Yearly Archives: 2009

Will Bank Recapitalization Succeed?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, March 4, 2009
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This post comes from Anil K. Kashyap of The University of Chicago.

I recently presented a new working paper co-written with Takeo Hoshi at the Law, Economics and Organizations workshop at Harvard Law School entitled Will the U.S. Bank Recapitalization Succeed? Lessons from Japan. In the paper, we look back at Japan’s decade-long response to its financial crisis and evaluate what has and hasn’t worked, and draw on the Japanese experience to evaluate the Troubled Assets Relief Program (TARP), which focused on the idea of purchasing troubled assets to stabilize the financial system, and the Capital Purchase Program (CPP), which focuses on acquiring stakes in banks in the form of preferred shares and warrants.

While it is widely known that the banking problems in both countries began after a sharp increase in land prices, the events in Japan from late 1997 to early 1999 closely track developments in the U.S. in 2008. One important similarity is the bank credit crunch that prevailed in both instances. More importantly, the Japanese banks emerged from the acute phase of its crisis with seriously undercapitalized banks. We identify four main problems with the string of Japanese asset purchase plans and capital injection programs that were pursued to combat the banking problems. First, the asset purchase plans were too narrow. The scope of assets to be purchased and the set of financial institutions included were limited, thus precluding a comprehensive plan. Second, the loan purchases that did take place, especially in the 1990s, involved little restructuring of the borrowers. This resulted in many of the companies operating with few changes while typically receiving more loans that subsequently went bad. Third, the capital purchase plans ran into trouble in getting the banks to accept funding. Fourth and most importantly, the overall amount of government money committed was too small to recapitalize the banks. Hence, the banks only really returned to being adequately capitalized in 2006 and 2007, when macroeconomic conditions improved and after supervision policy had changed.

In broad terms, the TARP and CPP programs mimic many elements of the Japanese plans. We present data comparing the largest U.S. banks, particularly in terms of the risks that they face from continued deterioration in the economy. Based on publicly available data it is hard to make confident assessments about the solvency of the banks. The lesson from Japan is that the details of the potential recapitalization program will be critical in determining whether any injections will increase the banks’ capital levels and hence their lending capacity. While the U.S. plans are still in flux, it appears that U.S. is at risk for running into some of the same problems that hobbled the Japanese policies.

The full paper is available for download here.

Jump-Starting the Market for Troubled Assets

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, March 3, 2009
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Editor’s Note: This post is an op-ed piece by Lucian Bebchuk published today at Forbes.com. The post outlines some of the key points of the Discussion Paper by Bebchuk, How to Make TARP II Work, issued last month by the Harvard Law School Program on Corporate Governance. This Discussion Paper builds in part on Bebchuk’s September 2008 article, A Plan for Addressing the Financial Crisis, which first proposed the idea of using competing privately managed funds to restart the market for troubled assets. The post was written before the appearance in today’s WSJ of a story suggesting that the Treasury is considering establishing a program for financing competing private funds. We hope to get from Professor Bebchuk another post on the subject as information about the Treasury’s plan becomes available.

Four weeks ago, Treasury Secretary Geithner announced the administration’s interest in developing a plan—which the Treasury is willing to back with up to $1 trillion of public funds—to partner with private capital to buy banks’ “troubled assets.” The announcement has met with substantial skepticism about the possibility of working out an effective plan to restart the market for troubled assets for such a public-private partnership. However, in a paper issued last month, How to Make TARP II Work, I show that this can be done, and explain how the plan should be designed to contribute most to restarting the market for troubled assets at the least cost to taxpayers.

The Bush administration was forced to abandon its own plan for directly purchasing troubled assets once it became clear that its plan could not be designed to effectively address concerns about arbitrary valuation and potential overpayments. This experience contributed to the doubts about the Obama administration’s new plan. With the stock market reacting negatively, one noted columnist observed that “[t]he market was right to worry because… nobody has yet devised a way to make such a scheme work.” Another columnist suggested that the market was “glum” because the announcement was “short on details – and no more so than on the critical question of how the government will address the problem of dealing with the toxic assets that have effectively rendered large portions of the nation’s financial system insolvent.”

Despite the widespread doubts, an effective plan for a public-private partnership in buying troubled assets can be designed. The key is to have competition at two levels. First, at the level of buying troubled assets, the government’s program should focus on establishing many competing funds that are privately managed and partly funded with private capital – and not creating one, large “aggregator bank” funded with public and private capital and engaging in purchasing troubled assets. Second, at the level of allocating government capital among the competing private funds, potential fund managers should compete for government capital under a market mechanism resulting in maximum participation of private capital and minimum costs to taxpayers.

