Monthly Archives: September 2011

The Myth of Corporate Tax Reform

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 in the Washington Post.

House Speaker John Boehner recently joined the chorus of notables calling for corporate tax reform in any deficit-reduction package. Both Democrats and Republicans want to reduce the corporate tax rate from 35 percent to 25 percent, in return for eliminating the tax credits and deductions available primarily to U.S. corporations.

The rationale behind the proposal is sound in theory — a lower tax rate would help all profitable corporations. By contrast, Congress often bestows tax benefits on industries that are perceived as potential winners or those wielding political clout.

In theory, this proposal would also be revenue-neutral. The rate reduction would decrease U.S. tax revenue by approximately $600 billion during the next five years, but this would be offset by the additional tax revenue gained with the elimination of corporate tax “loopholes.”

But the chances of this proposal passing Congress on a revenue-neutral basis are slim. Most of the corporate tax benefits that would need to be repealed have both a significant positive effect on economic growth and deep political support among powerful constituencies. Moreover, repeal would hurt many non-corporate entities, such as local governments and partnerships running operating businesses, that would gain nothing from a lower corporate tax rate.


Corporate Governance and the Information Content of Insider Trades

The following post comes to us from Alan Jagolinzer of the Department of Accounting at the University of Colorado; David Larcker, Professor of Accounting at Stanford University; and Daniel Taylor of the Department of Accounting at the University of Pennsylvania.

In the paper, Corporate Governance and the Information Content of Insider Trades, forthcoming in the Journal of Accounting Research, we examine the impact of the firm’s internal control process – specifically, actions taken by the general counsel (GC) – on addressing one specific governance issue, namely mitigating the level of informed trade. In order to investigate the effectiveness of the governance provisions in the insider trade policy (ITP) at mitigating informed trade, we examine the trades made by Section 16 insiders where we know the precise terms of the firm’s ITP. It is illegal for insiders to trade while in possession of material nonpublic information (Securities and Exchange Acts of 1933 and 1934; Insider Trading Sanctions Act of 1984 (ITSA); Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA)). However, prior research finds that insiders do appear to place, and profit from, trades based on superior information (e.g., Aboody and Lev, 2000; Ke et al. 2003; Piotroski and Roulstone, 2005; Huddart et al., 2007; Ravina and Sapienza, 2010). Building on these studies, we test the effectiveness of governance provisions in the ITP by examining whether such provisions are associated with (decreased) insider trading profits and the ability of insiders’ trades to predict future operating performance.


California Changes Law to Streamline Standards for Distributions and Dividends

Eduardo Gallardo is a partner focusing on mergers and acquisitions at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson Dunn Client Alert by David Hernand, Stewart McDowell, and Abigail Wen.

On September 1, 2011, the Governor of California signed into law California Assembly Bill No. 571 (“AB 571”), which will liberalize and streamline the legal standards for California corporations and quasi-California corporations to make cash and property distributions to shareholders, including dividends and share repurchases and redemptions. AB 571 amends portions of the California Corporations Code (the “Code”) limiting corporate distributions that have been in effect since 1977, which many lawyers and clients have found confusing and overly restrictive. The new law will make California’s restrictions on shareholder distributions more consistent with analogous restrictions applicable to California limited liability companies and limited partnerships and the corporate laws of most other states.

With AB 571, boards of directors of corporations will be free to consider the fair market value of a corporation’s assets, instead of historical carrying cost, and rely on whatever financial information a board deems reasonable under the circumstances, when determining whether the corporation has sufficient assets relative to its liabilities to distribute cash or property to its shareholders. This change alone will make it significantly easier for financially healthy corporations with historical book losses and appreciated assets (as is common with many growth companies) to pay dividends or redeem or repurchase shares.


Dodd Frank, One Year On

The following post comes to us from Paul Watterson, partner and co-head of the Structured Products & Derivatives Group at Schulte Roth & Zabel LLP, and is based on an article by Mr. Watterson and Craig Stein which was previously published in the International Finance Law Journal.

