Yearly Archives: 2009

Public Pension Fund Reform Code of Conduct

Posted by Edward F. Greene, Cleary Gottlieb Steen & Hamilton LLP, on
Wednesday, June 17, 2009
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This memo is based on a client memorandum by Edward Greene’s colleague Robert Raymond of Cleary Gottlieb Steen & Hamilton LLP.


Recently, New York Attorney General Andrew M. Cuomo announced an agreement with private equity firm The Carlyle Group (“Carlyle”) in connection with the Attorney General’s investigation, started in 2007, into relationships between New York State’s Common Retirement Fund (“NYCRF”) and investment firms doing business with it.[1] Carlyle agreed to pay $20 million to resolve its part in the investigation, and to abide by the Attorney General’s “Public Pension Plan Reform Code of Conduct” (the “Reform Code”). The Reform Code imposes strict requirements and prohibitions on dealings with retirement plans for federal or state governmental employees (“Public Pension Funds”),[2] including an outright ban on the use of placement agents, finders, lobbyists and other intermediaries (collectively referred to as “placement agents”) in arranging investments by Public Pension Funds.

The principles reflected in the Reform Code are likely to extend beyond the agreement with Carlyle, whether other industry participants voluntarily agree to abide by them or they are incorporated into new federal and/or state legislation or regulations. The Attorney General’s office has indicated that it expects the Reform Code to establish a generally applicable framework for relationships between Public Pension Funds and investment firms going forward; at a minimum, it appears likely that firms seeking to do business with New York Public Pension Funds will be asked to be bound by the Reform Code. Attorney General Cuomo has described the Reform Code as representing the “new rules of the game” [3] and praised Carlyle for “leading the industry toward critical change of the public pension investment system.” [4] However, as noted below, the Reform Code includes a number of provisions that are ambiguous or may be difficult to implement in practice. It remains to be seen whether other jurisdictions will adopt new rules similar to the Reform Code and, if so, whether and how they may refine the details and mechanics of these rules.

In our memorandum entitled “The New York Attorney General’s Public Pension Fund Reform Code of Conduct: “New Rules of the Game“” we outline the key provisions of the Reform Code and suggest action steps for investment firms that do business (or seek to do business) with Public Pension Funds and may become subject to its requirements or similar requirements. The full text of the Reform Code and the Assurance of Discontinuance issued by the New York Attorney General in respect of Carlyle (“Assurance of Discontinuance”), are available here and here, respectively.

The memorandum is available here.

Footnotes:

[1] The investigation is being conducted under New York’s “blue sky” law, the Martin Act, which permits very broad pre-lawsuit discovery by the Attorney General.
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[2] The term “Public Pension Fund,” as used in the Code of Conduct, means “any retirement plan established or maintained for its employees (current or former) by the Government of the United States, the government of any State or political subdivision thereof, or by any agency or instrumentality of the foregoing.” Thus, the restrictions that Carlyle agreed to by adopting the Code of Conduct are not, by their terms, limited to New York plans but purport to apply to any federal or state governmental pension plan. In a related development, New York State Comptroller Thomas P. DiNapoli announced on April 22, 2009 that he has banned the involvement of placement agents, paid intermediaries and registered lobbyists in investments with NYCRF.
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[3] “Cuomo Announces Carlyle Settlement; Firm Will Adopt Code of Conduct for Funds,” Pension & Benefits Daily (May 18, 2009).
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[4] “Cuomo Announces Landmark Agreement With the Carlyle Group to Eliminate Pay-to-Play in Public Pension Funds Nationwide” (announcement on New York Office of the Attorney General website, May 14, 2009), available here.
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Equity Compensation for Long-Term Results

Posted by Lucian Bebchuk and Jesse Fried, Harvard Law School, on
Tuesday, June 16, 2009
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This post is based on an op-ed piece by Lucian Bebchuk and Jesse Fried published today on Wall Street Journal online. The piece is based on Lucian Bebchuk’s testimony at the House Financial Services committee last Thursday, which is available here, and their forthcoming white paper, “Equity Compensation for Long-Term Performance.”