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Employee Indemnification

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, March 3, 2009
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This post comes from Wallace P. Mullin of George Washington University and Christopher M. Snyder of Dartmouth College.

In Should Firms be Allowed to Indemnify Their Employees for Sanctions? which was recently published by the Journal of Law, Economics, and Organization, we analyze the widespread practice of employee indemnification using a three player model, where there is a principal and agent, as well as a governmental player that sets and enforces sanctions. In our model, the government authority can always deter crime with a sufficiently high combination of fines on the firm and employee. The challenge is to deter crime at minimum social cost. We show that deterrence can typically be obtained at minimum social cost by sanctioning the firm alone. This maintains deterrence without exposing the agent to risk from sanctions or inducing the exit of productive, law-abiding firms.

Sanctioning the agent is valuable in limited circumstances. If deterrence is especially difficult, it may be optimal to hit the agent with a sanction large enough to bankrupt him. Although the de jure sanctions cannot vary with actual guilt—imperfect enforcement prevents this—bankrupting the agent allows the de facto agent sanction to vary with his wealth. The agent needs to be paid a premium to induce him to commit a crime, and so the agent of the criminal firm ends up having more wealth to be seized than the agent of a law-abiding firm. Indemnification need not be explicitly banned for this strategy to work: the agent’s sanction can be set so high that the firm would not choose to indemnify the agent even if allowed by law.

Indeed, if sanctions are set appropriately, the government’s policy toward indemnification becomes moot. Either the agent should not be sanctioned at all, in which case there is nothing for the firm to indemnify, or the agent should be sanctioned so harshly that the firm chooses not to indemnify the agent even if it could. The government’s policy toward indemnification is not moot in an extension of the corporate-crime model in which the agent’s cooperation can help convict a criminal firm. The authority can offer to reduce the employee’s fine in return for his cooperation; an offer the firm can unravel by pledging to indemnify him fully.

The broad lesson to be drawn from the analysis is that authorities should be wary of sanctioning employees let alone banning their indemnification. Typically, firm sanctions deter crime more efficiently than unindemnifiable employee sanctions. Readers can find a link that provides free access to the full paper at Professor Snyder’s homepage here.

Driving a Constitutional Stake through Section 16(b)

Posted by Phillip Goldstein, Bulldog Investors, on
Monday, March 2, 2009
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This post is by Phillip Goldstein of Bulldog Investors.

Section 16(b) of the Securities Exchange Act of 1934 has long been criticized for its “purposeless harshness,” and its “arbitrary, some might say Draconian” nature, as one court put it. Section 16(b) generally requires directors, officers and beneficial owners of more than 10% of the stock of a publicly traded corporation to disgorge to the corporation any so called “short swing profits” from purchases and sales of stock (or vice versa) made within a period of less than six months.

The stated purpose of Section 16(b) is to “[prevent] the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer.” To that end, the law authorizes any shareholder to file a derivative suit to recover such profit “if the issuer shall fail or refuse to bring such suit within sixty days after request.” There is no requirement that the shareholder own any shares at the time of the alleged insider trading. The predictable result has been to create a cottage industry of Milberg, Weiss style legalized barratry.

For example, The Children’s Investment Fund and 3G Capital Partners LP recently settled a Section 16(b) lawsuit brought by a small shareholder of CSX Corporation to recover their alleged short swing profits in CSX stock. The shareholder made no allegation that TCI or 3G were privy to any inside information let alone that any inside information about CSX even existed at the time of the trades. Under the settlement CSX will receive $10 million from TCI and $1 million from 3G and the plaintiff’s lawyer will seek approval by the court for fees and costs of up to $550,000, payable from the proceeds.

In another recent Section 16(b) case, Huppe v. Special Situations Fund III QP, L.P., No. 06 Civ. 6097 (S.D.N.Y. July 3, 2008) the District Court ruled that a 10% shareholder of WPCS International Incorporated had to disgorge its short swing profits to the company despite the absence of any allegation of the existence of inside information. The Court acknowledged that the shareholder’s purchase of stock from WPCS in an arm’s length transaction had probably rescued the issuer from financial disaster but ruled that equitable defenses are inapplicable in a Section 16(b) case:

Although it is undisputed in this case that WPCS genuinely needed and was provided capital through PE’s and QP’s purchases of WPCS stock, nothing in the statute permits the Court to consider as a mitigating factor the issuer’s intent or any benefit inuring to the issuer, nor is there any equitable defense available based on such theories.

