Yearly Archives: 2009

The Future of Securities Regulation

Posted by Luigi Zingales, University of Chicago Graduate School of Business, on
Monday, February 16, 2009
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This post is by Luigi Zingales of the University of Chicago Graduate School of Business.

The U.S. system of securities law was designed more than 70 years ago to regain investors’ trust after a major financial crisis. Today we face a similar problem. But while in the 1930s the prevailing perception was that investors had been defrauded by offerings of dubious quality securities, in the new millennium, investors’ perception is that they have been defrauded by managers who are not accountable to anyone. In a recently revised working paper entitled The Future of Securities Regulation, I analyze what the appropriate securities regulation is for this changed world. I start by reviewing the theoretical role for regulation: why and when competition in the marketplace is insufficient for protecting investors. I then compare the theoretical predictions with the experience of unregulated markets and their relative successes and failures. From this analysis, I derive three main areas of intervention.

First, a reform of corporate governance aimed at empowering institutional investors to nominate their own directors to the board. This reform will make it worthwhile for directors to develop a reputation of acting in the interest of shareholders and hence to make corporate managers accountable. However, to minimize the risk that institutional investors pursue a self interested agenda, institutional investors should be themselves independent. To achieve this goal, I propose a new Glass-Steagall Act, which instead of separating commercial and investment banking will separate mutual fund management from investment and commercial banking.

The second reform should be the protection of unsophisticated individuals with regard to their investments. The minimum this protection entails is enhanced disclosure. At the time of purchase, investors should be provided with a dollar estimate of all the expenses that will be charged to their investment, including the amount paid in trading commissions, itemized as commissions paid for trading and those paid for services. Similarly, at the time of the purchase, brokers should disclose the fee they receive on the different products they sell, including the “soft dollar” they receive in the form of higher trading costs. The same strict standards should apply to both brokerage accounts and money management accounts.

The third reform should be that of reducing the regulatory gap between public markets and private markets. The recent trend of migration from the former to the latter suggests that this differential is excessive. This migration should be stopped not only by deregulating the public market, but also by introducing some disclosure standards in the private market. In the public market, the empowerment of institutional investors will make it possible to transform some of the mandatory regulation into optional rules, following the British comply-or-explain system. On the private market front, there are compelling reasons to mandate a delayed disclosure provision in which hedge funds, private equity funds, and even companies private equity funds invest in report information and performance with a 1 to 2 year delay. This delay has the benefit of reducing the competitive cost of disclosure, while at the same time allowing for a serious statistical analysis of this market, which will improve allocation of savings.

The full paper is available for download here.

Economic “Stimulus” Legislation to Impose New Executive Compensation Restrictions

Posted by James Morphy, Sullivan & Cromwell LLP, on
Monday, February 16, 2009
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The post from James Morphy is based on a client memorandum prepared by attorneys at Sullivan & Cromwell LLP.

The final version of the American Recovery and Reinvestment Act of 2009, which was passed by the House on February 13 and was expected to be passed by the Senate later that night, includes extensive new restrictions on the compensation arrangements of financial institutions participating in the Troubled Asset Relief Program (“TARP”). The new legislation, which the President is expected to sign into law shortly, rewrites Section 111 of the Emergency Economic Stabilization Act of 2008 (“EESA”) (1) and directs the Treasury Department to establish standards and promulgate implementing regulations.

TREASURY TO ESTABLISH NEW STANDARDS
The new standards will codify many of the executive compensation guidelines for TARP recipients announced by the Treasury Department on February 4, 2009, impose additional restrictions and apply to all existing and future TARP recipients. It is not clear whether the standards will be immediately effective or will only be effective after regulations are issued.

Under the legislation, the standards are required to include the restrictions and other provisions summarized below, which include a variety of terms the meaning and scope of which have not been made clear.

• Financial Institutions Affected. The restrictions apply to all entities that have received or will receive financial assistance under the TARP during the period the TARP recipient has an obligation outstanding that arises from TARP financial assistance. However, the restrictions cease to apply if the Federal Government only holds warrants to purchase common stock of the TARP recipient.

