Yearly Archives: 2010

Strategic Flexibility and the Optimality of Pay for Sector Performance

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on

Wednesday, February 24, 2010

Executive Compensation, Executive performance, Incentives
More from: Fenghua Song, Radhakrishnan Gopalan, Todd Milbourn

This post comes to us from Radhakrishnan Gopalan, Assistant Professor of Finance at Washington University in St. Louis, Todd Milbourn, Hubert C. and Dorothy R. Moog Professor of Finance at Washington University in St. Louis, and Fenghua Song, Assistant Professor of Finance at Penn State University.

In our paper, Strategic Flexibility and the Optimality of Pay for Sector Performance, which is forthcoming in the Review of Financial Studies, we propose a model in which a CEO chooses the firm’s strategy as she faces uncertainty regarding future sector movements. She can put forth (personally) costly effort to generate an informative signal about future sector returns. The optimal contract rewards the CEO for firm performance induced by sector movements so as to provide her incentives to exert effort to forecast the sector movements and choose the firm’s optimal exposure to them.

As our model shows, benchmarking the CEO’s performance against her sector is the same as not offering her pay for sector performance and will make firm investment decisions insensitive to sector movements. This practice is suboptimal if sector performance affects firm performance. Our model also helps pin down situations in which the sensitivity of pay to sector performance is more likely to be present. We find that multi-segment firms, especially those in which the sector performances of the different segments are less positively correlated, will offer pay contracts that are more sensitive to sector performance as compared to single segment firms. This is because such firms provide greater opportunity to the CEO to actively shift resources towards sectors that are likely to outperform. We also find that the sensitivity of pay to sector performance will be greater in any firm that offers greater strategic flexibility to the CEO to alter firm exposure to sector movements and for more talented CEOs. Our model also shows that the optimal contract rewards a risk-averse CEO more when sector performance is good than punishes her when sector performance is bad; that is, the optimal contract is asymmetrically sensitive to good and bad sector performance.

Considerations for Directors in the 2010 Proxy Season

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on

Tuesday, February 23, 2010

Clawbacks, Executive Compensation, Proxy voting, Say on pay, SEC
More from: Aaron Briggs, Amy Goodman, Elizabeth Ising, Gillian McPhee, John Olson, Gibson Dunn

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 a Gibson Dunn alert by Mr. Olson, Amy Goodman, Elizabeth Ising, Gillian McPhee and Aaron Briggs.

The current economic and regulatory landscape poses unprecedented challenges for public companies and their boards of directors. They are facing scrutiny from shareholders, Congress, regulators and the public, and new proposals to address the causes of the financial crisis have been emerging on almost a daily basis for over a year now.

Some of these proposals have been adopted and some remain under consideration at a time when calendar-year companies are preparing for the 2010 proxy season, complicating the planning process. Of particular note, in December, the Securities and Exchange Commission (“SEC”) adopted new proxy disclosure rules that likely will be a focal point for public company directors, as the new rules relate to disclosures regarding the composition and operation of boards of directors. [1] This memorandum is an update of our client alert covering considerations for public company directors in the current environment issued on October 15, 2009.

Are Incentive Contracts Rigged by Powerful CEOs?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on

Monday, February 22, 2010

Equity-based compensation, Executive Compensation, Incentives
More from: Adair Morse, Amit Seru, Vikram Nanda

Editor’s Note: This post comes to us from Adair Morse, Assistant Professor of Finance at the University of Chicago, Vikram Nanda, Professor of Finance at the Georgia Institute of Technology, and Amit Seru, Assistant Professor of Finance at the University of Chicago.

In our paper Are Incentive Contracts Rigged By Powerful CEOs?, which is forthcoming in the Journal of Finance, we argue that powerful CEOs induce their boards to shift the weight on performance measures towards the better performing measures, thereby rigging the incentive part of their pay. The intuition is developed in a simple model in which some powerful CEOs exploit superior information and lack of transparency in compensation contracts to extract rents. The model delivers an explicit form for the rigging of CEO incentive pay along with testable implications that rigging is expected to (1) increase with CEO power; (2) increase with CEO human capital intensity and uncertainty about a firm’s future prospects; and (3) negatively impact firm performance.

Using a large panel of U.S. firms from 1992-2003, we find support for all our predictions. We find that rigging explains 10% to 30% of the incentive pay sensitivity to performance. Rigging increases with CEO human capital and with the uncertainty of a firm’s prospects, and stronger governance along other dimensions moderates contract rigging by powerful CEOs. Finally, rigging of incentive pay is shown to be associated with a decrease in future firm performance and value.

Sustainable Reform: Prioritizing Long-Term Investors

Posted by Luis A. Aguilar, Commissioner, U.S. Securities and Exchange Commission, on

Sunday, February 21, 2010

Financial regulation, SEC, TARP
More from: Luis Aguilar

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 remarks at the recent SEC Speaks conference. The views expressed in the post are those of Commissioner Aguilar, and do not necessarily reflect the views of the Commission, the other Commissioners, or the Commission staff. A transcript of Commissioner Aguilar’s speech is available here.