Treasury Secretary Timothy Geithner announced on Wednesday the Obama administration’s strong belief in tying executive compensation to long-term company performance. The regulations issued that day direct the new “compensation czar” to ensure that financial firms receiving “exceptional assistance” from the government don’t “reward employees for short-term or temporary increase in value.” Companies not covered by regulations are also currently seeking to tighten the link between pay and long-term performance. The question is how this could best be done.

With respect to equity compensation – a central component of modern executive pay arrangements – companies should prevent executives from cashing out vested grants of options and shares for a fixed number of years. But companies should avoid arrangements that block executives from cashing out options and shares until the executive’s retirement, or any other event that is at least partly under that person’s control.

Grants of equity incentives – options and restricted shares – usually vest gradually over a period of time. A specific number of options or shares vest each year, and the vesting schedule provides executives with incentives to remain with the company. Once options and shares vest, however, executives typically have unrestricted freedom to cash them out, and executives often liquidate them quickly after vesting.

The ability to cash out large amounts of equity-based compensation has provided executives with powerful incentives to seek short-term stock gains even when doing so involves excessive risk-taking. This short-termism problem, which was first highlighted in a book we published five years ago, “Pay without Performance,” has become widely recognized in the aftermath of the crisis – including by business leaders such as Goldman’s Lloyd Blankfein in a Financial Times op-ed.

The short-term distortions can be addressed by separating the time that options and restricted shares can be cashed out from the time that they vest. As soon as an executive has completed an additional year at her firm, the restricted options or shares that were promised as compensation for that year’s work should vest, and they should belong to the executive even if the executive immediately leaves the firm. But the executive should be allowed to cash them out only down the road. This would tie the executive’s payoffs to long-term shareholder value.

Some experts have called, including at Thursday’s hearing at the Financial Services Committee of the House of Representatives, for permitting executives to cash out shares and options only upon retirement from the firm. Shareholder proposals have also been urging companies to adopt such “hold-till-retirement” requirements. Such requirements, however, would be the wrong way to go.

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Empire-Building or Bridge-Building

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, June 16, 2009
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This post comes to us from Yuhai Xuan at Harvard Business School.

In my paper Empire-Building or Bridge-Building? Evidence from New CEOs’ Internal Capital Allocation Decisions, which was recently accepted for publication in the Review of Financial Studies, I examine CEOs’ decision-making processes for capital allocation in the context of power and relationships within corporations by investigating whether the job histories of CEOs influence their capital allocation decisions when they preside over multi-divisional firms. I investigate the capital allocation decisions made by 265 new CEOs at 230 diversified firms after turnovers between 1993 and 2002. CEO turnovers provide a good opportunity for this study because CEOs are likely to be most vulnerable to political complications at work when they are new to the post. In particular, I focus on the 98 new CEOs in my sample who advanced through the ranks from certain, but not all, divisions in their firms. I call these CEOs specialists and separate the segments in their firms into two groups based on their affiliation with the CEOs: divisions that the CEOs advanced through the ranks from (labeled the in-group), and the rest of the divisions (labeled the out-group). The empirical analysis in the paper focuses on changes in segment capital expenditures around CEO turnovers to determine whether specialist CEOs treat the in-group and the out-group segments differently when allocating capital after succession, and if so, whether they favor the in-group (“empire-building”) or the out-group (“bridge-building”) in their allocation decisions.

My results are broadly consistent with the bridge-building hypothesis. I find that, on average, the out-group segments experience a significant increase in capital expenditures after CEO turnover relative to the in-group segments. The average change in segment investment ratio (capital expenditures over assets) after a specialist CEO takes office is 0.013 higher for the out-group than the in-group, statistically significant at the 5% level or better. This difference of 0.013 is economically meaningful as it represents more than 20% of the average pre-turnover investment ratio of 0.06. Moreover, these findings also hold for specialist CEOs hired from outside the firm and are robust to the inclusion of segment-level, firm-level, and turnover-related controls as well as changes in the test specifications including the definition of specialists, the measure for capital expenditures, the time frame around turnover, and the sample period. I further test for the bridge-building hypothesis by examining whether the in-group and out-group difference in capital allocation change around turnover is related to the specialist CEO’s relative bargaining power within the firm. I find that the difference is more pronounced if the specialist CEO does not hold a corporate-level executive title such as chief operating officer or president before succession or if the in-group segments and the out-group segments are not in related industries. The results from the finer tests are consistent with the prediction of the bridge-building hypothesis that a specialist CEO with less power should engage in more bridge-building efforts, which imply a more pronounced pattern of reverse-favoritism in capital allocation.

