Monthly Archives: October 2011

Clearinghouse Over-Confidence

Editor’s Note: Mark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law. This post is Professor Roe’s most recent op-ed in his regular column series titled “The Rules of the Game” written for the international association of newspapers Project Syndicate, which can be found here.

To reduce the chance that a financial meltdown like that of 2007-2008 will recur, regulators are now seeking to buttress institutions for the longer-run – at least when they can turn their attention from immediate crises like those of Greece’s debt, America’s ceiling on governmental borrowing, and the potential eurozone contagion from sovereign debt to bank debt. Central to their effort has been to bolster clearinghouses for derivatives – instruments that exacerbated the implosion at AIG and others in the last financial crisis. But a clearinghouse is no panacea, and its limits, although easy to miss, are far-reaching.

When a company seeks to protect itself from currency fluctuation, it can reduce its exposure to the target currency with a derivative (for example, it promises to pay its trading partner if the euro rises, but gets paid if it falls). Although the company using the derivative reduces its exposure to the risk of a failing euro, the derivative comes packaged with a new risk – counterparty risk. The company risks that if its trading partner fails – as AIG, Bear Stearns, and Lehman did – it won’t be paid if the euro falls.

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Deviation from the Target Capital Structure and Acquisition Choices

The following post comes to us from Vahap Uysal of the Department of Finance at the University of Oklahoma.

In the paper, Deviation from the Target Capital Structure and Acquisition Choices, forthcoming in the Journal of Financial Economics, I explore the effects of a firm’s leverage deficit on its acquisition choices. In particular, I examine the extent to which a firm’s leverage deficit affects the likelihood of the firm making an acquisition as well as the effect of its leverage deficit on the payment method and on the premiums paid for the target firm. Because managers are likely to anticipate the constraints of overleverage on acquisition choices, I also analyze managerial decisions on capital structure in the light of potential acquisitions. Specifically, I test whether managers of overleveraged firms reduce their leverage deficits when they foresee a high likelihood of making acquisitions. Finally, I examine how capital markets react to the acquisition announcements of firms that deviate from their capital structures. Managers of overleveraged firms will face constraints on the form and level of financing and are more likely to be selective in their acquisition choices if they fail to decrease their leverage deficits substantially. Therefore, I hypothesize that managers of overleveraged firms will pursue only the most value-enhancing acquisitions, which, in turn, will foster favorable market reactions to the news of their acquisitions.

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Proxy Access: Only The Beginning

Editor’s Note: Francis H. Byrd is Senior Vice President, Corporate Governance & Risk Practice Leader at Laurel Hill Advisory Group. This post is based on a Laurel Hill newsletter. Related work on proxy access by the Program on Corporate Governance includes Private Ordering and the Proxy Access Debate by Bebchuk and Hirst, and the proceedings of The Harvard Law School Proxy Access Roundtable.

The recent decision by the SEC is not to seek a rehearing of the Appeals Court ruling staying process access now appears to set in motion a move toward the use of the shareholder proposal process to advance the proxy access concept.

An Access Free-for-All?

It is likely that some labor and public funds will file shareholder resolutions at specific issuers seeking access to the proxy. Also the so-called individual shareholder gadflies are expected to file proposal as well. Issuers however, should not expect a flood of these proposals in 2012. The governance advocate institutional investors will tread carefully and be quite selective in their targets – mega and large capitalization companies with poor performance or visible governance problems or scandals – while the hedge fund community, if they use this tactic at all, are more likely to target small-cap issuers.

Figuring into the equation is how ISS and Glass Lewis will treat these proposals. Each firm has essentially stated that their review will be on a case-by-case basis.

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Living Wills: FDIC Approves Final Rules

Editor’s Note: The following post comes to us from Dwight C. Smith, partner focusing on bank regulatory matters at Morrison & Foerster LLP, and is based on a Morrison & Foerster Client Alert by Mr. Smith, Alexandra Steinberg Barrage, and Jeremy Mandell.

