Monthly Archives: May 2010

FAS 157 and the Impact of Corporate Governance Mechanisms

This post comes to us from Chang Song, Assistant Professor of Accounting at Sungkyunkwan University, Wayne Thomas, Professor of Accounting at the University of Oklahoma, and Han Yi, Assistant Professor of Accounting at the University of Oklahoma.

In our paper, Value Relevance of FAS 157 Fair Value Hierarchy Information and the Impact of Corporate Governance Mechanisms, forthcoming in The Accounting Review, we use banking firm data from the first three quarters of 2008 to examine two important research questions related to fair value information provided by banks under FAS 157. First, we compare the value relevance of Level 1 and Level 2 fair values to the value relevance of Level 3 fair values. Second, we consider whether the impact of corporate governance on the value relevance of fair values is greater for Level 3 assets compared to Level 1 and Level 2 assets. Under FAS 157, firms are required to disclose fair values of asset and liability types by levels, where levels are based on inputs used to generate fair values: (1) Level 1 (observable inputs from quoted prices in active markets), (2) Level 2 (indirectly observable inputs from quoted prices of comparable items in active markets, identical items in inactive markets, or other market-related information), and (3) Level 3 (unobservable, firm-generated inputs). Thus, fair values are disclosed from most reliable (Level 1) to least reliable (Level 3), with a classification that potentially falls somewhere in the middle (Level 2).

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Detailed Summary of Senate Financial Reform Bill

Margaret E. Tahyar is a partner and member of the New York Financial Institutions Group at Davis Polk & Wardwell LLP. This post relates to a recent Davis Polk client memorandum, which is available here.

Financial regulatory reform is reaching the legislative end game.  On May 22, 2010, the United States Senate passed the Restoring American Financial Stability Act of 2010 (the “Senate bill”) by a vote of 59 to 39. The Senate bill is the culmination of nearly a year of work by the Senate – including a month of floor debate – all designed to craft a comprehensive financial reform package.  It is heavily influenced by the Obama Administration’s regulatory reform package released last summer as well as the House of Representatives’ Wall Street Reform and Consumer Protection Act (the “House bill”), passed by the House of Representatives on December 11, 2009.

In the coming weeks, the Senate and the House of Representatives will conference, probably televised, and resolve the differences between their bills. Congress is aiming to send a compromise bill to President Obama for his signature by the July 4th holiday weekend. While the Congressional conferees are not yet certain, press reports indicate that the Senate members will include, from the Democratic side of the aisle, Senators Dodd, Johnson, Harkin, Leahy, Lincoln, Reed and Schumer, and, from the Republican side of the aisle, Senators Corker, Chambliss, Crapo, Gregg and Shelby.

House Financial Services Committee Chairman Barney Frank has suggested that the Democratic House conferees be himself and Representatives Gutierrez, Kanjorski, Maloney, Meeks, Moore (KS), Waters and Watt.  The Republican conferees have not yet been reported.

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Pending U.S. and E.U. Legislation Promises Broad Changes for Private Fund Managers

Andrew R. Brownstein is a partner in the Corporate Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Brownstein, Andrew J. Nussbaum, Steven A. Cohen and Amanda N. Persaud.

Responding to the recent financial crisis, the U.S. and E.U. governments are taking steps to implement a broad extension of regulatory power to a wide range of private investment fund managers that previously operated globally subject to limited or no direct regulation.

Pending U.S. Legislation

The Restoring American Financial Stability Act, passed by the Senate, requires any investment adviser, other than an investment adviser to a “private equity fund” or “venture capital fund,” that has at least $100 million of assets under management, to register with the SEC and requires these advisers to maintain extensive records and reports. On its face, the bill would require investment advisers to hedge funds to register with the SEC, although the bill leaves it to the SEC to define “private equity funds” and “venture capital funds.” Similar to the House bill, investment advisers who are required to register will be subject to significantly increased reporting and disclosure obligations for each private fund they advise, including as to the amount of assets under management, use of leverage, counterparty credit risk exposures, trading and investment positions, trading practices, valuation policies and practices, asset-types held and side letter arrangements, along with other information the SEC deems necessary. Even exempt advisers will be required to maintain certain detailed records and reports. The bill also provides a limited exemption for certain “foreign private advisers” that have no place of business in the U.S., manage less than $25 million attributable to U.S. clients and have fewer than 15 U.S. clients.

