Monthly Archives: June 2010

Implicit Compensation

M. Todd Henderson is an Assistant Professor of Law at University of Chicago Law School.

Each year, CEOs sell billions of dollars of stock in their firms. Previous empirical work demonstrates that CEOs earn abnormal returns on these trades, suggesting some trading based on material non-public information. Critics of CEO compensation practices offer this fact as evidence of a manager-dominated process. According to their story, CEOs earn “extra” compensation from these profits that is not disclosed or taken into account by the board when setting CEO pay. CEOs are therefore systematically overpaid.

A new paper, available here, presents evidence boards of directors bargain with executives about the profits they expect to make from trades in firm stock. In general, the evidence suggests executives whose trading freedom is increased experience reductions in other forms of pay to offset the potential gains from trading. This “implicit compensation” is a significant component of pay (about 20 percent). This result is consistent with (and the flipside of) a study by Darren Roulstone, finding firms that restrict trading increase compensation to offset the lost opportunities from trading. While Roulstone finds that firms restricting trading pay more, this Paper finds that firms liberalizing trading pay less.


Just Say No to Wall Street: Putting a Stop to the Earnings Game

Michael Jensen is the Jessie Isidor Straus Professor of Business Administration, Emeritus, at Harvard Business School.

In a Journal of Applied Corporate Finance paper, Just Say No to Wall Street: Putting a Stop to the Earnings Game, my co-author, Joseph Fuller of The Monitor Group, and I discuss the notion of putting an end to the “earnings game.” This requires that CEOs reclaim the initiative by avoiding earnings guidance and managing expectations in such a way that their stocks trade reasonably close to their intrinsic value. In place of earnings forecasts, management should provide information about the company’s strategic goals and main value drivers. They should also discuss the risks associated with the strategies, and management’s plans to deal with them.

Using the experiences of several companies, we illustrate the dangers of conforming to market pressures for unrealistic growth targets. We argue that an overvalued stock, by encouraging overpriced acquisitions and other risky, value-destroying bets can be as damaging to the long-run health of a company as an undervalued stock.


Supreme Court to Decide Rule on Class Waivers in Arbitration Clauses

James Morphy is a partner at Sullivan & Cromwell LLP specializing in mergers & acquisitions and corporate governance. This post is based on a Sullivan & Cromwell client memorandum, and relates to an appeal in the case of AT&T Mobility LLC v. Concepcion; the decision of the Ninth Circuit from which the appeal arose, Laster v. AT&T Mobility LLC, is available here.

The U.S. Supreme Court recently granted certiorari in a case that is likely to resolve important outstanding questions regarding attempts to limit arbitration clauses so that they do not permit class action arbitrations. The case, AT&T Mobility LLC v. Concepcion, No. 09-893, presents the question whether the Federal Arbitration Act preempts state laws holding such class action waivers unconscionable if they are contained in consumer contracts. This case follows closely on the Court’s holding last month in Stolt-Nielsen S.A. v. AnimalFeeds Int’l Corp., No. 08-1198 (Apr. 27, 2010), that contracts that are silent on class arbitration must be read to bar that procedure.

Class Arbitration Waivers and Unconscionability Law

The case on appeal is Laster v. AT&T Mobility LLC, 584 F.3d 849 (9th Cir. 2009), which struck down a class waiver in an arbitration clause as unconscionable under California law. The Ninth Circuit held that the Federal Arbitration Act, 9 U.S.C. § 1 et seq. (“FAA”), does not preempt California law in this respect. 584 F.3d at 852.


Bankers Beware

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, a partner at Kirkland and relates to the recent case of In re Zenith National Insurance Corp. Shareholders Litigation, 5296-VCL. 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 Delaware Chancery bench decision from VC Laster denying a motion for a preliminary injunction to block the merger of Zenith National with Fairfax Holdings suggests increased sensitivity around issues of conflicts of interest for financial advisers.

In addressing disclosure claims relating to a potential conflict of interest affecting Zenith’s financial adviser, the court noted with concern that, while the financial adviser’s role advising Fairfax on an unrelated engagement soon before the Zenith deal was fully disclosed, the proxy statement omitted mention of the fact that the “day-to-day” banker, or “No. 2 fellow,” that advised Zenith on the Fairfax transaction was the same person who had represented Fairfax on the earlier engagement. VC Laster, in what he termed a “close issue” in denying an injunction based on these disclosure claims, noted that the overlap in deal teams was “not ultimately material” in reliance on a number of factors including the absence of testimony about what this particular banker did on each deal, the unaffiliated nature and cash merger structure of the Zenith deal, and the relatively limited involvement of the bankers in negotiating the Zenith/Fairfax deal. Absent such factors, the court indicated that it would have been prepared to enjoin the shareholder vote because of the failure to fully disclose the extent of the potential conflict resulting from the overlap in personnel.


Lucian Bebchuk’s Keynote Speech at the ICGN Annual Meeting

Lucian Bebchuk delivered a keynote address at the annual meeting of the International Corporate Governance Network (ICGN) taking place this month in Toronto, Canada. The meeting drew over 400 participants from 40 countries. Bebchuk’s speech focused on reforming executive pay structures to tighten the link between pay and long-term performance. The address built on three research studies issued by the Harvard Law School Program on Corporate Governance:

Bebchuk’s presentation slides are available here.

Next Tuesday, June 15, Bebchuk will discuss the above studies in a webinar sponsored by the IRRC Institute. Registration for the webinar is free and can be done here.

Are Sovereign Wealth Fund Investments Politically Biased?

