Yearly Archives: 2011

The Role of Earnings Guidance in Resolving Sentiment-driven Overvaluation

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, June 10, 2011
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The following post comes to us from Nicholas Seybert of the Department of Accounting & Information Assurance University of Maryland, and Holly Yang of the Accounting Department at the University of Pennsylvania.

In our paper, The Party’s Over: The Role of Earnings Guidance in Resolving Sentiment-driven Overvaluation, which was recently made publicly available on SSRN, we show that an important link between investor sentiment and firm overvaluation is optimistic earnings expectations, and that management earnings guidance aids in resolving sentiment-driven overvaluation. Understanding the underlying process linking investor sentiment to overvaluation provides insight into investor psychology and difficult-to-predict bull and bear markets. Currently, there are multiple possible explanations for why uncertain stocks are overvalued during high sentiment periods. For example, investors may exhibit different preferences, such as reduced risk aversion, during high sentiment periods, which would lead them to overpay for stocks with high valuation uncertainty. Under this scenario, in subsequent months, a general shift in investing trends or psychology would lead to the gradual decline in prices. Alternatively, investors may engage in a more detailed thought process that involves unrealistic expectations of future firm earnings, where there is more potential to overestimate future earnings for uncertain firms. Under this scenario, in subsequent months, revisions in earnings guidance or other earnings news released by the overvalued firms should lead to predictable price declines. We focus on the second explanation, examining management earnings guidance to test the extent to which the correction of earnings expectations mitigates the overvaluation problem.

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Clawbacks Under Dodd-Frank and Other Federal Statutes

Posted by Joseph E. Bachelder III, Law Offices of Joseph E. Bachelder, on
Thursday, June 9, 2011
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Joseph Bachelder is founder and senior partner of the Bachelder Law Firm. This post is based on an article by Mr. Bachelder that first appeared in the New York Law Journal.

As used in this post, “clawback” means a repayment of previously received compensation required to be made by an executive to his or her employer. Three federal statutes that provide for clawbacks are discussed in this post. They are:

  • 1. Sarbanes-Oxley Act of 2002 (SOA) §304; 15 U.S.C. §7243(a);
  • 2. Emergency Economic Stabilization Act of 2008 (EESA) §111(b)(3)(B), as added by Section 7001 of the American Recovery and Reinvestment Act of 2009 (ARRA); 12 U.S.C. §5221(b)(3)(B) (applicable only to recipients of assistance under the Troubled Asset Relief Program (TARP) that have not repaid the Treasury); and
  • 3. Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) §954, 15 U.S.C. §78j-4(b).

A summary comparison of the three statutory clawback rules is provided in the chart below.

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Supreme Court Holds “Loss Causation” Not a Prerequisite to Class Certification in Fraud Cases

Posted by Brad S. Karp, Paul, Weiss, Rifkind, Wharton & Garrison LLP, on
Thursday, June 9, 2011
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Brad Karp is chairman and partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP. This post is based on a Paul Weiss client memorandum, and relates to the Supreme Court decision in Erica P. John Fund Inc. v. Halliburton Co., which is available here.

In Erica P. John Fund Inc. v. Halliburton Co., No. 09-1403 (June 6, 2011), the Supreme Court of the United States decided that in seeking class certification, a plaintiff in an action under the federal securities laws is not required to prove facts demonstrating loss causation. [1] In so holding, the Supreme Court rejected a contrary rule, adopted only by the Fifth Circuit, that proof of loss causation is a prerequisite to class certification. Halliburton was the Supreme Court’s first significant re-examination of the “fraud-on-the-market” theory of reliance adopted in Basic Inc. v. Levinson, 485 U.S. 224 (1988).

The Supreme Court, however, decided only the narrow issue of whether loss causation is a prerequisite to class certification. According to arguments advanced by the Halliburton defendant before the Supreme Court, the Fifth Circuit had intended to rule only that in order to obtain class certification, a plaintiff in an action under the federal securities laws must prove “price impact.” “Price impact” refers to proof that the defendant’s alleged misrepresentation in fact distorted the market price of the security at issue in the case. The Supreme Court rejected the Halliburton defendant’s characterization of the Fifth Circuit’s decision. The Supreme Court viewed the Fifth Circuit as having required proof of “loss causation,” as the Supreme Court’s cases have defined that concept, and held only that this aspect of the Fifth Circuit’s decision was erroneous. The Supreme Court thus left open what were arguably the most important issues potentially presented by Halliburton. Those issues involve (i) whether a district court should examine evidence of price impact at the class certification stage, and (ii) whether, if so, at that stage a plaintiff has the burden of affirmatively proving price impact; a defendant instead has the burden of rebutting a presumption of price impact; or an intermediate structure of shifting burdens may apply.