“Either the CFTC or the SEC may prohibit an entity from participating in the US swap markets if it is domiciled in a country whose regulation of swaps undermines the stability of the US financial system”.

In July 2010, in response to the financial crisis of 2008/9 which resulted in the deepest economic recession in the United States since the Great Depression of the 1930s, the United States Congress passed, and President Obama signed into law, the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act addresses a broad range of issues including consumer protection, rating agencies, systemic risk, executive compensation, private fund adviser registration, the so-called Volker Rule, and prudential risk regulation. A significant component of the Act is the regulation of derivatives and participants in derivative markets.

In What the changes really mean (IFLR Derivatives Supplement, July 2010), the same authors discussed the provisions of the Act. The main provisions of the legislation relating to derivatives are increased transparency, clearing and exchange trading requirements, regulation of swap dealers and other swap market participants, restrictions on swaps trading by banks and increased capital and margin requirements. It was left to the regulators to promulgate rules and regulations implementing many details of the Act. For almost a year now, the regulators have been proposing many rules and industry participants have been commenting on those proposals. On some issues, the industry is still anxiously awaiting proposed rules in order to obtain clarification of the Act. Due to the incredibly large volume of rules that the regulators were required to adopt and the long process for public comments on proposed rules, although parts of the Act were originally intended to become effective beginning July 16 2011, that date may be extended.


Dodd-Frank for Bankruptcy Lawyers

The following post comes to us from Douglas G. Baird, Professor of Law at the University of Chicago, and Edward R. Morrison, Professor of Law and Economics at Columbia University.

In our paper, Dodd-Frank for Bankruptcy Lawyers, which was recently made publicly available on SSRN, we identify the core congruities between an “Orderly Liquidation Authority” (OLA) created by the Dodd-Frank financial reform legislation and the Bankruptcy Code. Title II of Dodd-Frank removes bankruptcy court jurisdiction from only a narrow range of cases—“financial companies” whose failure is sufficiently threatening to market stability. The vast majority of giant businesses, including systemically important ones (i.e., the General Motors of the next great recession), are not “financial companies” within the meaning of Title II. They remain squarely in the province of bankruptcy law. Moreover, the mechanics of the new receivership process incorporate basic bankruptcy principles. They effectively permit reorganization as well as liquidation, debtor-in-possession financing, asset sales free and clear of existing liens, claw-back of prepetition fraudulent and preferential transfers, and safe harbors for financial contracts.


Future of Institutional Share Voting Revisited: A Fourth Paradigm

Charles Nathan is Of Counsel at Latham & Watkins LLP and is co-chair of the firm’s Corporate Governance Task Force. This post is based on a Latham & Watkins Corporate Governance Commentary; the complete commentary, including omitted footnotes, is available here.

The Prevailing One-Size-Fits-All Voting Policy Paradigm

A year ago, we published a Corporate Governance Commentary titled Future of Institutional Share Voting: Three Paradigms. We began by observing that the prevailing paradigm for institutional investors voting of portfolio company shares is to delegate all but the most obvious economically related voting decisions to either an internal or external corporate governance team that is largely, or all too often totally, separate from the investment policy decision making team— in effect, a parallel universe of voting decision makers. Because of the huge number of voting decisions facing institutional investors, the prevailing corporate governance methodology for deciding how to vote portfolio shares is to apply formulaic voting policies that push all portfolio companies, no matter how different their particular circumstances, through a uniform one-size-fits-all voting mold.


Accounting Standards and Debt Covenants

The following post comes to us from Peter Demerjian of the Goizueta Business School at Emory University.