Between the effects and consequences of the economic crisis, the White House and Congressional focus on financial reform, the active Commission agenda, and the press and pundit scrutiny . . . it feels like five years have passed by. Yet, despite the intense focus on financial reform over the last year, very little has changed. Last year, I stood here and spoke about the need for sustainable regulatory reform oriented towards investors. It is clear that the need is even greater today.

John Wooden, the legendary UCLA basketball coach, used to say: “Never mistake activity for accomplishment.” This adage perfectly sums up the last year. While there was much activity this past year, very little has actually been accomplished. There have been many speeches given and many preliminary steps taken toward regulatory reform, but for all the activity, reform itself has yet to be achieved. For example, despite the clearly demonstrated need, OTC derivatives, hedge funds, and municipal securities markets still lack appropriate regulation, and our inspection and enforcement efforts in these areas continue to be severely undermined. Moreover, there are those who are using the process of reform as an opportunity to weaken strong investor-focused laws arising from lessons learned in prior crises. In my remarks today, I will highlight the progress we have made and the distance we have to go.

French Supreme Court Rules on SOX Whistleblowing Procedures in France

Posted by James Morphy, Sullivan & Cromwell LLP, on

Saturday, February 20, 2010

France, SOX, Whistleblowers
More from: Dominique Bompoint, François Barrière, Gauthier Blanluet, Gérard Mazet, James Morphy, Olivier de Vilmorin, Richard Vilanova, Sullivan & Cromwell

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 by François Barrière, Gauthier Blanluet, Dominique Bompoint, Gérard Mazet, Richard Vilanova and Olivier de Vilmorin.

Issues have arisen from time to time regarding potential conflicts between the whistleblowing requirements of the Sarbanes-Oxley Act of 2002 and the provisions of French privacy and worker protection laws. In a recent decision, the French Supreme Court, the Cour de cassation, has addressed such an issue for the first time.

On December 8, 2009, the Supreme Court, in overturning the decision of a lower court, invalidated the whistleblowing procedures set forth in the Code of Business Conduct of Dassault Systèmes (“Dassault”). The Court ruled that the provisions (i) were too broad in that they applied not only to complaints relating to the finance, accounting, banking and anti-corruption areas, but also to whistleblowing relating to actions which could harm the vital interests of Dassault or the physical or moral integrity of an individual employee, and (ii) did not provide in sufficient detail information on French legal protections relating to whistleblowing, such as the right of an individual who is the subject of a whistleblowing complaint to be properly notified of the nature of the complaint and the right of persons identified in a complaint to access and rectify such complaint. The Supreme Court also invalidated specific provisions of Dassault’s Code of Business Conduct related to the treatment of confidential information by employees (this aspect of the decision is not discussed in this memorandum).

Delaware Court of Chancery Addresses Proxy Contest Mechanics and Vote Buying

Posted by Trevor Norwitz, Wachtell, Lipton, Rosen & Katz, on

Friday, February 19, 2010

Delaware cases, Delaware law, Kurz v. Holbrook, Proxy voting
More from: Trevor Norwitz, William Savitt, Wachtell Lipton

Trevor Norwitz is a partner in the Corporate Department at Wachtell, Lipton, Rosen & Katz, where he focuses on mergers and acquisitions, corporate governance and securities law matters. This post is based on a Wachtell Lipton client memorandum by Mr. Norwitz and William Savitt. 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 decision involving dueling consent solicitations, the Delaware Court of Chancery cast welcome light on the “foggy” mechanics of proxy solicitations and offered guidance on “vote-buying” in corporate control contests. Kurz v. Holbrook., C.A. No. 5019-VCL (February 9, 2010).

The case involved a contest for control of EMAK Worldwide, a “deregistered, poorlyperforming microcap corporation” with one large preferred stockholder and an otherwise “diffuse” stockholder body. An insurgent slate sought to remove two directors and elect replacements, thereby taking control of the company. The incumbent group sought to amend EMAK’s by-laws to reduce the size of the board, thereby effectuating the dismissal of certain sitting directors, mooting the insurgents’ attempt to elect new directors, and ensuring a majority position for the large preferred stockholder. After a hard-fought contest, the incumbent’s by-law provisions obtained a close majority of consents. A few days later, however, the insurgent slate secured a majority of consents as well, but only after insurgents purchased 150,000 shares needed to provide a bare 50.89% majority. But the inspector of elections then disallowed some 1,000,000 shares held in “street name” because they were not accompanied by a DTC “universal proxy,” thus maintaining the incumbent group majority. The insurgents sued, challenging both the validity of the by-law and the invalidation of their “street name” votes.

