Monthly Archives: June 2011

SEC Adopts New Rules to Encourage Whistleblowers

Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton firm memorandum by Mr. Lipton, Steven A. Rosenblum, John F. Savarese, Wayne M. Carlin and Karessa L. Cain.

Recently, the SEC adopted controversial new rules that create significant financial incentives for whistleblower employees to report suspected securities law violations directly to the SEC, potentially circumventing company compliance programs in the process. Under the new rules, which were adopted pursuant to Section 922 of the Dodd-Frank Act, the SEC will pay awards to whistleblowers who voluntarily provide the SEC with original information about a violation of securities laws that leads to a successful enforcement action brought by the SEC and that results in monetary sanctions exceeding $1 million.

The size of potential bounty payments may range from 10% to up to 30% of the total monetary sanctions collected in successful SEC and related actions. In some cases, this could result in multimillion dollar cash payments to whistleblowers. The final rules set forth the SEC’s methodology for determining awards, with specified factors weighing in favor of an increase in the reward size and others weighing in favor of a reduction in the reward size. In addition, the rules provide that various persons will not be eligible for whistleblower payments, including compliance and internal audit personnel, but an exception is provided for such personnel if they believe disclosure “may prevent substantial injury to the financial interest or property” of the company or investors, and at least 120 days have elapsed since the whistleblower reported the information internally at the company or became aware of information that was already known to the company.


Janus Capital Group v. First Derivative Traders: Only the Supreme Court can “Make” a Tree

Editor’s Note: Jeffrey Gordon is the Alfred W. Bressler Professor of Law at Columbia Law School. This post discusses the Supreme Court decision in Janus Capital Group v. First Derivative Traders, available here; a post from Gibson, Dunn & Crutcher LLP concerning this case is available here.

The Supreme Court decision in Janus Capital Group v. First Derivative Traders is one of those cases that takes your breath away. The case astonishingly holds that an investment advisor is not liable for fraud in the prospectus of a sponsored mutual fund because the investment advisor is not the “maker” of those statements – even though the fund’s officers are all employees of the advisor (and paid for that service by the advisor) and the advisor prepares, files, and distributes the prospectus. Nevertheless, says the Supreme Court majority, the advisor did not “make” the fraudulent statement, because the fund, a legally separate entity, had “ultimate authority over the statement, including its content and whether and how to communicate it.”

Okay, we get that the Supreme Court is hostile to the implied private right of action under Rule 10b-5 yet seems to regard its existence as a “super-precedent.” But Janus Capital Group does real damage. First, the Court seems willfully to deny what it should have learned about the functioning of mutual funds in last term’s advisory fee case, Jones v. Harris Associates. A mutual fund is hardly a free-standing entity bargaining at arm’s length with a supplier of advisory services, notwithstanding the “independence” of the fund’s directors. At a time when an increasingly large share of investment activity occurs through large pools of capital, the decision exacerbates the problem of “agency capitalism” – the tendency of the managing agents to pursue their own objectives at the expense of the ultimate beneficiaries. Why strain to find ways to insulate wrong-doers from accountability systems?


External Networking and Internal Firm Governance

The following post comes to us from Cesare Fracassi of the Department of Finance at the University of Texas at Austin and Geoffrey Tate of the Department of Finance at the University of California, Los Angeles.

In our paper, External Networking and Internal Firm Governance, forthcoming in the Journal of Finance, we use panel data on S&P 1500 companies to identify external network connections between directors and CEOs. We observe network connections stemming from shared external board seats, prior employment in other firms, education, or charitable and leisure activities. We test whether these ties affect firm policies and performance.

A well-functioning board of directors provides both valuable advice to management and a check on its policies. An effective director should not just rubber stamp management’s actions, but should take a contrarian opinion when management’s proposals are not in the interest of the firm’s shareholders. Thus, it is important to identify director characteristics which affect their ability or willingness to bring valuable new information into the firm and to properly perform their monitoring role. Our results suggest that having directors with external network ties to the CEO may undermine the effectiveness of corporate governance.


Moving Twenty-Two S&P 500 Companies towards Board Declassification

Lucian Bebchuk and Scott Hirst are Professor of Law, Economics and Finance and Lecturer on Law, respectively, at Harvard Law School. Their earlier post about the work of the ACGI is available here.

This post provides a summary of work to declassify corporate boards done during the 2010-11 proxy season by the American Corporate Governance Institute (ACGI). This work contributed to moving 22 S&P 500 companies toward board declassification, which could result in as much as a 15% reduction in the incidence of board classification among S&P 500 companies from the beginning of the 2010-11 proxy season.

During the 2010-2011 proxy season, the ACGI worked with two institutional investors, the Florida State Board of Administration (SBA) and the Nathan Cummings Foundation (NCF), on the submission of shareholder declassification proposals. The ACGI assisted these institutional investors with designing and drafting proposals, selecting companies for submission of proposals, communicating with the Securities and Exchange Commission with respect to no-action requests, engaging with companies to reach negotiated outcomes, and, when such negotiations were not successful, presenting proposals at shareholder meetings.

