Monthly Archives: November 2010

Tests of Ex Ante versus Ex Post Theories of Collateral

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, November 19, 2010
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The following post comes to us from Allen Berger, Professor of Finance at the University of South Carolina; W. Scott Frame of the Federal Reserve Bank of Atlanta; and Vasso Ioannidou, Professor of Financial Intermediation at Tilburg University.

In our paper, Tests of Ex Ante versus Ex Post Theories of Collateral Using Private and Public Information, forthcoming in the Journal of Financial Economics, we test the empirical predictions generated by two broad classes of theories about why borrowers pledge collateral. The first set of theories motivates collateral as a way for good borrowers to signal their quality under conditions of ex ante private information. The second set of theories explains collateral as an optimal response to ex post contract frictions like moral hazard. A growing body of literature that empirically tests these models and the on-going financial crisis have raised significant academic and policy interest in understanding the role of collateral in debt contracts.

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Pharma Industry Consultant Indicted For Tipping Inside Information

Posted by Wayne M. Carlin, Wachtell, Lipton, Rosen & Katz, on
Thursday, November 18, 2010
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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, David A. Katz and David B. Anders.

The federal government’s focus on insider trading and hedge funds continues, with the recent filing of a criminal complaint and SEC enforcement action against a French medical doctor, who served on a steering committee overseeing a clinical trial of a drug under development by Human Genome Sciences, Inc. (“HGSI”). US v. Benhamou, 10-MAG-2424 (S.D.N.Y. Nov. 1, 2010); SEC v. Benhamou, 10-CV-8266 (DAB) (S.D.N.Y. Nov. 2, 2010). The doctor also had a consulting arrangement with a hedge fund portfolio manager, who he allegedly tipped concerning unfavorable developments in the clinical trial. The case highlights the potential risks entailed in obtaining information from industry consultants.

According to the government allegations, under his contract with HGSI, the doctor had a duty to maintain the confidentiality of information concerning the drug trial. The doctor participated in a series of meetings concerning adverse developments in the trial and was aware that HGSI was preparing to make a public disclosure. The criminal complaint alleges that the doctor simultaneously engaged in a series of communications with the fund portfolio manager, in which the doctor divulged material confidential information concerning the drug trial. Although the fund manager allegedly knew that the doctor was breaching his duty of confidentiality to HGSI, he caused six hedge funds that he co-managed to sell their holdings of HGSI stock. When HGSI made its disclosure, its stock price plummeted. The hedge funds allegedly avoided $30 million in losses through these trades.

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Comparing CEO Employment Contract Provisions

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, November 17, 2010
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The following post comes to us from Jennifer Hill, Professor of Corporate Law at the University of Sydney; Ronald Masulis, Professor of Finance at Vanderbilt University and at the University of New South Wales; and Randall Thomas, Professor of Law and Business at Vanderbilt University.

In our paper, Comparing CEO Employment Contract Provisions: Differences between Australia and the U.S., forthcoming in the Vanderbilt Law Review, we compare and contrast CEO employment contracts across two very different common law countries.

In the wake of the global financial crisis, executive compensation is front page news, with soaring rhetoric about excessive pay to ungrateful bank employees and personal attacks on CEOs and other executives. Frequently missing from the discussion, however, are basic facts surrounding the terms and conditions of the executives’ relationships with their firms. While several recent studies in the United States have begun to fill in some of the details surrounding American executive employment contracts, or the lack thereof, none have fully captured the U.S. experience, particularly from a legal perspective. Likewise, none of these studies even touch on Australian CEOs’ contractual employment relationships.

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Mortgage Lending Practice after the Dodd-Frank Act

Posted by Bradley K. Sabel, Shearman & Sterling LLP, on
Tuesday, November 16, 2010
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Bradley Sabel is a partner at Shearman & Sterling LLP. This post is based on a Shearman & Sterling client publication by Mr. Sabel and Chris M. Smith. Other posts about the Dodd-Frank Act can be found here.

I. Introduction

On July 21, 2010, the President signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), enacting numerous provisions intended to reform the mortgage lending industry with an eye towards consumer protection. Many of these provisions are contained within Title XIV of the Dodd-Frank Act, the Mortgage Reform and Anti-Predatory Lending Act (the “Mortgage Act” or the “Act”). In part, the economic and financial crisis stemmed from the subprime mortgage crisis, which was mostly caused by movement of creditors and mortgage originators away from traditional underwriting practices during the real estate boom, giving rise to risky mortgages and practices, such as allowing loans with “negative amortization” features, and to the proliferation of subprime mortgages. In an effort to prevent a recurrence of such misleading practices, Congress passed comprehensive mortgage reform legislation beginning in 2007 including the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (12 U.S.C. 5101 et seq., “SAFE Act”). The Mortgage Act continues these legislative efforts by amending provisions of the Truth in Lending Act (15 U.S.C. 1601 et seq., “TILA”) in order to reform consumer mortgage practices and provide accountability for such practices.

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Non-GAAP and Street Earnings

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, November 15, 2010
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The following post comes to us from Mary Barth, Professor of Accounting at Stanford University, Ian Gow, Assistant Professor of Accounting Information and Management at Northwestern University, and Daniel Taylor, Assistant Professor of Accounting at the University of Pennsylvania.

In the paper, Non-GAAP and Street Earnings: Evidence from SFAS 123R, recently made publicly available on SSRN, we examine how key market participants—managers and analysts—responded to SFAS 123R‘s controversial requirement that firms recognize stock-based compensation expense. Despite mandated recognition of the expense, some firms’ managers exclude it from non-GAAP earnings and some firms’ analysts exclude it from Street earnings.

