Monthly Archives: February 2010

Corporate Governance and the Financial Crisis: Causes and Cures

Editor’s Note: Theodore N. Mirvis is a partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This post is a summary of a discussion hosted by Mr. Mirvis at the Corporate Directors Forum at the University of San Diego; the slides from that presentation are available here.

A recent discussion that I moderated at the Corporate Directors Forum at the University of San Diego focused on the changing regulatory landscape triggered by the financial crisis. The focus was on the changing rhetoric in the corporate governance debate, and whether the rhetoric matches the proposals being advanced – i.e., does the “talk-the-talk” fit with the “walk-the-walk”.

The presentation that framed the discussion first outlined current legislative and regulatory proposals for changes in corporate governance, including changes regarding board structure, director elections, shareholder proxy access, risk management and compensation. The current corporate governance landscape includes proposed or actual reforms to these areas from federal legislation, SEC rule-making, state corporate legislation, changes to New York Stock Exchange rules, and stockholder proposals. The presentation mentioned recent comments on the regulatory and legislative landscape, including the following:


International Experts Form Council on Global Financial Regulations

Editor’s Note: This post draws on an article that first appeared on the Harvard Law School website.

Hal Scott, the Nomura Professor and director of the Program on International Financial Systems at Harvard Law School, has been named co-chair of the newly-organized Council on Global Financial Regulation. The Council has been formed by a group of private sector international financial leaders to provide national and international policymakers with independent recommendations from outside government for effective regulation of the global financial system, particularly regulation with significant cross-border implications.

According to a statement released by the Council on Global Financial Regulation, the Council believes that the worldwide financial crisis demonstrates that sound financial regulation must be achieved through international cooperation. Government leaders have called for a greater role for the G-20 and other international government bodies, such as the Financial Stability Board, to encourage a better coordinated international financial regulatory system. The Council aims to play a constructive role in supporting that process by providing government policymakers and regulators with independent recommendations, research, analysis and commentary. The Council also aims to be available for consultation with government officials as a resource on cross-border financial regulatory issues.


Increasing International Cooperation and Other Key Trends in Anti-Corruption Investigations

John F. Savarese is a partner in the Litigation Department of Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton client memorandum by Mr. Savarese, Ralph M. Levene and Carol Miller.

Last Fall, we noted that countries other than the United States were stepping up their efforts to combat international bribery and corruption. (See International Anti-Corruption Enforcement on the Rise – October 19, 2009.) Consistent with that trend, earlier this week the U.K. Serious Fraud Office in conjunction with the U.S. Department of Justice settled corruption charges with BAE Systems PLC, one of Europe’s largest defense contractors (learn more here). The charges relate to illegal payments to government officials in various countries. Under the terms of the settlements BAE will plead guilty to charges in both countries and pay $400 million to resolve U.S. charges, and a fine of £30 million – a record criminal fine for a company in the U.K. – to resolve the SFO investigation. The BAE settlement marks the first time that the SFO and DOJ have cooperated to jointly resolve an investigation and the SFO has called it a “groundbreaking global agreement.”

In another illustration of this trend, 22 executives and employees of 16 different companies in the military and law enforcement products industry based in the U.S., the U.K. and Israel were arrested on January 18, 2010 and charged with FCPA violations as a result of an undercover operation conducted by the FBI and DOJ, with assistance from the U.K.’s City of London Police (learn more here). According to the indictments, the defendants attempted to make improper payments to FBI agents posing as foreign procurement officials. The case represents the largest single investigation and prosecution in the history of DOJ’s enforcement of the FCPA. It also represents the first large-scale use of undercover law enforcement techniques, previously seen only in organized crime cases, to uncover FCPA violations.


Corporate Political Speech is Bad for Shareholders

Editor’s Note: This post is Lucian Bebchuk’s most recent op-ed in his series of monthly columns titled “The Rules of the Game” for the international association of newspapers Project Syndicate, which can be found here. This op-ed draws on his study with Zvika Neeman, “Investor Protection and Interest Group Politics,” forthcoming in The Review of Financial Studies.

The United States Supreme court recently struck down limits on the freedom of companies to spend money on political elections. Large, publicly traded companies in other countries also often face lax limits on their use of corporate resources to influence political outcomes, fueling fears that the interests of shareholders will trump those of other groups, such as consumers and employees. But corporate spending on politics can also hurt the interests of shareholders.

Stock market listed companies control a big share of almost every country’s resources, so the free flow of corporate money into politics can have a profound impact on politicians’ preferences and choices. In particular, the influence of corporations on politicians and political outcomes can be expected to weaken the rules that protect shareholders and ensure that companies are well-governed.