While my results are consistent with the bridge-building hypothesis, a key concern is the issue of endogeneity. CEOs are chosen by the board of directors, and the job histories of CEOs are observable by the board and may be an important selection criterion in the board’s choice for nomination. Even though the most obvious and natural endogeneity story is one that would lead to a bias that works in precisely the opposite direction to the empirical findings in this paper, I consider alternative versions of the endogeneity story in which the CEO might be chosen to grow the segments in the out-group or to reduce investments in the in-group, leading to the relative increase in the capital expenditures of the out-group segments observed in the data. I use two approaches to address this concern. First, I try to discriminate against this type of endogeneity story by identifying weak divisions in the firm based on segment cash flow and segment Q. I find that the in-group and the out-group segments experience differential capital allocation change regardless of segment operating performance and segment investment opportunity. The difference in capital expenditure change is significant and of the same magnitude even when one compares the strong segments in the in-group with the weak segments in the out-group, inconsistent with what the endogeneity story might suggest. Second, I estimate a segment’s propensity to be a member of the out-group based on pre-turnover segment characteristics, and use the propensity scores as a summary measure to match the out-group segments and the in-group segments. Again, I find a relative increase in the average change in capital expenditures for the out-group compared with those of the in-group after a specialist CEO takes office. The magnitude and significance level of the estimate are similar to those of the main results, further alleviating the concern that endogeneity might account for the findings.

Finally, I investigate whether having a specialist CEO affects segment investment efficiency by studying the changes in the sensitivity of segment investment to Q before and after the CEO turnover. My results show that the sensitivity of segment investment to Q increases significantly after CEO turnover in a generalist’s firm, indicating an improvement in investment efficiency. Segments under a specialist CEO, however, do not experience such improvements: the investment sensitivity to Q for these segments is virtually unchanged after the turnover. In addition, I examine the market’s reaction to the announcement of the appointment of specialist versus generalist CEOs and find that the cumulative abnormal returns around announcements are significantly higher for incoming CEOs who are generalists. The market’s response corroborates the finding that generalist CEOs are associated with improved segment investment efficiency after turnover and suggests that appointments of generalist CEOs are perceived by the market as positive news for the conglomerates.

Overall, my results suggest that the job histories of CEOs are an important determinant of their capital allocation decisions and that new specialist CEOs are affected by political concerns in the capital allocation process. New specialist CEOs use the capital budget as a bridge-building tool to elicit cooperation from powerful divisional managers in previously unaffiliated divisions.

The full paper is available for download here.

Assessing the Chrysler Bankruptcy

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, June 15, 2009
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Editor’s Note: This post by Professor Mark Roe appears today on Forbes.com.

Last week, the Supreme Court turned down the last appeal from the creditors objecting to the Chrysler reorganization and the deal closed on the next day. Chrysler has been sold in bankruptcy.

This is a good time to assess Chrysler’s bankruptcy. At one level, it’s reason to be optimistic that bankruptcy reorganizations could move more quickly than the year or two they usually take. As a matter of technical bankruptcy prowess–in moving through chapter 11 so quickly–it’s an admirable accomplishment. As a matter of governance structure, it has the United Auto Worker union retirees as major shareholders of the new Chrysler, mixing up the UAW’s incentives as employees looking for higher wages and as owners looking for more productivity, in a way that hasn’t obtained media attention yet but which may prove to be clever.

At another level, though, the speed of reorganization is a cause for concern: How could the Chrysler deal be done so much more quickly than a typical chapter 11 reorganization? Were corners cut?

Crucially, the government is flooding Chrysler with money on non-commercial terms, inducing enough players to agree to the deal, rather that fight over the scraps. Chrysler, which was in such horrid shape last fall that the government was ready to let it liquidate, gets another chance. The speed of the bankruptcy may not be replicable in a normal chapter 11, without the government flooding troubled companies with money.

