Yearly Archives: 2009

A New Capital Regulation For Large Financial Institutions

Posted by Oliver Hart, Harvard University, on
Wednesday, November 11, 2009
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If there is one lesson to be learned from the 2008 financial crisis, it is that large financial institutions (LFIs) are too big to fail. Whether the too-big-to-fail doctrine is based on economic thinking (the cost of a large failure is too high) or political reality (the pressure to save LFIs is too strong), the conclusion is the same: we need to rethink how we regulate these institutions. In A New Capital Regulation For Large Financial Institutions, which I recently presented at the Law, Economics and Organizations seminar here at Harvard Law School, my co-author Luigi Zingales and I view the goal of regulation as being to preserve the incentive effects of bankruptcy while avoiding the possibility that an LFI is insolvent with respect to its systemic obligations: interbank lending, derivatives and deposits.

We introduce a new capital requirement system designed specifically for LFIs. Our mechanism mimics the way margin calls function. LFIs will post enough collateral (equity) to ensure that the debt (all the debt, not just the deposits and derivative contracts) is paid in full with probability one. When the fluctuation in the value of the underlying assets puts debt at risk, LFI equity holders are faced with a margin call and they must either inject new capital or lose their equity. There are three main differences between margin calls and our new capital requirement system: the trigger mechanism, the action taken if the trigger is activated, and the presence of an additional cushion of junior long-term debt.

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SEC Reverses Position on Rules for Excluding Shareholder Proposals

Posted by James Morphy, Sullivan & Cromwell LLP, on
Wednesday, November 11, 2009
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This post is based on a Sullivan & Cromwell LLP client memorandum.

October 27, 2009, the SEC’s Division of Corporation Finance issued a Staff Legal Bulletin changing prior guidance on the application of Rule 14a-8(i)(7), and expanding the scope of matters that the Division considers permissible subjects for shareholder proposals in company proxy statements. Rule 14a-8(i)(7) permits a company to exclude a shareholder proposal from the company’s proxy statement insofar as the proposal deals with a matter relating to the company’s ordinary business operations.

In the Staff Legal Bulletin, the Division reverses its prior positions that proposals relating to environmental, financial or health risks and proposals related to CEO succession planning may be excluded under Rule 14a-8(i)(7). The Division’s action met with approval from environmental activists who have long sought to include shareholder proposals related to climate change issues in corporate proxy statements.

The Division also clarified that both companies and shareholder proponents may alert the Division in advance of their intent to submit correspondence in connection with a no-action letter request under Rule 14a-8.

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Corporate Governance Provisions Added to Financial Reform Bill

Posted by Martin Lipton, Wachtell, Lipton, Rosen & Katz, on
Tuesday, November 10, 2009
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This post is based on a Wachtell, Lipton, Rosen & Katz memorandum by Martin Lipton, Theodore N. Mirvis, Steven A. Rosenblum, David M. Adlerstein and Karessa L. Cain.

Senator Dodd unveiled his 1,136-page financial reform bill discussion draft today, which proposes a variety of new financial industry regulations and regulatory agencies. While the bill focuses on these wide-ranging and controversial financial reform proposals, a number of corporate governance reforms are also buried in the bill on pages 755 to 762, and are largely taken, albeit in somewhat weakened form, from Senator Schumer’s proposed Shareholder Bill of Rights Act. As we have previously commented, these governance reforms, while presented as a means of enhancing corporate governance and restoring stability to American companies, are likely to have just the opposite effect. See the Wachtell, Lipton, Rosen & Katz memoranda “A Crisis Is a Terrible Thing to Waste: The Proposed ‘Shareholder Bill of Rights Act of 2009’ Is a Serious Mistake,” posted on the Forum here, and “Corporate Governance in Crisis Times,” posted on the Forum here.

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Private Fund Investment Advisers Registration Act Approved by House Committee

Posted by Eduardo Gallardo, Gibson, Dunn & Crutcher LLP, on
Tuesday, November 10, 2009
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This post is based on a Gibson Dunn & Crutcher LLP client memorandum by Michael Bopp, Jennifer Bellah Maguire, Edward Nelson, Edward Sopher and Amanda Neely.

This update focuses on the House Financial Services Committee’s consideration and approval on October 27, 2009 of H.R. 3818, the Private Fund Investment Advisers Registration Act of 2009. The full text of the bill as amended by the Committee is not yet available.