This post comes to us from Rolando Avendano and Javier Santiso, both from the Organization for Economic Co-Operation and Development (OECD).

Our paper, Are Sovereign Wealth Fund Investments Politically Biased? Comparing Mutual and Sovereign Funds, which was recently made publicly available on SSRN, belongs to a series of studies on Sovereign Wealth Funds and their role in the new financial architecture. The study is a background paper for the Global Development Outlook 2010.

The resilience of Sovereign Wealth Funds was proven during the recent financial turmoil, confirming their status in today’s global financial landscape. Their importance is stressed today, when more countries are considering setting up wealth management institutions. Some emerging economies including Angola, Brazil, Indonesia, Malaysia, Mongolia, Nigeria and Saudi Arabia have recently created or expanded this type of structure for managing their national wealth, while the debate is open in others (Algeria, India).


Delaware Court Adopts Unified Standard for Controlling Stockholder Going Private Transactions

George Bason is the global head of the mergers and acquisitions practice at Davis Polk & Wardwell LLP. This post is based on a Davis Polk Client Newsflash, and relates to the recent decision In re CNX Gas Corp. Shareholders Litigation, which is available here. Gibson, Dunn & Crutcher LLP further describe the decision in a memorandum 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 a recent Delaware decision issued in In re CNX Gas Corp. Shareholders Litigation, C.A. No. 5377-VCL (Del Ch. May 25, 2010), Vice Chancellor Travis Laster imposed additional requirements for controlling stockholders and boards to obtain the benefit of the more deferential business judgment standard of review by a court in litigation over a going private tender offer, and advocates a unified standard of review for going private transactions generally, whether structured as a merger or a tender offer. Vice Chancellor Laster endorsed the reasoning first set forth in dicta in Cox Communications (Del. Ch. 2005), in which Vice Chancellor Leo Strine, Jr. argued that the Delaware courts should reject the notion that negotiated mergers with controlling stockholders are subject to the stringent “entire fairness” review, while certain two-step transactions (i.e., a tender offer followed by a short-form merger) with the same controlling stockholders are subject to the business judgment rule. In CNX, Vice Chancellor Laster held that the business judgment rule (and not entire fairness) will apply to a going private transaction by its controlling stockholder only if the transaction is both (1) negotiated and recommended by an active and informed special committee of independent, disinterested directors and (2) subject to a “majority-of-the-minority” tender or vote condition.


The Dark Side of Outside Directors

René Stulz is a Professor of Finance at Ohio State University.

In the paper, The Dark Side of Outside Directors: Do They Quit When They are Most Needed? which was recently made publicly available on SSRN, my co-authors (Rüdiger Fahlenbrach from the Ecole Polytechnique Fédérale de Lausanne and the Swiss Finance Institute and Angie Low from the Nanyang Technological University) and I focus on a cost of board independence that has not received attention so far and demonstrate that it is economically significant. Corporate governance reforms following the corporate scandals of the turn of the century focused heavily on increasing the representation of outside directors on boards. Listing standards on U.S. exchanges were changed to require boards to have a majority of outside directors. Many countries have introduced requirements on the percentage of outside directors on boards as well as on the fraction of outside directors on the nominating committee, compensation committee, and audit committee (see IOSCO (2007)).


How Financial Reforms Will Impact Private Equity Hedge Funds

John Finley is co-head of the Mergers and Acquisitions Group at Simpson Thacher & Bartlett LLP. This post is based on a Simpson Thacher memorandum.

On May 20, 2010, the U.S. Senate passed a comprehensive set of financial regulatory reforms that, if enacted, will represent the most sweeping set of changes to the U.S. financial regulatory system since the Great Depression. The reforms, which are set forth in a bill of more than 1,500 pages called the Restoring American Financial Stability Act of 2010 (S. 3217, or the “Senate Bill”) and which come after nearly a year of Congressional hearings and months of stop-and-start legislative negotiations, contain a number of provisions relevant to private funds and their advisers.

In its treatment of private funds, the Senate Bill tracks many of the themes contained in the Wall Street Reform and Consumer Protection Act (H.R. 4173, or the “House Bill”) that was passed by the U.S. House of Representatives on December 11, 2009. However, there are significant differences concerning, among other things, the registration of private fund advisers and restrictions on the relationship and activities of banking organizations with private equity and hedge funds. The bills also mandate specific executive compensation and corporate governance practices at U.S. public companies generally and, accordingly, would affect a subset of the portfolio companies of private equity, venture capital and other private funds.


Executive Compensation in the Courts

Randall Thomas is a Professor of Law and Business at Vanderbilt University. 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 the paper, Executive Compensation in the Courts: Board Capture, Optimal Contracting and Officer Fiduciary Duties, forthcoming in the Minnesota Law Review, my co-author, Harwell Wells, and I identify a theoretical impasse in our understanding of executive compensation and looks to recent developments in corporation law to find a practicable way out. At present, debates over executive compensation are waged between two scholarly camps. Advocates of Board Capture theory claim that, because boards of directors are dominated by corporations’ chief executive officers, those CEOs are able to set their own compensation and take home pay packages that are both too high and provide too few incentives for improved corporate performance. Optimal Contracting theorists disagree; while admitting that some compensation packages are inequitable, these theorists contend that, given the constraints of the current legal and regulatory system, most current CEO compensation agreements should be pretty good, rewarding CEOs appropriately and, equally important, providing for increased shareholder value. Despite vigorous scholarly debate, however, little progress has been made in the theory of, and little done in practice to curb, excessive compensation packages.


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