While structured in the form of a sale from the “old Chrysler” to a “new Chrysler” that Fiat and the UAW own, with the government having a sliver of an interest in the reorganized firm, the de facto deal was really that the government bought Chrysler from the creditors, giving it to the UAW, flooding Chrysler with cash, and hiring Fiat to manage it. The idea that Fiat is buying Chrysler is greatly exaggerated. All of the money came from the U.S. Treasury; and since government money doesn’t fuel ordinary chapter 11 reorganizations, there’s one reason to think Chrysler was a stand-alone bankruptcy event.

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Annual Survey of Developments in Delaware Corporation Law

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, June 14, 2009
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This post is from Eric S. Wilensky and Angela L. Priest of Morris, Nichols, Arsht & Tunnell LLP. 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.

In the current recessionary environment, rather than looking outward for the next big deal, many corporations are turning their focus inward, reviewing and shoring up their own governance structures, defensive mechanisms, indemnification schemes and governing documents. Knowledge of recent Delaware jurisprudence is helpful in such a review, as in numerous instances over the past year, the Delaware courts have released opinions addressing and interpreting corporate charter and bylaw provisions and indemnification agreements. This article surveys the relevant Delaware developments, which are summarized briefly below.

Bylaw Provision Cases

Bylaw provisions were a hot-button issue in 2008, with Delaware court opinions touching on advance notice, proxy expense reimbursement and indemnification and advancement provisions. Two of the most talked-about corporate opinions of 2008, JANA Master Fund, Ltd. v. CNET Networks, Inc. and Levitt Corporation v. Office Depot, Inc., focused on the legal interpretation of advance notice bylaw provisions, making clear in each case that the Delaware courts will likely construe such provisions strictly, and where ambiguous, in favor of the stockholder franchise.

The Delaware Supreme Court, on certification from the SEC, also weighed in on the legality of proxy expense reimbursement bylaw provisions in CA, Inc. v. AFSCME Employees Pension Plan, and the Delaware legislature thereafter approved amendments to the DGCL that will specifically allow corporations to include proxy reimbursement and proxy access provisions in their bylaws.

Finally, numerous opinions by the Delaware courts involved the interpretation of indemnification and advancement bylaw provisions. Specifically, the Court of Chancery discussed when indemnification and advancement rights vest (spurring the approval of legislation that clarifies this issue) and provided guidance on “fees on fees” awards in Schoon v. Troy Corp. The Delaware Court of Chancery also interpreted the terms “defense” (Reinhard v. The Dow Chemical Company, Zaman v. Amedeo Holdings, Inc., Duthie v. CorSolutions Medical, Inc. and Sun-Times Media Group, Inc. v. Black), “agent” (Jackson Walker LLP v. Spira Footwear, Inc. and Zaman), “proceeding” (Donohue v. Corning) and “final disposition” (Sun-Times), which terms consistently appear in indemnification and advancement bylaws.

Charter Provision Cases

In 2008 and early 2009, the Delaware courts also addressed Section 102(b)(7) charter provisions (limiting monetary liability for directors for breaches of the duty of care) in a series of fiduciary duty cases, beginning with Ryan v. Lyondell Chemical Co., in which the Court of Chancery denied a motion to dismiss a claim that non-conflicted directors breached their duty to act in good faith with respect to a transaction that would provide stockholders with a large premium for their shares. Subsequent cases, including McPadden v. Sidhu, In re Lear Corporation Shareholder Litigation and the Delaware Supreme Court’s reversal of Lyondell, however, made clear that such provisions remain a powerful shield for directors against monetary liability for breaches of the duty of care.

Indemnification Agreements

The Court of Chancery’s decision in Schoon highlighted the role of private indemnification agreements, and in Levy v. HLI Operating Co., the Court of Chancery focused both on the extent to which Section 145(f) of the DGCL may be relied upon in expanding the scope of indemnification and advancement beyond what is expressly set forth in the DGCL and on indemnification in the context of private equity fund designees serving on the board of a portfolio company.

