Yearly Archives: 2009

The Trilateral Dilemma in Financial Regulation

Posted by Howell Jackson, Harvard Law School, on
Wednesday, February 25, 2009
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This post is by Howell Jackson of Harvard Law School.

My recent article “The Trilateral Dilemma in Financial Regulation” analyzes a practice — which I label the trilateral dilemma — existing in many different sections of the financial services industry, including mortgage lending, retirement savings, investment management, insurance brokering and banking services. The practice arises in the context of a consumer seeking the recommendation of a financial adviser for the purpose of choosing financial products and services. With surprising frequency, these advisers receive side payments or other forms of compensation from the firms that provide the product or service the advisers recommend. Many times these payments are not clearly disclosed to the consumers; often they are entirely secret.

In the article I describe how trilateral dilemmas have arisen in many different sections of the financial services industry. I then review the many different regulatory strategies that legislatures, courts and regulatory bodies have employed to address the problem. The modal regulatory response is the imposition of some sort of fiduciary duty on the financial advisor along with a generalized disclosure to consumers affected by the transaction. I then discuss a range of recurring analytical issues that arise in policy debates over trilateral dilemmas in a variety of settings, and I also evaluate the possibility that side payments and other forms of indirect compensation may in fact be an efficient or at least innocuous means of financing the cost of distributing financial products and services. The article concludes with some thoughts about the implications of my analysis for devising regulatory responses and for the role that consumer education might play in helping consumers work through these difficulties.

The article is available here.

One specific — and highly controversial — example of the trilateral dilemma in the real estate context involves the payment of yield spread premiums by lending institutions to mortgage brokers for steering consumers towards particular loans. In a recent article entitled “Kickbacks or Compensation: The Case of Yield Spread Premiums“, Laurie Burlingame and I present an empirical study of approximately 3,000 mortgage financings of a major lending institution operating on a nationwide basis through both a network of independent mortgage brokers and some direct lending. The data for this study was obtained through discovery in litigation that was subsequently settled. The study offers a number of insights into the impact of yield spread premiums of mortgage broker compensation and borrower costs. In particular, the study suggests that for transactions involving yield spread premiums, mortgage brokers received substantially more compensation than they did in transactions without yield spread premiums. This estimated difference in mortgage broker compensation is statistically significant and robust to a variety of formulations.

Industry representatives have long argued that yield spread premiums are not harmful to consumers because these payments are recouped through lower direct payments to mortgage brokers. However, our analysis suggests that this claim is baseless, at least with respect to sample included in our database. With a high degree of statistical confidence and using multiple formulations, we can reject the proposition that consumers fully recoup the cost of yield spread premiums. Our best estimate is that consumers get less than 35 cents of value for every dollar of yield spread premiums, a very bad deal for consumers.

The article also provides evidence that the payment of yield spread premiums may allow mortgage brokers to engage in price discrimination among borrowers. The evidence suggests that yield spread premiums are not simply another form of mortgage broker compensation, but rather a unique form of compensation that allows mortgage brokers to extract excessive payments from many consumers. The article concludes with a discussion of the implications of the study, areas for regulatory focus, and proposals for regulatory reform.

The article is available here.

Dealing With the Executive Pay Problem

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, February 25, 2009
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Editor’s Note: This post by Ira M. Millstein is a letter to the editor of the WSJ responding to the op-ed by Lucian Bebchuk that appears on our forum here.

Lucian Bebchuk’s suggestions regarding bank executive compensation didn’t go far enough in controlling levels of executive compensation and their growing inequities. Experts continuously present suggestions to link pay to performance through a variety of stock options and other mechanisms. None of them is impervious to the gaming which takes place, and none has halted the escalation.

The responsibility to set and monitor compensation is in the boardroom. Boards have avoided that responsibility and remained tone deaf to the public’s concern. Structuring transparent, understandable fair compensation, even in the millions-of-dollars range, is one thing; failure to consider the risk of perverse escalating outcomes and perks is another. Institutional shareholders have the voice and capacity to put spine in the boardroom by communicating on compensation to Compensation Committees, filing proxy resolutions, and voting against directors believed to be improvident. Then, in turn, they should report to their beneficiaries what they have done.