That is because Section 16(b) creates a conclusive presumption that a 10% shareholder who realizes a short swing profit is presumed to have had access to and abused inside information. No allegation that inside information existed, e.g., a proposed merger or dividend increase, is even required. While there have been several failed due process challenges to Section 16(b), I know of none since Vlandis v. Kline, 412 U.S. 441 (1973), in which the Supreme Court held that an irrebuttable statutory presumption that a university student who recently moved to Connecticut was not a legitimate resident of the state (for university tuition purposes) is invalid because the presumption was not warranted. A court should be equally skeptical of Section 16(b)’s presumption that any short swing profits by a 10% shareholder stems from access to inside information. Unlike a director of a corporation, no shareholder has a legal right to obtain inside information and in fact, 10% shareholders of public corporation usually do not possess such information. Thus, a constitutional challenge based on Section 16(b)’s irrebuttable presumption of insider trading appears promising.

An even more obvious constitutional flaw of Section 16(b) is that it does not meet the Supreme Court’s requirement for Article III standing because it purports to authorize a “suit to recover such profit . . . by the issuer, or by the owner of any security of the issuer in the name and in behalf of the issuer” even though the issuer has not been harmed. In Gladstone, Realtors v. Village of Bellwood, 441 U.S. 91, the Supreme Court found that one could not sue for damages unless the party alleged that (1) it suffered an actual injury as a result of the defendant’s actions and (2) that a favorable ruling would compensate the plaintiff for the injury suffered:

Congress may, by legislation, expand standing to the full extent permitted by Art. III, thus permitting litigation by one “who otherwise would be barred by prudential standing rules.” Warth v. Seldin, 422 U.S., at 501, 95 S.Ct. at 2206. In no event, however, may Congress abrogate the Art. III minima: A plaintiff must always have suffered “a distinct and palpable injury to himself,” ibid., that is likely to be redressed if the requested relief is granted. Simon v. Eastern Kentucky Welfare Rights Org., supra, 426 U.S., at 38, 96 S.Ct., at 1924.

One might argue that Congress created “a distinct and palpable injury” to an issuer when it passed a law requiring the transfer of short swing profits from the statutory insider to the issuer. However, that is circular reasoning and contrary to the Court’s insistence that Congress cannot abrogate Article III’s requirement that the plaintiff must suffer a true injury to himself to have standing. If Congress could create an artificial injury by fiat, that would effectively eviscerate Gladstone.

Abe Lincoln reputedly popularized this riddle: “How many legs does a dog have if you call a tail a leg?” “The answer is four because calling a tail a leg does not make it a leg.” Similarly, Congress does not have the power to legislate the existence of “a distinct and palpable injury” to a corporation when such an injury does not exist. The plain truth is that a corporation does not suffer any injury from short swing profits realized by a 10% shareholder and hence does not have standing to bring a Section 16(b) lawsuit against that shareholder.

Navigating Tumultuous Times

Posted by Peter Atkins, Skadden, Arps, Slate, Meagher & Flom LLP, on
Sunday, March 1, 2009
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This post is by Peter Atkins of Skadden, Arps, Slate, Meagher & Flom LLP.

My firm has recently published “2009 Insights — Navigating Tumultuous Times,” a compendium of current memoranda on subjects we believe are likely to be of particular importance to directors, senior management and counsel in the coming year. The idea for the compendium was triggered by the difficult financial and business environments in the U.S. and globally as we move into 2009, and the advent of a new administration in Washington. In light of this, we thought there could be some real value in pulling together input from a large number of our practice areas and domestic and international offices to provide, in one place early in 2009, our perspective on the coming year. This perspective encompasses both problem areas, including approaches to dealing with them, and some opportunities.

The individual memoranda are intentionally brief, to facilitate review by business executives and directors — there clearly is much more to be said on virtually every subject. The following outline, from the compendium itself, indicates the breadth of territory covered in the 10 sections of the compendium.

• Capital Markets and Hedge and Private Equity Funds: For many of our clients, the area of most direct interest is how the tumultuous financial environment may impact their capital structure. We emphasize both advance planning and prophylactic measures that are applicable to most entities, whether or not currently under distress. We also examine potential opportunities created by the turmoil in financial markets and the impact on various capital markets sectors.