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Combining Banking with Private Equity Investing

This post comes to us from Lily Fang, Assistant Professor of Finance at INSEAD, Victoria Ivashina, Assistant Professor of Finance at Harvard Business School, and Josh Lerner, Professor of Entrepreneurial Management and Finance at Harvard Business School.

In the paper, “An Unfair Advantage”? Combining Banking with Private Equity Investing, which was recently made publicly available on SSRN, we explore the phenomenon and economics of private equity investment by bank-affiliated groups. This paper is motivated by recent regulatory efforts to limit the ability of banks to undertake proprietary investing and trading activities. Despite the controversy and policy debate that the proposed Volcker rule has engendered, we know remarkably little about how banks have fared as investors. Does the combination of banking and private equity investing endow banks with superior information that allows them to identify good prospects and garner superior returns? Or does the combination bestow banks with an unfair ability to expand their balance sheets, capturing benefits within the bank at the expense of the overall market and ultimately the tax payers? We focus here on understanding the experience of bank-affiliated funds with private equity to shed light on these questions.

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Inefficiencies in the Information Thicket

This post comes to us from Robert P. Bartlett III, Assistant Professor of Law at the University of California, Berkeley.

In the paper, Inefficiencies in the Information Thicket: A Case Study of Derivative Disclosures During the Financial Crisis, which was recently made publicly available on SSRN, I provide an empirical examination of the effect of enhanced derivative disclosures by examining the disclosure experience of the monoline insurance industry in 2008. Conventional wisdom concerning the causes of the Financial Crisis posits that insufficient disclosure concerning firms’ exposure to complex credit derivatives played a key role in creating the uncertainty that plagued the financial sector in the fall of 2008. To help avert future financial crises, regulatory proposals aimed at containing systemic risk have accordingly focused on enhanced derivative disclosures as a critical reform measure. A central challenge facing these proposals, however, has been understanding whether enhanced derivative disclosures can have any meaningful effect given the complexity of credit derivative transactions.

Like AIG Financial Products, monoline insurance companies wrote billions of dollars of credit default swaps on multi-sector CDOs tied to residential home mortgages, but unlike AIG, their unique status as financial guarantee companies subjected them to considerable disclosure obligations concerning their individual credit derivative exposures. As a result, the experience of the monoline industry during the Financial Crisis provides an ideal setting with which to test the efficacy of reforms aimed at promoting more elaborate derivative disclosures.

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Rating the Raters

Editor’s Note: This post is Lucian Bebchuk’s most recent op-ed in his regular column series titled “The Rules of the Game” written for the international association of newspapers Project Syndicate, which can be found here.

In the new financial order being put in place by regulators around the world, reform of credit rating agencies should be a key element. Credit rating agencies, which play an important role in modern capital markets, completely failed in the years preceding the financial crisis. What is needed is an effective mechanism for rating the raters.

There is widespread recognition that rating agencies have let down investors. Many financial products related to real estate lending that Standard & Poor, Moody’s, and Fitch rated as safe in the boom years turned out to be lethally dangerous. And the problem isn’t limited to such financial products: with issuers of other debt securities choosing and compensating the firms that rate them, the agencies still have strong incentives to reciprocate with good ratings.

What should be done? One proposed approach would reduce the significance of the raters’ opinions. In many cases, the importance of ratings comes partly from legal requirements that oblige or encourage institutional investors and investment vehicles to maintain portfolios of assets that have received sufficiently high grades from the recognized agencies.

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Understanding RiskMetrics Shareholder Rights “GRId”

Adam Emmerich is a partner in the corporate department at Wachtell, Lipton, Rosen & Katz focusing primarily on mergers and acquisitions and securities law matters. This post is based on a Wachtell Lipton firm memorandum by Mr. Emmerich, Eric S. Robinson, Trevor S. Norwitz, William Savitt and Gordon S. Moodie. Another aspect of the RiskMetrics system – its independence from a company’s ownership structure – is discussed in a study by the Program titled The Elusive Quest For Global Governance Standards, which is available here; previous posts regarding the “GRId” system are available here.

As we described in a prior memo, RiskMetrics has replaced its Corporate Governance Quotient (CGQ) with Governance Risk Indicators (GRIds). Using the new GRIds methodology, RiskMetrics will identify the level of concern (low, medium and high) for each company across four categories of corporate governance metrics used by RiskMetrics: Board Structure, Compensation, Audit and Shareholder Rights. Unlike CGQ, the GRIds metrics are both transparent – anyone can calculate a company’s scores by answering specified questions about its governance structure – and absolute – the scores are company-specific and do not depend upon practices of other companies. One of the GRIds metrics, called “Shareholder Rights,” seeks to measure corporate takeover defenses.

