Monthly Archives: September 2011

Executive Compensation and R&D Intensity

The following post comes to us from Rajiv Banker, Professor and Merves Chair of Accounting and Information Technology at Temple University; Dmitri Byzalov, Assistant Professor of Accounting at Temple University; and Chunwei Xian, Assistant Professor of Accounting at Northeastern Illinois University.

In our paper, Executive Compensation and Research & Development Intensity, which was recently made publicly available on SSRN, we examine the mediating effect of R&D intensity on the weights on signals of ability and financial performance measures in executive compensation contracts. There are many prior studies that investigate the impact of R&D intensity on total executive compensation (e.g., Dechow and Sloan 1991; Kwon and Yin 2006; Cheng 2004). However, prior studies did not incorporate adverse selection in their analysis. In other words, they did not investigate how R&D intensity affects the role of managerial ability in executive compensation. In contrast, we investigate how R&D intensity impacts the weights placed on human capital measures such as technical work experience, science and engineering degrees, and past experience in R&D intensive firms.

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A Closer Look at Antitrust Reverse Termination Fees

David Fox is a partner at Kirkland & Ellis LLP, focusing on complex mergers and acquisitions as a member of that firm’s Corporate Group. This post is based on a Kirkland & Ellis M&A Update by Mr. Fox, Timothy Muris, and Christine Wilson.

Perhaps no topic has engendered more conversation among dealmakers in recent months than the allocation between merging parties of the risk of obtaining antitrust approval of a proposed acquisition. With the increase in strategic combinations and the expectation of a more robust regulatory environment under the current administration, many recent merger agreements feature painstakingly negotiated provisions to address these risks. While much attention has been devoted to headline-grabbing reverse termination fees payable to the seller by the buyer upon failure to obtain required antitrust approvals in such deals as Google/Motorola Mobility ($2.5 billion or 20% of deal value) and AT&T/T-Mobile (~$6 billion of value/15%), it is important to realize that the reverse termination fee is just one facet (as often absent as not) of a complex matrix of provisions in the merger agreement that ultimately determines the risk-sharing between the parties on this issue.

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Acquirer Valuation and Acquisition Decisions

The following post comes to us from Itzhak Ben-David of the Department of Finance at The Ohio State University, Michael S. Drake of the School of Accountancy at Brigham Young University, and Darren T. Roulstone of the Department of Accounting and MIS at The Ohio State University.

In the paper, Acquirer Valuation and Acquisition Decisions: Identifying Mispricing Using Short Interest, which was recently made publicly available on SSRN, we provide new evidence helping to resolve an ongoing academic debate about the factors that lead firms to acquire other firms. In the center of the debate are two views. According to the neoclassical approach, acquisitions are an efficient way for firms to expand. The prediction of this school of thought is that mergers are more likely to take place for firms with high Tobin’s Q which is indicative of high investment opportunities. In contrast, the behavioral school of thought argues that firms that are temporarily overvalued have an incentive to engage in stock acquisitions in order to exchange their overvalued equity for real assets. Resolving the debate requires distinguishing overvaluation from high investment (or growth) opportunities. To date, most studies use variations of the market-to-book ratio to measure overvaluation as well as to measure investment opportunities. Hence, in order to distinguish between the two hypotheses, one needs an instrument to separate these two economic variables.

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Engaging With Strategy after the Financial Crisis

Jeffrey Stein is a partner in the Corporate Practice Group at King & Spalding LLP. This post comes to us from Mr. Stein and Bill Baxley, and is based on a report from the Lead Director Network, available here.

Oversight of corporate strategy has become an increasingly important board function in recent years, and boards are seeking ways to become more effective and spend additional time on strategy. Increasingly, corporate strategy is focusing on opportunities arising from globalization, which requires that boards also address the risks that arise from global operations. To be effective in overseeing global strategy, boards must focus on their own composition and directors’ experiences, and also draw effectively on management and experts outside their companies. Lead directors have a special responsibility for strategic oversight and can help their boards make greater contributions in this area.