To understand why, it is important to focus on the individuals who make decisions for companies. When corporations decide which politicians to support, what kind of messages to send, and which political outcomes to seek, their general investors are not consulted. Rather, such decisions are likely to reflect the preferences and objectives of the insiders who manage the companies, ostensibly on shareholders’ behalf. And politicians that benefit from corporate spending and access to corporate resources will have an interest in serving the insiders’ preferences and objectives.


Strategic Flexibility and the Optimality of Pay for Sector Performance

This post comes to us from Radhakrishnan Gopalan, Assistant Professor of Finance at Washington University in St. Louis, Todd Milbourn, Hubert C. and Dorothy R. Moog Professor of Finance at Washington University in St. Louis, and Fenghua Song, Assistant Professor of Finance at Penn State University.

In our paper, Strategic Flexibility and the Optimality of Pay for Sector Performance, which is forthcoming in the Review of Financial Studies, we propose a model in which a CEO chooses the firm’s strategy as she faces uncertainty regarding future sector movements. She can put forth (personally) costly effort to generate an informative signal about future sector returns. The optimal contract rewards the CEO for firm performance induced by sector movements so as to provide her incentives to exert effort to forecast the sector movements and choose the firm’s optimal exposure to them.

As our model shows, benchmarking the CEO’s performance against her sector is the same as not offering her pay for sector performance and will make firm investment decisions insensitive to sector movements. This practice is suboptimal if sector performance affects firm performance. Our model also helps pin down situations in which the sensitivity of pay to sector performance is more likely to be present. We find that multi-segment firms, especially those in which the sector performances of the different segments are less positively correlated, will offer pay contracts that are more sensitive to sector performance as compared to single segment firms. This is because such firms provide greater opportunity to the CEO to actively shift resources towards sectors that are likely to outperform. We also find that the sensitivity of pay to sector performance will be greater in any firm that offers greater strategic flexibility to the CEO to alter firm exposure to sector movements and for more talented CEOs. Our model also shows that the optimal contract rewards a risk-averse CEO more when sector performance is good than punishes her when sector performance is bad; that is, the optimal contract is asymmetrically sensitive to good and bad sector performance.


Considerations for Directors in the 2010 Proxy Season

John Olson is a founding partner of Gibson, Dunn & Crutcher’s Washington, D.C. office and a visiting professor at the Georgetown Law Center. This post is based on a Gibson Dunn alert by Mr. Olson, Amy Goodman, Elizabeth Ising, Gillian McPhee and Aaron Briggs.

The current economic and regulatory landscape poses unprecedented challenges for public companies and their boards of directors. They are facing scrutiny from shareholders, Congress, regulators and the public, and new proposals to address the causes of the financial crisis have been emerging on almost a daily basis for over a year now.

Some of these proposals have been adopted and some remain under consideration at a time when calendar-year companies are preparing for the 2010 proxy season, complicating the planning process. Of particular note, in December, the Securities and Exchange Commission (“SEC”) adopted new proxy disclosure rules that likely will be a focal point for public company directors, as the new rules relate to disclosures regarding the composition and operation of boards of directors. [1] This memorandum is an update of our client alert covering considerations for public company directors in the current environment issued on October 15, 2009.


Are Incentive Contracts Rigged by Powerful CEOs?

Editor’s Note: This post comes to us from Adair Morse, Assistant Professor of Finance at the University of Chicago, Vikram Nanda, Professor of Finance at the Georgia Institute of Technology, and Amit Seru, Assistant Professor of Finance at the University of Chicago.

In our paper Are Incentive Contracts Rigged By Powerful CEOs?, which is forthcoming in the Journal of Finance, we argue that powerful CEOs induce their boards to shift the weight on performance measures towards the better performing measures, thereby rigging the incentive part of their pay. The intuition is developed in a simple model in which some powerful CEOs exploit superior information and lack of transparency in compensation contracts to extract rents. The model delivers an explicit form for the rigging of CEO incentive pay along with testable implications that rigging is expected to (1) increase with CEO power; (2) increase with CEO human capital intensity and uncertainty about a firm’s future prospects; and (3) negatively impact firm performance.

Using a large panel of U.S. firms from 1992-2003, we find support for all our predictions. We find that rigging explains 10% to 30% of the incentive pay sensitivity to performance. Rigging increases with CEO human capital and with the uncertainty of a firm’s prospects, and stronger governance along other dimensions moderates contract rigging by powerful CEOs. Finally, rigging of incentive pay is shown to be associated with a decrease in future firm performance and value.


