller picture of the effect of an individual’s decisions.”

Goldman subsequently adopted compensation principles and announced them in its annual shareholder meeting last May. According to these principles, “cash compensation in a single year should not be so much as to overwhelm the value ascribed to longer term stock incentives that can only be realized through longer term responsible behavior.”

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A critique of the President’s financial regulation reforms

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, July 23, 2009
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Editor’s Note: This post is the first part of a two-part series by Richard A. Posner, and is based on a recent article in Lombard Street.

On June 17, the Treasury Department issued an 88-page report entitled Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation. The Report (as I’ll call it) is a blueprint for reform of financial regulation, with the aim of preventing another financial crisis. In this first part of a two-part article, I discuss weaknesses in the overall approach that the Report takes to the problem of reform, as well as weaknesses in the Report’s proposals for limiting “systemic risk.” Part II (which will be published in August) will discuss the proposals concerning executive compensation and consumer and investor protection, and will also suggest some alternative proposals for regulatory reform.

The Report’s fundamental weaknesses are its prematurity, overambitiousness, reorganization mania, and FDR envy. Let me start with the last. It is natural for a new President, taking office in the midst of an economic crisis, to want to emulate the extraordinary accomplishments of Franklin D. Roosevelt’s initial months in office. Under Roosevelt, within what seemed the blink of an eye, the banking crisis was resolved, public-works agencies that hired millions of unemployed workers were created, and economic output rose sharply. But that was 76 years ago. The federal government has since grown fat and constipated. The program proposed in the Report cannot be implemented in months or years, or perhaps even in decades—as would be apparent had the Report addressed costs, staffing requirements, and milestones for determining progress toward program goals and had the Report attempted an overall assessment of feasibility.

The Report is premature in two respects. The first is that it advocates a specific course of treatment for a disease the cause or causes of which have not been determined. Now it is not always necessary to understand the cause of something you don’t like in order to be able to eliminate the effect. If you have typical allergy symptoms you may get complete relief by taking an antihistamine; it is not necessary to find out what you’re allergic to. But generally, and in the case of the current economic crisis, unless the causes of a problem are understood, it will be impossible to come up with a good solution. The causes of the crisis have not been studied systematically, and are not obvious though they are treated as such in the Report. (Remember, the Great Depression of the 1930s ended 68 years ago and economists are still debating its causes.) We need some counterpart to the 9/11 Commission’s investigation of an earlier unforeseen disaster.

The Report asserts without evidence or references that the near collapse of the banking industry last September was due to a combination of folly—a kind of collective madness—on the part of bankers (in part reflected in their compensation practices), of credit-rating agencies, and of consumers (duped into taking on debt, particularly mortgage debt, that they could not afford), and to defects in the regulatory structure. This leaves out many potential causes that other students of the crisis have emphasized. The Report does not mention the errors of monetary policy by the Federal Reserve that pushed interest rates down too far in the early part of this decade. Because houses are bought mainly with debt (for example, an 80 percent mortgage), a reduction in interest rates reduces the cost of owning a house and can and did cause a housing bubble, which when it burst took down, along with the homeowners, the banks and related institutions that had financed the bubble. Mortgage debt is huge—$12 trillion—and the banks (a term I use broadly, to include other financial intermediaries as well) were therefore deeply invested in the housing industry and incurred substantial losses when housing values fell precipitously.

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Administration Proposes Regulations for Private Fund Investment Advisers

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on
Thursday, July 23, 2009
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This post is by John F. Olson’s colleague Susan Grafton.

On July 15, 2009, the Obama administration (the “Administration”) delivered to Congress draft legislation, the Private Fund Investment Advisers Registration Act of 2009. Under the proposed legislation, managers of most hedge funds, private equity funds and venture capital funds in the U.S. would be required to register with the Securities and Exchange Commission (the “SEC”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The existing exemption for investment advisers with fewer than 15 clients would be eliminated, and specific information reporting would be required for advisers to any “private fund.” A limited exemption will continue to apply to certain “foreign private advisers.” The existing threshold of $30 million of assets under management for mandatory SEC registration would continue to apply.

Andrew Donohue, the SEC’s Director of Investment Management, discussed these and other potential regulatory reforms in his testimony on July 15, 2009, before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs concerning the regulation of hedge funds and other private investment pools.

