Yearly Archives: 2009

SEC Brings First Regulation G Enforcement Action

Posted by David A. Katz, Wachtell, Lipton, Rosen & Katz, on
Saturday, December 5, 2009
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David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz specializing in the areas of mergers and acquisitions and complex securities transactions. This post is based on a client memorandum by Mr. Katz and David K. Lam.

The Securities and Exchange Commission recently filed its first civil enforcement action under Regulation G, alleging that a public company intentionally misclassified certain ordinary operating expenses as nonrecurring expenses in order to increase its earnings. SEC v. SafeNet, Inc., Litig. Rel. No. 21290 (Nov. 12, 2009). Regulation G provides that, if a public company discloses material information that includes a financial measure not calculated in conformity with generally accepted accounting principles (GAAP), the company must reconcile the non-GAAP financial measure to the most directly comparable GAAP financial measure. Regulation G also prohibits public companies from disseminating false or misleading non-GAAP financial measures or presenting non-GAAP financial measures in a manner that would mislead investors or obscure the company’s GAAP results.

The SEC alleged that the company failed to comply with Regulation G by making improper adjustments to the company’s expenses. The improper adjustments allegedly included reclassifying ordinary expenses as nonrecurring integration expenses, reducing accruals for professional fees and reducing inventory reserve accruals. According to the SEC’s complaint, these adjustments were made without factual support in order to inflate the company’s earnings, and the company provided false and misleading explanations to its independent auditors when the auditors questioned the adjustments. The SEC complaint also alleged that former corporate officers and internal accountants engaged in a fraudulent scheme to backdate stock option grants without recording the requisite compensation expense for the option grants and used improper accounting adjustments to achieve earnings targets.

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What Boards Should Be Doing Right Now

Posted by Jeffrey Stein, King & Spalding LLP, on
Friday, December 4, 2009
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Jeffrey Stein is a partner in the Corporate Practice Group at King & Spalding LLP. This post is based on a King & Spalding Board Leadership Advisory by Mr. Stein along with E. William Bates II, C. William Baxley, Andrew C. Hruska, and Meghan Magruder.

Public company boards have faced unprecedented challenges in recent years, and it appears that they will be subjected to new burdens over the coming months. Just as the failure of Penn Central in 1970 and the collapses of Enron and WorldCom earlier this decade led to fundamental changes in the U.S. corporate governance model, the corporate failures of 2008 are resulting in significant changes in the way that boards, management and shareholders govern U.S. public companies. Moreover, Congress, regulatory agencies and the stock exchanges are currently reviewing the U.S. corporate governance model and considering numerous proposals that would impose new and significant requirements on public company boards. Accordingly, as much as corporate boards have been challenged in recent times, they must be prepared for even more changes going forward.

Corporate boards are reacting to these challenges in a variety of ways. Boards are working harder, they are evaluating and prioritizing the issues that require their attention, and new best practices are beginning to emerge. Many directors and other corporate stakeholders are hopeful that if boards are successful in improving their own practices, they may be able to avoid another substantial re-regulation of public companies, in the style of the Sarbanes-Oxley Act of 2002.

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SEC Proposes Additional Transparency for “Dark Pools”

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Thursday, December 3, 2009
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This post is based on a Davis Polk & Wardwell LLP client memorandum by Annette L. Nazareth, member of the Financial Institutions Group at Davis Polk & Wardwell, along with Lanny A. Schwartz, Gerard Citera, and Robert L.D. Colby.

Taking another step in its review of equity market structure issues, on November 13, 2009, the Securities and Exchange Commission (the “SEC”) released a proposal to increase the transparency of “dark pools” of liquidity (Exchange Act Release No. 60997 (November 13, 2009)).

The term “dark pools” refers to non-exchange alternative trading systems (“ATSs”) that do not display bids or offers in the public quote stream. The SEC’s proposal to increase the transparency of dark pools is a part of its broader market structure review, including its previously announced proposal to eliminate flash orders and an anticipated concept release regarding, among other things, all forms of dark liquidity, the order flow arrangements of over-the-counter (“OTC”) market makers and undisplayed orders on exchanges.

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The Value of Control in Emerging Markets

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, December 2, 2009
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This post comes to us from Anusha Chari and Paige Ouimet, Assistant Professors of Finance at the University of North Carolina at Chapel Hill, and Linda Tesar, Professor of Economics at the University of Michigan.

Foreign acquisitions extend the boundaries of the firm across national borders. In the context of emerging markets, these boundaries are extended across countries with vast asymmetries in institutions and property rights protection. If developed-market firms can extend the benefits associated with superior institutions to their operations in emerging markets by acquiring control, the stock price of the acquiring firms should reflect these value gains. In our forthcoming Review of Financial Studies paper, The Value of Control in Emerging Markets, we examine the returns to shareholders of developed-market firms that undertook acquisitions in emerging markets.

