Monthly Archives: March 2010

Court Dismisses Madoff-Related Class Action as Preempted

Herbert M. Wachtell is a partner and co-founder of Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Wachtell, Stephen R. DiPrima, Emil A. Kleinhaus and Graham W. Meli.

In a decision with substantial implications for class action suits arising out of Bernard Madoff’s Ponzi scheme and other fraud cases, the United States District Court for the Southern District of New York threw out a class action against Union Bancaire Privée, which advised funds of funds with allocations to Madoff feeder funds. Barron v. Igolnikov, No. 09 Civ. 4471 (S.D.N.Y. Mar. 10, 2010). In so doing, the federal court reaffirmed that private securities class actions alleging misrepresentations or omissions must be brought under the federal securities laws.

The court dismissed the case in its entirety, holding that the plaintiff’s claims, which were brought entirely under state law, were preempted by both the Securities Litigation Uniform Standards Act (“SLUSA”) and New York’s Martin Act. Congress enacted SLUSA in 1998 in response to concerns that state-law class actions were being used to circumvent the heightened pleading requirements that apply to suits under the federal securities laws. The statute mandates dismissal of class actions based on state law if they allege misrepresentations or omissions of material fact in connection with the purchase or sale of a “covered security,” including securities traded on a national exchange. The court in Barron held that the requirements for SLUSA preemption were satisfied. Of particular note for other Madoff-related cases, the court held that (1) the “purchase or sale” requirement of SLUSA was satisfied by Madoff’s representations that he was buying and selling securities, even though he apparently never did so; (2) the “misrepresentation or omission” requirement was satisfied by Madoff’s fraud; and (3) even though the funds in which the plaintiff and the other members of the proposed class invested were not themselves “covered securities,” that requirement of SLUSA was satisfied because Madoff purported to be trading exchange-listed securities.


Convertible Bond Arbitrageurs as Suppliers of Capital

This post comes to us from Darwin Choi, Assistant Professor of Finance at Hong Kong University of Science & Technology, Mila Getmansky Sherman, University of Massachusetts at Amherst, Brian Henderson, Assistant Professor of Finance at George Washington University, and Heather Tookes, Associate Professor of Finance at Yale University.

In the paper, Convertible Bond Arbitrageurs as Suppliers of Capital, which is forthcoming in the Review of Financial Studies, we investigate the role of convertible bond arbitrageurs as suppliers of capital. Convertible bonds have been an important source of financing for a wide variety of firms and have been particularly popular among distressed firms with depressed equity prices. While much smaller than the market for straight debt, the convertible bond market has, at times, been comparable in size to the market for new equity issues. The convertible bond market provides a useful laboratory for studying the role of capital supply on issuance. One reason is that suppliers as a group are fairly well defined. Convertible bond arbitrage hedge funds are widely believed to purchase more than 75% of primary issues of convertible debt. By focusing on a market in which convertible bond arbitrage hedge funds account for such a large fraction of primary market activity, we are able to isolate important measures of capital supply (such as hedge fund flows).


Is “Pay-to-Play” Driving Public Pension Fund Activism in Securities Class Actions?

This paper comes to us from David H. Webber, an academic fellow at New York University’s Center for Law & Business, who will join Boston University Law School as an Associate Professor later this year.

Public pension funds have played a prominent role in securities class actions, comprising nearly half of all institutional investor lead plaintiffs. Overall, prior research has shown that the funds perform admirably in the lead plaintiff role, increasing recoveries for the class of defrauded shareholders, improving corporate governance, enhancing the independence of the board, and lowering attorneys’ fees. Recently, several articles in the business press and a concerted lobbying effort have argued that the funds’ participation in these class actions is driven by “pay-to-play”. In this context, “pay-to-play” means that politicians on pension fund boards direct the funds to obtain lead plaintiff appointments in exchange for campaign contributions from plaintiffs’ law firms. In my paper recently posted on SSRN, Is ‘Pay-to-Play’ Driving Public Pension Fund Activism in Securities Class Actions? An Empirical Study, I conclude that “pay-to-play” is, at most, a marginal factor in the funds’ participation in securities class actions.


Paid to Fail

This post is based on an op-ed article, coauthored by Lucian Bebchuk, Alma Cohen and Holger Spamann, written for the international association of newspapers Project Syndicate, as part of the series of monthly columns titled “The Rules of the Game,” which can be found here. The op-ed article draws on a discussion paper issued by the Program on Corporate Governance, which can be found here.

In a report just filed with the United States court that is overseeing the bankruptcy of Lehman Brothers, a court-appointed examiner described how Lehman’s executives made deliberate decisions to pursue an aggressive investment strategy, take on greater risks, and substantially increase leverage. Were these decisions the result of hubris and errors in judgment or the product of flawed incentives?