Applicability to Advisers to Private Funds

The new reporting requirements will generally apply to investment advisers to any “private fund,” which would be any investment fund that is relying on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 for exemption from registration, and that is either organized in or created under the laws of the U.S. or has 10 percent or more of its outstanding securities owned by U.S. persons.

Additional Reporting to the SEC

In addition to the existing regulatory obligations of registered investment advisers to private funds, the draft legislation would require all registered investment advisers to private funds (including newly registered advisers) to submit reports to the SEC as are necessary or appropriate in the public interest and for the assessment of systemic risk by the Federal Reserve Board (the “Federal Reserve”) and the proposed Financial Services Oversight Council (the “FSO Council”).

The reports would include at least the following information for each private fund:

1. Amount of assets under management;
2. Use of leverage, including off-balance sheet leverage;
3. Counterparty credit risk exposures;
4. Trading and investment positions;
5. Trading practices; and
6. Such other information as the SEC and the Federal Reserve determines are necessary or appropriate.

These records and reports would be deemed records and reports of the investment adviser, which would be required to maintain and keep them in accordance with retention requirements prescribed by the SEC. The SEC would be required to make the new systemic risk data and reports available to the Federal Reserve and the FSO Council. In addition, because the private fund’s records would be deemed records of the investment adviser, they would be subject to periodic examination by the SEC and its staff.

Although the draft legislation provides that the SEC would not be required to disclose the reports or their content, the SEC would not be permitted to withhold information from Congress or any federal agency or self-regulatory authority. Accordingly, confidentiality would not be completely safeguarded.

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Shareholder Lawsuits and Stock Returns

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, July 22, 2009
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This post comes to us from Amar Gande of the Edwin L. Cox School of Business, Southern Methodist University, and Craig M. Lewis of the Owen Graduate School of Management, Vanderbilt University.

In our forthcoming Journal of Financial and Quantitative Analysis paper, Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillovers, we analyze shareholder initiated class action lawsuits and the associated stock price reaction. Our analysis uses a comprehensive sample obtained from the Securities Class Action Lawsuit Clearinghouse (see here) at Stanford University (which tracks federal securities class action lawsuits since 1996). This service reports that 1,915 class action lawsuits were filed over the period 1996 through 2003 with litigation peaking in 2001 when 493 suits were filed. Not only do we examine price reactions on the lawsuit filing date, but we consider the possibility that these lawsuits signal that comparable firms are susceptible to similar lawsuits. If true, we expect these comparable firms to have negative stock price reactions that are significantly related to the probability of being sued.

We develop an econometric model for the propensity to be sued based on both firm and industry-specific factors. We show that shareholder wealth losses on the date that the filing of a lawsuit is announced are understated because investors partially anticipate these lawsuits and capitalize part of the losses in advance. In this regard, our methodology is consistent with the literature on conditional event study methods that emphasizes the role of explicitly conditioning for the expected information (i.e., partial anticipation of lawsuits) in estimating announcement effects, and suggests that the probability of an event (i.e., of being sued) is, as we find in this study, significantly related to the event date announcement effect. While other studies have examined whether investors partially anticipate corporate events, such as acquisitions and debt offerings, they are based only on firm-specific information. In contrast to these studies, we incorporate spillover effects based on industry specific information, such as the litigation environment, to determine both the propensity of a firm to be sued and the associated shareholder losses. We focus on the relation between investor reactions and the probability of being sued and demonstrate that prior expectations about the likelihood of being sued are significant determinants of the anticipated losses prior to the filing of an actual lawsuit and on the lawsuit filing date.

Our main findings are as follows. First, we find that investors partially anticipate lawsuits based on firm-specific and industry-specific information and capitalize losses prior to the filing of a lawsuit. Second, we show that filing date effects understate the magnitude of shareholder losses on average by approximately a third. Finally, we demonstrate that prior expectations about the likelihood of being sued are important determinants of the losses that investors capitalize in anticipation of being sued and of the losses on the lawsuit filing date. In particular, we show that the more likely a firm is to be sued, the larger is the partial anticipation effect (shareholder losses capitalized prior to a lawsuit filing date) and smaller is the filing date effect (shareholder losses measured on the lawsuit filing date). Our evidence suggests that previous research that typically focuses on the filing date effect understates the magnitude of shareholder losses, and such an understatement is greater for firms with a higher likelihood of being sued.

The full paper is available for download here.

