Monthly Archives: July 2011

Intellectual Capital, Corporate Governance, and Firm Value

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, July 18, 2011
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The following post comes to us from Paul Kalyta of the Department of Accounting at McGill University.

Previous empirical studies on the benefits of “good” governance perform comprehensive and detailed analyses of corporate governance structures and regulations, but make no reference to the board’s intellectual capital, or knowledge, thereby substantially limiting the understanding of the role of corporate governance in organizational value creation. In the paper, Intellectual Capital, Corporate Governance, and Firm Value, which was recently made publicly available on SSRN, I address this gap.

I use the number of scientists on the board of directors as a proxy for the board’s intellectual capital and investigate the impact of directors-scientists on firm value in the population of publicly-listed U.S. firms. I expect a positive contribution of scientists to firm value in knowledge-intensive sectors, such as information technology, pharmaceuticals and chemical products, characterized by significant R&D activities, product innovation, and long-term projects. Boards with strong scientific expertise are more likely to make effective strategic R&D decisions and subsequently monitor these decisions effectively than boards with limited scientific experience. Directors with scientific background are also expected to have a longer decision horizon than other directors; the boards with strong scientific expertise are therefore more likely to select long-term projects that maximize the firm’s net present value instead of the projects that focus on current profits.

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An Introduction to the US Cleared Swap Infrastructure

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, July 17, 2011
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The following post comes to us from David Felsenthal, a partner at Clifford Chance LLP focusing on financial transactions, and is based on a Clifford Chance client memorandum by Mr. Felsenthal, Gareth Old and David Yeres.

Introduction

In September 2009, the leaders of the G-20 stated that “All standardized OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”

In the United States, legislation to give effect to this statement was a central pillar of the over-the-counter derivates provisions of the Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Dodd-Frank requires that, following the effective date of detailed rules, standardized swaps that are accepted for clearing by clearing organizations must be submitted by the parties to the relevant clearing organization, unless one of the parties is an end-user exempt from the clearing requirement. Further, unless an end-user exemption applies, if a swap is accepted for trading by a registered execution facility, it must be traded on the exchange or by an approved off-exchange transaction like a block trade or “request-for-quote” (see “Swap Execution Facility” below).

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SEC Enforcement Actions Against Outside Directors Offer Reminder for Boards

Posted by Matteo Tonello, The Conference Board, on
Saturday, July 16, 2011
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Matteo Tonello is Director of Corporate Governance for The Conference Board, Inc. This post is based on a Conference Board Director Note by Amy L. Goodman and Justin S. Liu of Gibson, Dunn & Crutcher LLP, and is adapted from a Gibson Dunn client memorandum titled “SEC Targets Directors Who Ignore Red Flags.”

In recent months, the U.S. Securities and Exchange Commission has brought two enforcement actions against independent directors of two publicly traded companies. While the commission historically has not pursued public company directors, it does so when it deems the directors to have knowingly permitted or facilitated violations of the securities laws. This report discusses these recent cases in light of the SEC’s historical position on such offenses and offers recommendations for how board members can mitigate their risks.

The SEC enforcement actions were against four independent directors at two publicly traded companies. While these actions reflect the SEC’s interest in bringing actions against these types of directors, they are consistent with the commission’s historical practice of pursuing cases against independent directors only when it believes that they personally have engaged in violative conduct or have repeatedly ignored significant red flags (see “Historical SEC Actions against Outside Directors” below). One of the actions, which was brought as an administrative proceeding instead of as a complaint in federal court, illustrates how the commission may choose to use some of its new enforcement powers under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).

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The Volcker Rule and Evolving Financial Markets

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, July 15, 2011
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The following post comes to us from Charles K. Whitehead, an Associate Professor of Law at Cornell Law School. This post is part of a series discussing articles appearing in the inaugural issue of the Harvard Business Law Review, which is published in partnership with the Harvard Law School Program on Corporate Governance.

