Yearly Archives: 2011

Reflections on Dodd-Frank: A Look Back and a Look Forward

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, July 27, 2011
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Editor’s Note: The following post comes to us from Lee A. Meyerson, a Partner who heads the M&A Group and Financial Institutions Practice at Simpson Thacher & Bartlett LLP, and is based on the introduction of a Simpson Thacher compendium, available here. This post is part of a series following the first anniversary of the Dodd-Frank Act which was July 21, 2011, other Dodd-Frank posts are available here.

The impact of Dodd-Frank—like the U.S. financial industry it regulates—is greater than the sum of its parts. Dodd-Frank seeks to oversee and regulate financial markets as a whole, by increasing regulation of individual companies with the potential to compromise market stability, as well as implementing regulation of certain areas of the financial services sector previously not subject to federal supervision and regulation. Dodd-Frank also addresses consumer protection, through the creation of a new agency with broad consumer protection powers and new rules governing residential mortgage markets.

In comments regarding the impact of this historic legislation, Timothy Geithner, Secretary of the Department of Treasury, noted that “By almost any measure, the U.S. financial system is in much stronger shape” than it was prior to enactment of Dodd-Frank. [1] However, a huge amount of change still lies ahead. In the short run, uncertainty regarding the impact of Dodd- Frank on operations, capital and liquidity levels, costs and revenue, and increased litigation and enforcement risk, will continue to impact strategic decisions and valuations of financial institutions of all types and sizes. The long-term impact of the legislation is uncertain, although it could quite possibly usher in a new era of accelerated consolidation in the financial services industry.

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Accounting Conservatism, Going-Concern Horizon, and Earnings Informativeness

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, July 27, 2011
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The following post comes to us from Edward Owens of the Department of Accounting at the University of Rochester.

In the paper, Accounting Conservatism, Going-Concern Horizon, and Earnings Informativeness, which was recently made publicly available on SSRN, I examine how accounting conservatism shapes the relation between a firm’s going-concern status and the informativeness of its earnings for firm valuation. I extend earnings-persistence-based valuation theory to develop the study’s key insight that the difference between the earnings informativeness of a firm with a finite going-concern horizon and the earnings informativeness of a firm with an infinite going-concern horizon is a positive function of the proportion of capitalized value that is reflected in the earnings of future periods. Based on this insight, I predict that because of the asymmetric persistence implications of accounting conservatism, negative shocks to a firm’s assessed going-concern horizon diminish the informativeness of good news earnings but have no effect on the informativeness of bad news earnings. Using the setting of intra-industry bankruptcy to capture shocks to the market’s assessment of firms’ going-concern horizons, I provide empirical evidence consistent with my predictions.

This study makes several contributions to extant literature. First, my analysis and results provide additional insights into the dynamics of the going-concern assumption and firm valuation. In particular, I provide evidence that the negative relation between probability of bankruptcy and earnings informativeness is not symmetric across good and bad news realizations, as suggested implicitly by prior literature.

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Court Broadens Insider Trading Claims Under Delaware Law

Posted by Eduardo Gallardo, Gibson, Dunn & Crutcher LLP, on
Tuesday, July 26, 2011
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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 Alert by Jason J. Mendro, Adam H. Offenhartz, and Andrew S. Tulumello. This post is part of the Delaware law series, which is co-sponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Shareholders may state a derivative claim for insider trading without alleging injury to the company–so held the Delaware Supreme Court in an opinion it recently issued in Kahn v. Kolberg Kravis Roberts & Co., L.P., No. 436, 2010 (June 20, 2011) (“In re Primedia“). Following the In re Primedia decision, plaintiffs can be expected to rely increasingly on derivative actions as a means of pursuing insider trading claims. Although they would be subject to the requirements for asserting derivative claims, plaintiffs may exploit state law to evade many limitations that Congress has imposed on claims under the federal securities laws, including the heightened standard for pleading scienter under the Private Securities Litigation Reform Act of 1995. Significantly, derivative actions may not be removed to federal court under the Securities Litigation Uniform Standards Act of 1998.

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General Release — Handle with Caution

Posted by David Fox, Kirkland & Ellis LLP, on
Tuesday, July 26, 2011
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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.

A recent decision by the highest court in New York highlights once again the broad finality of a general release given in a transactional context, even in cases where significant fraud is subsequently alleged. As we noted in a prior M&A Update, courts are reluctant to permit parties to circumvent the typically broad language of general releases by allowing the aggrieved party to argue that it really did not mean to release the claim being pursued despite the claim clearly falling within the literal words of the release.