Electronic Arts Before the Second Circuit: The Amici Curiae Brief of 60 Corporate and Securities Law Professors

Posted by Jeffrey N. Gordon, Columbia Law School, on
Tuesday, February 24, 2009
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This post is by Jeffrey N. Gordon of Columbia Law School.

Last week, on behalf of sixty corporate and securities law professors from thirty-eight law schools around the country, I filed an amici curiae brief in the case of Lucian Bebchuk vs. Electronic Arts, Inc.. The case is  now pending before the United States Appeals Court for the Second Circuit. The professors’ amici curiae brief is available here, and the names of the professors joining the brief are listed at the bottom of this post.

The case focuses on a shareholder proposal that was submitted by Lucian Bebchuk to Electronic Arts (EA). The proposal is precatory and recommends that the board submit to a shareholder vote a charter or bylaw amendment that, if adopted, would require the company (to the extent permitted by law) to include in the company’s proxy materials qualified proposals for a bylaw amendment. For a proposal to be qualified, the proposal would have to meet certain significant requirements, including being submitted by a shareholder(s) with more than 5% of the company’s stock. The proposal is available here.

EA excluded the proposal from the company’s ballot, and the case focuses on whether the SEC’s shareholder proposal rule (Rule 14a-8) allows the company to do so.

The case comes before Second Circuit on appeal from the District Court for the southern District of New York. The District Court accepted the position of EA in a brief bench ruling and sent the case to the Second Circuit. The transcript of the District Court’s hearing is available here. The opening brief filed in the appeal by Lucian Bebchuk’s counsel, Grant & Eisenhofer, is available here. A sense of the position that EA can be expected to present in the appeal can be obtained from the opening brief and reply brief EA submitted to the District Court, which are available here and here, as well as from the amicus curiae brief, available here, submitted to the District Court by the Chamber of Commerce.

The professors’ amici curiae brief, filed in support of the appellant’s position, focuses on two central arguments made by EA in defense of excluding the proposal:

(1) Inconsistency with the Proxy Rules Argument:

In its bench ruling, the District Court, accepting the position of EA and the Chamber, held that EA may omit the proposal as inconsistent with Rule 14a-8. The District Court viewed any provision in the certificate of incorporation or the bylaws that would limit the discretion of EA’s directors to control access to the issuer’s proxy statement as inconsistent with Rule 14a-8. The District Court held that Rule 14a-8 mandates that the discretion it provides to companies to omit certain proposals be exercised fully and solely by the company’s board. The Court stated that “it is clear… that the SEC understand[s] the company to be those who act for the company … And that is a small, relatively small group of people, like the board of directors, who have management discretion to run the business and affairs of the company. And it is they that must have this discretion.”

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SOX Deficiencies and Firm Risk

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, February 23, 2009
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This post comes from Hollis Ashbaugh Skaife of the University of Wisconsin-Madison, Daniel W. Collins of the University of Iowa, William R. Kinney, Jr. of the University of Texas at Austin, and Ryan LaFond of Barclays Global Investors.

In our forthcoming Journal of Accounting Research paper entitled The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity, we explore the relation between internal control quality and idiosyncratic and systematic risk, and the potential benefits of effective internal control in terms of cost of equity. Specifically, we investigate whether firms that disclose internal control deficiencies (ICDs) exhibit higher systematic risk, higher idiosyncratic risk, and higher cost of equity relative to firms with effective internal controls. Further, we investigate whether managements’ initial disclosures of ICDs and remediation of previously reported ICDs are related to changes in firms’ cost of equity.

We conduct both (1) cross-sectional tests to assess whether firms with ICDs present higher information risk to investors relative to firms having effective internal controls; and (2) inter-temporal tests to assess whether changes in the effectiveness of internal control yield changes in cost of equity consistent with changes in information risk. The results of our cross-sectional tests indicate that firms reporting ICDs exhibit significantly higher idiosyncratic risk, betas, and cost of equity relative to firms not reporting ICDs. These differences persist after controlling for other factors shown by prior research to be related to these risk measures. Our finding that differences in these risk measures pre-date the first disclosures of ICDs suggests that market participants’ assessment of non-diversifiable market risk (beta), idiosyncratic risk, and cost of equity incorporated expectations about internal control risks based on observable firm characteristics prior to firms’ initial revelation of control problems.