Poison Pills Revisited

Posted by Eduardo Gallardo, Gibson, Dunn & Crutcher LLP, on

Thursday, February 18, 2010

Antitakeover, Delaware cases, Delaware law, Poison pills
More from: Adam Chen, Adam Offenhartz, Eduardo Gallardo, J. Ross Wallin, Gibson Dunn

Eduardo Gallardo is a partner focusing on mergers and acquisitions at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson Dunn client alert by Mr. Gallardo, Adam H. Offenhartz, J. Ross Wallin and Adam Chen. The authors represented the special committee of iBasis during its dispute with KPN. 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.

During the last decade, activist shareholders and corporate governance groups have been fairly successful in pressuring companies to voluntarily surrender a number of anti-takeover defenses, most notably the use of staggered boards and shareholder rights plans (also referred to as “poison pills”). In fact, according to FactSet SharkRepellent, between December 2002 and December 2009 the percentage of S&P 1500 companies with a staggered board decreased from 62.3% to 44.8%, and the percentage having a rights plan dropped from 61.6% to 23%. The success of activists and governance groups, at least as measured by these numbers, is partly attributable to the view held by certain groups that anti-takeover mechanisms are a reflection of poor corporate governance practices and, thus, antithetical to shareholder value. Also, given the healthy equity markets and high M&A transaction multiples, at least until recently companies may have been more willing to shed defense mechanisms as an easy give to appease activists and corporate governance groups. With respect to the termination of rights plans, companies also probably considered that, unless otherwise provided in the company’s organizational documents, the voluntary decision to terminate a rights plan did not restrict the board’s future ability to adopt a rights plan if it were to become the subject of an unsolicited tender offer.

Why Do Foreign Firms Leave U.S. Equity Markets?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on

Wednesday, February 17, 2010

Deregistration, Rule 12h-6, SEC
More from: Andrew Karolyi, Craig Doidge

This post comes to us from Craig Doidge, Associate Professor of Finance at the University of Toronto, G. Andrew Karolyi, Professor of Finance at Cornell University, and René Stulz, Professor of Finance at Ohio State University.

In our paper, Why Do Firms Leave U.S. Equity Markets?, which is forthcoming in the Journal of Finance, we analyze a sample of firms that voluntarily deregister from the SEC and leave the U.S. equity markets over the period from 2002 through 2008. Because it was extremely difficult to deregister before March 21, 2007 when the SEC adopted its new Exchange Act Rule 12h-6, foreign firms that wished to deregister most likely did not do so because they were unable to meet the necessary requirements. When Rule 12h-6 came into effect, deregistration became substantially easier and the change in the rules was followed by a large spike in the number of deregistrations. We investigate why foreign firms deregister, how the Rule change affected firms’ deregistration decisions, and what the economic consequences are of the decisions to deregister.

Two theories offer predictions on which firms are likely to deregister and on the consequences of deregistration for minority shareholders. The first theory follows directly from the bonding theory of cross-listing that predicts corporate insiders value a listing when their firm has valuable growth opportunities that they can finance on better terms by committing to the laws and rules that govern U.S. markets. The listing comes at a cost to insiders since it limits their ability to extract private benefits from their controlling position. If a firm is no longer expected to require outside financing because its growth opportunities have been taken advantage of, or because they have disappeared, a listing is no longer valuable for insiders; the costs of a U.S. listing outweigh the benefits. Consequently, firms that deregister should be those with poor growth opportunities, with little need for external capital, and those which perform poorly. We find support for these predictions.

Dow Reaffirms Delaware’s Business Judgment Rule

Posted by David A. Katz, Wachtell, Lipton, Rosen & Katz, on

Wednesday, February 17, 2010

Delaware cases, Delaware law, Derivative suits, In re Dow
More from: David Katz, Laura McIntosh, Wachtell Lipton

David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz specializing in the areas of mergers and acquisitions and complex securities transactions. This post is based on an article by Mr. Katz and Laura A. McIntosh that appeared in the New York Law Journal. 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.

The Delaware Chancery Court recently issued a resounding affirmation of the business judgment rule in the case In re the Dow Chemical Company Derivative Litigation. [1] Directors can take comfort in this timely reminder that, despite challenging economic circumstances and an environment of heightened scrutiny of boards and individual directors, the protections of the business judgment rule remain robust in Delaware.

The Dow Chemical Case

Dow was a shareholder derivative suit filed nearly a year ago amid turmoil over Dow’s planned acquisition of another chemical company, Rohm & Haas, for aggregate consideration of approximately $18.8 billion. The Dow stockholders alleged that the directors and officers of Dow had breached their fiduciary duties in at least three different respects: first, in approving the Rohm & Haas transaction without a financing contingency; second, in misrepresenting the connection between the Rohm & Haas transaction and another pending transaction, a joint venture with a Kuwaiti company for which a memorandum of understanding had been entered into six months previously; and third, in failing to detect and prevent various corporate misdeeds during the course of both transactions, including bribery, misrepresentation, insider trading and wasteful compensation.

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