Yearly Archives: 2010

Credit Default Swaps and the Empty Creditor Problem

Posted by Patrick Bolton, Columbia University, on
Friday, July 2, 2010

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Patrick Bolton is a Professor of Finance and Economics at Columbia University.

In the paper, Credit Default Swaps and the Empty Creditor Problem, which was recently made publicly available on SSRN, my co-author, Martin Oehmke of Columbia University, and I propose a limited commitment model of credit default swaps.

While many commentators have raised concerns about the ex-post inefficiency of the empty-creditor problem that arises when a debt-holder has obtained insurance against default but otherwise retains control rights, our analysis shows that credit default swaps add value by acting as a commitment device for borrowers to pay out cash. Hence, CDS have important ex-ante commitment benefits. Specifically, they increase investment and, by eliminating strategic default, can make existing projects more efficient. However, we also show that when creditors are free to choose their level of credit protection, they will generally over-insure, resulting in an empty creditor problem that is inefficient ex-post and ex-ante. This over-insurance occurs even when CDS markets perfectly anticipate the inefficient behavior of empty creditors, and leads to excessive incidence of bankruptcy and too little renegotiation with creditors relative to first best.

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Supreme Court Limits Federal “Honest Services” Fraud Statute

Posted by Edward F. Greene, Cleary Gottlieb Steen & Hamilton LLP, on
Thursday, July 1, 2010
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Edward Greene is a partner at Cleary Gottlieb Steen & Hamilton LLP focusing on corporate law matters. This post is based on a Cleary Gottlieb Alert Memo and relates to the U.S. Supreme Court decisions in Skilling v. United States and Black v. United States, which are available here and here.

Since the enactment of the “honest services” fraud statute, 18 U.S.C. § 1346, which defines the scope of the federal mail and wire fraud statutes to include the use of interstate means of communication to effect a “scheme or artifice to defraud … another of the intangible right of honest services,” federal prosecutors have used the provision in numerous cases to combat public and private corruption, and alleged corporate wrongdoing – even in situations where the defendant does not directly obtain money or property from the alleged victims of the fraud. Today, the U.S. Supreme Court issued two opinions that significantly restrict the scope of this statute. Skilling v. United States, 561 U.S, No. 08-1394 (June 24, 2010); Black v. United States, 561 U.S., No. 08-876 (June 24, 2010).

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Board Structure and Price Informativeness

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, June 30, 2010
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This post comes to us from Daniel Ferreira, Associate Professor of Finance at the London School of Economics, Miguel Ferreira, Associate Professor of Finance at the Universidade Nova de Lisboa, and Clara Raposo, Professor of Finance at Instituto Superior de Economia a Gestao.

In our paper, Board Structure and Price Informativeness, forthcoming in the Journal of Financial Economics, we theoretically and empirically identify important interactions between internal and external governance mechanisms. We find evidence that stock market monitoring is a substitute for board monitoring. The strength of this relation is influenced by other governance mechanisms such as pay-performance sensitivity and the market for corporate control.

We add a new element to the list of determinants of board structure – price informativeness. We find robust empirical evidence that stock price informativeness is negatively related to board independence. The correlation between price informativeness and board independence is as strong as the ones between board independence and other firm-level variables that have been documented in the literature on corporate boards. Given our long list of control variables and the use of fixed-effects methods, it is unlikely that price informativeness is capturing the effects of omitted variables.

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Bebchuk to Become President of the Western Economic Association International

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, June 29, 2010

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The corporate governance and law and finance research of Lucian Bebchuk, Director of the Program on Corporate Governance, was recently recognized by the Western Economic Association International (WEAI). The WEAI elected Bebchuk to serve as its Vice-President during 2010-2011, President-elect during 2011-2012, and President during 2012-2013.

Founded in 1922, WEAI is a non-profit, educational organization of economists, with 1,800 members around the world, dedicated to encouraging and communicating economic research and analysis. Its past presidents includes Nobel Laureates James Heckman (2007), Clive Granger (2003), Oliver Williamson (2000), Gary Becker (1997), Milton Friedman (1985), James Buchanan (1984), Kenneth Arrow (1981) and Douglass North (1976).

Delaware’s Antitakeover Statute Continues to Give Hostile Bidders a Meaningful Opportunity for Success

Posted by A. Gilchrist Sparks, Morris, Nichols, Arsht & Tunnell LLP, on
Tuesday, June 29, 2010
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A. Gilchrist Sparks is Of Counsel at Morris, Nichols, Arsht & Tunnell LLP. He was Chair of the Corporation Law Section of the Delaware State Bar Association and its liaison with the Delaware Legislature at the time Section 203 of the Delaware General Corporation Law was adopted. This post is based on an article by Mr. Sparks and Helen Bowers that recently appeared in The Business Lawyer. The article was a response to an article by Guhan Subramanian, Steven Herscovici and Brian Barbetta that was described on the Forum 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 their article, Is Delaware’s Antitakeover Statute Unconstitutional? Evidence from1988–2008, Professor Guhan Subramanian and co-authors Steven Herscovici and Brian Barbetta (“SHB”) claim to present “the first systematic empirical evidence since 1988 on whether Section 203 gives bidders a meaningful opportunity for success” after studying a small sample (sixty) of “hostile” or “unsolicited” tender offers for Delaware target companies from January 1, 1988, to December 31, 2008. They found that six hostile bidders (or 10%) went from less than 15% ownership in the target to more than 85% in a single tender offer, as required for exemption from Delaware’s antitakeover statute without prior board approval or approval by two-thirds of the stockholders. They also found that no hostile bidder achieved 85% ownership in a single tender offer between 1990 and 2008. Based on this “empirical evidence,” they claim that the constitutionality of Section 203 “is up for grabs.” After reading their article and examining their data, we conclude that SHB have failed to provide a reason to reexamine the constitutionality of Section 203.