• Corporate Restructuring: It is generally expected that 2009 will be dominated by a global wave of corporate restructuring activity. We provide information on various techniques that will be of assistance to stressed entities looking to restructure their balance sheets, as well as entities that may seek to acquire or consolidate with a troubled entity.

• Financial Institutions: The events of recent months have led to a series of financial crises and dramatic governmental responses. We examine legislative developments in the US and Europe, provide guidance regarding the current enforcement and litigation landscape, and look ahead to future developments affecting financial institutions.

• Global M&A: A significant amount of recent merger and acquisition activity has focused on restructuring prompted by the demands of governments or creditors. As corporations around the world continue to assess their financial and business environments, new strategic M&A scenarios likely will develop. We include information highlighting current influences on mergers and acquisitions.

• Governance: The financial and economic crises and the response of various governmental bodies, once again, emphasize the importance of proper corporate governance. The range of issues confronting directors and members of management are explored in a series of memoranda that assess trends and offer guidance on those issues, including directors’ duties, executive compensation and financial reporting.

• Governmental, Regulatory and Tax Enforcement: In the US, the EU and elsewhere, shifting governmental priorities in response to various factors, including the economic environment, will impact a wide range of industries. We assess these developments across governmental arenas.

• Intellectual Property and Information Technology: We address a number of areas of interest related to intellectual property — the most valuable asset of the so-called “new economy.”

• Litigation and International Arbitration: We anticipate the upheavals of the last year and a half will continue to result in increased litigation, much of which will be complex and international in nature. We discuss the expected trends and likely strategies for managing such disputes.

• New Markets: Brazil, China, India and Russia are not immune to the global financial and economic crisis, and their status as emerging markets creates unique circumstances for conducting business there. We discuss various issues, trends and laws relevant to business activity in each country.

• Real Estate: In the eye of the economic storm, the real estate industry, including REITs, faces a number of issues, which we discuss here.

The compendium is available here.

Note: Navigating tumultuous times requires keeping up to date. In the brief period since the compendium was issued, there have been significant changes in a number of areas, particularly U.S. economic stimulus legislation, regulation of financial institutions and executive compensation. We continue to monitor the areas covered in the compendium and publish memoranda addressing significant developments.

Amendments to the Delaware Corporation Code

Posted by Mark A. Morton, Potter Anderson & Corroon LLP (Delaware), on
Saturday, February 28, 2009
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This post is by Mark A. Morton’s partners Michael Tumas and John Grossbauer. 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 Council of the Corporation Law Section of the Delaware State Bar Association earlier today forwarded to Corporation Law Section members the proposed 2009 amendments to the Delaware General Corporation Law (“DGCL”). Consistent with Delaware’s preference for enabling legislation and maintaining maximum flexibility, the amendments eschew mandates for corporate action. Specifically, the proposed amendments create new Sections 112 and 113 that expressly permit Delaware corporations to adopt bylaws implementing proxy access and requiring reimbursement of stockholder proxy expenses in certain circumstances. Also included among the proposed amendments are changes to Section 213, to permit Delaware corporations to provide separate record dates for determining stockholders entitled to notice of and to vote at stockholder meetings, a new provision permitting judicial removal of directors in extreme, emergency circumstances, and a revision to Section 145(f) expressly providing that pre-existing indemnification and advancement rights provided in a corporation’s governing documents cannot be impaired by later amendments to those documents. The amendments are summarized in more detail below.

Access to Proxy Solicitation Materials (New Section 112)
The proposed amendments create a new section of the DGCL, Section 112, expressly authorizing a Delaware corporation to adopt a bylaw that grants stockholders the right to include within the corporation’s proxy solicitation materials stockholders’ nominees for the election of directors, subject to any lawful conditions the bylaws may impose. The subject of “proxy access” had been a significant one, and it promised to continue to be so in the current environment. The addition of proposed Section 112 removes any uncertainty regarding the ability of Delaware corporations to effect proxy access through adoption of a bylaw. In so doing, the proposed amendment clarifies that corporations may impose reasonable restrictions on the stockholders’ right to access company proxy materials and identifies a non-exclusive list of restrictions that are deemed to be reasonable.