Recently, the Federal Deposit Insurance Corporation (“FDIC”) Board unanimously approved two rules regarding resolution planning: one rule for large bank holding companies and nonbank financial companies supervised by the Federal Reserve Board of Governors (“FRB”), [1] and the other rule for large banks. [2]

The first rule (the “165(d) Rule”) is a final rule required by section 165(d) of the Dodd-Frank Act. The plan required under section 165(d) is a detailed contingency plan that describes how large bank holding companies and nonbank financial companies supervised by the FRB (collectively, “Covered Companies”) that are at risk of default can be sold, broken up, or wound down quickly and effectively in a way that mitigates serious adverse effects to U.S. financial stability. Covered Companies include (i) all bank holding companies (including foreign banking organizations that are or are treated as bank holding companies) with consolidated assets of $50 billion or more and (ii) all nonbank financial companies that the Financial Stability Oversight Council designates for supervision by the FRB. [3] A total of 124 Covered Companies are currently subject to the 165(d) Rule, the same number noted in the proposed rule. As with the proposed 165(d) Rule, the vast majority of Covered Companies appear to be foreign banking organizations. [4]

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Poor Corporate Governance and the Diversification Discount

The following post comes to us from Daniel Hoechle of the Department of Finance at the University of Basel; Markus Schmid, Professor of Finance at the University of Mannheim; Ingo Walter, Professor of Finance at New York University; and David Yermack, Professor of Finance at New York University.

Two important sources of company value are governance and diversification. In our paper, How Much of the Diversification Discount Can Be Explained by Poor Corporate Governance? forthcoming in the Journal of Financial Economics, we investigate links between these two attributes. We seek to determine whether the negative association between firm value and diversification, established in many other studies, can be partly attributed to the quality of corporate governance in conglomerate firms.

We estimate a wide range of panel data regression models similar to those used in prior studies of the diversification discount. We estimate our regressions with and without a large set of corporate governance control variables. Our analysis indicates that between 16% and 21% of the diversification discount arises because of conglomerate firms’ choices about which corporate governance parameters to adopt. Our conclusions are based on the degree to which the estimated diversification discount narrows and moves closer to zero when governance variables are added to our regressions.

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Inside Information and Risks for Claims Traders

Editor’s Note: The following post comes to us from Douglas P. Bartner, partner in the Bankruptcy & Reorganization Group at Shearman & Sterling LLP, and is based on a Shearman & Sterling client publication.

Distressed investors often find themselves confronting the dilemma over how to best exert the influence they have at critical times in the chapter 11 process, which almost always will involve negotiations over key disputed issues, and their ability to continue to trade in claims against the debtor. As demonstrated by a recent decision of the United States Bankruptcy Court for the District of Delaware in the Washington Mutual chapter 11 cases, [1] what such investors do with the potentially inside information they gain from those negotiations, and how and when they use it, may significantly affect their bankruptcy recovery and expose them to potential liability. Additionally, the decision, which is now on appeal, suggests that a creditor who has a blocking position in a creditor class may be considered an insider of the debtor and have a fiduciary duty to act for the benefit of other creditors within that class, even if the creditor does not sit on an official creditors’ committee appointed in the case.

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Delaware Court Issues Guidance for M&A Transactions with Controlling Stockholders

Editor’s Note: 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 Mr. Gallardo and Brian M. Lutz, and concerns a judgment by Chancellor Strine of the Delaware Court of Chancery, available here. Another memo regarding the decision, from Sullivan & Cromwell LLP, is 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.

On October 14, 2011, Chancellor Strine of the Court of Chancery of the State of Delaware issued a decision in In re Southern Peru Copper Corp. Shareholder Derivative Litig., C.A. No. 961-CS. In the 105-page decision, Chancellor Strine ultimately found that the controlling stockholder defendants had breached their fiduciary duty of loyalty and awarded damages of over $1.2 billion, which may be paid by the controlling stockholder by returning some of the stock consideration received from the controlled company in the transaction. The decision provides important guidance for companies engaging in M&A transactions with their controlling stockholders.

