Monthly Archives: February 2010

Dividend and Corporate Taxation in an Agency Model of the Firm 

This post comes to us from Raj Chetty, Professor of Economics at Harvard University, and Emmanuel Saez, Professor of Economics at UC Berkeley.

In our paper Dividend and Corporate Taxation in an Agency Model of the Firm, which is forthcoming in the American Economic Journal: Economic Policy, we propose a simple model based on the agency theory of the firm (Jensen and Meckling 1976) that provides an alternative to the two leading theories of corporate taxation – the “old view” (Harberger 1962, 1966, Feldstein 1970, Poterba and Summers 1985) and the “new view” (Auerbach 1979, Bradford 1981, King 1977). Our model is motivated by empirical studies of the 2003 dividend tax reform in the U.S. (e.g. Chetty and Saez 2005), which found that: (1) the 2003 dividend tax cut caused large, immediate increases in dividend payouts, and (2) the increases were driven by firms with high levels of share ownership among top executives or the board of directors. These empirical findings are difficult to reconcile with the two leading theories of corporate taxation.


Seven Law Firms Comment on “Opt-Out” Under SEC’s Proposed Proxy Access Rules

John Finley is member of the mergers and acquisitions group of Simpson Thacher & Bartlett LLP. This post refers to a comment letter submitted by Cravath, Swaine & Moore LLP, Davis Polk & Wardwell LLP, Latham & Watkins, LLP, Simpson Thacher & Bartlett LLP, Skadden, Arps, Slate, Meagher & Flom LLP, Sullivan & Cromwell LLP and Wachtell, Lipton, Rosen & Katz to the Securities and Exchange Commission in connection with its proposal regarding proxy access; the comment letter is available here.  The issues of private ordering and opting-out are also the focus of the Program’s Discussion Paper, Private Ordering and the Proxy Access Debate, co-authored by Lucian Bebchuk and Scott Hirst, which was also submitted to the Commission as a comment letter along with being featured on the Forum in this post.

Seven major law firms — Cravath, Swaine & Moore LLP, Davis Polk & Wardwell LLP, Latham & Watkins, LLP, Simpson Thacher & Bartlett LLP, Skadden, Arps, Slate, Meagher & Flom LLP, Sullivan & Cromwell LLP and Wachtell, Lipton, Rosen & Katz — collaborated on a 17-page comment letter  in response to a request by the SEC last December for additional comments on its proposed proxy access rules.  These seven firms previously submitted a comment letter  last August on the proxy access proposal, which was described on the Forum here.  In light of the additional data and analyses cited in the SEC’s request for additional comment, as well as the recent comments by some of the Commissioners regarding the possibility of permitting shareholders to approve a more restrictive proxy access standard, the comment letter elaborated on the seven firm’s earlier recommendation that shareholders should have the opportunity to modify or opt-out entirely from the SEC’s proxy access regime if Rule 14a-11 were adopted.  As currently proposed, Rule 14a-11 only permits shareholders to adopt less restrictive provisions (a one-way opt-out) to facilitate proxy access.  The most recent seven firm letter recommended that shareholders should be permitted to adopt either more or less restrictive provisions (a two-way opt-out), including a complete exemption or an alternative regime, for the following reasons:


Combating Insider Trading: What Works

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, Lawrence B. Pedowitz, David Gruenstein, Ralph M. Levene, Wayne M. Carlin and Amanda N. Persaud.

Last year’s headlines were filled with announcements of major new insider trading prosecutions. The DOJ and SEC have promised there will be more such cases to come in 2010, including through the use of more aggressive investigative techniques such as wiretaps and wired informants. The question is what can a firm practically do to stop insider trading, and if the risk of improper trading cannot be entirely eliminated, how to protect the firm and its constituencies?

Most responsible firms of sufficient size — hedge funds, investment advisors, broker-dealers and banks — have adopted and implemented written policies and procedures that are fairly standard. These written policies are helpful in educating people about the bright lines, but, as typical policies candidly recognize, they cannot cover every situation. In today’s world — which reflects an exponential expansion of the sources of information, as well as the means and speed of communication and the webs of relationships among trading professionals, consultants, advisors and corporate insiders — situations can arise where the lines are less than bright.


HLS Forum Publishes 1,000th Post

Last week the Forum on Corporate governance and Financial Regulation published its 1,000th post.  The Forum started operating with support from the Corporation Service Company in December 2006. In addition to posts from Harvard Law School faculty and fellows and posts by members of the Program on Corporate Governance’s Advisory Board, the Forum has featured posts from more than 165 guest contributors and many more additional contributors. Contributors of posts to the Forum have included prominent business leaders such as Carl Icahn and Goldman Sachs CEO Lloyd Blankfein, prominent public officials such as SEC Chairperson Mary Schapiro, the UK’s Lord Turner and Seventh Circuit Judge Richard Posner, prominent lawyers such as Martin Lipton and Ira Milstein, and prominent academics such as Jeffrey Gordon, Marcel Kahan, Andrei Shleifer, René Stulz, Raghuram Rajan, and Luigi Zingales.