After Bear Stearns and Lehman Brothers melted down, ushering in a worldwide crisis, media reports largely assumed that the wealth of these firms’ executives was wiped out, together with that of the firms they navigated into disaster. This “standard narrative” led commentators to downplay the role of flawed compensation arrangements and the importance of reforming the structures of executive pay.

In our study, “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman Brothers 2000-2008,” we examine this standard narrative and find it to be incorrect. We piece together the cash flows derived by the firms’ top five executives using data from Securities and Exchange Commission filings. We find that, notwithstanding the 2008 collapse of the firms, the bottom lines of those executives for the period 2000-2008 were positive and substantial.


RiskMetrics’ Introduces New Governance Measurement for Proxy Voting Reports

Margaret E. Tahyar is a partner and member of the New York Financial Institutions Group at Davis Polk & Wardwell LLP. This post is based on a Davis Polk General Counsel Update by Ning Chiu and William M. Kelly. Another Davis Polk General Counsel Update, available here, includes information and advice on preparing for the new Governance Risk Indicators. A detailed critique of the CGQ system and its methodology can be found in a discussion paper issued by the HLS Program on Corporate Governance, The Elusive Quest for Global Governance Standards, by Lucian Bebchuk and Assaf Hamdani, which was described on the Forum here.

RiskMetrics Group has recently overhauled its core corporate governance yardstick. Highlights for U.S. companies:

  • The Corporate Governance Quotient (CGQ), which for the past several years has ranked companies, both within their industry and on a broader basis, according to their overall adherence to RMG’s notions of governance best practices, is being discontinued as of June 2010.
  • RMG is adopting a new approach as of March 2010 called Governance Risk Indicators (GRId), which will be applied to all of the 6,400 U.S. companies that it reviews.  Under the GRId system governance practices will be grouped into four headings — Board Structure, Shareholder Rights, Compensation and Audit — and a color-coded risk assessment — High, Medium or Low Concern — will be applied to each category for each company.  These assessments will be made on an absolute rather than a relative basis.
  • The implementation timetable will affect companies with annual meetings after late-March 2010, as companies will start seeing the GRId appear on their proxy research reports beginning in early March for those meetings.
  • RMG is also abandoning its practice of “certifying” director education programs.


“No Mas” to “Just Say No”?

David Fox is a partner at Kirkland & Ellis LLP, focusing on complex mergers and acquisitions as a member of that firm’s Corporate Group. This post is based on a Kirkland & Ellis M&A Update by Mr. Fox and Daniel Wolf. 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 current takeover battle between Airgas and Air Products highlights one of the key areas of uncertainty in Delaware law today—the continued vitality of the “just say no” defense to unsolicited advances. Stated simply, if upheld, the “just say no” defense allows the board of directors of a target company to combine a refusal to negotiate and an unwillingness to waive structural defenses such as a poison pill or its less-effective statutory counterpart, Section 203 of the Delaware corporate code, to frustrate advances from an unwanted suitor. The defense is unique to the U.S. market— by comparison to the swift resolution of the recent Cadbury/Kraft hostile offer mandated by UK takeover rules, the defense can result in protracted battles that last for months, and sometimes years, oftentimes despite support for an offer from target shareholders.

Despite its popularity in the public (well, the dealmakers’) imagination, the “just say no” defense has a somewhat limited judicial pedigree. The case most often cited as establishing the validity of the defense is a 1995 Federal decision applying Delaware law to the defense by Wallace Computer against a hostile bid from Moore. In that case, the court upheld the refusal by Wallace’s board to redeem a pre-existing poison pill in the face of a non-coercive premium tender offer that was accepted by nearly 75% of Wallace’s shareholders. This ruling was seemingly inconsistent with the holdings in two 1988 Delaware Chancery decisions (Interco and Grand Metro) where redemption of a poison pill was mandated. The court held in the Wallace case that the mere refusal to redeem a historical poison pill can be viewed as defensive, thereby triggering the enhanced scrutiny of Unocal to the board’s decision. However, the court found that the board’s decision satisfied the two requirements of the Unocal test of defensive measures—the board’s good faith and sound investigation showed reasonable grounds for the board’s belief that a danger to corporate policy and effectiveness existed (i.e., the danger that shareholders, tempted by the premium, would tender at an inadequate price in ignorance of the true value of the target) and the retention of the poison pill, even beyond the period necessary to formulate an alternative plan to maximize shareholder value, was reasonable and proportionate to the danger posed. As such, the board’s defense was entitled to the presumptions of the “business judgment rule” and would not be second-guessed by the court.