The recent Court of Appeals decision arose out of a complicated set of transactions involving interests in various Latin American telecom businesses that culminated in a majority shareholder affiliated with Carlos Slim buying out the interests of minority shareholders. The sellers later alleged that they sold their interests at the agreed price only as a result of fraudulent information provided to them by the purchaser, resulting in an undervaluation of almost $1 billion. The purchaser asserted that all claims were barred by a broad release (“all manner of actions…whatsoever…future, actual or contingent…”) given by the sellers at the time the buyout was completed.

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One-Year Anniversary Dodd-Frank Rulemaking Progress Report

Posted by Margaret E. Tahyar, Davis Polk & Wardwell LLP, on
Monday, July 25, 2011
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Margaret E. Tahyar is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP. This post discusses a Davis Polk report which is available here. A post about the previous progress report is available here. This post is part of a series following the first anniversary of the Dodd-Frank Act which was July 21, 2011, other Dodd-Frank posts are available here.

This posting, the Davis Polk Dodd-Frank Rulemaking Progress Report, is the fifth in a series of Davis Polk presentations that illustrate graphically the progress of the rulemaking work that has been done and is yet to occur under the Dodd-Frank Act. The Progress Report has been prepared using data from the Davis Polk Regulatory Tracker™, an online subscription service offered by Davis Polk to help market participants understand the Dodd-Frank Act and follow regulatory developments on a real-time basis.

Among the key elements of this Progress Report:

  • An analysis of rulemaking progress, which shows that regulators have completed 33, or 20%, of the 163 rulemakings due to date. Overall, regulators have completed 13% of all rulemaking requirements in Dodd-Frank.  Rules fulfilling 13 rulemaking requirements were finalized in July and 104 rulemaking deadlines were missed – 76 on July 16, 2011 and 28 on July 21, 2011.
  • A summary of study progress, which shows 7 missed studies to date.
  • A ranking of the most popular topics of discussion in the more than 1,700 meetings that have taken place between regulators and market participants since Dodd-Frank’s enactment.
  • A graphical representation of the GAO’s analysis of the $1.25 billion cost to regulators for Dodd-Frank implementation over the next two years.
  • A breakdown, organized by affected groups within financial firms, of the 1,081 specific tasks identified by Davis Polk from CFTC and SEC releases that are applicable to swap dealers and major swap participants.

The Deterrence Effects of SEC Enforcement and Class Action Litigation

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, July 25, 2011
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The following post comes to us from Jared Jennings of the Department of Accounting at the University of Washington; Simi Kedia of the Department of Finance & Economics at Rutgers University; and Shivaram Rajgopal, Professor of Accounting at Emory University.

In the paper, The Deterrence Effects of SEC Enforcement and Class Action Litigation, we study whether SEC enforcement actions are associated with significant change in behavior of peer firms towards greater compliance. As complete compliance is not feasible, a rational enforcement policy implies enforcement efforts that maximize deterrence. Maximum deterrence is also explicitly mandated in directives from the US Congress as one of the main objectives of the SEC’s enforcement policy. Private securities class action litigation, though it does not aim to explicitly deter others, also has the potential to generate deterrence as such enforcement is more frequent and imposes higher monetary sanctions than the SEC.

We study accrual based earnings management in peers, operationalized as firms in the same industry, as the targeted firm in the aftermath of SEC enforcement and litigation to ascertain the existence and magnitude of deterrence. The results suggest significant reduction in accruals for peer firms of targets that are subject to SEC enforcement and/or litigation. Such reversal of accruals is not only highly statistically significant but also economically important. On average, every peer firm reduces discretionary accruals to the tune of 14% to 22% of its average ROA. This evidence of significant deterrence is robust to different definition of industry. It is also not isolated to events in a few years. Significant evidence of deterrence is seen in sub-samples and also over the extended time period from 1976 to 2006.

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Inside the Boardroom: Responding to a Negative Say on Pay Vote

Posted by Paul Rowe, Wachtell, Lipton, Rosen & Katz, on
Sunday, July 24, 2011
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Paul Rowe is a Partner in the Litigation Department at Wachtell, Lipton, Rosen and Katz. This post is based on a Wachtell Lipton memorandum by Mr. Rowe and Martin Lipton.