This work on behalf of the SBA and the NCF during this proxy season resulted in: (i) seven S&P 500 companies passing charter amendments to declassify their boards; (ii) six S&P 500 companies committing to submit management declassification proposals for shareholder approval at their 2012 shareholder meeting; and (iii) passage of shareholder declassification proposals, with average support of 82.2% of votes cast, at nine S&P 500 companies at which SBA and NCF proposals were voted on. We provide further details of each of these results below.

Charter Amendments to Declassify in Seven Companies

Following the submission of proposals, the ACGI assisted the SBA and NCF in negotiating and reaching agreements pursuant to which management agreed to bring charter amendments to declassify their boards of directors to a vote of shareholders. In addition, following the submission of one of the proposals (to Watson Pharmaceuticals, Inc.), the company announced a plan to bring a declassification proposal to a vote at its 2011 annual meeting. Altogether, the ACGI’s work contributed to the passage of seven charter amendments to declassify the boards of directors of S&P 500 companies. Those companies, with the percentage of votes cast and the percentage of outstanding shares supporting the declassification amendment, were as follows:


A Plan to Tax the Foreign Income of U.S. Companies

Editor’s Note: Robert Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. This post is based on an op-ed that appeared today in Bloomberg.

The current system for taxing foreign source income of U.S. corporations makes no sense. In theory, income earned by controlled foreign subsidiaries of American companies is taxed at the U.S. corporate rate of 35 percent; in practice, the Treasury receives no taxes on that income as long as it is held overseas. U.S. corporations now have overseas cash holdings of almost $2 trillion, which they are encouraged to deploy by acquiring companies and building facilities outside the U.S.

As an alternative, business lobbyists have advocated a so-called territorial system under which foreign source income would be taxed only in the country where it is earned. These lobbyists correctly argue that almost all advanced industrial countries now follow this system, though many don’t allow tax havens to take advantage of it.

This alternative is based on the premise that foreign source income is being taxed once somewhere, at a reasonable rate by a credible tax-enforcing government such as Germany. But this premise doesn’t apply to tax havens, like the Cayman Islands, where the tax rate is minimal, or a reasonable official rate isn’t enforced.


Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance?

The following post comes to us from Bernadette Minton of the Department of Finance at Ohio State University, Jérôme Taillard of the Department of Finance at Boston College, and Rohan Williamson of the Department of Finance at Georgetown University.

In our paper, Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance? which was recently made publicly available on SSRN, we examine how board independence and the percentage of financial experts among independent directors relate to risk taking and performance of commercial banks during the period from 2003 to 2008, which includes the most recent financial crisis. During the most recent financial crisis, banks and other financial institutions have been accused of engaging in excessive risk taking. Because boards are ultimately legally responsible for all major operating and financial decisions made by the firm, the recent crisis has been viewed by many as a general failure of board governance in the banking sector.

The composition of the board of directors should be a reliable proxy of how well the board can process information provided by insiders and advise as well as monitor the bank’s risk taking practices in the best interests of its shareholders. This study highlights the fact that larger and more independent boards are associated with lower levels of risk taking. We also document, on average, low levels of financial expertise among independent directors. Although many calls for reforms pinpoint the lack of financial expertise of the board as a reason behind the crisis, we show that during the crisis both stock performance and changes in firm value are worse for large banks with more financial expertise among its independent directors. Large banks are defined in this study as those with a bigger balance sheet than the median commercial bank at the onset of the financial crisis.


The Business Case for Corporate Social Responsibility

Matteo Tonello is Director of Corporate Governance for The Conference Board, Inc. This post is based on a Conference Board Director Note by Archie B. Carroll and Kareem M. Shabana, and relates to a paper by these authors, titled “The Business Case for Corporate Social Responsibility: A Review of Concepts, Research and Practice,” published in the International Journal of Management Reviews.

In the last decade, in particular, empirical research has brought evidence of the measurable payoff of corporate social responsibility (CSR) initiatives to companies as well as their stakeholders. Companies have a variety of reasons for being attentive to CSR. This report documents some of the potential bottomline benefits: reducing cost and risk, gaining competitive advantage, developing and maintaining legitimacy and reputational capital, and achieving win-win outcomes through synergistic value creation.

The term “corporate social responsibility” is still widely used even though related concepts, such as sustainability, corporate citizenship, business ethics, stakeholder management, corporate responsibility, and corporate social performance, are vying to replace it. In different ways, these expressions refer to the ensemble of policies, practices, investments, and concrete results deployed and achieved by a business corporation in the pursuit of its stakeholders’ interests.