In an attempt to assess whether a causal relation may exist between internal control quality and firms’ cost of equity, we construct four sets of inter-temporal change analysis tests. The first inter-temporal test finds that ICD firms experience a statistically significant increase in market-adjusted cost of equity, averaging about 93 basis points, around the first disclosure of an ICD. In our second change analysis, we find that ICD firms that subsequently receive an unqualified SOX 404 opinion exhibit an average decrease in market-adjusted cost of equity of 151 basis points around the disclosure of the opinion. In contrast, for our third change test we find that ICD firms that subsequently receive adverse SOX 404 audit opinions, which indicate that internal control problems persist, exhibit a modest but insignificant increase in cost of equity around the SOX 404 opinion release. In our final inter-temporal change analysis, we find no significant cost of equity change for firms least likely to report an ICD, but a significant decrease in the average market-adjusted cost of equity of 116 basis points around the release of an unqualified SOX 404 opinion for firms most likely to report ICDs.

Collectively our cross-sectional and inter-temporal tests present consistent evidence that information risk as proxied by ineffective internal control is an important determinant of both idiosyncratic risk and systematic market risk that affects the market’s assessment of firms’ cost of equity. We document that firms with effective internal control or firms that remediate previously reported ICDs are rewarded with a significantly lower cost of equity.

The full paper is available for download here.

An In-depth Analysis of Treasury’s Financial Stability Plan

Posted by Margaret E. Tahyar, Davis Polk & Wardwell LLP, on
Sunday, February 22, 2009
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This post is based on a client memorandum by Randall Guynn and Margaret Tahyar of Davis Polk & Wardwell.

The Treasury’s recently announced Financial Stability Plan reshapes the ground rules for capital injections into financial institutions, increases the size and scope of a previously announced non-recourse lending facility by the Federal Reserve, launches the idea of a public-private investment fund to purchase legacy or toxic assets from financial institutions and sets aside funds for the homeowner assistance plan outlined by President Obama on February 18. As has been widely noted, however, the plan is long on aspiration but short on detail.

Among the new features of the plan is a mandatory comprehensive “stress test” for banking institutions with assets in excess of $100 billion. Although “stress testing” is a term of art in the financial services and risk management realm and is an element of the risk-based approach taken by Basel II, the sense in which it will be applied by Treasury is unclear. The memorandum explores the possible meaning.

The plan also contemplates, but does not detail, ongoing measures to further enhance public disclosure of financial health. Political calls for more disclosure in the current environment, however, disguise the complexity of the issues that will have to be sorted out in order to arrive at a functional solution. Some of these challenges discussed in the memorandum include the possible necessity of international coordination in order to shape new norms for financial institution disclosures and the implications of the ongoing debate over mark-to-market accounting and dynamic provisioning.

In an effort to restart the currently illiquid market for legacy assets, Treasury announced the creation of the Public-Private Investment Fund. The key new feature of this initiative, compared to earlier discussions regarding an aggregator bad bank, is an element of private capital participation, although the specifics of this public-private partnership are still unclear. The memorandum discusses some of the challenges, including whether pricing mechanisms will indeed be easier to design due to private sector involvement.

Hardly any market has been more affected by the recent market turmoil than the private label securitization market. The pendulum appears to have swung from a failure of the financial markets to properly recognize and price the huge risks of certain securitization classes to a situation where securities backed by any asset class not also explicitly or implicitly backed by the government are virtually impossible to bring to the market. While banks have been broadly accused of being responsible for reduced lending activity, latest data published by Treasury shows that in fact, the absence of a functioning securitization market is the greatest contributor to a decline in lending. Therefore, it should come as no surprise that the implementation of a facility announced by the Federal Reserve in November of last year to revive the asset-backed securities markets, the Term Asset-Backed Securities Loan Facility, is greatly anticipated. The memorandum discusses salient features of the facility, including the manner in which it will allow for the participation of unregulated funds, and its potential expansion as part of the government’s plan.

The memorandum is available here.