In the paper, The Volcker Rule and Evolving Financial Markets, published in the inaugural issue of the Harvard Business Law Review, I question the effectiveness of the Volcker Rule in light of change in the financial markets over the last thirty years. The Volcker Rule largely prohibits proprietary trading by banking entities—in effect, reintroducing to the financial markets a substantial portion of the Glass-Steagall Act’s static divide between banks and securities firms. By removing proprietary trading, the Rule’s proponents expect utility services, such as taking deposits and making loans, to once again dominate the commercial banking business,

There is considerable uncertainty around the scope of the Volcker Rule and its impact on the financial markets, highlighted—but not resolved—by the recently published Financial Stability Oversight Council study. Chief among the concerns is defining “proprietary trading.” Trading activity can vary among markets and by asset class, and so what constitutes a “near term” or “short-term” transaction for one instrument, subject to the Volcker Rule, may be quite different for another. How, if at all, should the Volcker Rule distinguish among them? In addition, different firms employ different trading strategies, and so what would be considered proprietary at one firm may not be the same at another. A firm may also vary its approach to trading based on changes in the marketplace. A longer-term investment, for example, may be resold quickly in the face of an increasingly volatile market. How can regulators distinguish between changes in strategy and prohibited transactions? And how should regulators separate prohibited transactions from permitted activities, such as market-making?

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SEC Adopts Rule on Beneficial Ownership of Security-Based Swaps

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Friday, July 15, 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, Linda A. Simpson and Gabriel D. Rosenberg.

The SEC has readopted portions of Rules 13d-3 and 16a-1 to ensure that its current beneficial ownership definition, which applies for purposes of disclosure and short-swing profit rules, will continue in effect with respect to persons who purchase or sell security-based swaps (“SBS”) on and after July 16, 2011.

SBS include products such as credit default swaps on a single security or loan or a total return swap on one or a narrow-based index of securities, other than government securities. Currently, under Rules 13d-3 and 16a-1, contracts that will become SBS on July 16 may involve beneficial ownership for purposes of Sections 13 and 16 of the Exchange Act as follows:

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The Re-Introduction of the Shareholder Protection Act

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, July 14, 2011
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Editor’s Note: Lucian A. Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School. Robert J. Jackson, Jr. is Associate Professor of Law at Columbia Law School. Their paper, “Corporate Political Speech: Who Decides?”, is available here, and a previous Forum post discussing the paper is available here.

Several prominent members of the U.S. Senate and House of Representatives re-introduced yesterday the Shareholder Protection Act for debate. The bill would establish special corporate-governance rules for deciding when corporate resources may be spent on politics. Although it appears that the bill is unlikely to be adopted during this Congress, the approach it represents deserves consideration and support. In an article published last year in the Harvard Law Review, “Corporate Political Speech: Who Decides?,” we presented the case for such an approach. As we argued in “Corporate Political Speech,” political speech decisions are different from ordinary business decisions—and, thus, special rules are needed for deciding when a corporation may spend shareholder resources on politics.

The Shareholder Protection Act would establish a legal structure with three types of rules that apply when public companies wish to use corporate resources for political activity. These rules would require extensive disclosure, a role for independent directors, and shareholder approval.

First, the Shareholder Protection Act would require companies to disclose to shareholders each year both the amounts and recipients of the company’s spending on politics. Existing election law does not require disclosure of significant amounts of corporate spending on politics—especially contributions to intermediaries. Indeed, our article provided evidence indicating that five intermediaries who receive corporate contributions spent more than $130 million on lobbying and politics during the 2008 election cycle alone. Although the Act would mandate these disclosures by statute, the SEC currently has the authority to require disclosures of this type, and we urge the SEC to develop rules that would require that shareholders be given information on corporate political spending.

Second, the Act would require oversight of political spending by the board of directors. In our view, like other areas in which corporate law requires directors to take an active role in certain decisions—for instance, executive pay and financial audits—directors should be required to oversee corporate spending on politics. Because the interests of executives and shareholders may often diverge with respect to such spending, director oversight is especially desirable in this area. We also favor requiring directors to provide shareholders, in each year’s proxy statement, with a report explaining their choices and policies concerning the company’s spending on politics.

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What Should Be Done About the Private Money Market?

Posted by Morgan Ricks, Harvard Law School, on
Wednesday, July 13, 2011
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Morgan Ricks is a visiting assistant professor at Harvard Law School. This post is part of a series discussing articles appearing in the inaugural issue of the Harvard Business Law Review, which is published in partnership with the Harvard Law School Program on Corporate Governance.

What should be done about the private money market? It is widely recognized that this market was at the center of the recent financial crisis. Indeed, very nearly the entire emergency response to the financial crisis was aimed at stabilizing this market. Yet recent and proposed reform measures have done little to address this market squarely.