Against this background, the Lead Director Network (the “LDN”), a group of lead directors, presiding directors and non-executive chairmen from many of America’s leading companies, met on July 13, 2011 to discuss how boards engage with strategy in this global environment. Following this meeting, King & Spalding and Tapestry Networks have published a ViewPoints report here to present highlights of the discussion that occurred at the meeting and to stimulate further consideration of these subjects.

The following provides highlights from the meeting, as described in the ViewPoints report.

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Second Circuit Clarifies Materiality Requirement in Securities Fraud Cases

Brad Karp is chairman and partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP. This post is based on a Paul Weiss client memorandum.

Recently, the Second Circuit decided Fait v. Regions Financial Corp., No. 10-2311-cv (2d Cir. Aug. 23, 2011), in which the Court affirmed the dismissal of a putative class action alleging violations of Sections 11(a), 12(a)(2), and 15 of the Securities Act of 1933 (the “Securities Act”). The Second Circuit held that defendants’ alleged failures to write down goodwill in a timely manner and to increase loan loss reserves sufficiently during the financial crisis were not actionable, because defendants’ challenged statements were matters of opinion rather than fact. Thus, plaintiffs had to allege that defendants did not believe the statements were true at the time they were made, something the complaint failed to do. Fait promises to be a useful tool in defending claims under the Securities Act, as well as claims that a defendant otherwise misstated financial figures, when those figures depend on the judgment of management rather than strictly objective criteria. The decision may be particularly important with respect to claims against accounting firms, whose conclusions based on their audits of financial statements and internal control regularly take the form of an expression of opinion.

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Bribes and Benefits

The following post comes to us from Yan-Leung Cheung, Professor of Finance at Hong Kong Baptist University; P. Raghavendra Rau, Professor of Finance at the University of Cambridge; and Aris Stouraitis, Professor of Finance at Hong Kong Baptist University.

In the paper, Which firms benefit from bribes, and by how much? Evidence from corruption cases worldwide, which was recently made publicly available on SSRN, we analyze a hand-collected sample of 166 prominent bribery cases, involving 107 publicly listed firms from 20 stock markets that have been reported to have bribed government officials in 52 countries worldwide during 1971-2007. Prior papers have focused on the date of the revelation of the bribe on the firm’s stock price.

Our research questions are different from this literature. We try to answer three questions. First, who bribes? Second, how much do they pay? Third, what benefits do they get? In contrast to prior literature, to answer our research questions, we focus on the initial date of award of the contract for which the bribe was paid. At that time, the market was unaware that the firm obtained a particular contract by paying a bribe. So the change in market capitalization of the firm on the bribe paying date (which is only available ex-post) provides the magnitude of benefits firms get from the bribe. By subtracting the value of the bribe from the benefits, we get a measure of the NPV for the bribe.

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SEC to Allow Shareholders to Submit Proxy Access Proposals for 2012 Season

James Morphy is a partner at Sullivan & Cromwell LLP specializing in mergers & acquisitions and corporate governance. This post is based on a Sullivan & Cromwell client memorandum. More posts about proxy access, including several from the Program on Corporate Governance, are available here.

The Securities and Exchange Commission has announced that its revisions to the proxy rules to allow shareholders to propose proxy access bylaws and other election or nomination procedures will become effective shortly. The SEC had stayed the effectiveness of these changes to Rule 14a-8 pending the outcome of a judicial review of its mandatory proxy access rule, Rule 14a-11. On July 22, 2011, the U.S. Court of Appeals for the D.C. Circuit vacated Rule 14a-11, but the Rule 14a-8 changes were not litigated. The SEC’s stay order will automatically expire when the court decision is finalized, which is expected to occur on September 13, and the Rule 14a-8 changes will therefore become effective at that time absent further SEC action. The SEC stated that a notice of effective date will be published.