What Happens When The Government Enters The Ring?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, July 21, 2009
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Editor’s Note: This post by Professor Mark Roe appears today on Forbes.com

Bernanke and Paulson are still taking heat from Congress for pressing Bank of America’s Lewis into going forward with the Merrill Lynch purchase, a deal that shackled Bank of America with significant losses. And Bank of America’s Lewis took considerable heat from its shareholders for not telling them how bad Merrill looked at the time of the purchase.

Eventually, the Treasury put another $20 billion into Bank of America and documents now indicate that the government raised the possibility of ousting the bank’s senior management if the deal had not gone through.

Several core transactions in the financial crisis have the government in a dual role, as simultaneously being a regulator and a market-like player. It’s as if the referee in a sport started fielding his own team. Even first-rate refs doing their job well, and as fairly as they can, can distort how everyone else plays the game, once the referee becomes a player too. This problem also emerges when the governmental regulator becomes a market player too, as was the case three times in the past year: with Bank of America’s purchase of Merrill Lynch, when the government was standing behind Bank of America as a vital lender; with Morgan’s purchase of a failing Bear Stearns last year with the Fed and the Treasury brokering the deal; and with Chrysler’s rescue via government loans.

A standard objection to the government as market player–as, say, an owner of companies like GM and Chrysler–is that it’s a bad manager. It wastes resources, makes mistakes and misallocates capital. It’s insulated from market incentives.

But recent evidence suggests it might not be so bad as a manager. And when the government meddles with or replaces failed managements–viz. the American auto industry–it’s not replacing America’s most admired management teams, but its worst. The bar for it to clear is not all that high.

The government’s goals are usually seen as the bigger issue. Rather than profits, the government-as-owner seeks to maintain employment or another nonprofit goal. Sometimes these further sensible social policy. But because it isn’t focused on profits, the government often puts capital where it’s less effective in the long run. These reservations to the government as market player are standard.

There’s a third issue with the government as market actor, one that’s potentially as insidious as any of the others, but less vivid.

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Why re-regulating derivatives can prevent another disaster

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, July 21, 2009
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Editor’s Note: This post is by Lynn A. Stout of UCLA School of Law.

When credit markets froze up in the fall of 2008, many economists pronounced the crisis both inexplicable and unforeseeable. That’s because they were economists, not lawyers.

Lawyers who specialize in financial regulation, and especially the small cadre who specialize in derivatives regulation, understood what went wrong. (Some even predicted it.) [1] That’s because the roots of the catastrophe lay not in changes in the markets, but changes in the law. Perhaps the most important of those changes was the U.S. Congress’s decision to deregulate financial derivatives with the Commodity Futures Modernization Act (CFMA) of 2000.

It was the deregulation of financial derivatives that brought the banking system to its knees. The leading cause of the credit crisis was widespread uncertainty over insurance giant AIG’s losses speculating in credit default swaps (CDS), a kind of derivative bet that particular issuers won’t default on their bond obligations. Because AIG was part of an enormous and poorly-understood web of CDS bets and counter-bets among the world’s largest banks, investment funds, and insurance companies, when AIG collapsed, many of these firms worried they too might soon be bankrupt. Only a massive $180 billion government-funded bailout of AIG prevented the system from imploding.

This could have been avoided if we had not deregulated financial derivatives.

Derivatives “De”regulation?

Wait a minute, some readers might say. What do you mean, “de”regulated derivatives? Aren’t derivatives new financial products that have never been regulated?

Well, no. Derivatives have a long history that offers four basic lessons. First, derivatives contracts have been used for centuries, possibly millennia. Second, healthy economies regulate derivatives markets. Third, derivatives are regulated because while derivatives can be useful for hedging, they are also ideal instruments for speculation. Derivatives speculation in turn is linked with a variety of economic ills—including increased systemic risk when derivatives speculators go bust. Fourth, derivatives traditionally are regulated not through heavy-handed bans on trading, but through common-law contract rules that protect and enforce derivatives that are used for hedging purposes, while declaring purely speculative derivative contracts to be legally unenforceable wagers.

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Cuban Decision Casts Doubt on SEC Position on Insider Trading

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Monday, July 20, 2009
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The recent decision of the Court of Appeals for the Second Circuit in SEC v. Dorozhko further illustrates the uncertain state of the limits of insider trading. Reversing an earlier District Court decision, the Court held that while a breach of a fiduciary duty is required where the fraud is premised on silence, no such breach is required where there has been an affirmative misrepresentation. A memo by Davis Polk & Wardwell LLP, available here, discusses the decision.)