It is important to be precise about terminology. The term “private money market” refers to the multi-trillion dollar market for short-term IOUs that are neither issued by nor guaranteed by the federal government. This market includes repurchase agreements (“repo”), asset-backed commercial paper (“ABCP”), uninsured deposit obligations, and so-called Eurodollar obligations of foreign banks. It also includes the “shares” of money market mutual funds. (Contrary to widespread belief, commercial paper issued by non-financial firms is only a tiny fraction of the private money market—on the order of 2%. That is to say, the private money market is dominated by financial issuers, not commercial or industrial ones.)

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Supreme Court Limits the Power of Bankruptcy Courts to Hear Certain State Law Claims

Posted by Donald S. Bernstein and Marshall S. Huebner, Davis Polk & Wardwell LLP, on
Wednesday, July 13, 2011
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Donald Bernstein and Marshall Huebner co-head the Insolvency and Restructuring Practice at Davis Polk & Wardwell LLP. This post is based on a Davis Polk client memorandum which discusses the Supreme Court decision in Stern v. Marshall, which is available here.

Recently, the United States Supreme Court affirmed a 2010 ruling of the Ninth Circuit Court of Appeals and held that a bankruptcy court, as a non-Article III court, did not have the constitutional authority to decide a state law claim brought by a debtor against a creditor, even though the matter was part of the “core” statutory jurisdiction of the bankruptcy court. This significant decision limits the power of bankruptcy courts and may have wide-ranging implications, requiring certain types of claims to be decided in a non-bankruptcy forum, even where they are central to a debtor’s bankruptcy case.

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How the SEC Should Consider Possible Changes in Section 13(d) Rules

Posted by Lucian Bebchuk, Harvard Law School, and Robert J. Jackson, Jr., Columbia Law School, on
Tuesday, July 12, 2011
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Lucian A. Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School, and Robert J. Jackson, Jr. is Associate Professor of Law at Columbia Law School. This post is based on the authors’ submission to the SEC available here. An earlier post describing the Wachtell, Lipton rulemaking petition to which this post refers is available here.

In a letter submitted yesterday to the Securities and Exchange Commission, we provide a detailed analysis of the policy issues relevant for the Commission’s ongoing examination of changes to its rules under Section 13(d) of the Securities Exchange Act of 1934. These rules, which govern share accumulation and disclosure by blockholders, are the subject of a recent rulemaking petition submitted by Wachtell, Lipton, Rosen and Katz, which proposes that the rules be tightened.

We argue that the Commission should not view the proposed tightening as merely “technical” changes needed to modernize its Section 13(d) rules. In our view, the proposed changes should be examined in the larger context of the beneficial role that outside blockholders play in American corporate governance and the broad set of rules that apply to such blockholders.

Our analysis proceeds in five steps. First, we describe the significant empirical evidence indicating that the accumulation and holding of outside blocks in public companies benefits shareholders by making incumbent directors and managers more accountable and thereby reducing agency costs and managerial slack.

Second, we explain that tightening the rules applicable to outside blockholders can be expected to reduce the returns to blockholders and thereby reduce the incidence and size of outside blocks—and, thus, blockholders’ investments in monitoring and engagement, which in turn may result in increased agency costs and managerial slack.

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The Change in Information Uncertainty and Acquirer Wealth Losses

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, July 11, 2011
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The following post comes to us from Merle Erickson, Professor of Accounting at the University of Chicago; Shiing-Wu Wang of the Accounting Department at the University of Southern California; and X. Frank Zhang of Yale School of Management.

In this paper, The Change in Information Uncertainty and Acquirer Wealth Losses, forthcoming in the Review of Accounting Studies, we examine the possibility that the change in the acquiring firm’s information uncertainty is a factor contributing to acquiring firms’ long-term post-acquisition stock underperformance. By information uncertainty, we mean investors’ perceived uncertainty about a firm’s fundamentals, which captures the second moment of fundamentals. Prior literature focuses on the first moment of acquirer fundamentals. Uncertainty affects the discount rate (the cost of capital), which in turn influences stock price. Our discount rate theory offers an alternative explanation to the market’s mispricing of the acquirers’ fundamentals as a source of acquirers’ long-term underperformance. As suggested by standard finance theory, stock price responds to changes in either fundamentals or the discount rate. The prolonged integration process of M&As and complicated financial reporting issues are not fully anticipated ex ante and are likely to increase the uncertainty of the combined entity. An increase in acquirer’s uncertainty causes investors to demand a higher premium (higher cost of capital) to compensate for the rise in uncertainty/risk, which in turn results in acquirer stock price declines.

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