Overview of Process

While few things are predictable and nothing is certain about the legislative process, the Private Fund Investment Advisers Registration Act has a decent chance of becoming law in a form not unlike that which was reported out of the House Financial Services Committee last week. The once-controversial bill was the subject of a remarkably bipartisan mark-up, particularly in contrast to the Consumer Financial Protection Agency Act (H.R. 3126) mark-up, which followed shortly thereafter. Most amendments to the bill were adopted by near-unanimous voice votes, and the Committee approved the bill, as amended, by a vote of 67 to 1 (Representative Ron Paul (R-TX) was the lone dissent).

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Lessons for M&A Advisors in Crafting Engagement Letters

Posted by David A. Katz, Wachtell, Lipton, Rosen & Katz, on
Tuesday, November 10, 2009
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This post is based on a Wachtell, Lipton, Rosen & Katz memorandum by David A. Katz, William Savitt, and Ryan A. McLeod.

A federal court decision interpreting an investment bank’s engagement letter on a motion to dismiss highlights the risk that—absent careful drafting—financial advisors may be held liable to third-party beneficiaries on both contract and fiduciary duty claims. Baker v. Goldman Sachs, Civ. No. 09-10053-PBS (D. Mass. Sept. 15, 2009).

The financial advisor represented a closely held company, founded and controlled by the Bakers, in connection with its review of potential strategic transactions in early 2000. Allegedly relying on the financial advisor’s advice, the company entered into a stock-for-stock merger agreement with a Dutch buyer, and the deal closed in June 2000. Just months later, the Wall Street Journal uncovered a massive accounting fraud at the Dutch buyer, whose shares subsequently lost all value and whose collapse cost the Bakers their investment. Seeking to recoup some of their losses, the Bakers filed suit against the financial advisor for breach of contract and fiduciary duty. The financial advisor moved to dismiss, arguing that its engagement agreement was with the closely held company alone and that it owed neither fiduciary nor contractual duties to the Bakers.

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Is Delaware’s Antitakeover Statute Unconstitutional?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, November 9, 2009
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Editor’s Note: 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.

Steven Herscovici, Brian Barbetta, and I have a new article entitled Is Delaware’s Antitakeover Statute Unconstitutional? Evidence from 1998-2008. The working paper is available here. The article will be published in the Business Lawyer in May 2010, along with commentaries from academics, judges, and practitioners.

The article makes three simple points. First, three federal district courts held in 1988 that Delaware’s antitakeover statute must give bidders a “meaningful opportunity for success” in order to be valid under the Supremacy Clause of the U.S. Constitution. Second, these three courts upheld Section 203 because the empirical evidence available at the time showed that bidders were able to achieve an 85% tender in hostile offers reasonably often, but all three courts left open the possibility that future empirical evidence could change this constitutional conclusion. Third, no bidder in the past nineteen years has been able to achieve 85% in a hostile tender offer against a Delaware target. We conclude from these points that:

“[T]he empirical claim that the federal courts have relied upon to uphold Section 203’s constitutionality is no longer valid. It seems possible that the federal courts would uphold the constitutionality of Section 203 on different grounds. But at the very least the constitutionality of Section 203 would seem to be up for grabs.”

The Wall Street Journal and The Deal have written about our findings, and Wachtell, Lipton has issued a memorandum to clients criticizing our article. We respond to the Wachtell critique at pp. 47-48 and footnote 166 of the current draft, available above.

I am currently trying to collect data on practitioner perceptions about the viability of the 85% out. For any readers of this blog who are willing to fill out the very short poll available here, I will e-mail a synthesis of the findings to you in a few weeks. Thank you in advance for your help.

Taxing Unreasonable Compensation

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, November 8, 2009
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This post comes to us from Aaron Zelinsky.

In my paper, Taxing Unreasonable Compensation: §162(a)(1) and Managerial Power, which is forthcoming in the Yale Law Journal, I argue that IRS should disallow tax deductions for unreasonable compensation paid by publicly held corporations.

Section 162(a)(1) of the Internal Revenue Code allows companies to deduct “a reasonable allowance for salaries or other compensation.” The IRS has systematically interpreted “reasonable allowance” to apply only to closely held corporations, effectively concluding any amount of compensation paid by a publicly held corporation is “reasonable.” The IRS bases this interpretation on the presumed arms-length nature of the board-CEO relationship, which sets compensation at a “reasonable” level.

I argue that, in light of the managerial power hypothesis, executives may exercise undue influence over the board in setting their compensation. Therefore, publicly traded corporations may lack the appropriate oversight and incentive infrastructure to set executive compensation reasonably. Thus, the IRS should examine the compensation of both publicly and privately held corporations.

I suggest two methods for achieving this result: first, the IRS could employ the same multi-factor test to evaluate compensation paid by publicly traded corporations as it does for the compensation paid by their privately traded brethren. Second, the IRS could assess the objective traits of the corporations CEO-board relationship to determine the propensity for management influence in the setting executive compensation.