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Our article summarizes these developments within the context of the relevant corporate governing documents in order to aid in the review of such documents. We do not intend to conduct an exhaustive analysis on any particular topic or case, but rather to raise awareness of certain interpretive guidelines found within these opinions. Delaware law continues to provide much leeway for private ordering, and awareness of interpretive case law is important in ensuring that a corporation’s governing documents are drafted carefully, have the intended effects and reflect the needs and desires of the corporation.

The article is available here.

(The article is reproduced with permission from Securities Regulation & Law Report, 41 SRLR 921 (May 18, 2009). Copyright 2009 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com.)

Flaws in the AIG Trust

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Saturday, June 13, 2009
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Editor’s Note: This post is by J.W. Verret of the George Mason University School of Law.

I had the opportunity to testify before the House Oversight Committee recently on a panel along with Ed Liddy, the CEO of AIG, and the three trustees nominated by the Federal Reserve to manage the government’s $180 billion investment in AIG. The subject of my testimony, available here, was the Trust Agreement designed by the Federal Reserve Bank of New York to form the AIG trust. This Trust Agreement was crafted during Secretary Geithner’s tenure at the NY Fed, and Secretary Geithner has announced that he will be creating a Trust in the near future to manage the government’s voting common equity in Citigroup and other TARP banks. One concern motivating my testimony is that the flaws in the AIG Trust will find new life in these subsequent TARP Trusts. This is of particular concern because the government and the trusts it creates enjoy unprecedented immunity, despite being a controlling shareholder, under Section 3(c) of the Exchange Act, the Emergency Economic Stability Act, and through sovereign immunity principles generally.

The first cause for concern in the AIG trust is that the fiduciary duty of the trustees is not clearly defined, and is likely to be defined by the Treasury Department. The document states that the trustees’ standard of care is to act “in or not opposed to the best interests of the Treasury.” Though “Treasury Department” is a defined term in the document, “Treasury” is not. The AIG trustees argued that their personal understanding was they were required to maximize the value of the taxpayer’s investment, but that is not required by the AIG Trust. This threatens the very purpose of the AIG Trust, which is to serve as a buffer from the short term political interests of the government that may threaten AIG’s long term financial health. For more on that threat, see my op-ed in Forbes here.

Another controversial issue with the AIG Trust is that it includes a corporate opportunity opt-out provision. This permits the Trustees to personally take business or investment opportunities that fall within AIG’s line of business, and that they learn about through their service as Trustees, without notifying or getting permission from AIG or the Federal Reserve. Corporate Opportunity opt-outs are not unheard of in the corporate world, though they are controversial, and their use in this context requires serious consideration. Part of the testimony also featured a spirited debate between myself and one of the Trustees, also the CEO of El Paso Energy, over whether the indemnification provisions included in the Trust are consistent with the level of indemnification permitted for directors of Delaware corporations. I noted that Delaware does not permit indemnification for actions not in good faith, a limitation which is not included in the AIG Trust. The broadcast is available on C-Span here.

Designing the Trusts that manage the government’s investment in TARP Banks, Financial Companies, and the Automotive Industry requires precision and caution. Poor draftsmanship in these deal documents could have serious consequences for the government’s investment in TARP, as well as for the holdings of private shareholders in TARP companies.

Electing Directors

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, June 12, 2009
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This post comes from Jie Cai, Jacqueline L. Garner, and Ralph A. Walkling, all of Drexel University.

Shareholder representation by the board of directors is a fundamental component of corporate governance. A great deal of research has focused on the characteristics of corporate boards, yet we know little about uncontested director elections. The subject is particularly important in today’s environment. Congress, stock exchanges, and individual firms have instituted dramatic governance changes. Moreover, shareholders, activist organizations, the New York Stock Exchange (NYSE), and the Securities and Exchange Commission (SEC) have proposed and debated additional changes to the method by which directors are elected. Apart from directors, shareholders do not have representation in the companies they own. If shareholder impact on director elections is weak, so is the link between owners and managers.In our forthcoming Journal of Finance paper, Electing Directors, we examine the determinants as well as the efficacy of uncontested director elections on a large sample of firms in the post-Sarbanes Oxley Act (SOX) era. We test several hypotheses relating performance at both the firm and director levels to the votes directors receive. We also examine whether votes matter to subsequent performance, compensation, or governance.