• Employees Affected. Many of the restrictions extend beyond the TARP recipient’s CEO, CFO and three next most highly-compensated executive officers (the “senior executive officers”) and apply to other highly-compensated employees as well. It does not appear that other highlycompensated employees need to be officers of the TARP recipient, nor do any provisions specify how to identify such highly-compensated employees (for example, whether based on current or prior year compensation, whether a potential highly-compensated employee could drop off the prohibited group because of the bonus limit and how compensation would be defined for this purpose.

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Rights Plans Offer Special Benefits for Some Companies

Posted by John G. Finley, Simpson Thacher & Bartlett LLP, on
Sunday, February 15, 2009
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This post from John G. Finley is based on a client memorandum by attorneys at Simpson Thacher & Bartlett LLP.

The decline in the market capitalization of many companies has increased the number of pill adoptions, replacements and extensions. FactSet SharkRepellent’s data show that rights plan activity (i.e., adoptions, replacements and extensions) in 2008 was at the highest level since 2002 and more than 64% higher than 2007. A major reason for this uptick in activity has been the severe decline in market capitalizations resulting in an increased risk of opportunistic takeover threats, particularly for small cap companies.

OFF-THE-SHELF STRATEGY PROBLEMATIC FOR SMALL CAPITALIZATION COMPANIES

In recent years, most companies have not been adopting (or renewing) rights plans because of (i) diminished legal concern with respect to adopting plans in the “heat of the battle” and (ii) the RiskMetrics Group (“RMG”) policy, adopted in 2005, that generally recommends “withhold” or “against” votes with respect to directors who adopt a rights plan that is not subject to stockholder approval. Many companies have, therefore, refrained from adopting a pill with the knowledge that they could adopt a rights plan if and when a specific takeover threat emerged.

This “off-the-shelf” strategy is, however, not well suited to a company with a market capitalization that has fallen below roughly $500 million given the threat of an accumulation of control by an acquiror. The key warning signs of an accumulation—an antitrust filing under the Hart-Scott-Rodino Act ($65 million threshold) and a filing of a Schedule 13D (5% of the company’s outstanding common stock)–may not occur until after a substantial accumulation has already taken place. For example, if a company has a market capitalization of $250 million, then an HSR filing would not be required until the accumulation was at the 25% ownership level. While a Schedule 13D is required to be filed once the 5% threshold is crossed, there is a ten-day window before the filing is required. In addition, although Delaware’s “business combination” statute and similar statutes in other states limit the ability of stockholders who exceed specified ownership levels from engaging in certain business combinations for a prescribed period of time (e.g., three years following the threshold crossing in Delaware), these statutes do not prevent the actual accumulation of shares and the attendant implications of having a meaningful block of shares in the hands of an activist investor.

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Year-End Update On Class Actions

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on
Saturday, February 14, 2009
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This post is by John F. Olson’s colleagues Gail Lees, Andrew Tulumello, Chip Nierlich, Mark Whitburn and Chris Chorba.

Class action lawsuits are an increasingly pervasive force in today’s business world. Defending and defeating these cases efficiently and prudently is a top priority for many in-house legal teams and their outside counsel. This year-end update reports on key trends in class action practice. It provides an overview of Rule 23, reviews key class action decisions from 2008, and identifies important class action issues likely to be litigated in 2009 and in the years ahead.

The number of class actions has grown exponentially in recent years. Although reliable numbers are hard to come by, Federal Judicial Center statistics suggest that new class action cases filed in or removed to federal court increased 72% between 2001 and 2007,[1] reaching approximately 4,000 to 5,000 annually as of mid-2007 (the last period for which data are available). This represents more than a dozen new lawsuits every day.[2] And while the Class Action Fairness Act (“CAFA”) has shifted many putative nationwide class actions from the state to the federal system, our class action lawyers, who, according to Law360, are running one of the top five busiest federal class action practices in the country, report that state court class action activity in many courts has not diminished. CAFA has prompted a flurry of single-state class actions filed in state courts, and recent statistics show that in at least one forum favored by the plaintiffs’ bar (Los Angeles), state class action filings continue to grow.

