Monthly Archives: October 2011

Did Securitization Cause the Mortgage Crisis?

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, October 19, 2011
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The following post comes to us from Ryan Bubb, Assistant Professor of Law at the New York University School of Law, and Alex Kaufman, economist at the Board of Governors of the Federal Reserve System. The opinions, analysis, and conclusions set forth are those of the authors and do not indicate concurrence by members of the Board of Governors of the Federal Reserve System or of the Federal Reserve Bank of Boston.

Did mortgage securitization cause the mortgage crisis? One popular story goes like this: Banks that originated mortgage loans and then sold them to securitizers didn’t care whether the loans would be repaid. After all, since they sold the loans, they weren’t on the hook for the defaults. Without any “skin in the game” those banks felt free to make worse and worse loans until… kaboom! The story is an appealing one, and since the beginning of the crisis it has gained popularity among academics, journalists, and policymakers. It has even influenced financial reform. The only problem? The story might be wrong.

In this post we report on the latest round in an ongoing academic debate over this issue. We recently released two papers, available here and here, in which we argue that the evidence against securitization that many have found most damning has in fact been misinterpreted. Rather than being a settled issue, we believe securitization’s role in the crisis remains an open and pressing question.

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What Constitutes a Sale of Substantially All Assets?

Posted by David A. Katz, Wachtell, Lipton, Rosen & Katz, on
Wednesday, October 19, 2011
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David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz specializing in the areas of mergers and acquisitions and complex securities transactions. This post is based on a Wachtell Lipton firm memorandum by Mr. Katz, David K. Lam, and Ryan A. McLeod. 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.

The Delaware Supreme Court has affirmed the Court of Chancery’s decision not to aggregate a series of dispositions in determining whether they constitute a transfer of “substantially all” of a company’s assets under a bond indenture. See Bank of New York Mellon Trust Co. v. Liberty Media Corp., No. 284, 2011 (Del. Sept. 21, 2011) (en banc).

The case arose out of a June 2011 proposal by Liberty Media Corporation to split off its Capital and Starz businesses. Certain of Liberty’s bondholders objected to the split-off as a transfer of “substantially all” of the company’s assets in violation of Liberty’s bond indentures. Although the Capital and Starz businesses alone would not amount to “substantially all” of Liberty’s assets, the bondholders argued that the proposed split-off should be considered together with three prior dispositions undertaken by Liberty since March 2004.

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October 2011 Dodd-Frank Rulemaking Progress Report

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, October 18, 2011
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The following post comes to us from Margaret E. Tahyar and Gabriel D. Rosenberg of the Financial Institutions Group at Davis Polk & Wardwell LLP. This post discusses a Davis Polk report which is available here. A post about the previous progress report is available here. Other posts about the Dodd-Frank Act are available here.

This posting, the October Davis Polk Dodd-Frank Progress Report, is the seventh in a series of Davis Polk presentations that illustrate graphically the progress of the rulemaking work that has been done and is yet to occur under the Dodd-Frank Act. The Progress Report has been prepared using data from the Davis Polk Regulatory Tracker™, an online subscription service offered by Davis Polk to help market participants understand the Dodd-Frank Act and follow regulatory developments on a real-time basis.

In this report:

  • No New Deadlines. No new rulemaking requirements were due in September.
  • 3 Requirements Met, 1 Proposed. Three rulemaking requirements were finalized this month, including the FDIC’s Joint Final Rule on Resolution Plans (also known as “living wills”). The Federal Reserve is expected to issue their version of the rule soon. One rule was proposed for which the deadline had already passed.
  • Volcker Rule Expected. A coordinated proposed rule on implementation of the Volcker Rule is expected in the coming weeks.
  • 2 Studies Issued. The GAO and the SEC each published one study in September.
  • New Progress Report Feature. The Progress Report now divides missed deadlines into those for which a proposed rule has been published and those for which no proposed rule has been published. As deadlines are missed, this will help readers gauge progress.

Good Faith — Not Just an Aspiration

Posted by Daniel E. Wolf, Kirkland & Ellis LLP, on
Tuesday, October 18, 2011
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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.

In a recent Kirkland M&A Update, we reviewed a Georgia appellate decision upholding a $281 million jury award to a spurned suitor, showing that even careful drafting of “non binding” language in a letter of intent may not be effective in avoiding unanticipated binding obligations if the parties’ conduct is inconsistent with those provisions. We also noted, in an earlier Kirkland M&A Update, a Delaware decision underlining the potential pitfalls for parties entering into letters of intent or term sheets with the expectation that they merely represent an unenforceable “agreement to agree.” A recent Delaware decision by VC Parsons highlights that danger lurks for unwary dealmakers even when a court comes well short of finding a term sheet to be a binding agreement.

