Monthly Archives: August 2011

Implications of the Proxy Access Case

The following post comes to us from David B.H. Martin, co-head of the securities practice at Covington & Burling LLP, and is based on a Covington advisory memorandum by Mr. Martin and Keir D. Gumbs. Other posts related to proxy access, including a number by Lucian Bebchuk and Scott Hirst of the Program on Corporate Governance, are available here.

On July 22, 2011, the U.S. Court of Appeals for the D.C. Circuit issued a long-awaited decision in the case of Business Roundtable and Chamber of Commerce v. Securities and Exchange Commission, No. 10-1305 slip op. (D.C. Cir. Jul. 22, 2011), which vacated Rule 14a-11, the SEC’s shareholder access rule. By vacating the rule, the D.C. Circuit has dealt a significant blow to the SEC’s longstanding efforts to adopt a rule that would require, under certain circumstances, that public companies include in their proxy materials shareholder-proposed nominees to the board of directors. The decision also has import that goes significantly beyond shareholder access, as it will challenge the SEC (and, likely, other agencies) in assessing the economic consequences of future rulemakings. Nevertheless, the court’s decision does not end the shareholder access debate. Under an amendment to the shareholder proposal rule (Rule 14a-8) that was adopted last year at the same time as the shareholder access rule and voluntarily stayed by the SEC pending the outcome of the shareholder access rule litigation, shareholders may yet be able to submit shareholder proposals that seek to establish shareholder access regimes in 2012. The SEC has not yet indicated whether it will lift this stay, but there is no legal reason why it could not do so.

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Does the Director Election System Matter?

The following post comes to us from Yonca Ertimur of the Department of Accounting at Duke University and Fabrizio Ferri of the Department of Accounting at Columbia University.

In our paper, Does the Director Election System Matter? Evidence from Majority Voting, which was recently made publicly available on SSRN, we examine the economic consequences of a change in the director election system, namely, the switch from a plurality voting to a majority voting standard.

Under a plurality voting standard—until recently the default arrangement under most state laws—the candidate with the most votes “for” is elected, a system that helps avoid the disruptive effects of failed elections. In uncontested elections, the plurality voting standard means that each nominee will always be elected as long as she receives one vote “for,” irrespective of the number of votes “withheld” (under SEC rule 14a-4(b) shareholders cannot vote “against” a director nominee, they can only vote “for” or “withhold” support).

Under a majority voting (MV) standard, instead, even in uncontested elections a director would not be elected unless the majority of votes were cast in her favor. Starting in 2004, firms have begun to adopt some form of MV standard, often in response to non-binding shareholder proposals filed by activists and policy makers have debated whether to mandate a MV standard. By the end of 2007, about two thirds of the S&P 500 firms had adopted some form of MV.

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New Liability Exposure for Intermediaries in Private Placements

The following post comes to us from Roger Wiegley, General Counsel at AXA Liabilities Managers and founder of The Corporation Secretary.

The recent Supreme Court decision in Janus Capital Group, Inc. v. First Derivative Traders confirmed prior Court decisions regarding Rule 10b-5 of the Securities Exchange Act of 1934: Intermediaries in securities transactions could not be found liable for the issuer’s or seller’s violation of that rule. Fund managers and other intermediaries, such as broker-dealers, have no doubt taken great comfort in the Janus Capital decision. That comfort is misplaced. New provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act should dramatically change the liability exposure of intermediaries in the sale of securities.

Under Rule 10b-5, adopted by the SEC in 1942 pursuant to Section 10(b) of the 1934 Act, it is unlawful “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading” in connection with the purchase or sale of securities. This clearly applies to issuers and sellers, but the question before the Court in Janus Capital and prior cases has been the extent to which intermediaries in a securities transaction can be found liable for the issuer’s or seller’s primary violation. Somewhat surprisingly, in the past seventeen years the Supreme Court has considered this question twice before its most recent decision.

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Making the Business Case for Corporate Philanthropy

Matteo Tonello is Director of Corporate Governance for The Conference Board, Inc. This post is based on a Conference Board Director Note by Baruch Lev of New York University, Christine Petrovits of George Washington University, and Suresh Radhakrishnan of the University of Texas at Dallas. It is partially adapted from their paper “Is Doing Good Good for You? How Corporate Charitable Contributions Enhance Revenue Growth,” available here.

