Monthly Archives: July 2010

Does the Stock Market Harm Investment Incentives?

Alexander Ljungqvist is Professor of Finance at New York University.

In the paper, Does the Stock Market Harm Investment Incentives? which was recently made publicly available on SSRN, my co-authors, John Asker and Joan Farre-Mensa, and I examine whether the stock market harms investment incentives. The theory literature in economics and finance has long argued that the separation of ownership and control following a stock market listing can lead to agency problems between managers and dispersed stock market investors and hence to suboptimal investment decisions. The literature is divided on whether overinvestment (i.e., empire building) or underinvestment (due to rational short-termism) will result, or indeed whether effective corporate governance mechanisms can be devised to ensure investment does not suffer (Tirole (2001), Shleifer and Vishny (1997)).

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Investor Protection Provisions of the Dodd-Frank Act

This post comes to us from Stephen J. Crimmins, a partner in the Washington, D.C. and New York offices of K&L Gates LLP, and is based on a memorandum by Mr. Crimmins, Kay A. Gordon and Matt T. Morley.  The effect of the Dodd-Frank Act on securities litigation and enforcement was discussed in this post.  Additional posts relating to the Dodd-Frank Act are available here.

The investor protection provisions of Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong. (2010) promise to make major changes in the world of securities enforcement and regulation.  Thanks to Dodd-Frank, we will shortly see whistleblowers enticed by potentially lucrative bounties for reporting violations to a much larger and more powerful SEC.  In addition to seeing its budget likely double over the next five years, the SEC will benefit from relaxed proof standards in pursuing secondary actors, expanded jurisdiction over foreign cases, the ability to obtain penalty awards in SEC administrative cases, industry-wide bars for securities professionals, and the ability to subpoena trial witnesses nationally.  The SEC will also have the power to impose fiduciary standards on brokers, regulate short selling, restrict customer arbitration agreements, and engage in other extensive rulemaking.

With further changes in this area unlikely as the bill moves towards final enactment over the next few days, this alert reviews key provisions that will soon begin to impact investors, public companies, securities professionals and their counsel.

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Focusing the SEC’s Regulatory Agenda on Investors

Editor’s Note: Mary Schapiro is Chairman of the U.S. Securities and Exchange Commission. This post is based on Chairman Schapiro’s recent remarks at the Stanford University Law School Directors College, which are available here. The views expressed in the post are those of Chairman Schapiro and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners or the Staff.

Having served on boards, I know how challenging the role of director is. But I also know what an important job it is – perhaps more so today than ever. We have learned again and again over the last several years that active, informed and independent boards are often the difference between companies that successfully emerge from economic downturns, and those that are unable to do so.

Of course, I gave up my two corporate board seats when I accepted my current job, but I can sincerely say that board service is one of the things I miss most.

Fortunately, since I arrived at the SEC 17 months ago, there hasn’t been much time to look back.

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The Financial Reform Act and 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. Additional posts relating to the Dodd-Frank Act are available here.

The House and Senate conferees on H.R. 4173, the Restoring American Financial Stability Act of 2010 (RAFSA), have been reviewing and reconciling differences between the House and Senate versions of RAFSA since early June. [1] The conference is based on the Senate version passed May 20. RAFSA covers, among other things, a broad range of issues relating to the financial industry as well as issues relating to publicly traded companies not limited to the financial industry. Within this broad range are, among others, issues concerning so-called systemic risk for our financial system, regulatory supervision, derivatives, hedging, consumer protections, credit rating agencies, corporate governance and executive compensation.

The following discussion is limited to the executive compensation provisions in RAFSA Title IX, Subtitle E. Since passage is expected to be based largely on the Senate version, the following discussion is based on that version (references at the beginning of each part are to the Senate version).

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The Impact of Financial Reform on Securities Litigation and Enforcement

Wayne Carlin is a partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Carlin, Peter C. Hein, Eric M. Roth and Olivia A. Maginley. Additional posts relating to the Dodd-Frank Act are available here.

In addition to many significant regulatory provisions, the conference report text of the proposed Dodd-Frank Wall Street Reform and Consumer Protection Act contains a number of provisions in Title IX (Investor Protections and Improvements to the Regulation of Securities) which, if enacted, would have a significant impact on securities litigation and enforcement. Other proposed provisions were considered and discarded during the conference committee process. The highlights of the conference report text as it now stands include:

Private Cause of Action for Aiding and Abetting Violations Rejected. Efforts by some lawmakers to overturn well-settled Supreme Court authority by creating a private cause of action for aiding and abetting violations of the Securities Exchange Act of 1934 proved unsuccessful. The conference report text, at Sections 929M-929O, instead augments the SEC’s existing authority to pursue civil enforcement actions alleging aiding and abetting of violations of the Exchange Act by lowering the requisite state of mind to encompass “reckless,” in addition to “knowing,” acts, and by empowering the SEC to pursue actions premised on “knowingly or recklessly” aiding or abetting violations of the Securities Act of 1933, the Investment Company Act of 1940 and the Investment Advisers Act of 1940. Section 929Z of the conference report text requires the Comptroller General to conduct a “study” analyzing the impact of authorizing a private right of action for aiding and abetting violations of the federal securities laws.