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Preventing the Next Financial Crisis

Posted by Ivo Welch, Brown University, on
Wednesday, June 8, 2011
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Ivo Welch is Professor of Economics and Finance at Brown University.

We have weathered the worst of the financial crisis of 2008-9. Time for renewed optimism? Unfortunately not. The next financial crisis is already programmed. It’s somewhat like an earthquake in Southern California. We cannot predict exactly when it will happen, but we know that it will. Yet unlike earthquakes, financial crises are man-made. They need not happen. They happen because we allow them to happen. We could take many measures to reduce their frequency and depths, but we fail to do so.

What about Dodd-Frank? Won’t it help? To its credit, it contains many good ideas. For example,

  • Financial firms with access to the Fed should not be allowed to speculate. (The “Volcker Rule” prohibits proprietary trading.)
  • Financial firms that are too big to fail should be broken up by the financial risk council.
  • Financial firms should have higher capital requirements.
  • Compensation of executives in financial firms should be subject to claw back.
  • Whistle blowers can collect bounties for turning in executives if the executives’ compensation was based on inaccurate accounting.

Some good ideas, like an industry rescue fund, died along the way. Other good ideas have been put forth in academic discussions and been by-and-large ignored. For example, there is the suggestion that financial firms should be primarily equity-funded instead of debt-funded, that deposit insurance premia should be risk based, and that firms should disclose much more information about their bets publicly on a daily basis (which all large financial firms already have readily available), so that traders can become aware of systemic correlations in bets.

However, there are two critical problems with all these reforms and ideas. First, meaningful reforms will never happen. This even applies to the provisions already in Dodd-Frank. They will be castrated long before they are implemented. Wall Street simply has too much influence in Washington to allow any meaningful reform. More likely, Dodd-Frank will end up just as another Full Employment Act of Financial Lobbyists (a phrase coined by Barth, Caprio, Levine) and a source of rich campaign donations for influential politicians. As a whole, Washington is corrupt. This is not necessarily because individual politicians are corrupt, but because politicians that are well-funded by lobbyists tend to win elections.

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Harvard Faculty and Fellows Contribute Most of the Top Ten Corporate and Securities Law Articles of 2010

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, June 7, 2011
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This year’s list of the Ten Best Corporate and Securities Articles, selected by an annual poll of corporate and securities law academics includes six articles authored or co-authored by six Harvard Law faculty and fellows. The top ten articles were selected from a field of 440 pieces, and the selected articles will be reprinted in an upcoming issue of the Corporate Practice Commentator.

The HLS faculty and fellows contributing one or more articles to the top ten list are:

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Selectica Resets the Trigger on the Poison Pill

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, June 6, 2011
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The following post comes to us from Paul H. Edelman, Professor of Law and Mathematics at Vanderbilt University, and Randall S. Thomas, John S. Beasley II Professor of Law and Business at Vanderbilt University. Additional posts about poison pills, including several from the Program on Corporate Governance, 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.

In our forthcoming Indiana Law Journal paper, Selectica Resets the Trigger on the Poison Pill: Where Should the Delaware Courts Go Next?, we discuss a novel form of rights plan that has recently been developed (the NOL rights plan), which has a 5% trigger level that is particularly onerous for hostile bidders. The legitimacy of an NOL rights plan was first put to the test in Delaware litigation, applying the preclusion prong of the Unocal test for defensive tactics. Trilogy argued that the NOL pill unduly restricted its ability to win a proxy contest and therefore violated Moran and Unitrin. The Delaware Supreme Court rejected this claim in a decision that leaves us with little guidance about how they would rule on other poison pills with a 5% (or less) trigger level.

This lack of guidance is troubling both for potential bidders and their targets. Presumably the Delaware courts would uphold other NOL rights plans with similar trigger levels but is the court’s decision limited to companies, like Selectica, who have suffered significant economic losses? Or, does it apply more broadly? What about target companies that drop their pill trigger to 5% claiming that hedge fund activists pose a serious threat to their corporate well-being?

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Federal District Court Rebuffs Mutual Fund’s Prospectus Liability

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, June 5, 2011
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This post comes to us from David M. Geffen, Counsel at Dechert LLP who specializes in working with investment companies and their investment advisers. This post is based on a Dechert memorandum by Mr. Geffen, William K. Dodds, Matthew L. Larrabee and Grace M. Guisewite. The post relates to the decision in the case of Yu v. State Street Corp., which relies in part on certain arguments set forth in an article by Mr. Geffen which was described in this post.