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Pay for Regulator Performance

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, October 17, 2011
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The following post comes to us from Frederick Tung, Professor of Law at Boston University, and M. Todd Henderson, Professor of Law at the University of Chicago. Related works by the Program on Corporate Governance on the subject of pay incentives to avoid excessive risk-taking include Regulating Bankers’ Pay by Bebchuk and Spamann, Paying for Long-Term Performance by Bebchuk and Fried, and How to Fix Bankers’ Pay by Bebchuk.

Few doubt that executive compensation arrangements encouraged the excessive risk taking by banks that led to the recent Financial Crisis. Accordingly, academics and lawmakers have called for the reform of banker pay practices. In our paper, Pay for Regulator Performance, forthcoming in the Southern California Law Review, we argue that regulator pay is to blame as well, and that fixing it may be easier and more effective than reforming banker pay. Regulatory failures during the Financial Crisis resulted at least in part from a lack of sufficient incentives for examiners to act aggressively to prevent excessive risk. Bank regulators are rarely paid for performance. They are paid a fixed salary that does not depend on whether their actions improve banks’ performance, protect banks from failure, or increase social welfare.

We propose instead that regulators, specifically bank examiners, be compensated with a debt-heavy mix of phantom bank equity and debt, as well as a separate bonus linked to the timing of the decision to shut down a bank. [1] Giving examiners a stake in bank performance, both upside and downside, will improve their incentives to act in the public interest. A pay-for-performance culture will work better for bank examiners than other bureaucrats because of the objective metrics (i.e., stock and debt prices) available that directly track social welfare outcomes. We do not discount the value of public spiritedness as an inducement toward good regulatory performance.  We also believe, however, that monetary incentives tied objectively to socially desirable outcomes could improve examiner incentives, especially given the failure of existing inducements in the run-up to the Financial Crisis.

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The Proposed Restructuring of the UK Financial Regulatory Framework

Posted by Barnabas Reynolds, Shearman & Sterling, on
Monday, October 17, 2011
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Barnabas Reynolds is head of the global Financial Institutions Advisory & Financial Regulatory Group at Shearman & Sterling LLP. This post on a Shearman & Sterling client publication by Mr. Reynolds, William R. Murdie, Azad Ali, Thomas A. Donegan, John Adams, and Aatif Ahmad.

The UK Government has published a white paper and draft bill setting out further details of its proposals for a new structure of financial regulation. The FSA, currently the sole regulator of the financial sector, will be replaced with two bodies: (i) a prudential regulator, to be known as the Prudential Regulation Authority and (ii) a conduct of business regulator, to be known as the Financial Conduct Authority. In addition, macro-prudential or systemic risk regulation will fall to a new Financial Policy Committee of the Bank of England. The financial services industry is likely to face more intrusive and judgment-based regulation once the new structure is adopted.

Introduction

The UK Government will be pushing ahead with its plans to reform the financial regulatory system in the United Kingdom in line with its initial proposals. [1] In addition to the white paper, the regulatory approaches to be adopted by the Prudential Regulation Authority (the “PRA”) and Financial Conduct Authority (the “FCA”) have been further detailed in two subsequent papers. [2]

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Proxy Voting for Sustainability

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, October 16, 2011
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The following post comes to us from Peyton Fleming, Senior Director for Strategic Communications at Ceres, and is based on an article by Kirsten Spalding which discusses a Ceres report; the full report is available here.

It’s illogical – and quite myopic – that many of the nation’s largest institutional investors refer to shareholder-sponsored resolutions addressing material topics such as climate change, resource constraints and environmental stewardship as “special interest,” “non-routine” or involving “special circumstances.”

The opposite is in fact the case. We strongly agree with David Lubin and Daniel Esty’s contention in a recent Harvard Business Review article that sustainability is a core driver of competitive business strategies. Sustainability issues present both opportunities for competitive advantage and risks that, left unmanaged, will cause a company to lag its sector. If companies aren’t addressing sustainability they won’t be producing long-term value for their shareholders.

The financial numbers back this up: A review of 36 studies by Mercer Investment Consulting shows strong linkages between ESG (environmental, social and governance) integration and positive investment performance. “Eighty-six percent of the studies are neutral or positive,” Mercer’s Jane Ambachtsheer told the CalPERS Board of Directors in August.

With this in mind, Ceres recently unveiled the new and detailed Ceres Guidance: Proxy Voting for Sustainability to a Council of Institutional Investors breakfast in Boston. Our guidelines are a tool. But more importantly, they launch a serious effort to get mainstream investors moving now – immediately – to assert their prerogative, as part of their fiduciary duty, on these issues. Ceres, which coordinates the $10 trillion Investor Network on Climate Risk, has the partners in its network to leverage this initiative.

