Yearly Archives: 2010

FDIC Proposes Amending Insurance for Compensation Program Risk

Posted by H. Rodgin Cohen, Sullivan & Cromwell LLP, on
Wednesday, February 3, 2010
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H. Rodgin Cohen is a partner and chairman of Sullivan & Cromwell LLP focusing on acquisition, corporate governance, regulatory and securities law matters. This post is based on a Sullivan & Cromwell client memorandum.

The FDIC report referred to in this post cites and relies on a recent working paper of the Harvard Law School Program on Corporate Governance, “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008” by Lucian Bebchuk, Alma Cohen, and Holger Spamann, which was discussed in a Forum post here. An earlier working paper issued by the Program, “Regulating Bankers’ Pay” by Lucian Bebchuk and Holger Spamann, advocated making prudential regulation tighter for financial firms whose compensation arrangements encourage risk-taking, as the FDIC is now proposing; this paper is available here.

At the January 12, 2010 meeting, the Board of Directors of the Federal Deposit Insurance Corporation (“FDIC”) authorized publication of an Advance Notice of Proposed Rulemaking on Employee Compensation (the “ANPR”) by a vote of 3 to 2 (with Comptroller Dugan and OTS Director Bowman dissenting). The ANPR seeks comment on how, and whether, the FDIC’s risk-based deposit insurance assessment system applicable to all insured banks should be amended to account for risks imposed by employee compensation programs.

Citing a “broad consensus that some compensation structures misalign incentives and induce imprudent risk taking within financial organizations”, the FDIC is considering establishing criteria to determine whether a financial institution’s employee compensation programs provide incentives for employees to take excessive risks. The FDIC is concerned that such risk-taking increases the institution’s risk of failure and thereby could lead to increased losses to the Deposit Insurance Fund. The ANPR proposal could apply not only to compensation at the insured depository, but also at its parent and nonbank affiliates. Under the approach outlined in the ANPR, whether a financial institution’s compensation program either “meets” or “does not meet” the criteria would be used to adjust the institution’s risk-based assessment rate, thereby acting as an incentive for institutions that meet the criteria and a disincentive for those that do not. According to the ANPR, the criteria that the FDIC is considering are not aimed at limiting the amount that insured depository institutions can pay their employees, but rather are intended to compensate the Deposit Insurance Fund for risks associated with certain compensation programs.

The FDIC requests comments on the ANPR within 30 days after publication in the Federal Register.

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Leverage Choice, Credit Spread, and Risk

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, February 3, 2010
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This post comes to us from Murray Carlson, Associate Professor of Finance at the University of British Columbia, and Ali Lazrak, Associate Professor of Finance at the University of British Columbia.

CEO compensation typically includes both performance sensitive and performance insensitive components. This pay structure can be readily rationalized in a contracting setting (e.g., Holmstrom (1982)). Performance sensitive payments link a manager’s value enhancing actions to his wealth thereby aligning his incentives with those of the firm. These payments are risky, however, and in contracts with a risk averse manager risk sharing motives give rise to a role for the performance insensitive component. Compensation structure has a direct impact on manager objectives and it is natural to expect it to affect a manager’s choice of firm risk and, consequently, the dynamics of the firm’s security prices. Aspects of these linkages have been explored empirically, but the structural modeling of the impact of CEO pay on risk choice, capital structure, and the pricing of financial securities remains relatively unexplored.

In our paper, Leverage Choice and Credit Spread when Managers Risk Shift, forthcoming in the Journal of Finance, we demonstrate the relevance of the agency costs of Jensen and Meckling (1976) for structural models of leverage choice and credit spreads. Assuming a realistic compensation structure for risk-averse managers, consisting of cash and stock, we show that managers will optimally choose to lever the firm and that their resulting pay will be convex in the firm’s terminal liquidating pre-tax payout. This convexity induces asset substitution, leading to riskier payouts and higher credit spreads than predicted by the prior literature. We also demonstrate that optimal leverage choice is the result of a balance between tax benefits and the utility cost of ex-post risk shifting. Our work thus highlights that operating behavior induced by compensation terms can be of first-order importance for understanding debt levels and credit spreads.

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The CEO Pay Slice

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, February 2, 2010
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Editor’s Note: This post is based on Lucian Bebchuk, Martijn Cremers and Urs Peyer’s recent op-ed article for the international association of newspapers Project Syndicate, which can be found here. The op-ed article discusses the findings of Bebchuk, Cremers, and Peyer’s recent empirical study which can be found here.

There is now intense debate about how the pay levels of top executives compare with the compensation given to rank-and-file employees. But, while such comparisons are important, the distribution of pay among top executives also deserves close attention.