The SEC also confirmed that it will not seek a rehearing of or appeal the decision vacating Rule 14a-11. A statement by the SEC Chairman indicated that she remains committed to facilitating shareholder nominations of directors and that the SEC will continue to review the court decision and the comments received on their proposed rules in order to “determine the best path forward” on mandatory proxy access.

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Legislative Developments in Delaware’s “Alternative Entities”

A. Gilchrist Sparks is Of Counsel at Morris, Nichols, Arsht & Tunnell LLP. This post is based on a Morris Nichols update by David A. Harris, Louis G. Hering, and Walter C. Tuthill, and summarizes a survey of changes in Delaware law, available here. This post is part of the Delaware law series, which is co-sponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In its latest session, the Delaware legislature enacted several amendments to Delaware’s four “alternative entity” statutes – the Delaware Limited Liability Company Act (“DLLCA”), the Delaware Revised Uniform Limited Partnership Act (“DRULPA”), the Delaware Revised Uniform Partnership Act (“DRUPA”) and the Delaware Statutory Trust Act (“DSTA”). [1] Among other things, the amendments (i) provide a statutory default rule for the amendment of LLC agreements which requires the consent of all members; (ii)that a standard “supermajority amendment provision” applies only to supermajority provisions in an LLC agreement or partnership agreement and not to supermajority provisions under the applicable alternative entity statute; and (iii) modify the language relating to action by written consent by members, managers and partners to eliminate the requirement that the written consent set forth the action so taken thereby facilitating action by consent, particularly by electronic means.

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Avoiding Shareholder Suits Challenging Executive Compensation

Jeremy Goldstein is a partner at Wachtell, Lipton, Rosen & Katz active in the firm’s executive compensation and corporate governance practices. This post is based on a Wachtell Lipton firm memorandum by Mr. Goldstein and Jeannemarie O’Brien.

A number of derivative suits have been filed in recent months alleging that the senior executive compensation plans at public companies do not comply with Section 162(m) of the Internal Revenue Code. Section 162(m) provides that any compensation paid to the CEO and next three highest compensated proxy officers (other than the CFO) in excess of $1 million per year is not tax deductible unless, among other things, the compensation is subject to objective performance metrics that have been disclosed to and approved by shareholders. The complaints generally allege that the performance goals established by the plans are not sufficiently objective to comply with Section 162(m) and that the purported failure of the plans to comply with Section 162(m) renders the required proxy disclosure false and misleading in violation of Section 14(a) of the Securities Exchange Act. In addition, the complaints allege that the provision of non-deductible compensation to senior executives constitutes waste, unjust enrichment of the executives and a breach of the directors’ duty of loyalty.

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The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts

The following post comes to us from Jonathan Cohn of the Department of Finance at the University of Texas at Austin; Lillian Mills, Professor of Accounting at the University of Texas at Austin; and Erin Towery of the Department of Accounting at the University of Texas at Austin.

In our paper, The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts: Evidence from U.S. Corporate Tax Returns, which was recently made publicly available on SSRN, we study post-LBO financial performance and behavior for approximately the universe of U.S. LBO firms taking place between 1995 and 2007.  We overcome the lack of public financial data for most LBOs firms that has limited prior research by instead analyzing confidential federal corporate tax return data. Since all U.S. corporations, including those that are privately-held, must file tax returns, we can observe post-LBO income and balance sheet information for nearly all U.S. LBO firms.

We use our large, representative sample to test a number of long-standing hypotheses regarding the motivation for LBOs and their role in the economy. Arguably the most influential view on LBOs is that of Jensen (1989), who regards the LBO structure as superior to the structure of the publicly-traded firm. He argues that the concentration of ownership and high level of debt in the LBO structure disciplines managers. The high level of debt eliminates free cash flow that managers might otherwise waste on “empire-building” activities. Indeed, levering up the firm more than would be optimal from a long-term perspective puts pressure on management to earn its way out of the firm’s debt load.

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