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The Aftermath of Deepwater Horizon

Posted by Peter Atkins, Skadden, Arps, Slate, Meagher & Flom LLP, on
Monday, June 28, 2010
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Peter Atkins is a partner for corporate and securities law matters at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on an article by Mr. Atkins, Frank Bayouth and John Ale. Other posts discussing the Deepwater Horizons tragedy are available here.

The Deepwater Horizon incident is a seminal event for the offshore oil and gas industry. The ramifications will be felt by exploration and production companies, oilfield services companies and oilfield equipment manufacturers, both in the United States and around the world, for years to come in the form of a more difficult political environment, a more complex and intrusive regulatory regime, more stringent industry operating standards and practices and, possibly, a revised view of operational risk. In the near term, the financial consequences of the recently announced deepwater drilling moratorium, as well as regulatory delays and uncertainty with respect to other offshore activities, could result in significant liquidity issues that potentially could spread across the sector.

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The Determinants of Leverage and Pricing in Buyouts

Posted by Michael S. Weisbach, Fisher College of Business at The Ohio State University, on
Monday, June 28, 2010
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Michael Weisbach is Professor and Ralph W. Kurtz Chair in Finance at The Ohio State University.

In the paper, Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts, which was recently made publicly available on SSRN, my co-authors (Ulf Axelson at the London School of Economics; Tim Jenkinson at the University of Oxford, and Per Strömberg at the Stockholm School of Economics) and I empirically investigate the determinants of capital structure in LBOs, highlighting the crucial importance of debt markets in providing capital for the financing of buyouts.

Understanding the financial structure of private equity firms is important not only in and of itself, but also for understanding the role that capital structure plays for corporations in general. In 1989, Michael Jensen famously predicted that the leveraged buyout would eclipse the public corporation and become the dominant corporate form. His argument was based on the thesis that the governance and financing of leveraged buyouts was superior in dealing with agency problems and restructuring. Together with active boards, high-powered management compensation, and concentrated ownership, he considered leverage to be an essential part of this superior governance model. Unlike public firms, Jensen argued, private equity funds optimized the capital structure in companies they acquired, to take full advantage of the tax and incentive benefits of leverage (trading these benefits off against the costs of financial distress).

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Senate-House Conference Agrees on Final Volcker Rule

Posted by Margaret E. Tahyar, Davis Polk & Wardwell LLP, on
Sunday, June 27, 2010

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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, Robert L.D. Colby, Randall D. Guynn, Arthur S. Long and Annette L. Nazareth.

Early Friday morning, the House-Senate Conference on the Dodd-Frank Act of 2010 (the “Act”) agreed on the final legislative text of the Act, including Section 619 (the “Volcker Rule”). The Volcker Rule is a revised version of an amendment introduced by Senators Merkley (D–OR) and Levin (D–MI) in the final stages of the Senate debate, and takes the form of new Section 13 of the Bank Holding Company Act of 1956 and new Section 27B of the Securities Act of 1933.

Summary

Subject to certain exceptions, the Volcker Rule prohibits any “banking entity” from engaging in proprietary trading, or sponsoring or investing in a hedge fund or private equity fund. It also requires systemically important nonbank financial companies to carry additional capital and comply with certain other quantitative limits on such activities, although it does not expressly prohibit them.

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Volcker Rule Looms Over Asset Management and Fund Activities of Financial Institutions

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, June 26, 2010
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This post comes to us from Russell D. Sacks, a partner in Shearman & Sterling LLP’s Asset Management and Capital Markets Groups, and is based on a Shearman & Sterling Client Publication by Bradley Sabel and Gregg L. Rozansky.

The “Volcker Rule” – first introduced in the context of current financial reform legislation by the President in January – looms large in the financial regulatory reform package approved by the Senate on May 20, 2010 (the “Senate Bill”). As highlighted in this publication, fundamental questions remain regarding how the Volcker Rule would function in practice.

As addressed in greater detail below, if it becomes law, the Volcker Rule would:

  • redraw existing boundaries on the types of trading activities that U.S. depository institution holding companies and non-U.S. banks with U.S. operations may conduct,
  • significantly limit the fund-related activities that U.S. depository institution holding companies and non-U.S. banks with U.S. operations may conduct, and
  • place a cap on M&A-related growth of large financial groups operating in the United States. [1]

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Proxy Access is Back to Life

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, June 25, 2010
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Editor’s Note: Lucian Bebchuk and Scott Hirst, respectively, the Director and the Executive Director of the Program on Corporate Governance, are the authors of Private Ordering and the Proxy Access Debate, discussed here, and co-editors of the Harvard Roundtable on Proxy Access, discussed here.

Media reports indicate that last night, as part of the agreement of the senators and representatives on the conference committee regarding the financial reform overhaul, the senators agreed to withdraw the proposal they made last week to impose a hard wired 5% ownership threshold proxy access, and the proxy access provisions in the financial reform bill are now expected to affirm the authority of the SEC to adopt a proxy access rule without limiting the SEC’s discretion to set standards and thresholds.

This is a welcome development. As Lucian Bebchuk explained in an op-ed  in the New York Times’ DealBook section on Monday (available on the Forum here), adoption of the senators’ proposed amendment would have been a serious setback for investors and for governance reforms.  Hard wiring thresholds into legislation is inferior to letting the thresholds be set by the SEC, and adjusted over time as circumstances warrant. Furthermore, a 5% threshold would have made the proxy access provisions largely irrelevant for most long-term institutional investors, whose involvement in the director nomination process the proxy access reform is intended to facilitate.

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