Changing the Rules for Director Selection and Liability

Posted by Scott J. Davis, Mayer Brown LLP, on
Saturday, February 21, 2009
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This post is by Scott J. Davis of Mayer Brown LLP.

In my paper Would Changes in the Rules for Director Selection and Liability Help Public Companies Gain Some of Private Equity’s Advantages?, to be published in Volume 76 of the University of Chicago Law Review, I examine whether changes in existing legal rules governing how public company directors are chosen and the extent to which public company directors can be held liable for damages if they do not have a conflict of interest would be likely to increase the ability of public companies to obtain some of the benefits that companies owned by private-equity sponsors appear to have. It is widely believed that companies owned by private-equity sponsors have significant advantages over public companies. Among the advantages of private equity cited by commentators are: (1) better governance and a greater willingness to take risks, (2) the ability to focus on long-term issues and a more stable shareholder base, (3) the ability to attract better management talent, (4) creating a sense of urgency, (5) the ability to use leverage more effectively, (6) avoiding the costs imposed by the Sarbanes-Oxley Act, and (7) freedom from shareholder suits. It would be helpful if public companies could gain some of these advantages. My conclusion is that, while changing the rules for selecting directors would not be worthwhile, a reduction in the potential liability of directors for damages in situations in which they do not have a conflict of interest would be likely to increase the ability of public company companies to mirror the effectiveness of private-equity portfolio companies without creating other problems that would be unacceptable.

The paper is available here.

RiskMetrics Update Continues to Hamper Director Discretion

Posted by David A. Katz, Wachtell, Lipton, Rosen & Katz, on
Friday, February 20, 2009
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This post is by David A. Katz of Wachtell, Lipton, Rosen & Katz. Previous posts on this blog concerning RiskMetric Group’s policy updates are available here and here.

My colleague Laura A. McIntosh and I (with help from our colleague David Adlerstein) wrote an article entitled “RiskMetrics Update Continues to Hamper Director Discretion,” which discusses the 2009 updates to the domestic and international corporate governance policies of RiskMetrics Group (formerly know as ISS). RMG’s policy updates continue its trend of espousing policies that tend to shift corporate decision-making from boards of directors to shareholders, including activists and special interest groups. In particular, RMG’s updated policies seek to further limit directors’ discretion in areas traditionally within the board of directors’ clear authority under state law, including executive compensation, corporate governance matters and social policy.‬‪ ‬‪ As an example, RMG has revised its policy with respect to management proposals to ratify a shareholder rights plan. In addition to considering whether a shareholder rights plan includes RMG’s prescribed attributes (such as a 20 percent or higher triggering threshold and a shareholder redemption feature), RMG also will take into consideration a company’s existing governance structure, including board independence, existing takeover defenses and “any problematic governance concerns.” In the face of these new, subjective criteria, it remains to be seen in what circumstances RMG would, in fact, recommend in favor of adopting a shareholder rights plan. Importantly, RMG is continuing its policy of recommending “withhold votes” against an entire board of directors, if the board adopts or renews a rights plan without shareholder approval, does not commit to putting the rights plan to a shareholder vote within one year of adoption, or reneges on a commitment to put the rights plan to a vote and has not yet received a “withhold vote” recommendation for this issue. The article explains why we believe this policy update could be problematic for corporations in the current troubled market environment.‬ ‪ ‬‪

The article is available here.

Why ban short selling of financial sector stocks?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, February 19, 2009
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Editor’s Note: The post below by Commissioner Troy Paredes is a transcript of remarks by him at the Practising Law Institute’s “SEC Speaks” Program in Washington, D.C., on February 6, 2009.

It is a pleasure to be part of “The SEC Speaks in 2009.” This marks the first time I have participated in “SEC Speaks,” and I am honored to be with some of the nation’s finest securities lawyers — both inside the SEC and among the private bar. Before I begin, I must give you the standard disclaimer that the views I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or my fellow Commissioners.