We find that when developed-market acquirers gain control of emerging-market targets, they experience positive and significant abnormal returns of 1.16%, on average, over a three-day event window. In the context of the well-documented underperformance of acquiring firms in U.S. mergers and acquisitions (M&A) transactions, this return is somewhat anomalous. It is also fairly substantial when viewed in relation to the size of acquiring firms in these transactions. The acquirer stock price reaction suggests a median (mean) dollar value gain of $4.07 ($30.15) million for the acquirer. In comparison, the median (mean) transaction value in an emerging-market acquisition where control is acquired is $42.41 ($308.57) million. In contrast, acquisitions of minority stakes do not deliver significant acquirer returns.

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Taming the Stock Option Game

Posted by Lucian Bebchuk and Jesse Fried, Harvard Law School, on
Tuesday, December 1, 2009
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This post is based on Lucian Bebchuk and Jesse Fried’s recent op-ed for the international association of newspapers Project Syndicate, which can be found here. This article builds on their study “Equity Compensation for Long-term Performance.” Although Bebchuk serves as a consultant to the Department of the Treasury Office of the Special Master for TARP Executive Compensation, the views expressed in this op-ed article do not necessarily reflect the views of the Office of the Special Master or any other individual affiliated with it.

Executive compensation is now a central concern of company boards and government regulators. There is an aspect to this debate, however, that deserves greater scrutiny: the freedom of executives to pick the moment when they can cash out on their equity-based incentives. Standard pay arrangements give executives broad discretion over when they sell shares and exercise options that have been awarded to them. Such discretion is both unnecessary and undesirable.

The freedom to time the moment they cash out enables executives to use the special knowledge they have about their companies to sell before a stock-price decline. Although insider-trading laws supposedly prevent executives from using “hard” material information, executives usually also have “soft” information at their fingertips which gives them an advantage over the market. Indeed, it is a well documented fact that executives make considerable “abnormal” profits – that is, above-market returns – when trading in their own firms’ stock.

A second problem with executives being free to time the sales of their stock options and shares is that such freedom provides them with an incentive to use their influence over company disclosures to rig the stock price from declining before they execute their trades. Empirical studies have identified a connection between the level of executive selling and earnings manipulation – both legal and illegal.

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CEO Equity Incentives and Accounting Irregularities

Posted by David F. Larcker, Stanford Graduate School of Business, on
Monday, November 30, 2009
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David F. Larcker is the Director of the Corporate Governance Research Program at the Stanford Graduate School of Business.

In our forthcoming Journal of Accounting Research paper, Chief Executive Officer Equity Incentives and Accounting Irregularities, we examine the relationship between chief executive officer (CEO) equity incentives and accounting irregularities (e.g., restatements, Securities and Exchange Commission Accounting and Auditing Enforcement Releases, and shareholder class action lawsuits). Although equity holdings may alleviate certain agency problems between executives and shareholders, concerns have arisen among researchers, regulators, and the business press that “high-powered” equity incentives might also motivate executives to manipulate accounting information for personal gain. This view assumes that stock price is a function of reported earnings and that executives manipulate accounting earnings to increase the value of their personal equity holdings. If this allegation is true and the economic cost of accounting manipulation is large, this idea has important implications for executive-compensation contract design and corporate monitoring by both internal and external parties.

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Reviewing the 2009 Proxy Season And Looking Ahead to 2010

Posted by David A. Katz, Wachtell, Lipton, Rosen & Katz, on
Sunday, November 29, 2009
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David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz. This post is based on an article by Mr. Katz and Laura A. McIntosh, consulting attorney for Wachtell, Lipton, Rosen & Katz. The article first appeared in the New York Law Journal.

Although 2009 was more notable for legislative and regulatory corporate governance initiatives than for shareholder activism, the recently concluded proxy season produced several potentially significant results. As might be expected, executive compensation issues attracted a large number of shareholder proposals and a significant degree of shareholder support. In the general category of corporate governance, a few topics appeared to be increasingly popular with shareholders: the right to call special meetings, the majority election of directors and independent board chairmanship. Overall, shareholders focused on many of the same issues as did Congress and the Securities and Exchange Commission (SEC) over the last year. In light of the fact that the majority of legislative and regulatory initiatives proposed in 2009 will be pending through the beginning of 2010, a number of important variables remain unknown for next year’s proxy season.

