Monthly Archives: March 2010

Supreme Court Clarifies Standards for Judicial Review of Mutual Fund Fees

Editor’s Note: Eduardo Gallardo is a partner focusing on mergers and acquisitions at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson Dunn Alert by Mark Perry, who co-authored the amicus brief for the Independent Directors Council in Jones v. Harris. The decision of the Supreme Court in the case was made available in this post.

On March 30, 2010, the Supreme Court issued its decision in Jones v. Harris Associates L.P., No. 08-586.  The Court construed Section 36(b) of the Investment Company Act of 1940, which states that investment advisers to mutual funds are deemed to have a fiduciary duty with respect to the receipt of compensation for services and provides a private cause of action for breach of that duty.

The Supreme Court in Jones held that “to face liability under § 36(b), an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.”  Slip op. 9.


Federal Intervention in Executive Pay

Joseph Bachelder is founder and senior partner of the Bachelder Law Firm. This post is based on an article by Mr. Bachelder that first appeared in the New York Law Journal.

For approximately 75 years (at least), the federal government has intervened in executive pay—in both direct and indirect ways. Two examples of direct intervention are Pay Controls (1971-74) and the current TARP program, introduced in 2008 in respect of financial institutions (and subsequently extended to two automotive companies) and still in effect as to many of these institutions. [1]

An example of indirect intervention is the SEC’s requirement, commencing in the late 1930s, of disclosure regarding compensation of certain top executives in the annual proxy statements of publicly traded companies. [2] (Ironically, in contrast to direct controls, a major consequence of the SEC’s indirect intervention through required disclosure has been an upward “tilt” to executive pay—the so-called “ratcheting effect,” as discussed later in the column.)


Supreme Court Reverses 7th Circuit in Jones v Harris

Editor’s Note: This post relates to the decision of the Supreme Court in Jones et al. v. Harris Associates L.P., which is available here.

In the case of Jones et al. v. Harris Associates L.P. (No. 08-586, March 30, 2010), the United States Supreme Court has vacated the decision of the Court of Appeals for the Seventh Circuit in Harris Assocs. v. Jones.

The case was previously discussed on the Forum here and here. The Seventh Circuit Decision case was discussed on the Forum here; another post relating to the decision can be found here.

The petitioners were shareholders in mutual funds managed by Harris Associates L.P., an investment adviser. They filed suit alleging that Harris Associates violated §36(b)(1) of the Investment Company Act of 1940, which imposes a “fiduciary duty [on investment advisers] with respect to the receipt of compensation for services”.


Implications of Selectica for Next-Generation Poison Pills

Mark D. Gerstein is a partner in the Chicago office of Latham & Watkins LLP and Global Chair of that firm’s Mergers and Acquisitions Group. This post is based on a Latham & Watkins M&A Commentary by Mr. Gerstein, Bradley Faris, Joseph Kronsnoble and Christopher Drewry. Selectica v. Versata Enterprises was previously discussed on the Forum in this post. 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.

At a time when the number of corporations with stockholder rights plans “poison pills” is declining sharply and poison pills are heavily criticized by stockholder governance proponents and proxy advisory firms, the Delaware Court of Chancery, in Selectica, Inc. v. Versata Enterprises, Inc., [1] reaffirmed the value of the poison pill to boards seeking to protect and maximize stockholder value. In upholding a poison pill used outside the hostile offer context to protect an asset of the corporation, the court also reaffirmed the flexibility of Delaware law to respond to modern threats facing corporations. Selectica demonstrates that independent directors acting in good faith, on an informed basis and with the advice of outside experts, should be afforded substantial latitude to use new defensive technologies to respond to modern threats. Selectica also provides practical guidance for boards considering the adoption of poison pills.


Rating Agencies in the Face of Regulation

This post comes to us from Milton Harris, Professor of Finance and Economics at the University of Chicago, Christian Opp, Ph.D. Candidate in Finance at the University of Chicago, and Marcus Opp, Assistant Professor of Finance at UC Berkeley.

In our paper, Rating Agencies in the Face of Regulation – Rating Inflation and Regulatory Arbitrage, which was recently made publicly available on SSRN, we develop a rational expectations framework to analyze how rating agencies’ incentives are altered when ratings are used for regulatory purposes such as bank capital requirements. Rating agencies have been criticized by politicians, regulators and academics as one of the major catalysts of the 2008/2009 financial crisis. One of the most prominent lines of attack, as voiced by Henry Waxman, is that rating agencies “broke the bond of trust” and fooled trustful investors with inflated ratings. However, should sophisticated financial institutions be realistically categorized as trustful and fooled investors in light of the fact that they interacted with rating agencies not only as investors but also as originators of subprime mortgage securities? Why would these institutional investors care about ratings when they knew about rating agencies’ practices?


Judge Rejects SEC and Bank Proposal to Remove Firewall

Editor’s Note: A recent Davis Polk & Wardwell LLP Client Newsflash describing the modified Global Settlement discussed below is available here.

U.S. District Judge William H. Pauley III recently rejected a proposal by the Securities and Exchange Commission and a group of securities firms to modify the terms of their 2003 Global Research Equity Settlement (“Global Settlement”). Among other things, the Global Settlement, which binds 12 securities firms, including Goldman Sachs, JP Morgan, Merrill Lynch, Citigroup, Credit Suisse, Morgan Stanley and Deutsche Bank, puts in place limits on the interaction between the research and investment banking arms of the firms – a so-called “firewall”.