In 2004, Southern Peru Copper Corporation, an NYSE-listed mining company, received a proposal from its majority stockholder, Grupo Mexico, S.A.B. de C.V. Under the proposal, Southern Peru would acquire Grupo Mexico’s 99.15% interest in Minera Mexico, S.A. de C.V., a non-publicly traded Mexican mining company, for $3.1 billion in Southern Peru stock. Because of Grupo Mexico’s self-interest in the transaction, Southern Peru formed a Special Committee of disinterested directors to consider the transaction. The Special Committee retained its own financial and legal advisors.

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European Commission Draft Directive on Financial Transaction Tax

Editor’s Note: H. Rodgin Cohen is a partner and senior chairman of Sullivan & Cromwell LLP focusing on acquisition, corporate governance, regulatory and securities law matters. This post is based on a Sullivan & Cromwell LLP publication; the full version, including footnotes, is available here.

The European Commission has published its proposal for a financial transaction tax.

The tax would be paid

  • by financial institutions
  • on transactions in financial instruments
  • if at least one of the parties were located in the EU.

Sales and purchases of shares and bonds would be taxed at 0.1%, derivative contracts at 0.01%. The tax would be introduced from the start of 2014. Part of the revenue would belong to the EU; the rest would be retained by member states.

The Commission, France and Germany are willing to introduce a financial transaction tax at EU level. The UK and Sweden oppose such a tax if it is not global in scope. The German finance minister suggested recently that it could be implemented in the eurozone before the rest of the EU.

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Noble Prose: Sound Bites on Public M&A

Daniel Wolf is a partner at Kirkland & Ellis LLP focusing on mergers and acquisitions. This post is based on a Kirkland & Ellis M&A Update by Mr. Wolf and David B. Feirstein. 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.

Dealmakers working on public M&A transactions have recently seen increased focus on, and discussion of, what buyers and target boards “can” and “should” do in a sale context. Perhaps as a result of splashy headlines (such as the JCrew and Del Monte situations), market participants are more proactively asking what they need to be thinking about and doing in terms of process, terms and disclosure.

In a day of noteworthy production on September 30, VC Noble of the Delaware Chancery Court issued four significant opinions relating to M&A matters, three of which related to disputed public company transactions. Denying (1) a motion to dismiss post-closing shareholder claims in the infoGroup deal, (2) a motion for a preliminary injunction to block the OPENLANE transaction, and (3) a motion to expedite a preliminary injunction motion to block the AMAG acquisition of Allos, VC Noble offered broad-ranging insights into some of the key issues circulating in the market. While none of the views are necessarily groundbreaking and it is clear the decisions were largely driven by highly fact-specific elements, a quick review of some take-aways from these cases may prove useful as guidance for dealmakers.

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Credit Risk Transfer Governance

The following comes to us from Houman Shadab, Associate Professor of Law at New York Law School and an associate director of its Center on Financial Services Law.

In the paper, Credit Risk Transfer Governance: The Good, the Bad, and the Savvy, which was recently made publicly available on SSRN, I examine credit risk transfer (CRT) transactions and focus on credit default swaps (CDSs), collateralized debt obligations (CDOs), and other securitization transactions.

Governance research often focuses on the role of equityholders and directors at the institutional level. My paper, however, draws upon creditor governance scholarship and extends its insights to CRT at the transactional level. By examining CRT instruments such as CDSs and CDOs within the framework of creditor governance, it becomes possible to distinguish between good and bad CRT governance.

CRT governance consists of the transaction structures and practices that protect investors (and counterparties) against losses from the underlying credit risk being transferred. Good governance requires governance mechanisms to reduce the informational asymmetries and incentive misalignments of particular CRT transactions—the agency costs of CRT. Good CRT governance can protect investors (and counterparties) from losses even if the underlying assets whose credit risk is transferred experience significant losses. Bad CRT governance, by contrast, creates transaction structures that leave parties with highly sensitive exposures to losses in underlying credit assets. Savvy CRT transactions are those that produce gains for one side at the expense of the other because one side better understood how the governance of a particular CRT transaction should be priced, and positioned itself accordingly. Certain savvy hedge funds used synthetic CDOs to profit from the ultimate bursting of the housing bubble.

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