FDIC Proposes Amending Insurance for Compensation Program Risk

H. Rodgin Cohen is a partner and chairman of Sullivan & Cromwell LLP focusing on acquisition, corporate governance, regulatory and securities law matters. This post is based on a Sullivan & Cromwell client memorandum.

The FDIC report referred to in this post cites and relies on a recent working paper of the Harvard Law School Program on Corporate Governance, “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008” by Lucian Bebchuk, Alma Cohen, and Holger Spamann, which was discussed in a Forum post here. An earlier working paper issued by the Program, “Regulating Bankers’ Pay” by Lucian Bebchuk and Holger Spamann, advocated making prudential regulation tighter for financial firms whose compensation arrangements encourage risk-taking, as the FDIC is now proposing; this paper is available here.

At the January 12, 2010 meeting, the Board of Directors of the Federal Deposit Insurance Corporation (“FDIC”) authorized publication of an Advance Notice of Proposed Rulemaking on Employee Compensation (the “ANPR”) by a vote of 3 to 2 (with Comptroller Dugan and OTS Director Bowman dissenting). The ANPR seeks comment on how, and whether, the FDIC’s risk-based deposit insurance assessment system applicable to all insured banks should be amended to account for risks imposed by employee compensation programs.

Citing a “broad consensus that some compensation structures misalign incentives and induce imprudent risk taking within financial organizations”, the FDIC is considering establishing criteria to determine whether a financial institution’s employee compensation programs provide incentives for employees to take excessive risks. The FDIC is concerned that such risk-taking increases the institution’s risk of failure and thereby could lead to increased losses to the Deposit Insurance Fund. The ANPR proposal could apply not only to compensation at the insured depository, but also at its parent and nonbank affiliates. Under the approach outlined in the ANPR, whether a financial institution’s compensation program either “meets” or “does not meet” the criteria would be used to adjust the institution’s risk-based assessment rate, thereby acting as an incentive for institutions that meet the criteria and a disincentive for those that do not. According to the ANPR, the criteria that the FDIC is considering are not aimed at limiting the amount that insured depository institutions can pay their employees, but rather are intended to compensate the Deposit Insurance Fund for risks associated with certain compensation programs.

The FDIC requests comments on the ANPR within 30 days after publication in the Federal Register.


Leverage Choice, Credit Spread, and Risk

This post comes to us from Murray Carlson, Associate Professor of Finance at the University of British Columbia, and Ali Lazrak, Associate Professor of Finance at the University of British Columbia.

CEO compensation typically includes both performance sensitive and performance insensitive components. This pay structure can be readily rationalized in a contracting setting (e.g., Holmstrom (1982)). Performance sensitive payments link a manager’s value enhancing actions to his wealth thereby aligning his incentives with those of the firm. These payments are risky, however, and in contracts with a risk averse manager risk sharing motives give rise to a role for the performance insensitive component. Compensation structure has a direct impact on manager objectives and it is natural to expect it to affect a manager’s choice of firm risk and, consequently, the dynamics of the firm’s security prices. Aspects of these linkages have been explored empirically, but the structural modeling of the impact of CEO pay on risk choice, capital structure, and the pricing of financial securities remains relatively unexplored.

In our paper, Leverage Choice and Credit Spread when Managers Risk Shift, forthcoming in the Journal of Finance, we demonstrate the relevance of the agency costs of Jensen and Meckling (1976) for structural models of leverage choice and credit spreads. Assuming a realistic compensation structure for risk-averse managers, consisting of cash and stock, we show that managers will optimally choose to lever the firm and that their resulting pay will be convex in the firm’s terminal liquidating pre-tax payout. This convexity induces asset substitution, leading to riskier payouts and higher credit spreads than predicted by the prior literature. We also demonstrate that optimal leverage choice is the result of a balance between tax benefits and the utility cost of ex-post risk shifting. Our work thus highlights that operating behavior induced by compensation terms can be of first-order importance for understanding debt levels and credit spreads.


The CEO Pay Slice

Editor’s Note: This post is based on Lucian Bebchuk, Martijn Cremers and Urs Peyer’s recent op-ed article for the international association of newspapers Project Syndicate, which can be found here. The op-ed article discusses the findings of Bebchuk, Cremers, and Peyer’s recent empirical study which can be found here.

There is now intense debate about how the pay levels of top executives compare with the compensation given to rank-and-file employees. But, while such comparisons are important, the distribution of pay among top executives also deserves close attention.