Gibson Dunn predicts that these trends will increase in 2009, as recently enacted and anticipated legislation will expand the ability of the plaintiffs’ bar to bring new suits. Gibson Dunn already is seeing a surge in labor and employment, consumer fraud, and products liability litigation. That trend will continue, as a new administration and Democratic Congress enact laws–such as the Lilly Ledbetter Fair Pay Act–that expand or create new legal remedies, and cut back on or repeal federal statutes and administrative regulations that have in the past preempted state-law based suits.

Gibson Dunn also expects the Supreme Court to enter the debate over Rule 23. To date, there has been a significant mismatch between the Supreme Court’s docket and the pervasiveness of Rule 23 cases in the federal system. Despite the overwhelming number of class action cases flowing through the federal judiciary, the Supreme Court has continued to steer clear of core Rule 23 and class certification issues for many years–a trend that should not and cannot last much longer. In the last five terms alone, the Supreme Court has decided seven tax cases, six ERISA cases, five Title VII cases, and five cases under the Age Discrimination in Employment Act. However, in the last thirty-five years, the Supreme Court has decided fewer than a dozen cases involving core class action issues.[3] Splits across an important range of issues continue to develop and percolate in the lower courts, and it is appropriate and urgent for the Court to provide much-needed guidance on these issues.

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The Case for Big Government

Posted by Jeff Madrick, Schwartz Center for Economic Policy Analysis, on
Friday, February 13, 2009
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This post is by Jeff Madrick of the Schwartz Center for Economic Policy Analysis.

My recent book, The Case for Big Government, argues that America has been the victim of an anti-government ideology that has grown more intense, even under a Democratic president, Bill Clinton, since the late 1970s. It has long been part of the American national character to look with suspicion on government. After all, its very origins were a rebellion from central government tyranny.

But, in truth, America when it worked best, in my view, America used government robustly to embed its social and political values but also to create a foundation and capacity for economic growth and prosperity. The case against big government has always been ahistorical. There is no wealthy nation in the world today that does not have a big government.

Of course, some governments are bigger than others as a proportion of GDP. But the cross-country evidence is now clear. There is no statistical relationship between the size of government and the rate of growth of GDP per capita or productivity. The implication is that in many nations where government spending constitutes up to 50 percent of GDP, spending and outer social programs must in some ways significantly enhance productivity and build foundations for prosperity.

Because of America’s anti-government ideology, there is now a long and urgent to-do list in the nation. Too much has been neglected because of an over-reliance on markets and a distaste for taxes and new government programs. The list includes health care reforms, transportation and communications infrastructure, pre-K education, equal funding of k-12 education, alternative energy research and national energy policies, family work policies, among other issues. These are now at a critical stage. In time, when crisis passes, they will require an increase in taxes to pay for them.

The list also includes the need to focus serious attention on re-regulating American business. The dependence on financial markets to support growing overall demand through the issuance of debt, and also to remunerate CEOs and other high executives through the equity markets, is a direct reflection of faith-based ideology, not practical empiricism.

Despite the American mythology, there has never been laissez faire government in the U.S. Neo-classical economics provides much justification for government intervention and spending. But the extent is a matter of debate. Other economic theories are perhaps more relevant today.

America’s history may provide the stronger empirical case for government. Time and again, government changed in America to meet new needs. Even Jefferson, the heroic defender of laissez faire, bought Louisiana and demanded that there be regulations to control the sale of land. His party’s successors built the nation’s canals and free primary schools. The list goes on: grants of land to build colleges; land donations to subsidize the railroads; the building of sanitation systems, critical to the development of cities; the development of high schools; the building of roads and highways and parks; the subsidies of college and healthy research, and of course a century’s worth of laws to protect workers, make products safe, and, since the early 1900s, with many additions along the way, to regulate finance.

Most important, government is the nation’s key agent of change. There are no permanent rules as to where it can go and what it can do. These must be fluid, because societies and economies grow, and knowledge and expectations evolve.

Subjecting Private Funds to SEC Registration and Oversight

Posted by John G. Finley, Simpson Thacher & Bartlett LLP, on
Thursday, February 12, 2009
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This post from John G. Finley is based on a client memorandum by attorneys at Simpson Thacher & Bartlett LLP.