* * * *

Today, we are persevering through a tumultuous economy that recalls the challenges giving rise to the SEC and the laws it administers as part of the New Deal. During the past year, we have witnessed the demise of investment banks that were considered permanent fixtures on Wall Street. The notion that these institutions could fail had been unthinkable. We also have read about fraudsters whose Ponzi schemes preyed on investors and have heard allegations of market manipulation. We have seen the housing market collapse, credit freeze, IPOs stall, and unemployment rise, all while the government has taken unprecedented steps to stem the troubles. It is no surprise that investor confidence has suffered.

During the midst of the economic crisis last year, the SEC itself took a particularly extraordinary step: temporarily banning short selling.

Although perhaps not readily apparent, short selling can advance important economic goals. It can result in more liquidity, more capital formation, and more efficiently allocated risk. Short selling can buttress buying by allowing investors that go long — in other words, that purchase shares to hold as investments — to hedge their positions; and short selling can encourage market participation by leading to improved price discovery. Investors may be more reluctant to buy if the more pessimistic views of short sellers are not fully reflected in securities prices.

Short selling also is tied to investor confidence. Investor confidence depends on investors’ faith in the integrity of markets. Investors expect that securities prices are meaningful in that they reflect the market’s overall assessment of what a company is “worth” by aggregating into a single number the different views of market participants. Accordingly, in promoting market efficiency, short selling can foster investor confidence, as investors can be confident that securities prices reflect both optimistic and contrarian views.

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The Bailout Is Robbing the Banks

Posted by John Coates, Harvard Law School, on
Wednesday, February 18, 2009
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This post is based on an op-ed piece by John C. Coates and David S. Scharfstein published in today’s New York Times.

Many Americans are angry at banks for taking bailout money while still cutting back on lending. But the government is also to blame. For reasons that remain unclear, the Troubled Asset Relief Program has channeled aid to bank holding companies rather than banks. The Obama administration’s new Financial Stability Plan will have more influence on bank lending if it actually directs its support to banks.

To see why, it’s important to understand the distinction between banks and bank holding companies. Banks take deposits and make loans to consumers and corporations. Bank holding companies own or control these banks. The big holding companies also own other businesses, including ones that execute trades both on their clients’ behalf and for themselves.

It would seem obvious that helping banks, not holding companies, would be the most direct way to stimulate bank lending. But when TARP purchased preferred stock and warrants, it bought them from holding companies, not their bank subsidiaries.

While TARP has been generous with bank holding companies, these companies have not been so generous with their banks. Four large holding companies — JP Morgan, Citigroup, Bank of America and Wells Fargo — initially received a total of $90 billion in TARP money in the fall, but by the end of 2008 they had contributed less than $15 billion in equity capital to their subsidiary banks.

The holding companies seem to have invested most of their TARP money in their other businesses or else retained the option to do so by keeping it in deposit accounts, even as the capital of their banks decreased. At the same time the banks, which provide the majority of loans to large corporate borrowers, drastically reduced lending to new borrowers.

It’s easy to see why holding companies would withhold capital from their troubled banks. If a bank is insolvent — as many are now believed to be — and the government has to take it over, the holding company loses any capital it gave to the bank. Rather than take that risk, the holding company can opt to spend its money elsewhere, perhaps on trading of its own.

But this is not a good use of scarce capital. We might end up with too much of this proprietary trading and too little lending. It also means that when it comes time to recapitalize banks there is a bigger hole to fill, and when banks fail there is less capital available to meet the government’s obligations to insured depositors and other creditors. Keeping money at the holding company may benefit its shareholders, but it is costly for taxpayers.

Bailouts, at the very least, should reach their target. When Washington wanted to help Chrysler, it gave money to Chrysler. It did not write a blank check to Cerberus, the private equity firm that owns Chrysler, in the hope that the money would somehow find its way to the carmaker and not to the other companies Cerberus owns.

Some politicians, frustrated that the government’s costly interventions have not had their desired effect, have wanted to mandate higher levels of bank lending. Others have tried shaming chief executives of financial institutions into lending more, as when Representative Mike Capuano of Massachusetts admonished eight of them who came before the House Financial Services Committee: “Start loaning the money that we gave you. Get it on the street!”

