Yearly Archives: 2009

Opinions as Incentives

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, November 5, 2009

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This post comes to us from Yeon-Koo Che of Columbia University and Yonsei University and Navin Kartik of Columbia University.

 

Difference of opinion would be obviously valuable if it inherently entails a productive advantage in the sense of bringing new ideas or insights that would otherwise be unavailable. But could it be valuable even when it brings no direct productive advantage? Moreover, are there any costs of people having differing opinions? In our forthcoming Journal of Political Economy paper entitled Opinions as Incentives, we explore these questions by examining the incentive implications of difference of opinion.

We employ a framework that captures common themes encountered by many organizations.  More specifically, we study a setting in which a decision maker, or DM for short, consults an adviser before making a decision. Both individuals’ payoff from the decision depends on some exogenous state of the world. We model the decision and the state as real numbers, where the DM’s payoff-maximizing decision is equal to the state. At the outset, however, neither the DM nor the adviser knows the state; they only hold some prior views about it. The adviser can exert costly effort to try and discover an informative signal about the state; the probability of observing such a signal is increasing in his effort. Effort is unverifiable, however, and higher effort imposes a greater cost on the adviser. After the adviser privately observes the information, he strategically communicates with the DM. Communication takes the form of verifiable disclosure: sending a message is costless, but the adviser cannot falsify information, or equivalently, the DM can judge objectively what a signal means. The adviser’s strategic choice therefore is whether or not to reveal any information he has acquired. Finally, the DM makes her decision given her updated beliefs after communication with the adviser.

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Professor Bebchuk Intervenes in Israel’s Largest Reorganization

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, November 4, 2009
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At the request of one of Israel’s largest institutional investors, Professor Lucian Bebchuk submitted a report on whether the reorganization proposal of Africa-Israel Investments Ltd. would adequately protect the interests and contractual rights of public bondholders. Africa-Israel Investment Ltd., a conglomerate with business operations around the world (including the US where one of its subsidiaries owns the New York Times building), is the largest business firm to have undergone a reorganization process in Israel’s history. Given the importance of the reorganization of Africa-Israel Investments for investors, and the possibility that this reorganization might affect the structure of other reorganizations of financially distressed firms in Israel, Bebchuk carried out his review and analysis on a pro bono basis. Bebchuk’s report concluded that the proposal made by the company failed to provide adequate protection for the bondholders’ rights and interests and discussed ways in which the plan should be revised to provide bondholders with adequate protection.

Bebchuk’s report is available here. An article focusing on the report published by Haaretz, one of Israel’s main newspapers, is available here (in Hebrew).

Risk Management Lessons from the Global Banking Crisis

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, November 4, 2009
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The following post comes to us from William L. Rutledge, executive vice president in charge of the Bank Supervision Group at the Federal Reserve Bank of New York, and Chairman of the Senior Supervisors Group.

The events of 2008 clearly exposed the vulnerabilities of financial firms whose business models depended too heavily on uninterrupted access to secured financing markets, often at excessively high leverage levels. This dependence reflected an unrealistic assessment of liquidity risks of concentrated positions and an inability to anticipate a dramatic reduction in the availability of secured funding to support these assets under stressed conditions. A major failure that contributed to the development of these business models was weakness in funds transfer pricing practices for assets that were illiquid or significantly concentrated when the firm took on the exposure. Some improvements have been made, but instituting further necessary improvements in liquidity risk management must remain a key priority for financial services firms.

The Senior Supervisors Group (SSG), a group of senior financial supervisors from seven countries of which I am Chairman, recently forwarded a report to the Financial Stability Board entitled Risk Management Lessons from the Global Banking Crisis of 2008. The report reviews in depth the funding and liquidity issues central to the recent crisis and explores critical areas of risk management practice warranting improvement across the financial services industry. The report is a companion and successor to the SSG’s first report, Observations on Risk Management Practices during the Recent Market Turbulence, issued in March 2008.