Companies engage in corporate philanthropy for a mix of reasons. Charitable contributions have the potential to increase shareholder value. Nevertheless, executives also make corporate giving decisions based on self-interest. This report provides practical recommendations to companies and boards for ensuring the legitimacy of their corporate giving programs.

Corporations gave approximately $14.1 billion to a wide array of nonprofit organizations in 2009. [1] Despite the fact that almost all companies contribute some money to charity, corporate philanthropy remains controversial. Proponents believe that companies have a moral obligation to assist the communities in which they do business. Critics contend that corporate giving programs consume company resources and, more often than not, further the goals of management rather than the goals of shareholders. Most recently, corporate philanthropy has been labeled “tantamount to theft” and “a tax on shareholders.” [2] The opposing camps find common ground when corporate giving improves shareholder value as well as social welfare.

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Institutional Ownership and Conservatism

The following post comes to us from Santhosh Ramalingegowda of the Department of Accounting at the University of Georgia and Yong Yu of Department of Accounting at the University of Texas at Austin.

In our paper, Institutional Ownership and Conservatism, forthcoming in the Journal of Accounting and Economics as published by Elsevier, we examine the relation between institutional ownership and accounting conservatism. Ball (2001) and Watts (2003) propose that equity investors are an important source of demand for conservatism as a governance device. Recent empirical evidence supports this proposition. Consistent with equity investors creating demand for conservatism, LaFond and Roychowdhury (2008) show that conservatism is greater when the separation of ownership and control is more pronounced, and LaFond and Watts (2008) find that higher information asymmetry between managers and shareholders leads to more conservative reporting. These findings raise an important question: Which equity investors demand conservatism?

A large body of research documents that individual investors are generally small unsophisticated investors who trade primarily for reasons unrelated to information (e.g., liquidity or rank speculation). Accordingly, individuals are unlikely to be sophisticated enough to gauge whether firms consistently use conservative financial reporting. In contrast, institutional investors are both more sophisticated and more important price setters in capital markets. Thus, if conservative financial reporting provides governance benefits, institutional investors are more likely to understand and value such benefits, and as a result, demand conservative accounting from managers. On the other hand, as institutional investors likely have privileged access to management and inside information (Carleton et al. 1998), they may rely more on direct monitoring and less on monitoring through accounting numbers. Thus, whether institutions demand conservative financial reports is an empirical question.

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The Challenges of Implementing the Dodd-Frank Act

Editor’s Note: Kathleen L. Casey is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Casey’s recent remarks before the Forum for Corporate Directors, which are available here. The views expressed in the post are those of Commissioner Casey and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

I thought I would try and give you some insight into what is happening on the ground, so to say, at the SEC as well as highlight some of the implications and implementation issues flowing from the new Dodd-Frank law. Some of these issues are worth closely noting because I believe they signal important shifts in how we have historically regulated our financial markets and raise serious questions about how such a shift will affect investor choice and protection, U.S. capital formation, innovation and competitiveness.

It’s early Spring in Washington, and while that means March Madness and filling out NCAA tournament brackets to most people, at the SEC it means filling out ambitious Dodd-Frank rulemaking mandates. Personally, I am a hockey fan, so I wouldn’t know better anyway.

That said, in many ways, I think it is hard for people to appreciate the enormity of what Dodd-Frank requires of federal regulators, and, in particular, the SEC. In terms of breadth and scope, Dodd-Frank is arguably the most significant financial legislation in modern history. The legislation ushers in a breathtaking amount of changes that will result in fundamental shifts in the legal, regulatory and policy landscape affecting our markets and our economy in a short period of time. These changes touch every aspect of our financial markets, from consumer credit to proprietary trading at financial firms, from OTC derivatives markets to securitization markets, and from private fund registration and regulation to corporate governance at public companies.

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What Now For Proxy Access?

Stanley Keller is a partner at Edwards Angell Palmer Dodge LLP. Other posts related to proxy access, including a number by Lucian Bebchuk and Scott Hirst of the Program on Corporate Governance, are available here.

With the United States Court of Appeals for the District of Columbia Circuit having struck down Rule 14a-11 in Business Roundtable et al v. Securities and Exchange Commission (No. 10-1305, July 22, 2011), the question is where does proxy access now stand and what can now be expected?