This report discusses the business case for CSR—that is, what justifies the allocation of resources by the business community to advance a certain socially responsible cause. The business case is concerned with the following question: what tangible benefits do business organizations reap from engaging in CSR initiatives? This report reviews the most notable research on the topic and provides practical examples of CSR initiatives that are also good for the business and its bottom line.


Too Big to Fail or Too Big to Change

Chad Johnson is a partner in the litigation practice at Bernstein Litowitz Berger & Grossmann LLP. This post is based on an article by Ross Shikowitz in the Spring 2011 edition of the BLB&G publication Advocate for Institutional Investors.

Two and half years removed from the worst financial crisis since the Great Depression, the investing public has grown increasingly frustrated with the lack of criminal prosecutions of, and absence of truly significant fines levied against, the senior executives and companies responsible for igniting the subprime meltdown. Pundits have criticized the Securities and Exchange Commission (the “SEC”) and the Department of Justice (the “DOJ”) as capitulating to the interests of “big finance,” citing SEC settlements that have been characterized as mere “slaps on the wrist” and the DOJ’s failure to convict a single executive responsible for creating the “great recession” despite significant evidence of intentional misconduct.

For decades, the public’s trust in the integrity of U.S. capital markets was a source of economic stability and unparalleled prosperity. To maintain this trust, investors must believe that they compete on a relatively equal playing field and that the laws governing the markets will be strictly enforced. In furtherance of these goals, violators of federal rules face civil penalties from the SEC or criminal prosecution by the DOJ. In connection with previous corporate scandals, the government held a significant number of the principal wrongdoers civilly and criminally accountable for their misconduct. In the wake of the current financial crisis, however, many argue that the lack of such accountability has eroded the public’s faith in U.S. capital markets.


When It Pays to Pay Your Investment Banker

The following post comes to us from Andrey Golubov of Cass Business School, City University London; Dimitris Petmezas from the School of Management, University of Surrey; and Nickolaos Travlos of the ALBA Graduate Business School, Greece.

In our paper, When It Pays to Pay Your Investment Banker: New Evidence on the Role of Financial Advisors in M&As, forthcoming in the Journal of Finance, we provide new evidence on the role of financial advisors in M&As. Mergers and acquisitions (M&As) constitute one of the most important activities in corporate finance, bringing about substantial re-allocations of resources within the economy. In 2007 alone, when the most recent merger wave peaked, corporations spent $4.2 trillion on M&A deals worldwide. Investment banks advised on over 85% of these deals by transaction value, generating an estimated $39.7 billion in advisory fees.

The investment banking industry is dominated by a group of the so-called “bulge bracket” firms. These top-tier investment banks have built up reputation as experts in capital markets transactions, which, theoretically, should ensure that they perform superior services for their clients in return for premium fees. Surprisingly, however, the pertinent empirical literature fails to support this intuitive reputation-quality mechanism, and reports a negative or, at best, insignificant relationship between bidder financial advisor reputation and bidder returns in mergers and acquisitions. This raises several interesting questions. Does the reputational capital mechanism fail in the market for merger advisory services? If so, why do firms employ top-tier advisors? Are top-tier banks employed just as execution houses to ensure deal completion for their clients? Finally, are there situations where it pays off to pay for a top-tier financial advisor?


U.S. Supreme Court Clarifies the Scope of Private Liability Under Rule 10b-5

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 Mark A. Perry, who led the team that won the case in the U.S. Supreme Court, Janus Capital Group Inc. v. First Derivative Traders, which is discussed below; that decision is available here. For further discussion about the Janus case see also a client memorandum from Brad S. Karp at Paul, Weiss, Rifkind, Wharton & Garrison LLP, available here.

On June 13, 2011, the U.S. Supreme Court concluded that Janus Capital Management (JCM) cannot be held liable in a private suit under the Securities and Exchange Commission’s Rule 10b-5 for drafting allegedly misleading prospectuses for the mutual funds it advises. Reversing a contrary decision by the Fourth Circuit, the Court held in Janus Capital Group Inc. v. First Derivative Traders, No. 09-525, that the only proper defendant in a private Rule 10b-5 suit is the “maker” of a statement—”the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it,” slip op. at 6—and that “[t]he statements in the [mutual fund] prospectuses were made by [the mutual funds], not by JCM,” id. at 12.

JCM is a registered investment adviser that, among other things, advises the Janus family of mutual funds; the Janus Funds are governed by an independent Board of Trustees, and are not owned or controlled by JCM. First Derivative Traders invested in the stock of JCM’s parent company, Janus Capital Group Inc. (JCG). It alleged that the price of JCG’s stock was artificially inflated as a result of misleading statements in the Janus Funds’ prospectuses, and that JCM had drafted those statements. Although the district court dismissed the operative complaint for failure to state a claim, the Fourth Circuit reversed, holding that, “by participating in the writing and dissemination of the prospectuses,” JCM “made the misleading statements contained in [those] documents.” Slip op. at 4 (emphasis in original).


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