In our recent research, we studied the distribution of pay among top executives in publicly traded companies in the United States. Such firms must disclose publicly the compensation packages of their five highest-paid executives. Our analysis focused on the CEO “pay slice” – that is, the CEO’s share of the aggregate compensation such firms award to their top five executives.

We found that the pay slice of CEOs has been increasing over time. Not only has compensation of the top five executives been increasing, but CEOs have been capturing an increasing proportion of it. The average CEO’s pay slice is about 35%, so that the CEO typically earns more than twice the average pay received by the other top four executives. Moreover, we found that the CEO’s pay slice is related to many aspects of firms’ performance and behavior.

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51 Law Firms Issue Consensus Interpretation of NY Power of Attorney Law

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, February 2, 2010
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This post is based on a white paper issued by 51 law firms interpreting recent changes to the New York Power of Attorney Law. The white paper is available here. The 51 law firms endorsing the white paper are listed below.

A group of fifty-one law firms has issued a White Paper, Interpretive Issues Related to Recent Changes to the New York Power of Attorney Law, which examines principles of New York and federal law to reach a finding that, at the least, substantial portions of the recently amended New York General Obligations Law §§ 5-1501 et seq. (the “Statute”) do not apply to proxies for shares of New York corporations and non-New York corporations, certain powers of attorney executed in connection with the registration of transfer of certificated securities or many powers of attorney granted in connection with the formation and governance of non-New York limited liability companies and non-New York limited partnerships.

On September 1, 2009, several amendments to the Statute, which governs powers of attorney executed by individuals while physically present in New York, took effect. These amendments, enacted as a result of perceived abuses in elder care connected to financial matters, including estate planning, changed the requirements for creating certain types of valid powers of attorney in New York. The amendments have given rise to troublesome concerns for transactional business lawyers, as the Statute appears potentially to have the unintended consequence of invalidating a wide variety of common corporate, commercial and financial documents. The purpose of the White Paper is to provide a blueprint for a consensus among practitioners on the issues it addresses because of the concern that an overly conservative interpretation of the Statute may become the accepted version of the law. The arguments in the White Paper are summarized below.

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SEC Enforcement in 2009: A Year of Changes, with More This Year

Posted by Eduardo Gallardo, Gibson, Dunn & Crutcher LLP, on
Monday, February 1, 2010
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Eduardo Gallardo is a partner focusing on mergers and acquisitions at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson Dunn client memorandum by Mark Schonfeld, John Sturc, Barry Goldsmith, Eric Creizman, Ladan Stewart, Akita St. Clair, Siham Nurhussein, Matthew Estabrook, Darcy Harris, Jonathan Fortney, Nili Wexler and Karen Grus.

In our 2009 “Mid-Year Review of SEC Enforcement,” we reviewed the transformation that had begun in 2009 at the SEC’s Division of Enforcement under the agency’s new Chairman, Mary Schapiro, and the Division’s new Director, Robert Khuzami, as well as the measurable increase in enforcement activity that had resulted. Since then, Mr. Khuzami has articulated more specifically the changes the he plans to make, some of which are already in effect and others that have yet to be implemented. Nevertheless, the results of the Enforcement Division continue to reflect the heightened enforcement initiative that has been the calling card of this Commission. In this review of enforcement in 2009, we focus on the significant enforcement developments of the second half of the year, as well as notable cases and important trends revealed by annual enforcement statistics, both those disclosed by the SEC, as well as those that result from our own analysis. We also look ahead to the significant developments to anticipate this year.

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Risk and the Corporate Structure of Banks

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, February 1, 2010
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This post comes to us from Giovanni Dell’Ariccia, Advisor in the Research Department at the International Monetary Fund, and Robert Marquez, Professor of Finance at Boston University.

In our paper Risk and the Corporate Structure of Banks, which was recently accepted for publication in the Journal of Finance, we analyze how risk affects the organizational structure of banks’ foreign operations. Our primary focus is on a bank’s decision to set up affiliates as either subsidiaries or as branches. Subsidiaries are locally incorporated stand-alone entities endowed with their own capital and protected by limited liability at the affiliate level. In other words, they are foreign-owned local banks for which the parent bank’s legal obligation is limited to the capital invested. By contrast, branches are merely offices of the parent bank without an independent legal personality. As such, the liabilities of branch affiliates represent real claims on the parent bank. Therefore, the decision to enter as either a subsidiary or a branch has important implications for the parent bank’s risk exposure.

We focus on two different, albeit related, sources of risk. First, banks are subject to credit or economic risk in the host market. Some of this risk can arise as a result of changes in macroeconomic conditions as shocks to economic activity and interest rates affect the credit worthiness of borrowers and may lead them to default on their loans, making the affiliate’s revenue uncertain. Second, host governments may engage in policies that infringe on the bank’s property rights and expropriate either fully or partially the bank’s revenue and capital. Such actions may entail direct expropriation, but extend to other policies including discretionary taxation, capital controls on repatriated profits, the redirecting of business toward state-owned or favored institutions, or forcing banks to hold government debt.