When stockholders deliver a negative vote on say on pay, directors face the question whether to change corporate policy in response – even if their best business judgment tells them that existing compensation programs are well-designed and are working well. In fact, a negative vote on say on pay does not change the board’s fiduciary duty to implement compensation policies that the directors believe are the best way to attract, retain and incentivize top-quality managers:

  • The law is clear in all American jurisdictions that setting compensation policy and structuring compensation agreements are decisions reserved for directors and not shareholders. That is why say on pay resolutions are advisory and do not carry mandatory force.
  • Dodd-Frank does not affect this basic legal principle. It specifically provides that say on pay votes do not change the board’s fiduciary duties and traditional powers in this area.

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Change of Control Special Committee: Breathing Life into CNX

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, July 23, 2011
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The following post comes to us from Samuel C. Thompson Jr., Professor of Law and Director of the Center for the Study of Mergers & Acquisitions at the Pennsylvania State University School of Law. This post is part of the Delaware law series, which is co-sponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Notwithstanding the excellence of the Delaware judiciary, the multiple standards of review under Delaware law for reviewing the actions of a target’s directors involved in a merger or acquisition transaction are cumbersome, a source of needless litigation, and economically inefficient. In my paper Change of Control Special Committee: Breathing Life into CNX, recently made public on SSRN, I put forward a proposal to resolve these issues through changes in Delaware’s General Corporation Law (“DGCL”). DGCL should be amended to permit the shareholders of a corporation to adopt a provision requiring that if the corporation becomes a target of a bona fide acquisition proposal, the board of the corporation must petition the Delaware Court of Chancery for the appointment of an independent, disinterested, and knowledgeable special committee of the board (a “Change of Control Special Committee”). This Committee would have complete power over the acquisition transaction. At the discretion of the Delaware Court of Chancery, a member of the current board could be appointed to the Change of Control Special Committee.

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D.C. Circuit Strikes Down Proxy Access Rules

Posted by Adam O. Emmerich, Wachtell Lipton Rosen & Katz, on
Friday, July 22, 2011
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Adam Emmerich is a partner in the corporate department at Wachtell, Lipton, Rosen & Katz focusing primarily on mergers and acquisitions and securities law matters. This post is based on a Wachtell Lipton firm memorandum. Other posts about proxy access, including several papers from the Program on Corporate Governance, are available here.

In an opinion issued today in the challenge brought by the Business Roundtable and U.S. Chamber of Commerce to the SEC’s adoption of proxy access,  the U.S. Court of Appeals for the D.C. Circuit vacated the entire proxy access regime as an “arbitrary and capricious” exercise of the SEC’s authority.  The opinion, written by Judge Ginsburg, chides the SEC for failing “adequately to assess the economic effects” of  the rules. The court levels particular criticism at the SEC’s analysis of the likely costs associated with, and the frequency of, proxy contests utilizing the access rules, reliance upon “insufficient empirical data” to support a conclusion that proxy access would improve board performance, and failure to address the possibility that unions and pension funds would use the rules as a bargaining chip in unrelated negotiations with issuers.  While noting that these overall defects in the rule render it invalid with respect to all types of issuers, the opinion offers lengthy criticism in particular of the decision to subject investment companies to the proxy access rules, due to the enhanced regulation imposed by the Investment Company Act of 1940.

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Advisory Directors

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, July 22, 2011
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The following post comes to us from Olubunmi Faleye of the Finance Department at Northeastern University, Rani Hoitash of the Department of Accountancy at Bentley University, and Udi Hoitash of the Accounting Department at Northeastern University.

In our paper, Advisory Directors, which was recently made publicly available on SSRN, we study the characteristics and effects of directors dedicated to providing strategic counsel to the chief executive officer (CEO). The question of how to structure corporate boards for effective oversight of top management has attracted significant academic and regulatory efforts in recent years. In contrast, how best to structure the board for optimal advising remains an important but much less investigated topic.

In an attempt to bridge this gap, we propose that the board’s advising functions are best performed by a distinct class of independent directors minimally involved in monitoring management. Specifically, we define an advisory director as an independent director who does not serve on any of the principal monitoring committees but serves on at least one advisory committee if the company has any. We argue that such directors are best positioned for effective advising because their minimal involvement in monitoring enables them to develop a trusting relationship with the CEO and provides the time needed to focus on strategic issues. This facilitates information exchange with the latter, makes him more likely to seek their opinions, and provides a friendly sounding board for important strategic proposals.

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