A bill introduced in the Senate on January 29, 2009 would generally require private funds to register with the U.S. Securities and Exchange Commission and impose other regulatory requirements, including the filing of information for public disclosure such as the identity of investors and the value of fund assets. The “Hedge Fund Transparency Act” (the “Bill”) was introduced by senior senators Carl Levin (D-MI) and Chuck Grassley (R-IA). Despite the name of the Bill, it applies to all types of private funds and not just hedge funds.

ALL TYPES OF PRIVATE FUNDS REGULATED
Unlike recent unsuccessful regulatory efforts focused only on the hedge fund industry,[1] the Bill would apply to nearly all types of private funds. Aside from certain de minimis exclusions (e.g., funds with assets of less than $50,000,000), all hedge funds, private equity funds and other private funds would be subject to the new regulations through proposed amendments to the definition of an investment company in the Investment Company Act of 1940 (the “Investment Company Act”). Traditionally, private funds have relied on exemptions from the definition of an investment company under the Investment Company Act pursuant to §3(c)(1) (exempting any issuer whose securities are privately placed and owned by no more than 100 investors) and §3(c)(7) (exempting any issuer whose securities are privately placed and owned exclusively by “qualified purchasers”). The Bill proposes to amend the definition of “investment company” by deleting those two exemptions in their entirety, moving them to become the new §6(a)(6) (formerly §3(c)(1)) and §6(a)(7) (formerly §3(c)(7)). The text of the replacement sections would remain largely the same, with the notable differences that funds falling under these sections would now be considered “investment companies” and any “large investment companies” (funds with assets of $50,000,000 or more) would be required to meet certain registration and reporting conditions in order to be excluded from the onerous regulatory requirements otherwise imposed on investment companies required to register under the Investment Company Act (i.e., mutual funds).

PROPOSED REPORTING REQUIREMENTS
The Bill would impose the following registration and reporting requirements on any private fund relying on §6(a)(6) or §6(a)(7) with assets of $50,000,000 or more:

• Registration with the SEC

• Maintenance of such books and records as the SEC may require

• Cooperation with the SEC in regard to any request for information or examination

• The filing of an electronically-searchable “information form” at least once a year to be made publicly available by the SEC and to include information such as:

  • the names and current addresses of each natural person who is a beneficial owner of the fund, any company with an ownership interest in the fund and the primary accountant and primary broker of the fund,
  • an explanation of the structure of ownership interests in the fund,
  • information on any affiliation that the fund has with another financial institution,
  • a statement of any minimum investment requirement,
  • the total number of investors, and
  • the current value of the assets of the fund and any assets under management by the fund (apparently on an aggregate basis rather than on an investment-by-investment basis).

The Bill’s requirement of public disclosure of the names of private fund investors is likely to spark debate. The policy rationale for providing public disclosure of the names and addresses of investors in private funds is unclear and raises significant privacy concerns, especially for entities used in personal planning contexts.

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Is Investor Protection the Top Priority of SEC Enforcement?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, February 11, 2009
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This post comes to us from Stavros Gadinis, who is a Post-graduate Fellow at Harvard Law School.

A paper I recently posted on SSRN, “Is Investor Protection the Top Priority of SEC Enforcement? Evidence from Actions Against Broker-Dealers,” provides the first empirical account of SEC enforcement efforts against the firms at the center of the current market turmoil: investment banks and brokerage houses. It suggests that the SEC favors defendants associated with big (listed) firms compared to defendants associated with smaller firms. Moreover, the paper finds tentative support for the hypothesis that SEC officials favor prospective employers.