It would be more effective to simply ensure that the Financial Stability Plan is directed at banks. When the government buys stock, it should buy bank stock. And if it chooses to buy stock in holding companies, it should at least require that the new capital reaches the bank and non-bank subsidiaries that the government wishes to support. If the government chooses to help private investors buy toxic bank assets, as the planned Public-Private Investment Fund is supposed to do, it should not allow the banks to send those investments to their holding companies. And if the government decides to guarantee debt, it should guarantee the debt of banks, not of holding companies.

The Obama administration seems to understand that reviving bank lending is key to economic recovery. Now it needs to make sure that the banks get the money.

Readers interested in more information on the points in this op ed can read this forthcoming article in the Yale J. Reg.

Congress, Don’t Give up on Incentives

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, February 17, 2009
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Editor’s Note: This post, which focuses on the executive pay restrictions imposed by the stimulus bill passed last Friday, is based on an op-ed piece by Lucian Bebchuk published in today’s Wall Street Journal. A related op-ed piece by Professor Bebchuk, published earlier this month in the Wall Street Journal and dealing with the pay guidelines proposed by the Obama administration, is available here. Memoranda providing a detailed review and analysis of the restrictions by Wachtell, Lipton, Rosen & Katz and Sullivan & Cromwell LLP are available here and here, respectively. A memorandum by Davis Polk & Wardwell highlighting important interpretive questions raised by the bill is available here.

In a last-minute addition to the stimulus bill passed Friday, Congress imposed tight restrictions on pay arrangements in all financial firms that have or will receive TARP funding.

While I have long been a critic of corporate compensation practices, these restrictions leave me concerned. They weaken executives’ incentives to deliver the long-term performance that is needed to benefit banks, the economy, and taxpayers who have injected vast amounts of capital into these institutions.

While the new restrictions seem to have been motivated by a desire to limit total pay, it is the pay structure that they tightly regulate. The Obama administration’s proposals focused on constraining pay unrelated to performance. The stimulus bill takes the opposite approach—constraining incentive compensation, limiting it to one third of total pay.

To be sure, incentive compensation in many public companies has been flawed. Some incentive compensation has been so in name only, and some of it has provided perverse incentives to focus on short-term results to the detriment of long-term performance.

But these problems require tightening the link between pay and long-term performance—not giving up on it altogether. Mandating that at least two-thirds of an executive’s total pay be decoupled from performance, as the stimulus bill does, is a step in the wrong direction.

Another wrong step is the bill’s categorical prohibition on using any form of incentive compensation other than restricted stock. In the first place, some executives covered by the bill (up to 25 in some firms) run limited parts of the company’s operations. Their incentive pay might be best tied to the performance of their unit’s particular results, not to that of the whole company.

But even for top executives, the banks’ special circumstances may make exclusive use of restricted stock contrary to taxpayer interests. In many banks, the shareholders’ equity, which is junior to the government’s investments in preferred shares and the claims of bondholders, now represents a small fraction of the bank’s capital. Indeed, the value of some banks’ common shares might largely represent an “out-of-the-money option,” expected to deliver value only if things considerably improve.

In such circumstances, restricted stock may provide incentives for executives to take excessive risks with the bank’s survival. Consider the case where an infusion of additional capital would greatly dilute the value of common shares but would be best for the bank, while failing to get that capital would put the bank’s future at risk. In such circumstances, compensation in restricted common shares would provide executives with an incentive to avoid raising capital (which would wipe out their shares’ value) and gamble on survival without additional capital.

The compensation restrictions have another adverse effect on incentives. Executives can sidestep them by returning TARP funds and avoiding them in the future. Some observers argue that such actions would be unlikely because they would be costly to the bank. This overlooks the divergence between the interests of the bank and its executives. The bill provides executives with counterproductive and unnecessary private incentives to terminate or avoid TARP funding, even when doing so would not be in the bank’s best interest.

The stimulus bill’s adverse incentives deserve special attention because of the government’s current approach to the banking sector. While infusing large amounts of capital into banks, the government has chosen to leave their management largely to the discretion of bank executives. This makes executive incentives of paramount importance.

Compensation structures with distorted incentives may have already imposed large losses on investors and the economy. Public officials should be wary of introducing new distortions and perverse incentives. With so much hanging in the balance, ensuring that those running the country’s banks have the right incentives is as important as ever.

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