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Deal Protection — One Size Does Not Fit All

Posted by David Fox, Kirkland & Ellis LLP, on
Saturday, November 28, 2009
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This post is based on a Kirkland & Ellis LLP client memorandum by David Fox and Daniel E. Wolf. Mr. Fox and Mr. Wolf are both partners at Kirkland & Ellis LLP specializing in corporate and mergers and acquisitions law.

As noticeable as it is for its size, the recent Berkshire Hathaway/Burlington Northern transaction is also conspicuous as an apparent example of the parties taking a thoughtful approach to the issue of deal protection in crafting a package of terms that could be viewed as “off-market” individually, but more middle-of-the-road when taken as a whole.

In almost every public company merger, “deal protection” provisions are among the most heavily negotiated terms of the transaction agreement. Deal protection describes a suite of merger agreement terms designed to protect the buyer’s deal from being jumped by a competing bidder. Of course, many a seller would like to leave open the possibility of a superior bid emerging for reasons both practical (obtaining a better price) and legal (under Delaware law, a target board may not agree to a combination of deal protection mechanisms that are so onerous as to be preclusive of a higher bid emerging). Since the collapse of the credit markets in 2007 and with the emerging recovery, we have seen a noticeable trend toward ever tighter deal protection terms favoring buyers in many public merger agreements. While this trend is certainly not without exception, it does reflect a shift in perceived “market terms” on many of these negotiated issues. Much as we argued in our recent M&A Update entitled “Deal Certainty: The Fallacy of a New Market,” we suggest that market participants and their advisers avoid arguments based on recent precedent and instead engage in the “nuanced, fact-intensive inquiry” deemed necessary by VC Strine in his 2005 decision in the Toys “R” Us litigation with the goal of ensuring that the right balance is struck in light of the particular circumstances in question.

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Testimony Concerning the Discussion Draft of The Financial Stability Improvement Act

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, November 27, 2009
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Editor’s Note: Elisse Walter is a Commissioner of the Securities and Exchange Commission. This post is the written copy of her testimony before the Committee on Agriculture, United States House of Representatives, omitting introductory and concluding remarks. The complete written testimony is available here.

I am pleased to have the opportunity to testify concerning the Discussion Draft of the Financial Stability Improvement Act (Discussion Draft). [1] This legislation, currently being marked-up by the House Financial Services Committee, [2] would make significant changes to the regulation and resolution of large, interconnected financial firms whose disorderly failure might put the financial system at risk.

Lessons from the Recent Financial Crisis

There are many lessons we can learn from the recent financial crisis and events of last fall. In particular, these events demonstrated the need to watch for, warn about, and eliminate conditions that could cause a sudden shock to lead to a market seizure or cascade of failures that put the entire financial system at risk. While traditional financial oversight and regulation can help prevent systemic risks from developing, it is clear that this regulatory structure failed to identify and address systemic risks that were developing over recent years. The current structure was hampered by regulatory gaps that permitted regulatory arbitrage and failed to ensure adequate transparency. This contributed to excessive risk-taking by market participants, insufficient oversight by regulators, and uninformed decisions by investors.

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Internal Governance of Firms

Posted by Raghuram G. Rajan, University of Chicago Graduate School of Business, on
Wednesday, November 25, 2009

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Raghuram Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business.

In The Internal Governance of Firms, which was co-written with Viral Acharya and Stewart Myers, and which I recently presented at the Finance Seminar at Harvard Business School, we argue that there are important stakeholders in the firm, particularly its junior managers, who care about its future even if the CEO acts in his or her short-term self interest and shareholders are dispersed and powerless. These stakeholders, because of their power to withdraw their contributions to the firm, can force the CEO to act in a more public-spirited and far-sighted way. We call this process internal governance.

The basic intuition behind the model is as follows. Think of a partnership run by an old CEO who is about to retire. The CEO has a young manager working under him who will be the future CEO. Three ingredients go into producing the firm’s cash flow: the firm’s capital stock; the CEO’s ability to manage the firm, based on his skill and firm specific knowledge, and the young manager’s effort, which allows her to learn and prepare for promotion. We assume the CEO can commit to a pre-determined amount of investment. The CEO will leave the investment behind as the firm’s capital stock. The CEO can appropriate everything else: he can tunnel cash out of the firm, consume perks, or convert cash to leisure by shirking. Because the CEO has a short horizon, he could simply decide to take all of the cash flow, investing nothing for the future. But he needs the young manager’s effort in order to generate the cash flow. If the manager sees that the CEO will leave nothing behind, she has scant incentive to exert effort, and cash flow falls significantly. To forestall this, the CEO commits to investing some fraction of current cash flow, building or enhancing the firm’s capital stock in order to create a future for his young employee, thereby motivating her. This allows the firm to build substantial value, despite being led by a sequence of myopic and rapacious CEOs.

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