One condition specified in Section 112 would permit the bylaws to establish minimum ownership requirements for stockholders to become eligible to include nominees in company proxy materials, measured both by amount and duration of ownership. The bylaws may establish this minimum ownership threshold by defining beneficial ownership to include ownership of options or other rights relating to stock, including derivative rights. Because Section 112 is intended to apply to stockholder nominations of short slates of directors and not as a vehicle for effecting changes of control through the corporation’s own proxy materials, the new section also expressly permits the bylaws to condition eligibility for inclusion in the corporation’s proxy materials to nominations for a limited number of seats that may be contested and to preclude entirely inclusion of nominations by persons who own or propose to acquire (such as through a tender offer) more than a specified percentage of the corporation’s stock. The bylaws also may require the nominating stockholder to submit specified information such as information concerning the ownership of the corporation’s stock by the stockholder and the stockholder’s nominees. The bylaws also may condition eligibility to require inclusion of nominees in the corporation’s proxy materials on the nominating stockholder’s execution of an undertaking to indemnify the corporation for any loss resulting from any false or misleading information submitted by the stockholder and included in such proxy materials, or on “any other lawful condition.”

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Delaware Supreme Court Orders Entire Fairness Review

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, February 28, 2009
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This post comes to us from Robert S. Reder, Alan J. Stone, Peter Heller and Dean Sattler of Milbank, Tweed, Hadley & McCloy 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 a previous Client Alert, [1] we discussed a decision of the Delaware Court of Chancery dismissing a stockholder suit that alleged breach of fiduciary duty by directors who initiated, but later abandoned, a sale process that had generated three attractive offers. In Gantler v. Stephens [2], the Court of Chancery applied the business judgment rule to the board’s conduct, rather than the Unocal [3] standard of enhanced review, because the directors’ actions were not “defensive” in nature. In affording the directors the benefit of the business judgment presumption, the Court of Chancery found that the directors breached neither their duty of loyalty nor their duty of care, and therefore declined to undertake an “entire fairness” review of the board’s conduct.

On January 27, 2009, the Delaware Supreme Court reversed the Court of Chancery’s decision. In the Supreme Court’s view, the complaint pled “sufficient facts to overcome the business judgment presumption,” thereby requiring an examination of plaintiffs’ allegations under the entire fairness standard of review.[4] The Supreme Court’s analysis provides helpful insight into the nature of the pleading required to overcome the presumption of the business judgment rule in the M&A context. The Gantler decision also clarifies the nature of the fiduciary duties owed by corporate officers to a Delaware corporation, as well as the scope and application of the shareholder ratification doctrine under Delaware law.

Background

In August 2004, the board of directors of First Niles Financial, Inc. authorized a process to sell the company, and retained financial and legal advisors to assist. At the next board meeting, with the sale process underway, management advocated abandoning the process in favor of a so-called “going private” transaction. The board did not act on management’s proposal, but instead allowed the sale process to continue.

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The Welcome Reaffirmation of the Business Judgment Protection

Posted by Martin Lipton, Wachtell, Lipton, Rosen & Katz, on
Friday, February 27, 2009
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This post is based on a client memorandum by Martin Lipton, Steven A. Rosenblum, and Sabastian V. Niles of Wachtell, Lipton, Rosen & Katz. 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.

Despite increasing political and media focus on and criticism of risk assessment and risk management efforts by corporate boards, yesterday’s In Re Citigroup Inc. Shareholder Derivative Litigation, No. 3338-CC (Feb. 24, 2009), decision by the Delaware Court of Chancery is a welcome indication that the business judgment rule will survive the financial crisis intact.

The plaintiffs in the case alleged, among other things, that the defendants had breached their fiduciary duties by not properly monitoring and managing the business risks that Citigroup faced from subprime mortgages and securities, and by ignoring alleged “red flags” that consisted primarily of press reports and events indicating worsening conditions in the subprime and credit markets. Declaring that “oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk,” Chancellor Chandler dismissed these claims on the ground of failure to adequately plead demand futility. The only claim the court did not dismiss was an allegation that the defendants had engaged in waste by approving a multimillion dollar payment and benefit package for Citigroup’s former CEO upon his retirement.

The decision reaffirms and clarifies several key features of Delaware law, established by the Caremark decision and its progeny, with respect to oversight responsibilities. First, that plaintiffs face “an extremely high burden” in bringing a claim for personal director liability for a failure to monitor business risk. Second, that while directors could be liable for a failure of board oversight, “only a sustained or systemic failure of the board to exercise oversight – such as an utter failure to attempt to assure a reasonable information and reporting system exists – will establish the lack of good faith that is a necessary condition to liability.” Third, that a bad business decision is not evidence of the bad faith necessary to establish oversight liability. Notably, the court drew an important distinction between oversight liability with respect to business risks and oversight liability with respect to illegal conduct, emphasizing that courts will not permit oversight jurisprudence to be distorted by “attempts to hold director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly.”

