Monthly Archives: December 2010

CFTC Proposes to Register and Regulate Swap Dealers and Participants

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, Lanny A. Schwartz and Gabriel D. Rosenberg.

On November 10, 2010, the CFTC proposed rules concerning swap dealers and major swap participants (“swaps entities”) under the Dodd-Frank Act. The rules address entity registration, conflicts of interest involving research and clearing activities, chief compliance officer designation and risk management, reporting and operational requirements.

While the proposed rules do not address other key topics, including margin, capital, documentation standards, reporting and sales practices, they provide considerable insight into the CFTC’s vision of how these newly regulated swaps entities will operate. In particular, the proposals impose very tight operational and compliance controls, buttressed by empowered chief compliance officers, independent risk management programs, periodic compliance certifications, tightly controlled new business processes, organizational barriers between certain sensitive functions, vigorous internal audit programs and a high degree of transparency to the CFTC and other regulators. While the proposed rules claim to afford swaps entities latitude to design policies and procedures that are appropriate to their own business profile, they will raise the costs of conducting the swaps business, expose swaps entities to enforcement actions for internal operational problems, and impose challenging organizational limitations.


Why Do CFOs Become Involved in Material Accounting Manipulations?

The following post comes to us from Mei Feng of the Department of Accounting at the University of Pittsburgh; Weili Ge of the Department of Accounting at the University of Washington; Shuqing Luo of the Department of Accounting at the National University of Singapore; and Terry Shevlin, Professor of Accounting at the University of Washington.

In the paper, Why Do CFOs Become Involved in Material Accounting Manipulations? we investigate why CFOs become involved in material accounting manipulations. To address this research question, we examine two possible explanations. CFOs might instigate accounting manipulations for immediate personal financial gain, as reflected in their equity compensation. Alternatively, CFOs could manipulate the financial reports under pressure from CEOs.

Using a comprehensive sample of material accounting manipulations disclosed between 1982 and 2005, we investigate the costs and benefits associated with intentional financial misreporting for CFOs. We find that CFOs bear substantial legal costs when involved in accounting manipulations. We also document that these CFO equity incentives (measured by pay-for-performance sensitivity) are not significantly different from those of CFOs of control firms. However, CEOs of the manipulation firms have significantly higher equity incentives and power than CEOs of the control firms. Moreover, CFO turnover is significantly higher within three years prior to the occurrences of material accounting manipulations for manipulation firms than control firms, consistent with CFOs facing significant costs (loss of job) for saying no to CEO pressure. Finally, our AAER content analyses suggest that CEOs of manipulation firms are more likely than CFOs to be described as having orchestrated the manipulation and to be requested to disgorge financial gains from the manipulation. Taken together, our findings suggest that CFOs are likely to become involved in material accounting manipulations because they succumb to CEO pressure, rather than because they seek immediate financial benefit.


Recent Decisions Maintain Stability in Delaware Corporate Law

This post comes to us from Bradley R. Aronstam and David E. Ross, partners in the Business Law Group of Connolly Bove Lodge & Hutz LLP. This post is based on an article that originally appeared in Vol. 12, No. 1 of the Delaware Law Review; that article can be found 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.

Delaware’s renowned corporation law rests upon a director-centric premise, reflected in Section 141 of the Delaware General Corporation Law (“DGCL”), that the business and affairs of corporations are to be managed by boards of directors. In carrying out this mandate, directors owe fiduciary duties requiring that they act in an informed manner (i.e., the duty of care) and only in the best interests of the corporation and all of its shareholders (i.e., the duty of loyalty). Consistent with the legislative judgment placing directors at the helm of the corporate enterprise, and mindful of the necessary risk-taking inherent in that role, the Delaware courts afford unconflicted, informed, and properly motivated directors wide latitude in carrying out their duties. That deference is reflected in the venerable business judgment rule, under which courts will not second-guess the decisions of independent and disinterested directors acting in good faith and following an appropriate decision-making process.


Crossing State Lines — Cautionary Tender Offer Tales

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.

With the increasing popularity of tender offers continuing unabated, dealmakers have quickly developed a comfort zone around structure and terms for Delaware targets. They are finding, however, that unique, and often quirky, provisions of state law in other jurisdictions mean that caution and creativity are required to implement the tender offer structure for targets incorporated in other states. These adjustments span the obvious (e.g., using a two-thirds minimum condition in states where that is the merger vote threshold) to the much more obscure. Below is a brief selection of examples of these issues that we have seen in recent deals:


Empty Voting and the Efficiency of Corporate Governance

The following post comes to us from Alon Brav, Professor of Finance at Duke University, and Richmond Mathews, Associate Professor of Finance at Duke University.

In our paper Empty Voting and the Efficiency of Corporate Governance, which is forthcoming in the Journal of Financial Economics, we model corporate voting outcomes when an informed trader, such as a hedge fund, can establish separate positions in a firm’s shares and votes. Recent research has shown that some hedge funds may use “empty voting”—a practice whereby they accumulate voting power in excess of their economic share ownership—to manipulate shareholder vote outcomes and generate trading gains. This practice is possible even when one share, one vote is the explicit rule. It can be accomplished, for example, by borrowing shares of stock on the record date, or by hedging economic exposure in the derivatives markets. This can lead to perverse voting incentives, and may decrease the efficiency of the corporate governance process. However, there may be an offsetting benefit if empty voting enables parties with superior information to have a greater impact on voting outcomes. Our theoretical model explores this trade-off.