Editor’s Note: This post is by Annette Nazareth’s colleagues William M. Kelly, Joseph A. Hall, Michael Kaplan, William J. Fenrich, and Janice Brunner.

On Friday, a federal district court in the Northern District of Texas dismissed the SEC’s insider trading case against Dallas Mavericks owner Mark Cuban. While the celebrity of the defendant has undoubtedly contributed to the widespread publicity of the dismissal, the real news is that the SEC has, for the moment at least, lost a case on what might seem to have been slam-dunk facts:

• Company shares material nonpublic information with its largest shareholder, who agrees to keep the information confidential.• The shareholder, upon learning the information, says “Well, now I’m screwed. I can’t sell”.

• Shareholder nonetheless turns around and dumps all of his shares, sparing himself a $750,000 loss when the material nonpublic information is later disclosed.

What’s missing here? Mr. Cuban, abetted by a group of law professor amici, argued that Rule 10b-5 liability requires a fiduciary or fiduciary-like relationship with the provider of the information, and that a mere agreement cannot provide a basis for liability. The court rejected this view, but it also rejected the SEC’s long-held view, reflected in its adoption of Regulation FD and Rule 10b5-2, that third parties who accept material nonpublic information from a company on a confidential basis are precluded from trading on the information. The court held that Mr. Cuban’s oral agreement to maintain confidentiality, without an agreement not to trade, was not enough.

What does this decision mean for potential providers and recipients of material nonpublic information?

For providers—for example, companies interested in sharing information with potential investors or acquirers—the case says that if you want the recipient not to trade, you had better be specific. The safest approach, of course, is to seek a written contractual standstill from recipients. But agreements of this sort are often difficult to get parties to agree to, especially where, as in this case, the recipient would be asked to sign the agreement “blind”, without knowing the nature of the information. As a practical matter, providers may have to content themselves with a “sole use” provision, along the lines of “recipient agrees to use the information solely for the purpose of considering an investment”. Had such a provision been in place, the result in this case might well have been different.

For recipients of material nonpublic information, our advice is not to rely on this decision. The case was decided at the trial court level, is not binding on other courts, and the SEC has been given the right to file an amended complaint. Whether or not the SEC chooses to replead the case or to appeal the decision, we are certain that it will not accept the case as the final word and will continue to seek enforcement action on facts like these. Thus, while the decision will provide comfort to parties who have to defend themselves for what they have done, we would not use it as a basis for deciding what you should do. The prudent judgment continues to be that if you have agreed to keep information confidential, you should not use it as a basis for trading.

Lastly, the case highlights the curious fact that, 75 years after the enactment of the Securities Exchange Act and the creation of the SEC, and after decades of judicial exegesis of the Delphic text of Section 10(b), we still don’t quite know when insider trading is illegal.

See S.E.C. v. Cuban, No. 3:08-CV-2050-D (N.D. Tex. July 17, 2009)

Corporate Governance in Crisis Times

Posted by Martin Lipton, Wachtell, Lipton, Rosen & Katz, on
Monday, July 20, 2009
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This post is based on a client memo by Martin Lipton and Ted Mirvis of Wachtell, Lipton, Rosen & Katz.

Since the apex of the economic crisis last year, American companies have been buried in an avalanche of corporate governance initiatives designed to increase the power of fund managers to dictate corporate policies to boards of directors. Unfortunately, few, if any, of the proposals focus on what must be the overriding objective of corporate governance—encouraging long-term economic growth: the type of growth that is achieved without risking the environment or the financial system; the type of growth that creates and maintains full employment; the type of growth that creates affordable housing, healthcare and education for all.

The evidence is irrefutable that the pressure for short-term performance and quick stock market profits were prime factors in causing the economic crisis. Indeed, President Obama has said that compensation practices tied to short-term performance were responsible for “a reckless culture and a quarter-by-quarter mentality that in turn wrought havoc in our financial system.”

It is critical that we recognize that short-termism encourages excessive risk and diversion from the long-term planning essential to sustainable economic growth and that we use this insight to critically evaluate the entire range of corporate governance initiatives that are now on the table. There is no reason to embrace a plethora of ill-conceived federal regulation and legislation that usurps the traditional role of state law and thereby overturn the fundamental legal doctrines that have formed the bedrock of history’s most successful economic system. The engine of true economic growth will always be the informed business judgment of directors and managers, and not the hunger of short-term oriented shareholders for quick profits.