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SEC Staff Focus on Offshore Cash Holdings

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, October 15, 2011
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The following post comes to us from Brian V. Breheny, partner at Skadden, Arps, Slate, Meagher & Flom LLP, and is based on a Skadden memorandum by Mr. Breheny, Andrew J. Brady, and Derek B. Swanson.

As reported recently in the press, the SEC staff has, with greater regularity, been issuing comments to companies seeking disclosure of the extent of offshore cash holdings and the impact of such offshore holdings on the company’s liquidity position.  In general, the staff appears to be concerned about the U.S. federal income tax consequences of repatriation of offshore holdings, especially where it appears those holdings serve as a key source of liquidity for the company on a consolidated basis.

Consistent with the SEC’s recent interpretive guidance on the presentation of liquidity and capital resources disclosures in Management’s Discussion and Analysis, the staff appears to be focusing its attention on companies that have significant offshore cash (and cash equivalents) holdings to enhance disclosures in respect of those cash holdings.  In particular, the staff has asked companies to, among other things:
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Executive Overconfidence and the Slippery Slope to Financial Misreporting

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, October 14, 2011
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The following post comes to us from Catherine Schrand, Professor of Accounting at the University of Pennsylvania, and Sarah Zechman of the accounting group at the University of Chicago Booth School of Business.

In the paper, Executive Overconfidence and the Slippery Slope to Financial Misreporting, forthcoming in the Journal of Accounting and Economics as published by Elsevier, our detailed analysis of a sample of 49 firms subject to SEC Accounting and Auditing Enforcement Releases (AAERs) suggests two distinct explanations for the misstatements. Just over one quarter of the cases represent many of the well-publicized examples of corporate fraud including Adelphia, Enron, Healthsouth, and Tyco. The nature of the misstatements, their timing, and an analysis of the executives suggest that the activities are consistent with a strong inference of intent on the part of the respondent and consistent with the legal standards necessary to establish fraud.

However, perhaps more surprising, we find that the actions by the executives in the remaining three quarters of the cases are not consistent with the pleading standards required to establish an intent to defraud. Rather, our analysis of the 49 AAER firms suggests that optimistic bias on the part of executives can explain these AAERs. We show that the misstatement amount in the initial period of alleged misreporting is relatively small, and possibly unintentional. Subsequent period earnings realizations are poor, however, and the misstatements escalate. Using a matched sample of non-AAER firms, we show that the misreporting firms did not simply get a bad draw on earnings. Nor does it appear that weaker monitoring relative to the matched sample explains why the misreporting manager’s optimistic bias affects the financial statements.

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The Territorial Reach of U.S. Securities Laws After Morrison v. National Australia Bank

Posted by Robert J. Giuffra, Jr., Sullivan & Cromwell LLP, on
Thursday, October 13, 2011
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Robert Giuffra is a partner in Sullivan & Cromwell LLP’s Litigation Group. This post is based on a Sullivan & Cromwell client memorandum by Matthew Schwartz and Thomas White; the full memo, including omitted footnotes, is available here.

In June 2010, in Morrison v. National Australia Bank, the U.S. Supreme Court held that U.S. securities antifraud laws do not reach transactions by non-U.S. investors in securities of non-U.S. companies effected on non-U.S. exchanges, even if the investors claim that their losses arose from conduct in the United States. In its decision, which overturned the so-called “conduct” and “effects” tests previously followed by U.S. courts, the Supreme Court adopted a “transactional” test for determining the territorial scope of the U.S. securities laws. In rejecting the efforts of the plaintiffs’ bar to end-run Morrison, lower federal courts have applied the Supreme Court’s reasoning to avoid the extraterritorial application of the U.S. securities laws. Most notably, in separate securities fraud actions against UBS AG (“UBS”) and Porsche Automobil Holding SE (“Porsche”), federal courts recently dismissed claims (i) based on purchases of securities outside the United States where the non-U.S. issuer had dually listed the class of relevant securities on both U.S. and non-U.S. exchanges, (ii) by U.S. purchasers of a non-U.S. issuer’s securities on a non-U.S. exchange, and (iii) based on securities-based swap agreements referencing shares traded on non-U.S. exchanges. (S&C partners Bob Giuffra and Suhana Han represented both UBS and Porsche.) Following these and other post-Morrison decisions, non-U.S. issuers should take some comfort that they will not expose themselves to “worldwide” securities class actions simply by participating in U.S. capital markets.

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