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Fed Proposes Incentive Compensation Policies for Banking Organizations

Posted by James Morphy, Sullivan & Cromwell LLP, on
Tuesday, November 3, 2009
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This post is based on a Sullivan & Cromwell LLP client memorandum. The approach followed by the Federal Reserve was advocated in Regulating Bankers’ Pay, a discussion paper by Lucian Bebchuk and Holger Spamann issued by the Program on Corporate Governance last spring, which was described in a post on the Forum here.

On October 22, 2009, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a comprehensive proposal (the “Proposal”) on incentive compensation policies that is intended to ensure that these policies do not undermine the safety and soundness of banking organizations by encouraging excessive risk-taking. The Proposal applies to all banking organizations supervised by the Federal Reserve (U.S. bank holding companies, state member banks, Edge and agreement corporations, and the U.S. operations (including securities subsidiaries) of foreign banks with a branch, agency, or “commercial lending company” subsidiary in the United States (each a “banking organization”)). It covers executive and non-executive employees who receive any current or potential compensation that is tied to achievement of one or more performance metrics, as well as “golden parachute” and “golden handshake” arrangements.

The Proposal is based on three key principles that are designed to govern incentive compensation arrangements. There are no prescriptive requirements, such as “caps” or “claw backs”, but there is extensive guidance as to the development, implementation and relevant considerations for these arrangements.

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Creating Reform That Is Sustainable for Investors

Posted by Luis A. Aguilar, Commissioner, U.S. Securities and Exchange Commission, on
Tuesday, November 3, 2009
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(Editor’s Note: The post below by Commissioner Aguilar is a transcript of his remarks at the Hofstra Investment Management Conference, omitting introductory and conclusory remarks; the complete transcript is available here. The views expressed in this post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission or the other Commissioners.)

Right now there are many voices clamoring to be heard regarding financial reform. This clamor is composed of some recommendations that are intuitive and others that are not. There are those calling for reforms that are limited to the factors that contributed to the crisis and others who see the possibility of broader legislative and administrative action as an opportunity. Some see it as an opportunity to advance their existing commercial interests, and others, like me, see it as an opportunity to reestablish a comprehensive, but flexible, capital markets regulatory framework that can better react to current and future events.

I think it is important to step back and think through the principles that should motivate any proposed reforms. As a regulator standing on the precipice of legislative and administrative action, I think it is important to focus on how things should be rather than how they are. Rahm Emmanuel’s oft-quoted remark that we should not waste a good crisis is absolutely right. I firmly hope that the opportunity will not be wasted. Unfortunately, it is clear that some transformational changes are no longer on the table — such as a merger of the SEC and CFTC. In addition, there are robust efforts underway to scale back the Obama Administration’s effort to regulate the multi-trillion dollar over-the-counter derivatives industry.

My goal for today’s remarks is to discuss an appropriate construct for financial reform and to consider examples from the current debate that exemplify these principles.

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A Costly Lesson in the Rule of “Loser Pays”

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, November 2, 2009
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(Editor’s Note: This post is based on an op-ed piece published in today’s print edition of the Financial Times and is available here.)

The UK is reviewing rules governing its civil justice system, including class actions. Lord Justice Jackson is expected to publish a report in the next few months that will take up a number of proposals, including proposals to abolish the “loser pays” rule in collective lawsuits. Yet US experience – as illustrated by a current case before the US Supreme Court – may provide a useful caution. Jones v. Harris Associates L.P., argued on November 2, 2009, demonstrates that lowering the “loser pays” barrier could have serious consequences.

In the US, of course, each side in a lawsuit – including class actions ­ pays its own costs regardless of outcome, and plaintiff lawyers can often extract a settlement that covers their costs (plus a bit), even if the case would lose at trial. A prime example is Jones v. Harris. In that case, plaintiffs’ attorneys allege a financial adviser breached its duties by overcharging clients of its collective investment schemes (mutual funds) for services. In the trial court, they lost. The adviser, after all, had produced above-average returns over many years in return for fees well within industry norms – and well below typical advisory fees in the UK. But the case has survived two rounds of appeal – despite independent trustees having negotiated the fees on behalf of investors, despite investors having approved the fees, and despite the fact that investors are free to liquidate at net asset value at any time and move their funds elsewhere in a highly competitive market.