The Effects of Executives on Corporate Tax Avoidance

This paper comes to us from Scott Dyreng, Assistant Professor of Accounting at Duke University, Michelle Hanlon, Associate Professor of Accounting at MIT, and Edward Maydew, Professor of Accounting at the University of North Carolina.

In the paper, The Effects of Executives on Corporate Tax Avoidance, which is forthcoming in the Accounting Review, we investigate whether individual executives have an effect on their firm’s tax avoidance that cannot be explained by characteristics of the firm. Despite decades of empirical research in corporate taxation, little attention has been focused on whether individual executives have an effect on their firm’s tax avoidance. Until recently, most empirical tax research focused on the role of firm characteristics in tax avoidance. In this prior literature, executives were either ignored or treated as homogenous inputs to the tax avoidance process. In contrast, our paper considers the possibility that individual top executives are partially responsible for variation in tax avoidance across firms, not necessarily through direct involvement in the tax function, but by setting the “tone at the top.”


Implications of Beneficial Ownership Distinctions for Shareowner Communications and Voting

Alan L. Beller and Janet L. Fisher are partners in the New York office of Cleary Gottlieb Steen & Hamilton LLP. This post is based on a white paper prepared by Mr. Beller and Ms. Fisher for the Council of Institutional Investors. The white paper is available here.

A shareowner’s right to vote on matters as allowed under state or federal law, stock exchange rules or otherwise is a key right. Shareowner voting has also become an increasingly important element in the consideration of public company corporate governance. Recent developments have spotlighted the nature and quality of the communication process and its impact on shareowner voting and governance. These developments include adoption by a number of public companies, especially larger companies, of majority voting in uncontested director elections, the amendment of New York Stock Exchange (NYSE) Rule 452 to prohibit broker discretionary voting in uncontested director elections and the increased influence of activist shareowners and proxy advisory firms. The confluence of these developments has heightened the likelihood of more meaningful, and contested, shareowner votes and elevated the importance of shareowner communications in the context of voting and governance.


Corporate Governance and Executive Compensation in the New Dodd Bill

Richard J. Sandler is a partner at Davis Polk & Wardwell LLP and co-head of that firm’s global Capital Markets Group. This post is based on a Davis Polk client memorandum.

The past 18 months have been witness to tremendous legislative and regulatory activity in the area of corporate governance and executive compensation. The 1,336-page Restoring American Financial Stability Act of 2010 (“2010 Dodd Bill”), introduced yesterday by Senate Banking Committee Chairman Christopher Dodd, contains meaningful governance and executive compensation mandates that extend beyond financial institutions. The provisions are similar to those in Senator Dodd’s prior attempt in November 2009 to overhaul financial regulation (“2009 Dodd Bill”), [1] but with some notable changes. In some cases, these changes bring the 2010 Dodd Bill closer to the provisions of the Wall Street Reform and Consumer Protection Act of 2009 passed in the House on December 11, 2009. [2] These governance and compensation sections are a small part of the overall 2010 Dodd Bill, which is expected to undergo significant discussion and debate in Congress.

As with the 2009 Dodd Bill, rather than simply preempting state corporate law, which might have been the more straightforward approach, other than say on pay, the governance and compensation elements of the 2010 Dodd Bill work through the SEC’s power to approve the listing standards of national stock exchanges. The 2010 Dodd Bill would authorize the SEC to promulgate rules that would, within one year after the date of enactment, prohibit the listing of any US public companies that fail to adopt the bill’s standards. The SEC would have the authority to exempt companies from any of the requirements based on size, market capitalization, number of shareholders or other criteria that the SEC deems appropriate. The 2010 Dodd Bill would also empower the SEC to provide for transition and cure periods.


Regulation Fair Disclosure and the Cost of Equity Capital

This post comes to us from Zhihong Chen, Assistant Professor of Accounting at City University of Hong Kong, Dan Dhaliwal, Professor of Accounting at the University of Arizona, and Hong Xie, Associate Professor of Accounting at the University of Kentucky.

In our paper, Regulation Fair Disclosure and the Cost of Equity Capital, which is forthcoming in the Review of Accounting Studies, we examine the effect of Regulation Fair Disclosure (Reg FD) on the cost of capital using methods recently advanced in the accounting and finance literatures for estimating ex ante or implied cost of equity capital.

Given the critical importance of the cost of capital measures for our study, we use two approaches to estimate the cost of capital. The first approach estimates the cost of capital and long-term growth simultaneously for a portfolio of firms at a particular point in time. The second approach estimates the cost of capital for a firm at a particular point in time using assumed long-term growth and analysts’ earnings forecasts as expected earnings. These two approaches complement each other and thus enhance the reliability of our findings.


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