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EU Still Not Taking Shareholder Rights Seriously

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Sunday, November 14, 2010
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Editor’s Note: The following post comes to us from Pavlos E. Masouros, a Fellow of Corporate Law at Leiden University.

Proponents of the global shareholder activism movement have recently praised the EU for generously empowering shareholders through the so-called Shareholder Rights Directive (“SRD”) (Directive 2007/36/EC). A year after the deadline for the transposition of the SRD into national corporate laws an article in the current issue of European Company Law entitled Is the EU Taking Shareholder Rights Seriously? An Essay on the Impotence of Shareholdership in Corporate Europe checks what progress has really been made regarding the issue of shareholder involvement in European corporate governance.

The article attempts to show that the deficit in the European corporate governance model with regard to the status of the shareholders persists even in the post-SRD era and that there is still a long distance to be covered in order to truly empower shareholders in the EU. The deficiencies of the past in shareholder governance have not been cured by the SRD, while the latter does not interact satisfactorily with the existing EU and national legal framework in order to unfetter shareholders from the mechanisms that restricted their active engagement.  European corporate law is still captive of an ideology that wants other corporate constituencies to be protagonists in corporate affairs.

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Reviewing Asset-Backed Securities – Investors Deserve Better

Posted by Luis A. Aguilar, Commissioner, U.S. Securities and Exchange Commission, on
Saturday, November 13, 2010
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Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s statement at a recent open meeting of the SEC, which is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff. The post relates to a proposed SEC rule on issuer review of assets in offerings of asset-backed securities; the release is available here.

The rule before us is designed to implement a requirement of the Dodd-Frank Act to strengthen the process by which asset-backed securities are offered. [1] I fear that today’s proposal does not implement this Congressional intent. Instead, this proposal will frustrate investor protection by endorsing an “anything goes” approach for issuers reviewing assets underlying an asset-backed security because it sets no minimal standards.

Leading up to the financial crisis, underwriters and others involved in offering asset-backed securities had, and I quote Professor John Coffee’s Senate Testimony, “decreased their investment in due diligence, making only a cursory effort by 2006.” [2] Because market participants approached due diligence as just a formality, there was a significant erosion in market discipline by those involved. [3] As just one example, it has been reported that by 2005, outside due diligence firms hired by securitizers to conduct asset reviews were only evaluating 5 percent of the loans in the underlying mortgage pools. [4]

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Missing Elements in US Financial Reform

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, November 12, 2010
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The following post comes to us from Edward Kane, Professor of Finance at Boston College.

In the paper, Missing Elements in U.S. Financial Reform: A Kubler-Ross Interpretation of the Inadequacy of the Dodd-Frank Act, which was recently made publicly available on SSRN, I summarize the incentive conflicts that led creditors and internal and external supervisors to short-cut and outsource due diligence. It is instructive to think of excessive financial-institution risk-taking as a disease, Congress and regulators as doctors, and the Dodd-Frank Act as a treatment plan. The success of any treatment plan depends on how completely the problems it targets have been diagnosed and how effectively the therapy prescribed can ameliorate these problems.

The Act purports to reduce systemic risk by expanding and reallocating regulatory authority. But officials’ way of thinking about systemic risk neglects the pivotal role that political pressure and their own incentive structure play in generating it. During the pre-crisis housing bubble, regulatory and supervisory entities misdiagnosed and mishandled the buildup of systemic risk in part to transfer subsidies to financial institutions, homeowners, and builders. When the bubble burst, regulators billed taxpayers for financial-institution losses without weighing rescue costs against those of alternative programs and without documenting how their program would distribute benefits and costs across the populace. Along with the policy of near-zero interest rates (which also help to recapitalize insolvent institutions), the rescue policies chosen inflicted substantial losses on depositors, on future taxpayers, on pension plans, and on persons living on interest income.

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SEC Issues Proposed Rules on Say-on-Pay Voting and Disclosures

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, November 11, 2010
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This post comes to us from John J. Cannon, a partner in the Executive Compensation and Employee Benefits Group Shearman & Sterling LLP, and is based on a Shearman & Sterling Client Memorandum by Mr. Cannon, Linda E. Rappaport, Jeffrey P. Crandall, Kenneth J. Laverriere and Doreen E. Lilienfeld. Previous posts about the SEC’s say-on-pay regulations can be found here.

On October 18, 2010, the Securities and Exchange Commission issued proposed rules implementing the say-on-pay provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. [1] Section 951 of the Reform Act requires (1) a non-binding shareholder vote on executive compensation, (2) a non-binding vote on the frequency of the say-on-pay vote, (3) disclosure of “golden parachute” arrangements in connection with specified change in control transactions, and (4) a non-binding shareholder vote on golden parachute arrangements in connection with these change in control transactions.

The proposed rules clear up many issues on say-on-pay left unanswered by the Reform Act and expand issuer disclosure obligations in ways not required by the Act.

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The Insignificance of Proxy Access

Posted by Marcel Kahan, NYU School of Law, on
Wednesday, November 10, 2010
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Marcel Kahan is the George T. Lowy Professor of Law at the New York University School of Law. This post discusses a recent paper by Professor Kahan and Professor Edward Rock of the University of Pennsylvania School of Law. Their paper, titled “The Insignificance of Proxy Access”, is available here.

The SEC recently adopted rules on proxy access. These rules grant shareholders who hold at least 3% of the company stock for three years the right to nominate directors and to have their nominees included in the company’s proxy statement and the ballots distributed by the company. Because proxy access is viewed as dramatically lowering the costs of an election contest, both proponents and opponents of these rules predict that they will have a significant impact. Contrary to this conventional wisdom, we argue that proxy access will lead to few shareholder nominations, that most of these nominees will be defeated, and that the occasional nominee who does get elected will have little impact.

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