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Securitization and Moral Hazard

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, November 2, 2009
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This post comes from Ryan Bubb and Alex Kaufman of Harvard University.

 

Perhaps no academic paper has done more to convince scholars and policymakers that mortgage securitization led to lax screening by lenders and fueled the subprime crisis than did the recent paper by Keys, Mukherjee, Seru, and Vig (forthcoming in the Quarterly Journal of Economics, 2010) (hereafter, KMSV, who published a post in June on the Forum, which is available here). In an innovative paper, they argue that mortgage purchasers follow a “rule of thumb” in deciding which loans to purchase: they are, for exogenous reasons, much more willing to buy mortgage loans given to borrowers with credit scores above 620 than those given to borrowers with credit scores below 620. In a dataset containing only securitized loans, they find that loans made to borrowers just above 620 (where securitization is easy) default at a higher rate than those just below and argue that this is strong evidence that securitization really did result in lax screening by lenders.

In a new paper, Securitization and Moral Hazard: Evidence from Lender Cutoff Rules, which we recently presented at the Harvard Business School / Harvard Economics Finance Lunch Seminar, we reexamine the credit score cutoff rule evidence with a better dataset and through a theoretical lens that assumes rational equilibrium behavior and reach a very different conclusion.

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Some Tender Offer Quirks

Posted by David Fox, Kirkland & Ellis LLP, on
Monday, November 2, 2009
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This post is based on a Kirkland & Ellis LLP client memorandum by David Fox, Daniel E.Wolf, and Susan J. Zachman.

Much has been written about the advantages of structuring a friendly acquisition as a tender offer followed by a back-end squeeze-out merger as compared to a single-step merger. Some of these perceived benefits include speed to closing, avoiding adverse recommendations from proxy advisory firms such as RiskMetrics (ISS) and mitigating the risk of “empty voting.” With SEC clarifications to the “best price” rules in 2006 and the occurrence of a few all-equity sponsor buyouts, we have seen a significant uptick in tender offer activity in both the private equity (e.g., Apax/Bankrate and Apollo/Parallel Petroleum) and strategic (Bristol Myers/Medarex and J&J/Omrix) spaces. In considering a tender offer structure, practitioners should be aware of a number of quirks that have come to light in recent tender offer transactions that may impact or offset the advantages of using this structure.

The policies and practices of index and quantitative funds with respect to participation in tender offers vary widely. Many such funds will not tender into an offer where the market price is above the offer price. Moreover, many will not tender into an offer at all, regardless of the relationship of the market price to the offer price, so long as the stock is still included in the relevant index the fund is mirroring or tracking. In situations where there is significant holding of the target stock by these funds and reaching the minimum tender condition is a close call, these policies and practices can be determinative of success or failure. In addition, to the extent such fund decisions are in fact affected by market price at the time of the expiration of the tender offer, these practices create an additional opportunity for arbitrageurs interested in the success (or failure) of a tender offer to influence the outcome of the offer by effecting minor price movements above or below an offer price. Finally, even if a tender offer is successful in achieving the minimum condition, the ability of an acquirer to reach the minimum threshold (usually 90 percent) required to effect a short form merger on the back end (and thereby avoid the expense and delay of a full-blown proxy statement) may be constrained by the behavior of those funds that will not tender under any circumstances while the stock is still in the relevant index.