Our sample consists of 13,384 director elections at 2,488 different shareholder meetings during 2003 to 2005. We find that while director and firm performance as well as corporate governance characteristics affect how shareholders vote, the resulting differences in the level of votes are trivial. In general, the differences in votes are statistically significant but economically minor. At both the firm and director levels, votes exceeding 90% are the norm even for poorly performing firms and directors. There are two exceptions: directors attending less than 75% of board meetings or receiving a negative ISS recommendation receive 14% and 19% fewer votes, respectively. However, even though the variation in director votes is small, we find that fewer votes for compensation committee directors significantly impact subsequent abnormal CEO compensation, and fewer votes for independent directors impact subsequent CEO turnover. Also, the removal of poison pills and classified boards is significantly linked to director votes. Nevertheless, lower levels of votes appear to have little impact on the election of directors themselves or on subsequent firm performance. Directors also do not appear to suffer reputational effects from low votes.

The full paper is available for download here.

Compensation Structure and Systemic Risk

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, June 11, 2009
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Editor’s Note: This post is the written testimony (with footnotes and appendix omitted) submitted by Professor Lucian Bebchuk to the Committee on Financial Services, United States House of Representatives. Professor Bebchuk will be testifying today in the hearing on “Compensation Structure and Systemic Risk.” The hearing will begin today at 10a.m., and information about it and a link to a webcast of it can be found here. Professor Bebchuk’s complete written testimony (including footnotes and appendix) can be found here.

Mr. Chairman and distinguished members of the Committee, thank you very much for inviting me to testify today.

Below I discuss how executive pay arrangements have produced incentives for excessive risk–taking and contributed to bringing about the current financial crisis, how compensation arrangements can be reformed to avoid such incentives, and what role the government should play in bringing about such reforms.

Section I describes the distortions that have been produced by the short-term focus of pay arrangements, and discusses the best ways for tying executive pay – particularly equity compensation – to long-term results. Section II describes another separate and important source of incentives that has thus far received little attention but that could well have contributed substantially to excessive risk-taking in financial firms: the tying of executive payoffs to levered bets on the value of the bank’s capital. That section also discusses how this problem can be best addressed.

Finally, section III discusses the role of the government. For financial firms that pose systemic risks, bank regulators seeking to protect the safety and soundness of such firms should monitor and regulate the extent to which pay arrangements provide incentives for risk-taking. For other publicly traded firms, the government’s role should be limited to strengthening the rights of shareholders and the governance processes inside firms, and the government should avoid intervening in the substantive choices made by the firms.

A fuller development of some of the points made in Section I can be found in “Equity Compensation for Long-term Performance,” a forthcoming white paper co-authored with Jesse Fried. Sections II and III draw on “Regulating Bankers’ Pay,” a discussion paper co-authored with Holger Spamann, which develops more fully the points made in these sections and is attached as an Appendix.

For simplicity of exposition, I will use the term “banks” to refer also to any other financial institutions that are deemed to pose systemic risk and are therefore the subject of potential government support and government regulation.

I. PAYING FOR LONG-TERM PERFORMANCE

Much attention is now focused on the fact that pay arrangements have provided executives with incentives to focus on short-term results. This problem was first highlighted in a book that Jesse Fried and I published five years ago, Pay without Performance: The Unfulfilled Promise of Executive Compensation, and in a series of accompanying articles. It has recently become widely recognized.

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Putting Investors First in Regulatory Reform

Posted by Luis A. Aguilar, Commissioner, U.S. Securities and Exchange Commission, on
Wednesday, June 10, 2009
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Editor’s Note: The post below by Commissioner Aguilar is a transcript of remarks by him at the Compliance Week Annual Conference on June 3, 2009 in Washington, D.C.

I am honored to be speaking to a room full of people who spend their days building a culture of compliance. As a former general counsel of a large global asset manager, I have a deep appreciation for the challenges that Compliance Officers face. These challenges are particularly great today. In these times of drastic cost cutting and shrinking revenues, compliance personnel face incredible pressure to do more with less resources and fewer personnel.