In our recent research, we studied the distribution of pay among top executives in publicly traded companies in the United States. Such firms must disclose publicly the compensation packages of their five highest-paid executives. Our analysis focused on the CEO “pay slice” – that is, the CEO’s share of the aggregate compensation such firms award to their top five executives.

We found that the pay slice of CEOs has been increasing over time. Not only has compensation of the top five executives been increasing, but CEOs have been capturing an increasing proportion of it. The average CEO’s pay slice is about 35%, so that the CEO typically earns more than twice the average pay received by the other top four executives. Moreover, we found that the CEO’s pay slice is related to many aspects of firms’ performance and behavior.


51 Law Firms Issue Consensus Interpretation of NY Power of Attorney Law

This post is based on a white paper issued by 51 law firms interpreting recent changes to the New York Power of Attorney Law. The white paper is available here. The 51 law firms endorsing the white paper are listed below.

A group of fifty-one law firms has issued a White Paper, Interpretive Issues Related to Recent Changes to the New York Power of Attorney Law, which examines principles of New York and federal law to reach a finding that, at the least, substantial portions of the recently amended New York General Obligations Law §§ 5-1501 et seq. (the “Statute”) do not apply to proxies for shares of New York corporations and non-New York corporations, certain powers of attorney executed in connection with the registration of transfer of certificated securities or many powers of attorney granted in connection with the formation and governance of non-New York limited liability companies and non-New York limited partnerships.

On September 1, 2009, several amendments to the Statute, which governs powers of attorney executed by individuals while physically present in New York, took effect. These amendments, enacted as a result of perceived abuses in elder care connected to financial matters, including estate planning, changed the requirements for creating certain types of valid powers of attorney in New York. The amendments have given rise to troublesome concerns for transactional business lawyers, as the Statute appears potentially to have the unintended consequence of invalidating a wide variety of common corporate, commercial and financial documents. The purpose of the White Paper is to provide a blueprint for a consensus among practitioners on the issues it addresses because of the concern that an overly conservative interpretation of the Statute may become the accepted version of the law. The arguments in the White Paper are summarized below.


SEC Enforcement in 2009: A Year of Changes, with More This Year

Eduardo Gallardo is a partner focusing on mergers and acquisitions at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson Dunn client memorandum by Mark Schonfeld, John Sturc, Barry Goldsmith, Eric Creizman, Ladan Stewart, Akita St. Clair, Siham Nurhussein, Matthew Estabrook, Darcy Harris, Jonathan Fortney, Nili Wexler and Karen Grus.

In our 2009 “Mid-Year Review of SEC Enforcement,” we reviewed the transformation that had begun in 2009 at the SEC’s Division of Enforcement under the agency’s new Chairman, Mary Schapiro, and the Division’s new Director, Robert Khuzami, as well as the measurable increase in enforcement activity that had resulted. Since then, Mr. Khuzami has articulated more specifically the changes the he plans to make, some of which are already in effect and others that have yet to be implemented. Nevertheless, the results of the Enforcement Division continue to reflect the heightened enforcement initiative that has been the calling card of this Commission. In this review of enforcement in 2009, we focus on the significant enforcement developments of the second half of the year, as well as notable cases and important trends revealed by annual enforcement statistics, both those disclosed by the SEC, as well as those that result from our own analysis. We also look ahead to the significant developments to anticipate this year.


Risk and the Corporate Structure of Banks

This post comes to us from Giovanni Dell’Ariccia, Advisor in the Research Department at the International Monetary Fund, and Robert Marquez, Professor of Finance at Boston University.

In our paper Risk and the Corporate Structure of Banks, which was recently accepted for publication in the Journal of Finance, we analyze how risk affects the organizational structure of banks’ foreign operations. Our primary focus is on a bank’s decision to set up affiliates as either subsidiaries or as branches. Subsidiaries are locally incorporated stand-alone entities endowed with their own capital and protected by limited liability at the affiliate level. In other words, they are foreign-owned local banks for which the parent bank’s legal obligation is limited to the capital invested. By contrast, branches are merely offices of the parent bank without an independent legal personality. As such, the liabilities of branch affiliates represent real claims on the parent bank. Therefore, the decision to enter as either a subsidiary or a branch has important implications for the parent bank’s risk exposure.

We focus on two different, albeit related, sources of risk. First, banks are subject to credit or economic risk in the host market. Some of this risk can arise as a result of changes in macroeconomic conditions as shocks to economic activity and interest rates affect the credit worthiness of borrowers and may lead them to default on their loans, making the affiliate’s revenue uncertain. Second, host governments may engage in policies that infringe on the bank’s property rights and expropriate either fully or partially the bank’s revenue and capital. Such actions may entail direct expropriation, but extend to other policies including discretionary taxation, capital controls on repatriated profits, the redirecting of business toward state-owned or favored institutions, or forcing banks to hold government debt.


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