Monthly Archives: April 2011

Capital versus Performance Covenants in Debt Contracts

The following post comes to us from Hans Christensen and Valeri Nikolaev, both of the Department of Accounting at the University of Chicago.

In the paper, Capital versus Performance Covenants in Debt Contracts, which was recently made publicly available on SSRN, we propose a simple classification of financial covenants into two distinct groups: performance covenants and capital covenants. Performance covenants rely on measures of profitability and efficiency whereas capital covenants rely on information about sources and uses of capital, i.e., balance sheet information. We argue that capital covenants align incentives between borrowers and lenders by limiting the amount of debt in the borrower’s capital structure. In contrast, performance covenants act as tripwires that transfer control to lenders when performance deteriorates and hence incentive conflicts between shareholders and lenders become more acute.


SEC Claws Back Again

Editor’s Note: Wayne Carlin is a partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Carlin and John F. Savarese.

The SEC recently announced a settled enforcement action in which it obtained a “clawback” of prior compensation and stock sale profits from a CEO pursuant to Sarbanes-Oxley Section 304.  SEC v. McCarthy, No. 1:11-CV-667-CAP (N.D. Ga. March 3, 2011).  This case marks the second time the SEC has obtained this type of relief without alleging that the CEO in question personally engaged in any wrongdoing.  See our prior memos concerning Section 304 clawbacks dated June 16, 2010 [“Sarbanes-Oxley Clawback Developments”] and July 24, 2009 [“SEC Pursues Unprecedented Sarbanes-Oxley Clawback”].

Section 304 requires a CEO or CFO to return incentive-based compensation to an issuer when a financial restatement occurs “as a result of misconduct. . . .”  The SEC’s position is that the issuer’s “misconduct” alone is a sufficient predicate for this relief, and that it need not establish any personal misconduct by the CEO or CFO.  The SEC’s position is supported by the one federal district court decision that has been rendered on this issue.  SEC v. Jenkins, 718 F. Supp. 2d 1070 (D. Ariz. 2010).


Materiality of Misrepresentations in U.S. Securities Litigation

Robert Giuffra is a partner in Sullivan & Cromwell’s Litigation Group. This post is based on a Sullivan & Cromwell client memorandum.

The U.S. Supreme Court has recently curtailed the scope of securities fraud actions and tightened pleading requirements, making it more difficult for plaintiffs to allege securities fraud and ultimately making such claims more prone to an early dismissal. As such, in electing to review the “materiality” issue in Matrixx Initiatives, Inc., et al. v. Siracusano, et al., No. 09-1156, some observers thought that the high court might tighten further the pleading requirements in securities litigation.

Last week, the Supreme Court issued its decision in Matrixx, holding that plaintiffs had adequately pleaded material misrepresentations by defendants for failing to disclose “adverse event reports” relating to Matrixx’s popular nasal spray, while declining to adopt a bright-line standard for determining the materiality of such reports in actions against pharmaceutical companies. In applying existing law to the allegations and circumstances present in the case, the Court’s decision is narrow and does not alter the class action landscape.


The SEC Push for Enhanced Disclosure of Litigation Contingencies

Edward Herlihy is a partner and co-chairman of the Executive Committee at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Herlihy and Eric M. Roth.

Over the last several days, there has been a raft of SEC filings in which companies have disclosed “reasonably possible” litigation losses. These filings are the result of SEC pressure and an interpretative position advanced by the Staff. In recent speeches, the Chief Accountant of the SEC’s Division of Corporation Finance has questioned whether companies are complying with the existing disclosure standards applicable to litigation contingencies. ASC 450 (formerly known as SFAS 5) requires the disclosure of a litigation contingency if there is at least a “reasonable possibility” that a loss has been incurred, and the disclosure must include an estimate of the possible loss or range of loss or a statement that such an estimate cannot be made. The Chief Accountant has stated that the Staff is “seeing a lack of disclosure with respect to ‘reasonably possible’ losses.” Moreover, in comment letters sent to various financial services companies, the Division of Corporation Finance has questioned the adequacy of litigation-related disclosures that do not either set forth estimates of possible losses or range of losses or explain why such estimates cannot be provided.


How Stable Are Corporate Capital Structures?

The following post comes to us from Harry DeAngelo, Professor of Finance at the University of Southern California, and Richard Roll, Professor of Finance at the University of California, Los Angeles.

In the paper, How Stable Are Corporate Capital Structures? which was recently made publicly available on SSRN, we examine the stability of corporate capital structures. Overall, the evidence indicates that time-series variation in the leverage of individual firms is of first-order importance, with leverage instability reflecting the external funding of company expansion and with mature firms trending away from conservative financial policies. Capital structure stability is the exception rather than the rule at publicly held industrial firms, with the preponderance of firms having leverage ratios that take on a wide range of values and that differ over time in mean value. Leverage stability occurs only infrequently and, when it does, is virtually always temporary, with stability episodes largely occurring when firms have low leverage. Departures from stability are rarely followed by rebalancing to the prior stable leverage regime or by establishment of a new stable regime. Leverage instability is strongly associated with asset growth and external funding to support that growth, and also reflects a trend away from conservative leverage that played out mainly over the 1950s and 1960s and that began in the mid- to late-1940s with the need to fund expansion during the post-World War II boom.