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Corporate Governance and Executive Compensation Provisions of the Dodd-Frank Act

David Huntington is a partner in the Capital Markets and Securities Group at Paul, Weiss, Rifkind, Wharton & Garrison LLP. This post is based on a Paul Weiss client memo by Mr. Huntington, Mark S. Bergman, Lawrence I. Witdorchic and Frances Mi. Other memoranda on the corporate governance and executive compensation provisions of the Dodd-Frank Act by Forum contributors are available here (from Wachtell, Lipton, Rosen & Katz) and here (from Sullivan & Cromwell LLP); a chart summarizing those provisions by Forum contributors from Kirkland & Ellis LLP is available here. Additional posts relating to the Dodd-Frank Act are available here.

On June 25, 2010, a House and Senate conference committee negotiating the blueprint for the reform of the U.S. financial system agreed on text of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). The Act as embodied in the conference report is currently scheduled to be approved by Congress this week before being sent to President Obama for signature.

The Act includes a number of significant corporate governance and executive compensation provisions that will apply to all U.S. public companies. We discuss these measures below and will be covering other aspects of this legislation in separate client memoranda. A copy of the entire Act is available here; however, for ease of use, we have excerpted the relevant corporate governance and executive compensation provisions here.

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Collins Amendment Sets Minimum Capital Requirements

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 client memorandum by Ms. Tahyar, Daniel N. Budofsky, Luigi L. De Ghenghi, John L. Douglas, Randall D. Guynn, Arthur S. Long, and Reena Agrawal Sahni. Additional posts on the Dodd-Franks Act are available here.

The Collins Amendment, originally drafted by the FDIC staff and reflecting views held by Chairwoman Bair, imposes, over time, the leverage and risk-based standards currently applicable to U.S. insured depository institutions on U.S. bank holding companies, including U.S. intermediate holding companies of foreign banking organizations, thrift holding companies and systemically important nonbank financial companies. One of the effects of the Collins Amendment is to eliminate trust preferred securities as an element of Tier 1 capital. Implementing regulations must be issued no later than 18 months from the bill’s effective date. As with all changes in capital requirements, there are highly negotiated transition periods and grandfathering exemptions, which we describe below. Please see a more complete implementation timeline at the end of this memorandum.

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Summary of Dodd-Frank Financial Regulation Legislation

David Huntington is a partner in the Capital Markets and Securities Group at Paul, Weiss, Rifkind, Wharton & Garrison LLP. This post is based on a Paul Weiss client memo by Mr. Huntington, Robert M. Hirsh, Manuel S. Frey, Mark S. Bergman, Frances Mi and Da-Wai Hu. Other Forum contributors from Wachtell, Lipton, Rosen & Katz have published a firm memorandum on the impact of the Dodd-Frank Act on fund managers, which is available here. Additional posts relating to the Dodd-Frank Act are available here.

On June 25, 2010, a House-Senate conference committee reached final agreement on the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). The conference report must be approved by the House and Senate before the bill is presented to the President for signature. The House is expected to approve the conference report on June 29 and the Senate is expected to vote shortly thereafter.

The Act is comprehensive in scope, providing for significant changes to the structure of federal financial regulation and new substantive requirements that apply to a broad range of market participants, including public companies that are not financial institutions. Among other measures, the Act includes corporate governance and executive compensation reforms, new registration requirements for hedge fund and private equity fund advisers, heightened regulation of over-the-counter derivatives and asset-backed securities and new rules for credit rating agencies. The Act also mandates significant changes to the authority of the Federal Reserve and the Securities and Exchange Commission as well as enhanced oversight and regulation of banks and non-bank financial institutions.

This memorandum summarizes the key provisions of the Act.

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Dodd-Frank Act Finalizes Swap Pushout Rule

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP. This post is based on a Davis Polk client memorandum by Ms. Nazareth, Daniel N. Budofsky, Robert L.D. Colby, Luigi L. De Ghenghi, John L. Douglas, Randall D. Guynn, Arthur S. Long, Reena Agrawal Sahni and Margaret E. Tahyar. Additional posts on the Dodd-Franks Act are available here.

On June 25, 2010, the Senate-House conference on the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Bill”) agreed on the final legislative text of the Bill, including Section 716 (the “Swap Pushout Rule”). The Swap Pushout Rule is a revised version of a provision originally introduced by Senator Blanche Lincoln (D–AR) to the Senate Agriculture Committee. The provision led to significant controversy, including the objections of several key politicians and regulators. The controversy continued through the early morning hours of June 25, when compromise language was finally agreed upon. The result is a provision that includes an unusual number of ambiguities and apparent contradictions.

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Rethinking the Regulation of Securities Intermediaries

Jill Fisch is a Professor of Law at the University of Pennsylvania.

In the paper, Rethinking the Regulation of Securities Intermediaries, which is forthcoming in the University of Pennsylvania Law Review [Jill E. Fisch, Rethinking the Regulation of Securities Intermediaries, 158 U. Pa. L. Rev. (forthcoming 2010)], I argue that existing regulation of mutual funds has serious shortcomings. In particular, the Investment Company Act, which is based primarily on principles of corporate governance and fiduciary duties, fails to support and, in some cases impedes, market forces. Existing evidence suggests that retail investing behavior and the dominance of sales agents with competing financial incentives further weakens market discipline.

As a solution, I propose that funds should be treated primarily as financial products rather than corporations and, correspondingly, investors should be treated primarily as consumers rather than corporate shareholders. To implement this approach, I propose the creation of a new federal agency that would develop standardized financial products coupled with corresponding disclosure principles. Sellers of retail products would be required either to conform their products to these standards or to explain material differences. The goal is to enhance market discipline while making retail funds less complicated and more understandable for individual investors.

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