As boards of directors review the risk oversight and management programs of their companies (see our November 2008 memorandum entitled “Risk Management and the Board of Directors”), this week’s decision in Citigroup should provide some comfort that, even in the current environment, the Delaware courts will continue to protect informed business judgments made by corporate boards in good faith.

“Say on Pay” Now a Reality for TARP Participants

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Friday, February 27, 2009
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This post is by Annette L. Nazareth’s colleagues Beverly Fanger Chase, Ning Chiu, Edmond T. FitzGerald, Kyoko Takahashi Lin, Jean M. McLoughlin, and Barbara Nims.


Media and public attention surrounding the American Recovery and Reinvestment Act of 2009, enacted on February 17, 2009 and commonly referred to as the stimulus bill, has typically focused on the law’s restrictions on the amounts and forms of compensation payable to executives of TARP participants.[1] An important provision of the stimulus bill that has not as yet received much notice, but is now a reality for all institutions that receive or have received government assistance under TARP, is the requirement that such institutions permit their shareholders to vote on executive compensation – a so-called “say on pay” vote.

Shareholder proposals advocating for say on pay have been a recent priority item on shareholders’ governance agenda, with reports indicating that as many as 100 proposals have been submitted to public companies for the 2009 season. Support for the approximately 70 proposals submitted to shareholders in the 2008 season averaged approximately 42%, with ten proposals reported as receiving majority support from shareholders. Although say on pay has not been widely adopted by companies, 18 companies to date have agreed to institute company proposals seeking a say on pay vote in their proxy statements. Six of these companies have already included such a company proposal in their proxy statements, with shareholder support for the companies’ executive compensation ranging from 62.5% to 98.7%.

The new SEC leadership has publicly expressed its support of adopting say on pay for all companies outside the context of the stimulus bill. Mary Schapiro, Chairman of the SEC, stated in a recent speech that “giving shareholders a greater say on . . . how company executives are paid” is on the SEC’s agenda. Further, SEC Commissioner Elisse B. Walter in recent remarks stated that she believes say on pay can help restore investor trust, and she encouraged more companies to voluntarily adopt say on pay.

Stimulus Bill Requires Say on Pay, But Timing of Implementation Originally Unclear
The stimulus bill requires that the shareholders of any institution that has received or will receive financial assistance under TARP be provided with an annual non-binding say on pay vote on executive compensation each year during the period in which any obligation arising from such financial assistance remains outstanding. In its annual meeting proxy statement, each institution must provide a separate shareholder vote to approve the compensation of the institution’s executives as disclosed pursuant to the SEC’s compensation disclosure rules, which include the compensation discussion and analysis, the compensation tables and related narrative.

The stimulus bill called for the SEC to issue final regulations regarding this say on pay provision within one year after the date of the bill’s enactment. The legislation did not indicate whether the say on pay provision was effective immediately upon its enactment, or would only become effective after the SEC issued these regulations.

The stimulus bill also makes clear that this shareholder vote is not intended to be binding upon an institution’s board of directors and may not be construed as overruling any board decision, nor does it create or imply any additional fiduciary duty of the board.

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What Matters in Corporate Governance?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, February 26, 2009
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Editor’s Note: This post is by Lucian Bebchuk, Alma Cohen, and Allen Ferrell of Harvard Law School.

This month’s issue of The Review of Financial Studies features our article, “What Matters in Corporate Governance?.”

The article investigates the relative importance of the 24 provisions followed by the Investor Responsibility Research Center (IRRC) and puts forward an entrenchment index based on six provisions: staggered boards, limits to shareholder bylaw amendments, poison pills, golden parachutes, and supermajority requirements for mergers and charter amendments. The article shows that increases in the index level are monotonically associated with economically significant reductions in firm valuation as well as large negative abnormal returns during our period of examination. The other eighteen IRRC provisions not in our entrenchment index were uncorrelated with either reduced firm valuation or negative abnormal returns.

Since the initial version of our study was first circulated in the fall of 2004, many researchers have used the entrenchment index we put forward. A list of over 75 studies using the index is available here. For those who might wish to use the entrenchment in subsequent research, data on firms’ entrenchment index levels during the period 1990-2007 is available here.

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Below we describe the article’s results and contributions: There is now widespread recognition, as well as growing empirical evidence, that corporate governance arrangements can substantially affect shareholders. But which provisions, among the many provisions firms have and outside observers follow, are the ones that play a key role in the link between corporate governance and firm value? This is the question on which our article focuses.

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