Key Issues for Directors in 2011

Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton firm memorandum by Mr. Lipton.

For a number of years, as the new year approached, I have prepared a one-page list of the key issues for boards of directors that are newly emerging or will be especially important in the coming year.  Each year, the legal rules and aspirational best practices for corporate governance matters, as well as the demands of activist shareholders seeking to influence boards of directors, have increased.  Earlier this year, in The Spotlight on Boards, I published a list of the roles and responsibilities that boards today are expected to fulfill.  Looking forward to 2011, it is clear that in addition to satisfying these expectations, the key issues that boards will need to address include:


Leverage, Moral Hazard, and Liquidity

The following post comes to us from Viral Acharya, Professor of Finance at New York University, and S. Viswanathan, Professor of Investment Banking at Duke University.

In the paper, Leverage, Moral Hazard, and Liquidity, forthcoming in the Journal of Finance (February 2011), the authors argue that the buildup of leverage in the financial sector in good economic times helps explain why adverse asset shocks in such times are associated with a severe drying-up of liquidity and deep discounts in asset prices. We illustrate that while the incidence of financial crises is lower when expectations of fundamentals are good, their severity can in fact be greater in such times due to greater system-wide leverage.

The core foundation of their theoretical model lies in the idea that when adverse asset shocks wipe out capital base of financial intermediaries, their short-term debt cannot be rolled over due to attendant agency problems, in particular, due to the problem that intermediaries may gamble excessively if leverage is not reduced. They tie this problem of rollover risk with the following facts: (i) the prominence of short-term rollover debt in the capital structure of financial firms, and (ii) the low cost of rollover debt in good economic times, which leads to the entry of highly leveraged firms in the financial sector. All of these factors played an important role in the financial crisis of 2007 to 2009 and the period preceding it.


Challenge to SEC Proxy Access Rules

John Olson is a founding partner of Gibson, Dunn & Crutcher’s Washington, D.C. office and a visiting professor at the Georgetown Law Center. This post is based on an Opening Brief that was prepared by a Gibson Dunn team representing the Chamber of Commerce and the Business Roundtable. The team is led by Amy Goodman, Eugene Scalia and Daniel Davis. The complete brief is available here. More details about the case can be found here.

Business Roundtable and the Chamber of Commerce have challenged SEC rules requiring public companies in certain circumstances to include shareholder nominees for director in the company’s proxy materials.  The final rules comprise two main rules: (1) Rule 14a-11, which would require a publicly-traded company to include in its proxy materials a candidate nominated by shareholders that have held shares representing at least 3 percent of the voting power of the company’s stock for the past 3 years; and (2) amendments to Rule 14a-8(i)(8), which would require companies in certain circumstances to include in their proxy materials shareholder proposals regarding director nomination procedures.  The Business Roundtable and Chamber of Commerce have challenged Rule 14a-11 and its related amendments, but not amended Rule 14a-8(i)(8).  The Summary of Argument from the Business Roundtable and Chamber of Commerce Opening Brief appears below.


Do Investors See Through Mistakes in Reported Earnings?

The following post comes to us from Katsiaryna Salavei Bardos of the Finance Department at Fairfield University; Joseph Golec of the Finance Department at the University of Connecticut; and John Harding, Professor of Finance and Real Estate at the University of Connecticut.

In the paper Do Investors See Through Mistakes in Reported Earnings?, forthcoming in the Journal of Financial and Quantitative Analysis, we test whether investors see through mistakes in reported earnings by examining market reaction to initially reported erroneous earnings and valuation of restating firms during the error period, before earnings are corrected. We also examine the long-run return performance of restating companies in three periods: (1) the period prior to the mistake (pre-error period); (2) the period after the mistake has been made but before the restatement (error period); (3) and the period after the restatement (post-restatement period). We focus on the error period, which we split into four quartiles.


New SEC Whistleblower Rules Fall Short

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, Theodore A. Levine and John F. Savarese.

The SEC recently released its proposed rules implementing the whistleblower program established under Section 922 of the Dodd-Frank Act.  The proposed rules do not go far enough to avoid undermining corporate compliance systems.  We summarize our key observations in this memo, and a more detailed discussion of the proposal and the issues it presents is attached.

To be eligible for a bounty, a whistleblower must supply “original information” which the SEC has not otherwise already obtained.  This creates an incentive to race in to the SEC to stake the first claim, rather than report up through established corporate compliance channels.  The rules would allow a whistleblower’s report to the SEC to relate back to the date of the same person’s earlier internal corporate report, as long as the whistleblower contacts the SEC within 90 days of reporting internally.  While this provision would allow for internal reporting, it would do nothing to encourage it.  We propose that internal reporting should be a prerequisite to an SEC whistleblower report, absent extraordinary circumstances, and that up to 120 days should be permitted for the internal review to proceed.


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