The paper uses a new dataset of all SEC actions against broker-dealers in 1998, 2005, 2006, and the first four months of 2007. It presents systematic data on the types of violations the SEC pursues, the typical sanctions it imposes, and the enforcement venues (courts and administrative proceedings) and settlement patterns in its actions. More importantly, the paper investigates whether the SEC treats large and well-known investment houses more favorably than small broker-dealers. Because the SEC may choose to pursue a broker-dealer by either filing a civil lawsuit or by initiating administrative proceedings before an administrative law judge, the paper first explores the factors that determine the agency’s choice of venue. Courts are a worse forum for finance professionals, since, conditional on a finding of violation, a court is more likely than an administrative law judge to ban defendants from the securities industry. The paper finds that, for the same violation and comparable levels of harm to investors (proxied by disgorgement awards), big firms and their employees are more likely to avoid courts and face administrative proceedings instead.

The paper then turns to administrative cases, which the SEC controls more directly than court cases. Again, the paper finds that, for the same violation and comparable levels of harm to investors, big firms and their employees are less likely to receive a ban from the securities industry, compared to small firms and their employees. Some theories could justify the differential treatment of large and small firms, on the basis of systemic risk considerations or concerns about unduly penalizing entire firms because of limited violations. However, no public policy justification exists for the preferential treatment of individual employees in large firms.

Despite controls concerning violation types and levels of harm, it is possible that big firms’ conduct is systematically less reproachable than small firms’ conduct, because of better compliance systems, higher quality personnel and sophisticated clients. To address these concerns, the paper presents qualitative evidence on a subset of cases where these concerns would be greatest: cases involving a failure to supervise subordinates. It finds that small- and big-firm violations are so similar in terms of fact-patterns, types of supervisory failures, and specific omissions, that they are virtually indistinguishable from a law enforcement perspective.

Finally, the paper tentatively links the above results with concerns about the post-SEC career trajectories of agency officials, who find employment in big firms’ compliance departments or in premier law firms. The paper shows that big firms headquartered in favorable locations receive lower sanctions than big firms around the country, indicating that SEC officials may respond to future employment prospects. The paper also provides some evidence that variation in the quality of legal representation between big and small firms cannot account for the observed differences in sanctions, because these differences persist even for cases where both big and small firms are likely to hire outside counsel.

The paper is available here.

Madoff – Could it Have Happened in the UK?

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, February 11, 2009
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This post is by Michael Raffan and Andrew Marsh of Freshfields Bruckhaus Deringer LLP in London.

This post outlines what the alleged Madoff fraud involved and how it was able to happen. It looks at relevant aspects of the US regulatory system and draws attention to some similarities in the UK system.

The Madoff debacle
Bernard Madoff’s alleged Ponzi scheme is reported to have cost clients $50bn. His business was run through Bernard L Madoff Investment Securities (‘Madoff’), based in New York. For years it appeared that Madoff was consistently making large returns from a sophisticated investment strategy involving purchases of equities hedged by out-of-the-money put-and-call index options. It now seems that those returns were fictitious and that payments to investors were being financed from the proceeds of new investments.

Not a hedge fund story
Initially the press reported this as a hedge fund story, no doubt because of Madoff’s purported complex investment strategy. But it seems that Madoff did not establish a hedge fund as an investment vehicle. Instead, it simply managed clients’ investment portfolios on a segregated, client-by-client basis. Indeed, Madoff seemed particularly keen to minimise the number of legal entities involved. It not only managed the accounts as discretionary investment manager, it also executed the trades itself as broker and acted as the custodian of clients’ cash and investments.

Ironically, it would have been much harder to maintain a fraud if Madoff had operated a hedge fund. Although hedge funds are typically established in less heavily regulated jurisdictions, they generally use an independent administrator, third party brokers and a custodian (often a prime broker) that is not itself the investment manager. The need for frequent reconciliations between the various confirmations, statements, reports and records of these entities makes concealment of fraud much more difficult.

Madoff and the regulatory system in the US
Inevitably, questions are being asked about whether the Madoff debacle has shown up deficiencies in the US regulatory system. The US system clearly distinguishes between broker dealers on the one hand and investment advisers (including discretionary investment managers) on the other hand. Madoff operated both types of businesses, which it carried out on separate floors of the same building. Initially it was registered only as a broker dealer. It claimed that its discretionary investment management activity did not require it to register as an investment adviser because it was remunerated only by trading commissions, rather than by a percentage of assets under management or profits.