The Court overturned the SEC’s attempt to give shareholders the right under the federal proxy rules to have their director nominees included in management’s proxy materials because of the SEC’s failure to adequately justify Rule 14a-11 on a cost-benefit basis. The SEC has several alternatives which undoubtedly are being considered. It could seek rehearing either by the panel or en banc or appeal the decision to the U.S. Supreme Court, it could amplify its analysis of the economic justification for Rule 14a-11 and readopt the rule, it could modify Rule 14a-11 and seek to justify the modification in a way that it believes will pass judicial scrutiny, or it could do nothing on Rule 14a-11 and let it disappear. Under any of these alternatives, the question is what will the SEC do about the amendment of Rule 14a-8, which offers another route to proxy access through shareholder proposals. The amendment has been stayed pending resolution of the court action challenging Rule 14a-11 and further notice from the SEC. Again, the SEC has several alternatives – it could lift the stay and let the amendment take effect as adopted or it could revisit the Rule 14a-8 amendment. I will not presume to predict what the SEC will do, or worse, tell it what it should do regarding Rule 14a-11. However, I have some observations regarding a path forward.

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CSX Decision Narrows Definition of Section 13(d) Groups

Phillip Goldstein is the co-founder of Bulldog Investors. This post discusses the recent Second Circuit Appeals Court decision in CSX Corp. v. The Children’s Inv. Fund Mgmt. (UK) LLP, available here.

I think that for most activist shareholders the most significant takeaway from the Second Circuit’s CSX opinion is not about swap contracts.

More important is that it reduces the fear that mere communication between like-minded shareholders can subject them to a lawsuit alleging that they formed an undisclosed 13d group. The Court significantly narrowed the ability of an issuer (or the SEC) to allege that such a group exists. Merely alleging “concerted action” is not enough. Instead, applying the statute literally requires that coordinated purchases must be alleged (and proven). It said:

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Shelf-Eligibility Requirements for Asset-Backed Securities

Editor’s Note: Mary Schapiro is Chairman of the U.S. Securities and Exchange Commission. This post is based on Chairman Schapiro’s opening statement at a recent open meeting of the SEC, which is available here. The views expressed in the post are those of Chairman Schapiro and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff. This post discusses re-proposed rules concerning asset-backed securities, available here.

Next, we will consider re-proposing rules outlining the requirements for an issuer of asset-backed securities to be able to use shelf registration.

Today’s actions partially re-propose a set of rules the Commission proposed in April 2010 that would significantly revise the regulatory regime for asset backed securities. Among other things, the 2010 proposals were designed to increase transparency and to improve the quality of securities that are offered through the shelf registration process.

Subsequent to our proposal, Congress — through the Dodd-Frank Act — sought to address some of the same concerns and we have reevaluated the proposals in light of those provisions. The proposals today also take into consideration suggestions from commenters on the April proposal.

Today the staff is recommending that we re-propose shelf eligibility requirements for ABS issuers and seek additional comment on certain parts of our April 2010 proposal.

As we consider a final set of rules, we will look to the rules we proposed in 2010 as well as the revisions to those proposals we are considering today.

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Corporate Governance Reforms and Cross-Border Acquisitions

The following post comes to us from E. Han Kim, Professor of Finance and International Business at the University of Michigan, and Yao Lu of the School of Economics and Management at Tsinghua University.

In our paper, Corporate Governance Reforms and Cross-Border Acquisitions, which was recently made publicly available on SSRN, we investigate how investor protection affects the allocation of foreign capital inflows at the firm level. A simple model provides an explanation for a well-documented but little understood phenomenon on international capital flows—the tendency of foreign investors to target better-performing firms in emerging markets.

When a foreign acquirer‘s country has stronger IP than a target country, the acquirer‘s controlling shareholder values control premiums less than controlling shareholders of local firms because stronger IP imposes greater constraints on diversion for private benefits. Within the target country, controlling shareholders of firms with more profitable investments take fewer private benefits and, hence, demand lower control premiums. Foreign acquirers, which value control premiums less, will target firms with more profitable investments. This cherry picking tendency will intensify (moderate) as the IP gap between the acquirer and target countries increases (decreases).

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