The SEC and the firms had agreed on a proposal to loosen some of the restrictions contained in the Global Settlement, including the firewall. The proposal would have permitted:

“Research personnel Investment Banking personnel to communicate with each other, outside the presence of internal legal or compliance staff, regarding market or industry trends, conditions or developments, provided that such communications are consistent in nature with the types of communications that any analyst might have with investing customers.”

Judge Pauley rejected the proposal. His ruling stated that:

Such a proposed amendment is counterintuitive and would undermine the separation between research and investment banking. On May 7, 2003, SEC Chairman William H. Donaldson emphasized the importance of that separation to the Senate Committee on Banking, Housing and Urban Affairs when he testified: “[T]here will be no overlap between the jobs of investment bankers and research analysts … To ensure that the separation between investment banking and research is comprehensive, firms will create and enforce firewalls between the two operations reasonably designed to prohibit improper communications between the two.” … The parties’ proposed modification would deconstruct the firewall between research analysts and investment bankers erected by the parties when they settled these actions. This Court declines to approve the proposed modification to Section I.10.a because it would be inconsistent with the Final Judgments and contrary to the public interest.

Judge Pauley’s full order is available here; the brief of the firms seeking the order is available here.

Delaware Offers Guidance on Special Litigation Committee Process

Theodore Mirvis is a partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Mirvis, William Savitt and Ryan A. McLeod, and relates to the decision in London v. Tyrrell, which is available here. 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.

A recent decision from the Delaware Court of Chancery confirms that Special Litigation Committees (SLCs) can be an effective means of responding to derivative litigation— but only when carefully structured and properly implemented. London v. Tyrrell, C.A. No. 3321-CC (Del. Ch. Mar. 11, 2010).

The decision arose in a suit by the founders and former directors of iGov, alleging that company insiders had intentionally manipulated the valuation process used to set the strike price of certain options for the purpose of entrenching themselves and diluting plaintiffs’ interest in the company. In 2008, after the Court concluded that demand on the board was excused and refused to dismiss the complaint, the board formed an SLC comprised of directors appointed after the filing of the lawsuit to evaluate whether the derivative claims should be pursued on behalf of the company. The SLC retained advisors, reviewed documents, and conducted twelve interviews over the course of four months, and then filed a report recommending dismissal.


Curbing Excessive CEO Pay by Disentangling Wall Street and Corporate America

John Wilcox is Chairman of Sodali, a director of, and former Head of Corporate Governance at TIAA-CREF.

Peter Drucker, the revered management guru, deplored excessive CEO pay. He argued that CEOs should not be paid more than 20 to 25 times the average salary of company employees. While his approach is schematic, Drucker’s reasons for opposing high executive compensation resonate today even more than during his lifetime. Essentially, Drucker believed that the leadership, motivation and teamwork needed for a successful business are undermined when the CEO is overpaid. He maintained that business leaders should set an example of responsibility, not privilege. He defined the CEO’s role in terms of stewardship, not self-interest.

The financial crisis certainly validated Drucker’s concerns. A Who’s-Who of respected global business leaders have recently gone on record advocating changes in executive compensation. The list includes Paul Volcker, Bill Gates, George Soros, Warren Buffett, Jeff Immelt, Mervyn King — even Allen Greenspan.

Conspicuously absent from the list have been the leaders of Wall Street, and herein lies an important clue to what went wrong, what should be done and why the task is so difficult.


Equity-Debtholder Conflicts and Capital Structure

This post comes to us from Bo Becker, Assistant Professor of Finance at Harvard Business School, and Per Strömberg, Professor of Finance at the Stockholm School of Economics.

In the paper, Equity-Debtholder Conflicts and Capital Structure, which was recently made publicly available on SSRN, we present a novel approach to identifying debt‐equity conflicts and the associated agency costs, employing a 1991 legal event as a natural experiment. Our natural experiment revolves around the fiduciary duties of corporate officers. Broadly speaking, these duties require that officers take actions that are in the interest of owners. Historically, the position of U.S. courts has been that such duties are owed to the firm as a whole and to its owners, but not to other firm stakeholders, such as creditors. Creditors are assumed to be able to protect themselves by contractual and other means (e.g. covenants). This situation changes once a firm becomes insolvent. At this point, fiduciary duties are owed to creditors, since for insolvent firms creditors become the residual claimants. As long as the firm is solvent, however, the traditional view was that no such rights were held by creditors. This changed with the Delaware court’s ruling in the 1991 Credit Lyonnais v. Pathe Communications bankruptcy case. The case ruling argued that when a firm is not insolvent, but in the “zone of insolvency”, duties may already be owed to creditors.


The Most Influential People in Corporate Governance

A review of the most recent Directorship 100 list – a list of the most influential people in corporate governance put together each year by Directorship magazine – indicates that individuals affiliated with Harvard Law School and its Program on Corporate Governance play a central role in the corporate governance landscape.

The Directorship 100 list includes such well-known figures as President Barack Obama, Chairman Barney Frank, SEC Chair Mary Schapiro, activist investor Carl Ichan and Goldman Sachs CEO Lloyd Blankfein. The Forum was pleased to learn that the list includes thirty-four individuals who are (i) HLS faculty and fellows, (ii) Members of the Advisory Board of the Program on Corporate Governance, (iii) Guest Contributors to the HLS Forum, and/or (iv) Harvard Law School grads.  The “Harvard Thirty-Four” are as follows (for HLS alums, the year in parenthesis refers to graduation year):

The full Directorship 100 list is available here.

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