Monthly Archives: May 2010

Capital Markets Committee Proposes Blueprint for Compromise on Financial Reform

Hal Scott is the Director of the Program on International Financial Systems at Harvard Law School and the co-chair of the Committee on Capital Markets Regulation. This post relates to a letter recently submitted to U.S. Congressional leaders by Committee on Capital Markets Regulation; the letter is available here.

As Senator Dodd and Senator Shelby continue to meet and search for a bipartisan financial regulatory reform bill, the Committee on Capital Markets Regulation (CCMR), an independent, non-partisan research organization and proponent of broad financial regulatory reform, has sent congressional leaders a letter outlining a blueprint for a compromise that would achieve practical and effective financial reform legislation.

In the 37-page letter the CCMR comprehensively evaluates all major elements in the financial reform proposals that have emerged from Senate committees, but focuses especially on four as areas ripe for compromise:

  • “Never” is bad public policy. Federal regulators must have the ability to use tax dollars (and recoup them later) to pay for the orderly resolution of failing institutions in cases where they judge the alternative would be national and/or international financial catastrophe. However, the CCMR does not support the arbitrary $50 billion fund in the proposed Dodd bill, since no one can or should try to guess the cost of such bailouts. A better solution: give the Secretary of the Treasury the power to use public money, and then recoup funds after any needed bailout, starting first by recovering bailout funds from the creditors of the failed bank.

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Can a Clearinghouse Really Stop the Next Financial Crisis?


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Editor’s Note: Mark Roe is a professor at Harvard Law School, where he teaches bankruptcy and corporate law. This post is based on an op-ed by Professor Roe that appeared today in the Wall Street Journal.

As the Senate finalizes its financial reform legislation, a consensus is developing that if we could just get derivatives traded through a centralized clearinghouse we could avoid a financial crisis like the one we just went through.

This is false. Clearinghouses provide efficiencies in transparency and trading, but they are no cure-all. They can even exacerbate problems in a financial crisis.

If I agree to sell you a product next month through a clearinghouse, I’ll deliver the product to the clearinghouse and you’ll deliver the cash to the clearinghouse on the due date. Let’s say we both have many trades going through the clearinghouse and we’ve posted collateral to cover any single trade that fails. This is more efficient than each of us posting collateral privately for each trade. Moreover, we’re not worried that I won’t deliver or you won’t pay because we both count on the clearinghouse to deliver and pay up if one of us doesn’t.

This clearing system makes trading more efficient. If you default, the cost is spread through the clearinghouse so I don’t get hurt severely. And if the clearinghouse has enough collateral from you, there’s no loss to spread. But there’s also a potential downside: The clearinghouse reduces our incentives to worry about counterparty risk. Your business might collapse before you need to pay up, but that’s not my problem because the clearinghouse pays me anyway. The clearinghouse weakens private market discipline.

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The Vote is Cast: The Effect of Corporate Governance on Shareholder Value

This paper comes to us from Vicente Cuñat, Lecturer at the London School of Economics, Mireia Gine, Associate Director of WRDS at the University of Pennsylvania, and Maria Guadalupe, Associate Professor of Economics and Finance at Columbia University.

In our paper, The Vote is Cast: The Effect of Corporate Governance on Shareholder Value, which was recently made publicly available on SSRN, we present novel evidence of the effect of corporate governance on the market value and long-term performance of firms. We use a regression discontinuity model on the outcomes of votes on governance proposals in shareholder meetings. We exploit the fact that firms that pass a proposal by a close margin are ex-ante similar to those that reject it by a close margin, so that passing a provision is “locally” exogenous. Therefore, this approach provides a causal estimate and overcomes the endogeneity problems that have plagued the literature thus far. In addition, our empirical strategy also allows us to recover an estimate of the effect of governance even if the market had already incorporated the probability of passing the shareholder proposal into stock prices. This is because, proposals that fall around the majority threshold were ex-ante the most uncertain, such that investors could not perfectly predict whether they would pass or not. It is for these proposals that we are able to observe a price reaction.

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Principles for Tying Equity Compensation to Long-Term Performance

Lucian Bebchuk is the William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance at Harvard Law School. Jesse Fried is a Professor of Law at Harvard Law School. This post builds on their discussion paper Paying for Long-Term Performance, issued by the Harvard Law School Program on Corporate Governance, which is available here.

In our recent study, Paying for Long-Term Performance, we provide a detailed blueprint for how equity-based compensation should be designed to tie executive payoffs to long-term results and to avoid excessive risk-taking incentives. Our conclusions can be distilled into the following eight “principles:”

  • 1. Executives should not be free to unload restricted stock and options as soon as they vest except to the extent necessary to cover any taxes arising from vesting.
  • 2. Executives’ ability to unwind their equity incentives should not be tied to retirement.

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Is It Too Late for Goldman Sachs to Play Offense?


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Editor’s Note: Ben W. Heineman, Jr. is a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government. This post is based on an article that first appeared in the online edition of the Harvard Business Review.

What should you do to rehabilitate your general reputation if you are in Goldman Sachs’ executive suite at 200 West Street in New York?

Beset by an SEC complaint, a criminal investigation, a Senate grilling, and the resulting loss in two weeks of more than $20 billion in market capitalization, Goldman has assumed a defensive posture. This is so even though the firm just announced $3.46 billion in first quarter earnings.

Both in response to the SEC and to Senate questioning, Goldman repeatedly said that what it had done in the past was legal and consistent with industry practice.