Following various allegations of potential fraud, a Securities and Exchange Commission (SEC) enforcement investigation was launched in 2006. Although this failed to find any evidence of fraud, Madoff was found to be in breach of the investment adviser registration requirement. Madoff then registered as an investment adviser (in addition to its broker dealer registration) in September 2006. Madoff’s investment advisory business therefore became subject to the SEC’s regular inspection regime for investment advisers in 2006. But no inspection had in fact been carried out before the firm’s collapse.

Does any of this suggest that changes are needed to the US regulatory system? Clearly the SEC’s failure to detect fraud in its 2006 investigation suggests that there may be lessons to be learned about how such investigations should be conducted. But it is difficult to tell at this stage how far the SEC was at fault in this respect. If Madoff had been required to register as an investment adviser much sooner, there would have been a greater chance of detecting problems earlier. However, it is much more difficult to detect fraud when one or a few individuals are able to maintain control over books and records without any independent examination of whether the transactions in those books and records are real. It also appears that SEC investigators lacked the financial sophistication to understand that Madoff’s financial results were highly suspect – even though a number of commercial banks and brokerage houses harboured suspicions about this business activity and therefore refused to deal with Madoff.

One of the most interesting aspects of this case is that the concentration of investment functions in one place is not prohibited under the US regulatory system. There is nothing to prevent an investment adviser from acting as custodian, broker and administrator. This is the case even for ordinary retail and unsophisticated investors. By contrast, regulators have long recognised the importance of segregation of functions within a firm to prevent, for example, the same individual from performing both trading and settlement functions. The fact that no such requirements apply at the level of the firm itself allows opportunities for fraud if the firm is institutionally corrupt.

Could it happen here?
The simple answer is ‘yes’. Importantly, the UK system is the same as the US’s in allowing investment management, execution and custody to be performed by the same entity firm, even for retail clients. The more flexible Financial Services Authority (FSA) system based on ‘risk‑based’ regulation may have led the FSA to keep a closer eye on the firm’s operations, but that would of course have depended on the FSA having identified the firm as being higher risk in the first place. The job of assessing a firm’s risk profile is a difficult one, which seems deceptively easy only with hindsight. In the light of the Madoff experience it seems likely that the concentration of investment functions in a single firm will rank more highly as a risk factor with the FSA.

Areas for Enhanced Board Focus

Posted by Ira M. Millstein, Weil, Gotshal & Manges LLP, on
Tuesday, February 10, 2009
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This post is based on a client memo by Ira M. Millstein, Holly J. Gregory and Rebecca C. Grapsas of Weil, Gotshal & Manges LLP.

Recent events in the financial markets and the ensuing economic turmoil has shattered the trust of investors, regulators and Main Street in financial institutions and the capital markets on a global scale. The crisis has heightened focus on the importance of risk management at all corporations and has encouraged a fresh look at the role of the board in risk oversight. Although the manner in which a board fulfills its risk oversight responsibilities is a matter of business judgment, directors should bear in mind that conduct will be judged by investors, regulators, the media and others with the benefit of 20-20 hindsight. There is benefit to be had in going beyond the standards of care set by Caremark and its progeny, which require board oversight of an effective compliance and reporting system. Remembering that “best practices” provide a zone of comfort with respect to avoiding director liability, we set forth below ten areas for the board to enhance its focus in 2009 in light of the current environment. They are all related in some respect to enhancing the board’s ability to oversee management’s efforts to identify and avoid, mitigate or manage risk, with the caveat that specific actions to be taken will vary for each company.

1. Apply judgment in tailoring governance structures and processes to the current needs of the company. Remember that adopting a one-size-fits-all check-list approach to corporate governance is fundamentally inconsistent with effective governance. Care should be taken to avoid bowing to pressures to adopt practices that may not be in the company’s interest, while at the same time actively considering the viewpoints of key shareholders on appropriate matters. Boards should tailor their governance practices and structures to the company’s unique needs. The Key Agreed Principles to Strengthen Corporate Governance of U.S. Public Companies published in October 2008 by the National Association of Corporate Directors with support and input from The Business Roundtable and the International Corporate Governance Network (available here and briefly outlined in the Appendix to this document) reflect an effort to distill and articulate fundamental principles-based aspects of governance on which there is broad consensus. The Key Agreed Principles capture the current baseline consensus among boards, managements and shareholders about a range of effective governance practices. Their articulation may help improve the quality of discussion and debate about those governance issues that have not yet gained consensus, and also serve as a touchstone for boards in tailoring governance and avoiding a rote approach. We urge boards to gain familiarity with the Principles and consider them in tailoring their own governance structures and practices to meet the needs of their respective companies.