Poison Pills in 2011

Matteo Tonello is Director of Corporate Governance for The Conference Board, Inc. This post is based on a Conference Board Director Note by Andrew L. Bab and Sean P. Neenan. Additional posts about poison pills, including several from the Program on Corporate Governance, can be found here.

Having been buffeted by sustained attacks from activists and proxy voting advisors in past years, the shareholder rights agreement is no longer as prevalent as it once was—a phenomenon that has been documented by many corporate governance observers like The Conference Board. However, the most recent case law confirms the validity of poison pills that are properly structured, adopted, and administered. This report discusses these new trends and provides guidance to boards considering whether to adopt a pill and how to formulate its terms.

Despite the continued decline in the number of outstanding poison pills maintained by U.S. public companies, Delaware courts in several cases in 2010 and early 2011 have steadfastly confirmed the continuing legal vitality of pills that are properly structured, adopted, and administered. The most recent of these cases demonstrates how powerful a poison pill can be when working in tandem with a classified board: Air Products withdrew its 16-month long hostile pursuit of Airgas promptly after the Delaware Court of Chancery upheld Airgas’ combined defenses. [1] It is interesting, therefore, that fewer and fewer companies are maintaining classified boards; companies may find that without them, the effectiveness of their poison pills will be significantly reduced.


FDIC’s Second Notice of Proposed Rulemaking under the Orderly Liquidation Authority

Margaret E. Tahyar is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP. This post discusses a Davis Polk client memorandum by Randall Guynn and Reena Agrawal Sahni which is available here.

This Davis Polk memorandum, primarily written by Randy Guynn and Reena Agrawal Sahni, describes the FDIC’s second notice of proposed rulemaking, published on March 23, 2011, to implement its new Orderly Liquidation Authority (OLA) under Title II of the Dodd-Frank Act. The proposed rules raise significant issues in a number of areas, including the recoupment of compensation from senior executives and directors and the treatment of set off rights under OLA.

Overall, the Second NPR strikes a more balanced tone between how the FDIC will use its new authority to end taxpayer-funded bailouts of creditors and other stakeholders, while avoiding the sort of “disorderly” liquidation or reorganization under the Bankruptcy Code that could trigger a chain reaction of panic and failures that could result in a severe destabilization or collapse of the U.S. financial system. While it is too early to tell whether the Second NPR signals a permanent change in the tone of the FDIC’s rulemakings and other public statements, it is an important first step.

The complete memorandum is available here.

Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay

Jesse Fried is a Professor of Law at Harvard Law School.

Academics, regulators, and investors have been urging firms to tie executive pay to the long-term stock price. In the paper, Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay, which was recently made publicly available on SSRN, I explain why tying executive pay to the future value of the firm’s stock—even the stock’s long-term value—can sometimes perversely reward executives for taking steps that reduce the value flowing from the firm to its public investors over time.

The paper describes and analyzes two distortions caused by tying an executive’s payoff to a stock’s future value. The first is “costly contraction:” when the stock’s current price is below its actual value, the executive may have an incentive to divert cash from productive projects in the firm to fund bargain-price share repurchases. If the stock trades for a low enough price, a bargain-price repurchase can boost the value of the executive’s shares even if the repurchase forces the firm to cut back on profitable investments.


Florida SBA Supports Proxy Access and Advisory Firm Transparency

Michael McCauley is Senior Officer, Investment Programs & Governance, of the Florida State Board of Administration (the “SBA”). This post is based on an excerpt from the SBA’s 2011 Corporate Governance Report by Mr. McCauley, Jacob Williams and Lucy Reams. Mr. Williams and Ms. Reams are Corporate Governance Manager and Senior Corporate Governance Analyst, respectively, at the SBA. The complete report is available here; further information regarding the SBA’s governance activities, including proxy voting data, is available here.

Proxy Access

The SEC passed a new rule which would give shareowners greater “Proxy Access” and an avenue to challenge unresponsive directors. By a 3-2 vote, the SEC gave individual (or groups of shareowners) who held 3 percent ownership for 3 years the right to put candidates on corporate ballots. Shareowners would be able to nominate at least one director and as much as 25 percent of a board. In September, the Business Round Table and the U.S. Chamber of Commerce filed legal challenges to the rule arguing that the SEC failed to adequately measure the costs imposed on companies. As a result, the SEC put a hold on the implementation of Proxy Access until the legal questions are resolved, with its earliest application occurring in 2012 if it passes the legal challenges.


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