The full paper is available for download here.

Merrill Bonuses Raised Issues in Merger with Bank of America

Posted by Joseph E. Bachelder III, Law Offices of Joseph E. Bachelder, on
Saturday, November 7, 2009
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This post comes is based on an article that first appeared in the New York Law Journal.

On Jan. 1, 2009, Merrill Lynch & Co. Inc. (“Merrill”) merged with Bank of America Corporation (“BofA”). [1] At the end of 2008, prior to the close of the merger, Merrill awarded approximately $3.6 billion in bonuses to its employees. The payment of these bonuses has been the subject of numerous investigations and lawsuits. This column discusses (i) the background to the payment of these bonuses and (ii) a pending lawsuit charging BofA with not furnishing adequate information to its shareholders in connection with their vote on Dec. 5, 2008, in which they approved the merger. [2]

Background

In the one-week period beginning Sept. 13 and ending Sept. 19, 2008, crises erupted at a number of major financial firms. The investment firm of Lehman Brothers filed for bankruptcy. The insurance conglomerate AIG received a pre-TARP bailout of $85 billion (giving the Federal Reserve a 79.9 percent stockholder position; additional amounts subsequently were provided with the total bailout amounting to approximately $170 billion). A third firm facing a financial crisis was Merrill. [3]

On Saturday, Sept. 13, 2008, Kenneth Lewis, the chief executive officer of BofA, met with John Thain, the chief executive officer of Merrill. They discussed the possible acquisition by BofA of Merrill. Merrill’s losses were turning out to be significantly greater than anticipated earlier in the year. Merrill’s losses, the deepening crisis on Wall Street and the precipitous drop in Merrill’s stock price threatened its survival.

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Should Bondholders be Bailed Out?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, November 6, 2009
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(Editor’s Note: This post is Lucian Bebchuk’s most recent column in his series of monthly commentaries titled “The Rules of the Game” for the international association of newspapers Project Syndicate, which are available here.)

A year after the United States government allowed the investment bank Lehman Brothers to fail but then bailed out AIG, and after governments around the world bailed out many other banks, key question remains: when and how should authorities rescue financial institutions?

It is now widely expected that, when a financial institution is deemed “too big to fail,” governments will intervene if it gets into trouble. But how far should such interventions go? In contrast to the recent rash of bailouts, future government bailouts should protect only some creditors of a bailed-out institution. In particular, the government’s safety net should never be extended to include the bondholders of such institutions.

In the past, government bailouts have typically protected all contributors of capital of a rescued bank other than shareholders. Shareholders were often required to suffer losses or were even wiped out, but bondholders were generally saved by the government’s infusion of cash.

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Practical Solutions To Improve The Proxy Voting System

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, November 6, 2009
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On October 21, 2009 The Altman Group submitted a proposal to the SEC titled Practical Solutions To Improve The Proxy Voting System (available here).

Effective January 1, 2010 brokerage firms will no longer be able to vote for non-responding clients with regard to uncontested elections of directors as a result of the SEC’s recent approval of Amended NYSE Rule 452. Also, for many years corporations have complained about a lack of access to the names of all of their beneficial owners. Finding ways to deal effectively with these issues is now of significant importance to public companies of all sizes.

Our proposal to the SEC suggests certain reforms to the proxy voting system. Among the key issues which we propose the SEC take action on are the following 5 points:

  • 1. First and foremost, a new methodology called ABO (i.e., All Beneficial Owners) should replace the current NOBO/OBO mechanism which has existed for 25 years, at least with regard to record dates for annual or special meetings.
  • 2. The SEC should seek to authorize the establishment of a second mail and tabulation methodology, one that would give companies the ability (using the names available under ABO) to choose a different vendor to take responsibility for the mailing and tabulation process, while retaining the option to use the current Broadridge system. This new option would be akin to the way most companies currently use their transfer agent to mail and tabulate the votes of registered owners.
  • 3. The SEC should require the NYSE to implement as quickly as possible a robust investor education program to try and ameliorate at least some of the impact resulting from the loss of broker voting on non-contested director elections under Amended NYSE Rule 452.
  • 4. The SEC should amend Rule 13(f) so that information reported by institutions reflects both shares owned and also voting rights after taking into account loans and other transactions that alter such rights. We also suggest shortening the reporting period for 13(f) information to 15 days from 45 days after the end of a calendar quarter and reducing from 20 to 10 business days the pre-notification of a company’s annual meeting record date.
  • 5. The SEC should establish new procedures to deal with issues like “empty voting” and the use of derivative positions to alter voting rights.
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