2. Take a fresh look at board composition and director competency. While a board is more than the sum of its parts, it requires key skill sets and experiences to be positioned to provide and oversight of risk and compliance. The nominating/corporate governance committee should review with rigor the composition of the board and determine whether the board is comprised of people with the optimal mix of experience given the business, circumstances and nature of the risks facing the company. The right mix of competencies will change over time as the company evolves and care needs to be taken to avoid a mindset of “permanent tenure” for directors. The board should use the evaluation process (as well as term/age limits where appropriate) to refresh itself periodically. It is not enough to pull together a distinguished group of men and women if those directors do not have the expertise necessary to understand the fundamentals of the company’s business as the business changes over time and the attendant risks. Given the emphasis on independent directors, boards need to take special care to ensure that persons on the board have industry specific expertise and distinct sources of information about the intricacies of the business and related risks. The board should consider ways to ensure that it is not simply dependent on management for its understanding of the business and the industry. The nominating/corporate governance committee should ensure that company-specific director education and orientation programs are presented to the full board periodically, especially programs that address risk oversight and risk management generally, providing directors with the opportunity to learn about specific risks affecting the company and changes in business conditions and legal standards that may impact on risk.

3. Consider implementing some form of independent board leadership. The ability to exercise effective oversight may be compromised where the board lacks any defined leadership for the independent and non-management directors. Management has natural conflicts and blind spots — in monitoring CEO performance, providing risk oversight and evaluating the strategic plan. The long-range trend is toward a separation of the chair and CEO positions, with an independent director filling the chair role, and that trend is likely to accelerate as shareholders seek assurances that the board is strongly positioned to provide objective judgment in its review of management decisions in key areas. The board — and in particular the independent directors assisted by the nominating/corporate governance committee — should evaluate whether to appoint a separate independent chairman or a strong lead director to assist the board in fulfilling its oversight responsibilities, and should explain its choice to shareholders. For companies that combine the roles of CEO and chairman, expect increased pressure from shareholders to separate the positions or at a minimum create a strong lead director position with an appropriate range of responsibilities. Indications are that independent board leadership will be a “hot button” issue for shareholders during the 2009 proxy season.

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Risk and The Chief Legal Officer: Expanding Exposure

Posted by Peter Atkins, Skadden, Arps, Slate, Meagher & Flom LLP, on
Tuesday, February 10, 2009
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This post is by Peter Atkins of Skadden, Arps, Slate, Meagher & Flom LLP.

My firm has prepared a memo entitled “Risk and The Chief Legal Officer: Expanding Exposure,” which addresses what we believe is expanding exposure facing Chief Legal Offices (CLOs) of US public companies. The first two sections briefly address the two key underpinnings of this phenomenon: (1) increasing focus on the CLO as a central player in the fight for improved corporate governance and legal/ ethical compliance; and (2) an increasingly complex legal environment, with the prospect of more legislation and regulation.

The third section provides the distilled practical guidance of a large number of Skadden lawyers from a broad range of relevant practice areas, developed in response to a basic question: “Based on your personal experience, what do you think would be particularly valuable for a CLO of a public company to know about the CLO’s risk exposure today and how best to manage it?” Our guidance comes in the form of a series of intentionally pithy headline observations, followed by some important elaboration on each. Broadly speaking, our guidance relates to the two basic areas of CLO risk management — responding to a potential or actual problem which arrives on the scene and dealing in advance with preventative measures. Some points clearly fall into one category or the other; a few are relevant to both.

While targeted for CLOs of U.S.public companies, the memo may be of interest to CLOs of many non-U.S. public companies, as well.

The memorandum is available here.

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