Against this backdrop, there is a debate on regulatory reform that deeply affects all of us. Changes to the financial regulatory system will have a significant impact on who regulates the entities you represent and the relationship between the regulator and your employer.

As I consider what is being said about these issues, it has struck me that the regulatory discussion is not being properly oriented. There is a need to shift the dialogue from the discussion of how best to preserve financial institutions to what is best for investors. I firmly believe that the SEC needs to be a strong voice in that discussion, and to vigorously advocate for its mission to protect investors, facilitate capital formation, and maintain fair and orderly markets. The SEC has the right orientation and has the right values to be one of the leaders in the discussion of regulatory reform. The SEC’s job is to fight for Main Street even if that means Wall Street will have to reform. That is why it is so important that the SEC be reinvigorated by Congress and that it strongly reasserts itself into our national policy discussions. Investors need the SEC now more than ever.

Investors around the country are feeling the pain of this economic crisis — in their retirement nest eggs, their college savings plans and in their brokerage accounts. Any credible effort at regulatory reform has to work for investors, so that they can feel confident in our markets. My objective is to ensure that prioritizing investors is the primary goal of any regulatory reform.

To that end, I want to concentrate my remarks today on how to structure a regulatory reform proposal that enhances, rather than undercuts, investor protection. And I want to make clear that the thoughts I express are my own, and they do not necessarily reflect the views of the other Commissioners or the staff of the Commission.

In pursuing regulatory reform, I believe the following must happen:

• First, there must be a searching inquiry into the causes of the crisis;

• Second, there must be a reversal of the philosophy that resulted in the affirmative decisions that forced gaps in, and otherwise undercut, regulatory protections in order to favor the industry;

• Third, there needs to be an assessment of whether the current regulatory reform proposals will protect investors and promote market integrity;

• And I will end with an outline of some reforms I support because they would enhance investor protection.

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Proposed Changes to Regulation of OTC Derivatives and CDSs

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Wednesday, June 10, 2009
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This post is by Annette L. Nazareth of Davis Polk & Wardwell LLP.

Recently, the House Energy and Commerce Committee Chairman Henry A. Waxman and Subcommittee Chairman Edward J. Markey introduced H.R. 2454, the American Clean Energy and Security Act of 2009 (the “Waxman-Markey Bill” or the “Bill”). The Energy and Commerce Committee approved the Bill on May 21, 2009. Eight other House panels, including Financial Services, have jurisdiction to review the Bill. The Waxman-Markey Bill comprehensively addresses a broad range of issues relating to energy and climate change policy.

Subtitles D and E of Title III of the Waxman-Markey Bill contain significant provisions relating to the regulation of over-the-counter (“OTC”) derivatives generally and energy derivatives in particular (the “Derivatives Provisions”). First, the Bill would shut the Enron Loophole, the London Loophole and the Swaps Loophole. Second, the Bill would subject all OTC derivatives to centralized clearing. Third, the Bill would make “naked” credit default swaps illegal and rescind the preemption of state gaming laws with respect thereto. Finally, the Bill would give the Commodity Futures Trading Commission initial jurisdiction over markets for “regulated allowance derivatives” to regulate in the same manner as energy transactions.

In a memorandum entitled “Derivatives Provisions in the American Clean Energy and Security Act of 2009,” Daniel N. Budofsky, Robert L. D. Colby, Faisal Baloch and I provide a brief background on energy derivatives regulation to place the Waxman-Markey Bill in context. We then summarize and discuss the key Derivatives Provisions of the Bill.

The memorandum is available here.

In another memorandum, entitled “The National Conference of Insurance Legislators’ Model CDS Bill,” Bjorn Bjerke, Daniel N. Budofsky, Robert L. D. Colby, Ethan T. James and I describe model legislation being drafted by the NCOIL that would subject credit default swaps to a state regulatory regime closely modeled on that regulating financial guaranty insurance in New York. The memo discusses NCOIL’s plans for a state CDS regulatory regime and explores the implications of such a regime on the CDS market. That memo is available here.

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