In a decision that could sharply curtail the potential liability of mutual funds and their advisers and directors for non-fraudulent prospectus misrepresentations, on March 31, 2011, the U.S. District Court for the Southern District of New York dismissed a putative class action arising out of the precipitous decline in the share price of a mutual fund during the 2007 and 2008 credit crisis. [1] The plaintiffs asserted claims under §§ 11 and 12(a)(2) of the Securities Act of 1933 (Securities Act), alleging that the prospectus for the SSgA Yield Plus Fund misrepresented the Fund’s exposure to mortgage-related securities.

The court rejected the plaintiffs’ claims on loss causation grounds. The measure of permissible damages under §§ 11 and 12(a)(2) is limited to the decline in a security’s value that results from the revelation of the artificial inflation of the security’s purchase price by a misrepresentation. Because the only price at which a mutual fund may sell or redeem its shares is determined by a statutory formula based on the net asset value (NAV) of the securities owned by the fund, prospectus misrepresentations cannot inflate a fund’s NAV nor, upon revelation, cause the NAV to decline. Accordingly, the court found that the plaintiffs’ complaint failed to allege the requisite loss causation and, therefore, dismissed the action with prejudice.

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Regulators Propose Swap Margin and Capital Rules

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Saturday, June 4, 2011
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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 April 12, 2011, the U.S. banking regulators proposed rules regarding the capital and margin requirements applicable to uncleared swaps. In general, the proposed rules would not impose new capital requirements on bank swap entities. However, the proposed rules would require bank swap entities to collect initial and variation margin from counterparties, including, in some cases, end users. In addition, the proposed rules establish collateral eligibility and segregation requirements and methodologies for calculating initial and variation margin requirements. The proposed rules have an expansive approach to extraterritoriality, providing only a slender exception for certain wholly offshore transactions.

On the same day, the CFTC proposed rules governing margin requirements for uncleared swaps entered into by non-bank swap entities subject to its jurisdiction. Based upon the Fact Sheet and Q&As that were released by the CFTC, the CFTC’s proposal appears to be similar, but not identical, to the banking regulators’ proposal. The SEC has not yet released a proposal for capital or margin requirements for security-based swap entities.

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Managers Who Lack Style

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, June 3, 2011
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The following post comes to us from C. Edward Fee of the Finance Department at Michigan State University; Charles Hadlock, Professor of Finance at Michigan State University; and Joshua Pierce of the Finance Department at the University of South Carolina.

In the paper, Managers Who Lack Style: Evidence from Exogenous CEO Changes, which was recently made publicly available on SSRN, we study managerial style effects in firm decisions by examining exogenous CEO changes in a panel of 8,615 Compustat firms from 1990 to 2007. The hypothesis that managers have varying preferences or traits that affect their corporate decisions has a great deal of intuitive appeal and is implicit in many discussions of leadership. Prior empirical evidence lends support to this general hypothesis and suggests that managerial style effects play a substantive role in firms’ investment and financing choices. This raises the possibility that much of the unexplained variation in these and related choices is driven by the identities of a firm’s leaders rather than more traditional factors such as various economic tradeoffs.

While prior research on this issue has generated many interesting findings, a major weakness arises from the fact that endogenous leadership changes are used to identify style effects. In this paper we overcome this weakness by identifying a large set of exogenous CEO changes arising from deaths, health concerns, and, in some parts of the analysis, natural retirements. Quite surprisingly, we find no significant evidence of abnormal changes in asset growth, investment intensity, leverage, or profitability subsequent to exogenous CEO changes.

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Seventh Circuit Makes Life Tougher for Directors with Conflicts

Posted by Andrea Unterberger, Corporation Service Company, on
Thursday, June 2, 2011
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Andrea Unterberger is Vice President and Assistant General Counsel at Corporation Service Company (CSC). This post is by Ms. Unterberger, and Sandra E. Mayerson and Peter A. Zisser of Squire, Sanders & Dempsey LLP.

In CDX Liquidating Trust v. Venrock Assocs., et al., 2011 U.S. App. LEXIS 6390 (7th Cir. March 29, 2011), the United States Court of Appeals for the Seventh Circuit, reversing the District Court’s ruling, held under Delaware law that a director’s disclosure of a conflict, in and of itself, is insufficient to protect that director from liability for breach of the fiduciary duty of loyalty arising from that conflict.  Similarly, the other party to whom the conflicted director owes loyalty (under the right circumstances) can be held liable for aiding and abetting a breach of fiduciary duty.  Nor does the mere existence of independent directors shield these parties from liability.

In Venrock, the debtor (“Debtor”) was a company which manufactured internet modems. The founders received common stock.  Two venture capital firms (the “VCs”) received preferred stock in exchange for an investment made at the beginning of 2000.  A principal of one of the venture capital firms (the “VC Principal”) became a member of Debtor’s five-member board of directors (the “Board”) upon the firm’s investment.  In April 2000, the Board rebuffed a tentative offer to buy Debtor’s assets for $300 million.

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