Monthly Archives: June 2011

Should Size Matter When Regulating Firms?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, June 13, 2011
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The following post comes to us from Deniz Anginer, Financial Economist in the Development Research Group at the World Bank; M. P. Narayanan, Professor of Finance at the University of Michigan; Cindy Schipani, Professor of Business Law at the University of Michigan; and H. Nejat Seyhun, Professor of Finance at the University of Michigan.

In our paper, Should Size Matter When Regulating Firms? Implications from Backdating of Executive Options [15 N.Y.U. J. Legis. & Pub. Pol’y (forthcoming Winter 2011)], we present a data point relevant to significant issues of policy concerning areas of law where small firms have either been granted exemption from regulations or not investigated for violations of laws that, on their face, apply to them. Whether small firms should be exempted is an empirical question the answer to which depends on the likelihood of such firms violating regulations.

There are numerous instances in the law where small firms have been granted exemptions from regulatory restrictions. The major justification offered by the proponents for this exemption of small firms is the claim that regulation has a disproportionate effect on these companies. For example, in the area of securities law, regulation of small firms has drawn criticism throughout the years. It has been lamented that “the [Securities Exchange Commission] SEC [has] never . . . understood small businesses, their capital needs, their importance to our economy, and the special circumstance they face…” Similarly, since its enactment in 2002, the Sarbanes-Oxley legislation (SOX) has been highly criticized for the level of expense it has imposed upon firms’ efforts to comply with the legislation. In order to decide if regulation should be lenient towards small firms, we need to first understand what types of firms are likely to be engaged in illicit activity. If we knew that small firms are also likely to violate laws, as a matter of public policy, should we continue to exempt firms from regulatory scrutiny solely due to size? That is, should size matter in regulatory policy decisions? Furthermore, should size be a factor when prosecutors target firms for investigation?

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June 2011 Dodd-Frank Rulemaking Progress Report

Posted by Margaret E. Tahyar, Davis Polk & Wardwell LLP, on
Sunday, June 12, 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. Other posts about the Dodd-Frank Act are available here.

This posting, the Davis Polk Dodd-Frank Rulemaking Progress Report, is the third 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.

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Strine Nominated for Chancellor

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, June 10, 2011

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The HLS Forum was pleased to learn that Vice Chancellor Leo Strine, Jr., a Senior Fellow of the Harvard Law School Program on Corporate Governance, has been nominated for the position of Chancellor of the Delaware Chancery Court.

Vice Chancellor Strine is the author of many important and influential decisions, as well as numerous insightful academic articles. Forum posts about his decisions appear here (relating to Yucaipa American Alliance Fund II, L.P. v. Riggio), here (discussing Production Resources Group v. NCT Group, Inc.), and here (discussing the American International Group, Inc. Consolidated Derivative Litigation).

At Harvard, Vice Chancellor Strine has been co-teaching the Mergers & Acquisitions course with Professor Robert Clark, and has participated in the activities of the Program on Corporate Governance, including most recently the Program’s M&A Roundtable. We wish Vice Chancellor Strine the best of luck with the important role of Chancellor.

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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