In the paper, Accounting Standards and Debt Covenants: Has the “Balance Sheet Approach” Led to a Decline in the Use of Balance Sheet Covenants?, forthcoming in the Journal of Accounting and Economics as published by Elsevier, I examine whether the “balance sheet approach” has led to a decline in the use of balance sheet covenants. Debt contracts, and especially private loan agreements, frequently include accounting-based debt covenants. Many of these covenants require the borrower to maintain a threshold level of some financial ratio or measure. A broad range of financial measures are employed in these financial covenants. Some are written on earnings from the income statement; the borrower may be required to maintain a minimum level of earnings relative to their interest expense (interest coverage) or their total debt (debt-to-earnings). Similarly, covenants are also written on values from the balance sheet; these include covenants requiring a minimum level for the book value of equity (net worth) or a maximum amount of debt in the capital structure (leverage). If the borrower fails to maintain a covenant threshold, the debt enters technical default. In technical default, the creditor has the option to attempt action against the borrower; a common consequence is renegotiation with stricter contract terms.


CFTC Finalizes Whistleblower Bounty Program

The following post comes to us from Mark D. Young, partner in the Derivatives Regulation and Litigation Group at Skadden, Arps, Slate, Meagher & Flom LLP, and is based on a Skadden, Arps memorandum by Mr. Young, Prashina J. Gagoomal, and Timothy S. Kearns.

On August 4, 2011, the Commodity Futures Trading Commission (CFTC or Commission) voted 4-1 to adopt final regulations implementing the whistleblower incentives and protections set forth in Section 748 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). See 76 Fed. Reg. 53172 (Aug. 25, 2011) (to be codified at 17 C.F.R. Part 165). The CFTC’s whistleblower program generally obligates the CFTC to pay a bounty to whistleblowers who provide information leading to the assessment of monetary sanctions against those found to have violated the Commodity Exchange Act (CEA). The reach of the whistleblower provisions is quite broad — they apply to “any individual” (not just employees of companies) and to information regarding any possible violation of the CEA. Dodd-Frank Section 748 also creates strong, new anti-retaliation protections for individuals who provide information to the CFTC.


The Urgent Need to Re‑establish the Investor Advisory Committee

Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on a statement by Commissioner Aguilar available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Recently, the Securities and Exchange Commission (“SEC”) announced the formation of a new Advisory Committee on Small and Emerging Companies (the “ACSEC”), pursuant to the Federal Advisory Committee Act. My vote to approve the establishment of the ACSEC was conditioned on the Investor Advisory Committee [1] being formed and operating prior to, or at the same time as, the formation of the ACSEC.

Advisory committees are an extraordinary way of providing input to the SEC. Establishing an advisory committee grants special access to a small group of representatives that is funded by public taxpayer money. This should not be done lightly. Since 1972, advisory committees have been subject to regulation under the Federal Advisory Committee Act. Concerned about inappropriate influence in public policy and waste of federal resources, [2] the Federal Advisory Committee Act seeks to ensure that resources are allocated responsibly and that the membership of each committee is “fairly balanced in terms of the points of view represented.” [3]


Contractual Versus Actual Severance Pay Following CEO Turnover

The following post comes to us from Eitan Goldman of the Department of Finance at Indiana University and Peggy Huang of the Department of Finance at Tulane University.

In our paper, Contractual Versus Actual Severance Pay Following CEO Turnover, which was recently made publicly available on SSRN, we analyze the bargaining game between the CEO and the board of directors at the time of CEO departure. We find that about 40% of S&P500 CEOs who leave their firm receive separation payments that are in excess of what the firm is legally required to give them based on their existing contract. Furthermore, we find that the average discretionary separation pay is around $8 million – close to 242% of a CEO’s annual compensation. The analysis in the paper aims to uncover the reasons behind this discretionary pay and the source of CEO power exactly at the point in time when the CEO is least likely to have any ability to bargain.

Specifically, we investigate whether CEOs who receive discretionary pay are those who have control over the board of directors or whether discretionary pay represents a tool used by the board of directors in order to help and facilitate an amicable and efficient departure of the incumbent CEO. We hypothesize that in cases when the CEO departure is voluntary, discretionary separation pay represents a governance problem. By contrast, we hypothesize that when the CEO is forced to depart, discretionary separation pay is used to help the company move on from the failed ex CEO to a better one, specifically by reducing the likelihood of a prolonged battle with the departing CEO.


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