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Tackling the Root Causes of Shareholder Passivity and Short-Termism

Posted by Simon Wong, Northwestern University School of Law, on
Sunday, January 31, 2010
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Simon Wong is Managing Director at Governance for Owners and Adjunct Professor of Law at Northwestern University School of Law.

Streams of recommendations have begun to flow from bodies tasked with remedying the persistent problem of institutional investor passivity and short-termism. While the suggestions of the Institutional Shareholders’ Committee (ISC) and Walker Review are generally sensible, they are incomplete because significant asset owner issues remain unresolved. Until the root causes – particularly the inability of pension funds and other institutional asset owners to robustly monitor asset managers and the misalignment of interest between the two parties – are tackled head-on, reforms in this area will have limited impact.

Current reform efforts assume that asset owners maintain a strong interest in, and possess capabilities to meaningfully evaluate, their fund managers’ corporate governance activities. Many don’t.

To fulfill obligations under the Myners Principles to monitor fund managers’ adherence to the ISC Statement of Principles on the Responsibilities of Institutional Shareholders and Agents, many asset owners ask their investment managers the following annually: “Does your firm comply with the ISC Principles?” It is disconcerting that a perfunctory “yes” is often a sufficient response. Equally worrying, this exercise frequently transpires between the owner’s pension consultants and the manager’s client relationship team. Little or no effort is made by pension fund trustees or staff to speak directly with investment firm personnel who vote and engage on their behalf to discuss successful and problematic interventions, sufficiency of allocated resources, and areas for improvement.

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Street Name Registration: An Antiquated Idea

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, January 30, 2010
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This post comes to us from James McRitchie, Editor of CorpGov.net and Glyn Holton, Executive Director, United States Proxy Exchange.

“Street name registration” largely took root under emergency conditions stemming from a paperwork crisis during the 1960s, before networked computers were ubiquitous in trading markets. Immobilizing stock and registering it in the name Cede &Co., which was presumed by many to a temporary measure, now undermines our ownership culture.

Just as poker chips allow us to play under rules that often favor the house, those holding “security entitlements,” instead of registered stock, do not acquire the rights of real shareowners.

Street name registration, and the costs associated with shareowners learning each other’s identity, escalates the cost of proxy solicitations to hundreds of thousands of dollars—and that exorbitant cost is why entrenched boards routinely run unopposed. Eliminating street name registration, in favor of a direct registration system (DRS), could bring the cost of proxy solicitation down to a few thousand dollars. That could have a bigger impact on shareowner rights than the SEC’s proposed proxy access initiative.

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A Gap-filling Theory of Corporate Debt Maturity Choice

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, January 29, 2010
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This post comes to us from Robin Greenwood, Associate Professor of Business Administration at Harvard Business School, Samuel Hanson, Ph.D. Candidate in Business Economics at Harvard University, and Jeremy Stein, Professor of Economics at Harvard University.

In our paper A Gap-filling Theory of Corporate Debt Maturity Choice, which was recently accepted for publication in the Journal of Finance, we develop a new theory to explain time-variation in corporate maturity choice. As in BGW (2003), our theory allows for predictability in bond market returns and has the feature that corporate issuers tend to benefit from this predictability – ­i.e., they use short-term debt more heavily when its expected returns are lower than the expected returns on long-term debt. Crucially, however, we do not assume any forecasting advantage for corporate issuers: they have no special ability to predict future returns, or to recognize sentiment shocks. Instead, the key comparative advantage that corporate issuers have relative to other players in our model is an advantage in macro liquidity provision.

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FDIC and Private Capital: Moving the Goal Lines

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, January 28, 2010
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Editor’s Note: 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 John Douglas, Luigi De Ghenghi, Arthur Long and William Taylor.

For the second time since adopting its Final Statement of Policy for Failed Bank Acquisitions (the “Policy Statement”), the FDIC has issued “Questions and Answers” (the “Revised Q&As”) about the Policy Statement that appear to make it more difficult for private investors to avoid the onerous standards and requirements of the Policy Statement. [1] The FDIC will now presume that, if more than two-thirds of the total voting stock of an insured depository institution or its holding company that acquires a failed bank or thrift is held by private investors that each own 5% or less of the voting stock, the private investors are acting in concert as a single investor group. The private investors will be subject to the requirements of the Policy Statement unless they can satisfy the FDIC that the presumption has been rebutted. This position seems to confirm the FDIC’s preference for transactions in which an existing bank holding company owns at least two-thirds of the voting stock of the acquiring depository institution or its holding company or is itself the acquirer (with new private investors limited to no more than one-third of the existing bank holding company’s total equity).

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