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Agency Costs, Mispricing, and Ownership Structure

This post comes to us from Sergey Chernenko, C. Fritz Foley, and Robin Greenwood at Harvard Business School.

In our NBER working paper, Agency Costs, Mispricing, and Ownership Structure, we propose an explanation based on stock market mispricing for why firms with a controlling shareholder raise outside equity even when they cannot commit not to expropriate minority shareholders. Our main idea is that the controlling shareholder takes advantage of stock market mispricing to offset the burden of agency costs. To the extent that agency costs are deadweight instead of distributional transfers, mispricing facilitates the creation of inefficient ownership structures.

In perfectly efficient markets, minority shareholders anticipate the full extent of agency problems and form unbiased estimates of the cash flows they will receive. If the controlling shareholder is expected to divert resources, minority shareholders price the equity accordingly, and it is the controlling shareholder who ultimately bears all agency costs. Controlling shareholders therefore sell shares to dispersed outside investors only when there are substantial benefits to doing so. The existing literature focuses on motivations related to financial constraints. Our findings suggest another possible, though not mutually exclusive, explanation: equity is sold when it is overpriced. Stock mispricing offsets agency costs and induces a controlling shareholder to raise capital. Higher misvaluations are required to support the creation of ownership structures that give rise to more expropriation.

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OECD Provides Guidance for Anti-Bribery Compliance Programs

This post comes to us from Jeff Kaplan, a partner in Kaplan & Walker LLP specializing in corporate compliance and ethics programs, and is based on a Kaplan & Walker client memorandum.

In March 2010, a working group of the Organization of Economic Cooperation and Development (“OECD”), representing the thirty OECD member nations and eight other countries (the “Working Group”), issued its much-awaited Good Practice Guidance for anti-bribery compliance programs. For global companies, this represents what could well be the most significant set of compliance and ethics (“C&E”) program expectations ever promulgated, as we briefly describe in this memorandum.

Background: the “how” and “why” of good C&E programs

Nearly nineteen years ago, the U.S. government established an original and compelling model for promoting legal compliance by businesses. This new approach was set forth in the Federal Sentencing Guidelines for Organization (the “Sentencing Guidelines”), which offered companies both strong incentives for implementing C&E programs and meaningful guidance on how to do so.

Since then, a small number of other nations have followed this lead, at least in limited ways. But until recently, there had been no true global acceptance of the Sentencing Guidelines’ strategy of providing business organizations with incentives (the “how”) and methodologies (the “why”) for adopting strong C&E programs.

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Delaware Chancery Court Allows Preferred Stockholder Derivative Action

William Savitt is a partner in the Litigation Department of Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Savitt, David E. Shapiro and Ryan A. McLeod, and relates to the decision of the Chancery Court of Delware in MCG Capital Corp. v. Maginn, which is available here.

In a recent decision, the Delaware Court of Chancery for the first time held that preferred stockholders have standing to bring derivative suits on behalf of a corporation. MCG Capital Corp. v. Maginn, C.A. No. 4521-CC (Del. Ch. May 5, 2010).

The plaintiff was the sole holder of Jenzabar, Inc.’s preferred stock but held no common stock of the corporation. Plaintiff brought suit alleging that the board’s decision to pay certain compensation to executive management breached fiduciary duties owed to the corporation and violated both the corporation’s charter and contractual consent rights. Resolving an issue of first impression under Delaware law, the Court held that “preferred shareholders have standing to bring derivative claims unless the ability to bring a derivative claim has been expressly limited in the articles, preferred stock designations, or some other appropriate document.” Delaware corporations are thus now on notice that preferred stockholders presumptively have the same rights as common stockholders to attack corporate action through derivative litigation. At the same time, the Court indicated that express limitations on preferred holder derivative standing will be enforced.

Coming in the wake of the Supreme Court’s 2007 Gheewalla decision, which explained that the creditors of a corporation may bring derivative suits once the corporation is insolvent, MCG Capital Corp. expands the universe of potential derivative plaintiffs, and, accordingly, potential derivative liability. Nevertheless, and in accordance with Delaware’s longstanding policy favoring private ordering, the Chancellor took pains to reassure Delaware companies that limitations on such standing will be respected if clearly set forth in the charter or the preferred stock’s designations.

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