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Implementing Proxy Access Under Delaware Law

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, November 1, 2009
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This post comes to us from John Mark Zeberkiewicz and Joseph L. Christensen of Richards, Layton & Finger, P.A. 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 SEC recently announced that it would delay voting on the adoption of its mandatory proxy access regime to consider the comments and feedback it received in response to its proposed Rule 14a-11. Meanwhile, at the state level, corporate practitioners are closely following whether (and, if so, in what form) Delaware corporations will voluntarily adopt proxy access bylaws pursuant to the recent amendments to the DGCL. In a brief article appearing in the latest issue of The Review of Securities & Commodities Regulation, we compare Delaware’s approach of authorizing corporations to adopt narrowly tailored proxy access bylaws to the SEC’s approach of prescribing a generally applicable proxy access rule. We illustrate the differences between the two approaches by describing a model proxy access bylaw adopted under the DGCL and pointing out various ways in which that model bylaw could be modified to meet the needs of a particular corporation. Some highlights of the model bylaw are as follows:

  • Granting the proxy access right to the stockholder or group with the greatest holdings (14a-11 grants the right based on a first-in-time system)
  • Requiring the stockholder proponent (and each member of a group) to continue to hold shares through the date of the meeting
  • Prohibiting the stockholder proponent (and each member of a group) from materially increasing its ownership stake for a specified period
  • Excluding nominations from proponents whose nominees have failed to gain substantial support in prior elections
  • Requiring a stockholder nominee to submit a conditional resignation that would become effective upon a finding that information included in the proponent’s nomination request, or information furnished by the proponent and included in the proxy statement, was false or misleading
  • Requiring proponents to indemnify the corporation against any liability, loss or damage arising out of a stockholder nomination submitted pursuant to the bylaw

The article is available here and the model bylaw (with annotations explaining ways in which various provisions may be modified) is available here.

Bailouts, Bonuses, And The Return Of Unjust Gains

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Saturday, October 31, 2009
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(Editor’s Note: This post comes to us from Tracy A. Thomas of the University of Akron, and is based on a comment in the Washington University Law Review.)

In March 2009, ailing insurance giant American International Group (AIG) triggered a national outcry when it paid out $165 million in government bailout funds for employee bonus incentives. [1] President Obama called the bonus payments an “outrage” and promised that his administration would “pursue every single legal avenue to block these bonuses and make the taxpayers whole.” [2] He chastised the firm for its audacity of using borrowed taxpayer monies to reward financial recklessness and greed. This was the same company, of course, who within days of receiving its first infusion of government cash in September 2008, sent its executives on a half-million dollar boondoggle retreat at a fancy desert spa. [3] And just several months after the initial fiasco, AIG tried to award $265 million in further bonuses, [4] adding to performance bonuses of $454 million paid to employees and executives in 2008. [5] It was just over a year ago when AIG turned to the government for its survival. The government stepped in to assist AIG when the company faced imminent death from its risky financial derivative products that were backed by precarious mortgages. [6] Fearful that the toppling giant would trigger a cataclysmic domino effect, the government authorized the bailout funds to keep AIG, and the entire U.S. financial sector, afloat. [7] The government agreed to loan AIG the money, now totaling over $173 billion, collateralized with AIG’s assets and an 80% equity ownership of the company. [8] The first infusion of cash to AIG was authorized by the Federal Reserve in September 2008, supplemented with funds authorized in October by Congress in the $700 billion bailout bill, the Emergency Economic Stabilization Act (EESA), which established the Troubled Assets Relief Program (TARP).

As a result of the AIG bonus debacle, the President and Congress took several steps to try and avoid these problems in the future. In the EESA, Congress gave the Treasury Secretary the power to require these troubled financial institutions to meet appropriate standards for executive compensation, but did not directly prohibit the type of employee bonuses at AIG. [9] The subsequent American Recovery and Reinvestment Act (Recovery Act), passed in February 2009 after the transition to the Obama administration, added significant new restrictions for highly-paid executives of financial institutions that receive TARP assistance, including prohibitions against paying bonuses, retention awards, or incentive compensation, except as payments of long-term restricted stock. [10] President Obama also installed Kenneth Feinberg, former special master of the 9/11 Fund, as the pay czar to oversee all employee bonuses and payments for companies receiving large amounts of bailout funds, including AIG. [11]

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