Sustainable Reform: Prioritizing Long-Term Investors

Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at the recent SEC Speaks conference. The views expressed in the post are those of Commissioner Aguilar, and do not necessarily reflect the views of the Commission, the other Commissioners, or the Commission staff. A transcript of Commissioner Aguilar’s speech is available here.

Between the effects and consequences of the economic crisis, the White House and Congressional focus on financial reform, the active Commission agenda, and the press and pundit scrutiny . . . it feels like five years have passed by. Yet, despite the intense focus on financial reform over the last year, very little has changed. Last year, I stood here and spoke about the need for sustainable regulatory reform oriented towards investors. It is clear that the need is even greater today.

John Wooden, the legendary UCLA basketball coach, used to say: “Never mistake activity for accomplishment.” This adage perfectly sums up the last year. While there was much activity this past year, very little has actually been accomplished. There have been many speeches given and many preliminary steps taken toward regulatory reform, but for all the activity, reform itself has yet to be achieved. For example, despite the clearly demonstrated need, OTC derivatives, hedge funds, and municipal securities markets still lack appropriate regulation, and our inspection and enforcement efforts in these areas continue to be severely undermined. Moreover, there are those who are using the process of reform as an opportunity to weaken strong investor-focused laws arising from lessons learned in prior crises. In my remarks today, I will highlight the progress we have made and the distance we have to go.


French Supreme Court Rules on SOX Whistleblowing Procedures in France

James Morphy is a partner at Sullivan & Cromwell LLP specializing in mergers & acquisitions and corporate governance. This post is based on a Sullivan & Cromwell client memorandum by François Barrière, Gauthier Blanluet, Dominique Bompoint, Gérard Mazet, Richard Vilanova and Olivier de Vilmorin.

Issues have arisen from time to time regarding potential conflicts between the whistleblowing requirements of the Sarbanes-Oxley Act of 2002 and the provisions of French privacy and worker protection laws. In a recent decision, the French Supreme Court, the Cour de cassation, has addressed such an issue for the first time.

On December 8, 2009, the Supreme Court, in overturning the decision of a lower court, invalidated the whistleblowing procedures set forth in the Code of Business Conduct of Dassault Systèmes (“Dassault”). The Court ruled that the provisions (i) were too broad in that they applied not only to complaints relating to the finance, accounting, banking and anti-corruption areas, but also to whistleblowing relating to actions which could harm the vital interests of Dassault or the physical or moral integrity of an individual employee, and (ii) did not provide in sufficient detail information on French legal protections relating to whistleblowing, such as the right of an individual who is the subject of a whistleblowing complaint to be properly notified of the nature of the complaint and the right of persons identified in a complaint to access and rectify such complaint. The Supreme Court also invalidated specific provisions of Dassault’s Code of Business Conduct related to the treatment of confidential information by employees (this aspect of the decision is not discussed in this memorandum).


Delaware Court of Chancery Addresses Proxy Contest Mechanics and Vote Buying

Trevor Norwitz is a partner in the Corporate Department at Wachtell, Lipton, Rosen & Katz, where he focuses on mergers and acquisitions, corporate governance and securities law matters. This post is based on a Wachtell Lipton client memorandum by Mr. Norwitz and William Savitt. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In a recent decision involving dueling consent solicitations, the Delaware Court of Chancery cast welcome light on the “foggy” mechanics of proxy solicitations and offered guidance on “vote-buying” in corporate control contests. Kurz v. Holbrook., C.A. No. 5019-VCL (February 9, 2010).

The case involved a contest for control of EMAK Worldwide, a “deregistered, poorlyperforming microcap corporation” with one large preferred stockholder and an otherwise “diffuse” stockholder body. An insurgent slate sought to remove two directors and elect replacements, thereby taking control of the company. The incumbent group sought to amend EMAK’s by-laws to reduce the size of the board, thereby effectuating the dismissal of certain sitting directors, mooting the insurgents’ attempt to elect new directors, and ensuring a majority position for the large preferred stockholder. After a hard-fought contest, the incumbent’s by-law provisions obtained a close majority of consents. A few days later, however, the insurgent slate secured a majority of consents as well, but only after insurgents purchased 150,000 shares needed to provide a bare 50.89% majority. But the inspector of elections then disallowed some 1,000,000 shares held in “street name” because they were not accompanied by a DTC “universal proxy,” thus maintaining the incumbent group majority. The insurgents sued, challenging both the validity of the by-law and the invalidation of their “street name” votes.


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