Particularly at a time of depressed stock market valuations and the resulting danger of opportunistic attacks to bust up or takeover American companies, directors and managers must remain free to invest in the future and take the long-term view, so as to ensure prosperity for future generations. To the same extent that we need to avoid legislative and regulatory actions that would undermine the ability of companies to achieve long-term growth, the courts should continue to recognize the prerogative of directors to plan for and achieve long-term value for the company and its stockholders, protected against short-termist pressure from any source and especially from the unintended consequence of proposed “reforms” (such as shareholder proxy access) that are not appropriately defined and contained. In particular, the right of a well-informed board of directors to “Just Say No” to a takeover bid remains a critical deterrent to short-termism. Under the Business Judgment Rule, directors must remain unfettered in their ability to engage in long-term planning and investment.

Financial Integration, Investment, and Economic Growth

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, July 20, 2009

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This post comes to us from Moritz Schularick of the Free University of Berlin and Thomas M. Steger of ETH Zurich and CESifo.

In our forthcoming The Review of Economics and Statistics paper: Financial Integration, Investment, and Economic Growth. Evidence from Two Eras of Financial Globalization, we turn to the economic history of the first era of financial globalization (1880-1914) for new insights into whether international financial integration boosts economic growth. We rely on models and techniques employed before in order to ensure the comparability of our results with those of previous studies, since our primary aim is to benchmark the present to the past. Economic historians have often underscored the contribution that international capital flows made to economic growth in developing countries during the “first era of globalization” – the years of the classical gold standard from 1870-1914. Yet it has not been tested econometrically for a broad cross-section of countries whether the first era of financial globalization does provide evidence that financial globalization can indeed spur growth.

We assembled the largest possible dataset for the years 1880-1914 covering 24 countries from all world regions that accounted for more than 80 percent of world output at the time. We use capital flows from the United Kingdom – the world’s leading financial centre at the time – as a proxy for the degree of financial openness of individual countries. Such detailed capital flow data are available from a recently published analysis of the geographical patterns of stock and bond issues at the London Stock Exchange (Stone, 1999). We also employ older data for foreign investment stocks (Woodruff, 1966) and net capital movements as implied by current account balances (Jones and Obstfeld, 1997) to corroborate our findings.

The new dataset allows us to show that international financial integration had a statistically significant effect on growth in the first era of global finance. We ensure the robustness of our model specification by first estimating our regressions on a dataset for 1980-2002. Using these models on our data, we find the first era of financial globalization saw a positive relationship between international financial integration and economic growth. Importantly, our study also suggests that a comparable effect cannot be found today. If financial integration contributes to economic growth today, the effect would need to be conditional on certain types of capital flows or on third factors such as the institutional framework.

We can show that before 1914 opening up to the international capital market went hand in hand with higher domestic investment. Today, changes in identical measures for financial integration are essentially uncorrelated with changes in domestic investment. Our explanation for this phenomenon focuses on the different patterns of financial globalization. The first era was marked by massive net capital flows from rich to poor economies (“development finance”). In contrast, today’s globalization is marked by high gross flows (“diversification finance”) and limited net capital transfers. In other words, in the historical period financial globalization led to long term net flows of capital from rich to poor economies. It is these net flows of capital that we suggest lead to growth.

The full paper is available for download here.

Responding to the SEC Proxy Access Rule Proposal

Posted by Charles M. Nathan, Latham & Watkins LLP, on
Sunday, July 19, 2009
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This post comes to us from Charles Nathan of Latham & Watkins LLP and Rhonda Brauer of Georgeson Inc.

Now that the SEC has issued its proposed proxy access rules and asked for comments by August 17, a critical issue for public companies is what do to in response to this SEC initiative and when. In this Proxy Access Analysis, we provide suggestions for how general counsel and corporate secretaries may begin to educate their management and boards on the issues presented by the proposed rules, evaluate the alternatives for commenting on the proposed rules and plan a course of action for their companies if proxy access is adopted for the 2010 proxy season.

There is a limited amount of time for dealing with proxy access, given the August 17 deadline for SEC comments and the SEC’s apparent intent to promulgate final proxy access rules by the end of November so that they can be effective for the 2010 proxy season. As a result, general counsel and corporate secretaries should be reviewing their board and governance committee meeting schedules now to be sure that there is ample time to educate their management and boards and to take any actions deemed appropriate by their boards, with sufficient flexibility to accommodate the SEC’s proxy access rule-making calendar as it develops.

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