But just because something was “legal” in the past, doesn’t mean it is “right” in the future. (See my views from the morning of Goldman’s Senate hearing.)

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Delaware Addresses Vote Buying and Synthetic Ownership

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, Eric S. Robinson, Adam O. Emmerich, Trevor S. Norwitz and William Savitt, regarding the decision in Crown Emak Partners v. Kurz; the decision in that case 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.

In an important decision for proxy and takeover contests, the Delaware Supreme Court last week addressed significant questions of corporate “vote-buying” and stock ownership. Crown Emak Partners v. Kurz, No. 64, 2010 (April 21, 2010). (See this post.)

In the course of a corporate control contest, the incumbent directors amended the company’s by-laws to reduce the size of the board, thereby mooting the insurgents’ attempt to elect new directors. During the same period, the insurgents purchased from a former corporate employee the right to vote just enough shares to secure a bare majority, as well as the future economic interest in those shares. Because the former employee was contractually prohibited from selling his shares until 2011, however, the parties left “bare legal title” in his hands. After the inspector of elections invalidated pro-insurgent votes cast by holders of shares held in street name (for want of an appropriate “universal proxy”), the insurgents sued, challenging the validity of the by-law and the invalidation of their votes. The incumbents, in turn, alleged that the share purchase amounted to impermissible vote-buying. The Court of Chancery ruled for the insurgents, holding that street name holders – the banks and brokers who appear on the “Cede breakdown” – are “stockholders of record” for purposes of deciding who has the right to vote or act by written consent under Delaware law. Chancery also ruled that the share transaction was not impermissible vote-buying and that the by-law amendment was impermissible under Delaware law.

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Short Selling in Initial Public Offerings

This post comes to us from Amy Edwards, Assistant Chief Economist at the SEC Office of Economic Analysis, and Kathleen Weiss Hanley, Senior Economist, Risk Analysis Section, at the Federal Reserve Board of Governors.

In our paper, Short Selling in Initial Public Offerings, forthcoming in the Journal of Financial Economics, we use short sale transactions data recently made publicly available to explore the nature of short selling in initial public offerings. Many academic papers rely on the assumption that short selling is constrained early in the IPO process and that such constraints contribute to the high level of underpricing of some IPOs. In contrast, we find that short selling is prevalent on the initial trading day and many short sales occur close to the open.

Tests of whether short selling is related to divergence of opinion indicate that short selling is increasing in the level of the first day return. While our results are consistent with the hypothesis that short sellers are attracted to IPOs with more divergence of opinion and hence, higher first day returns, they are inconsistent with the notion that short selling constraints are the reason for high underpricing.

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The International Dimension of Issuer Liability

This paper comes to us from Alexander Hellgardt, Senior Research Fellow at the Max Planck Institute and Lecturer in Law at Ludwig Maximilians University, and Wolf-Georg Ringe, Lecturer in Law at the University of Oxford and Visiting Professor of Law at Columbia Law School.

In the upcoming decision Morrison v. National Australia Bank, the U.S. Supreme Court will decide on a ‘foreign-cubed’ securities class action for the first time. The case involves only foreign plaintiffs, who bought their shares on a foreign (Australian) exchange, and sued an Australian issuer. Because the Securities Exchange Act of 1934 and Rule 10b-5 so far [1] are silent as to their international application, the extraterritorial reach of U.S. securities liability is still unclear. The success of securities claims, however, crucially depends on the place where the plaintiffs can bring their case. The U.S. legal system contains some features, namely opt-out class actions and the fraud-on-the-market theory, which make U.S. courts the preferred venue in international securities fraud actions. As a consequence, the discussion so far has tried to strike the balance between restricting the access of ‘foreign-cubed’ cases to the U.S. courts, while allowing such cases to be litigated in which the U.S. has an own interest, e.g. because the fraud was committed here or has produced substantial effects in the U.S. Yet, there is another dimension to international jurisdiction in securities litigation that has not garnered a lot of attention so far: Securities liability is a major corporate governance enforcement mechanism. Hence, the question of the applicable law in securities claims has important implications for corporate governance and should be viewed in the broader context of the rules governing the applicable corporate governance regime. Against this background, the conflict-of-law rules for securities fraud have been the object of major discussions in Europe, where the question is of particular significance if an integrated European financial market is to co-exist with national securities laws.

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Trend Spotting — Are Courts Becoming Less Friendly to Distress Investors?

This post comes to us from Alan Gover. Mr Gover is a senior partner in White & Case LLP’s global business and financial restructuring practice. The post is based on White & Case Insolvency Note by Mr. Gover and John Lynch.

When the Bankruptcy Code was enacted in 1978, it embodied a bias in favor of reorganization of going concerns wherever possible. This has been the singular distinction between the “American style” of restructurings and the approach used in most other commercial countries. The very concept of “debtor-in-possession” suggests a belief in the chance of renewal which is absent from the “receivership style” of insolvency prevalent outside the United States. This policy predisposition toward recovery has been a powerful stimulus for the involvement of financial investors in the bankruptcy process, which in turn has attracted liquidity that has itself fostered the reorganization of troubled businesses. The very possibility of a corporate turnaround has encouraged investors to take risk in buying discounted equity and debt in restructurings, where there would be far less interest in asset trading in liquidations. On the other hand, the bankruptcy process is not about aspirations and dreams. It is a hard-nosed business and legal environment that is dependent on sophisticated financial parties having confidence in the logic of outcomes. The purpose of this article is to explore whether certain recent trends could undermine that confidence.

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