Monthly Archives: November 2011

The Reliability of Voluntary Disclosures: Evidence from Hedge Funds

The following post comes to us from Andrew Patton of the Department of Economics at Duke University, and Tarun Ramadorai and Michael Streatfield, both of the Saïd Business School.

In the paper, The Reliability of Voluntary Disclosures: Evidence from Hedge Funds, which was recently made publicly available on SSRN, we examine the reliability of these voluntary disclosures by hedge funds, by tracking changes to statements of performance in the publicly available hedge fund databases recorded at different points in time between 2007 and 2011. In each vintage of these databases, hedge funds provide information on their performance from the time they began reporting to the database until the most recent period. We find evidence that in successive vintages of these databases, older performance records (pertaining to periods as far back as fifteen years) of hedge funds are routinely revised. This behavior is widespread: nearly 40% of the 18,382 hedge funds in our sample have revised their previous returns by at least 0.01% at least once, and over 20% of funds have revised a previous monthly return by at least 0.5%. While positive revisions are also commonplace, negative revisions are more likely and larger when they occur, i.e., on average, initially provided returns present a rosier picture of hedge fund performance than finally revised performance. Moreover, these revisions are not random. Indeed, we employ information on the characteristics and past performance of hedge funds to predict them. For example, funds in the Emerging Markets style are significantly more likely to have revised their histories of returns than Fixed Income funds, and larger funds, more volatile funds, and less liquid funds are all more likely to revise.

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Surveying Sponsor-Backed Going Private Transactions

The following post comes to us from Douglas P. Warner, partner and co-head of the Hedge Fund practice at Weil, Gotshal & Manges LLP, and discusses a Weil survey, available here.

Weil, Gotshal & Manges LLP recently conducted our fifth annual survey of sponsor-backed going private transactions. Weil surveyed 60 sponsor-backed going private transactions announced from January 1, 2010 through December 31, 2010 with a transaction value (i.e., enterprise value) of at least $100 million (excluding target companies that were real estate investment trusts).

Thirty-nine of the surveyed transactions in 2010 involved a target company in the United States, thirteen involved a target company in Europe and eight involved a target company in Asia-Pacific. The publicly available information for certain surveyed transactions did not disclose all data points covered by our survey; therefore, the charts and graphs in this survey may not reflect information from all surveyed transactions.

With a significant rebound in the availability of debt financing for new acquisitions, 2010 was a strong year for sponsor-backed going private transactions in the United States. Thirty-nine sponsor-backed going private transactions in the United States were announced over the course of 2010.

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A Changing Landscape: The MiFID II Legislative Proposal

Editor’s Note: Barnabas Reynolds is head of the global Financial Institutions Advisory & Financial Regulatory Group at Shearman & Sterling LLP. This post is based on a Shearman & Sterling client publication by Mr. Reynolds, Azad Ali, Mehran Massih, Thomas A. Donegan, and Anna Doyle; the complete publication, including omitted footnotes, is available here.

On 20 October 2011, the European Commission published its long-awaited legislative proposal to revise the Markets in Financial Instruments Directive (better known by its acronym MiFID). The proposal is divided into two parts, a Directive and a Regulation, both of which are expected to enter into force in 2013. Financial institutions and users of financial services will now need to prepare to negotiate a wider regulatory perimeter, which captures previously unregulated and more weakly regulated business areas. Pre-trade and post-trade transparency will apply to a broader scope of instruments. Firms should also be aware of the wider interventionist powers for EU and national regulators under contemplation.

Introduction

The original Markets in Financial Instruments Directive (“MiFID”) came into force almost four years ago, in November 2007. MiFID was intended to enhance investor protection, improve cross-border market access and promote competition in the financial markets across the EU. Although MiFID has arguably achieved some of these aims, it is widely considered that the regime requires updating to reflect the lessons of the financial crisis and developments in the markets. The terms of MiFID itself anticipate a review in any event. However, the financial crisis has undoubtedly led to a far more wide-ranging proposal than might otherwise have been expected.

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CEO Inside Debt Holdings and the Riskiness of Firm Investment and Financial Policies

The following post comes to us from Cory Cassell, Shawn Huang, Juan Manuel Sanchez, and Michael Stuart, all of the Department of Accounting at the University of Arkansas.

In the paper, Seeking Safety: The Relation Between CEO Inside Debt Holdings and the Riskiness of Firm Investment and Financial Policies, forthcoming in the Journal of Financial Economics, we investigate whether CEOs with large inside debt holdings protect the value of their holdings by implementing less risky investment and financial policies. The recent near-collapse of global financial markets led to renewed scrutiny of executive compensation practices by journalists, academicians, politicians, and regulators.  Much of the scrutiny focused on alleged excesses in the compensation packages of the executives deemed (at least partially) responsible for the economic turmoil (e.g., Karaian, 2008; Rappeport, 2008; McCann, 2009). However, the financial crisis also highlighted the vulnerability of certain components of firm-specific executive wealth during times of financial distress as several prominent chief executive officers (CEOs) surrendered significant portions of their inside debt holdings (pension benefits and/or deferred compensation) when their firms failed during the crisis. Inside debt holdings are at risk because they generally represent unsecured and unfunded liabilities of the firm, rendering these executive holdings sensitive to default risk similar to that faced by other outside creditors (Sundaram and Yermack, 2007; Edmans and Liu, 2011).

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Corporate Governance and Shareholder Activism in 2011

James R. Copland is the director of the Manhattan Institute’s Center for Legal Policy. This post is based on the executive summary of report from the Proxy Monitor project; the full report is available here.

In recent years, a small number of activist shareholders have increasingly sought to use their equity stock holdings to exert influence over business management. Proponents of “shareholder democracy” have successfully pushed shareholder proposals offered for votes at the annual meetings of public corporations that change the manner in which directors are elected and in which shareholders can force corporate action outside those annual meetings. Proponents of “corporate social responsibility” have pushed companies to change their behavior with a clear interest in pursuing policy goals rather than share-price maximization. Critics of management’s pay levels have pushed for shareholder advisory votes on executive compensation—a practice borrowed from Britain but unheard of in the United States a decade ago—and such “say on pay” votes are now mandated under federal law by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Academics and investors alike have debated shareholder activism generally and these proposals specifically; but to date, hard data have generally not been publicly available about this phenomenon. To fill in this informational gap and to uncover and analyze trends in this aspect of shareholder activism and its influence over corporate governance, the Manhattan Institute launched its Proxy Monitor project. The ProxyMonitor.org database assembles information on the 150 largest corporations (by revenues, as ranked by Fortune magazine) and currently includes searchable and sortable information on every shareholder proposal submitted at each company from 2008 through August 1, 2011. (Earlier years’ proposals, and a broader data set of companies, will be added to the database in the months ahead.)

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Delaware Court Upholds Board Discretion in Setting Compensation Practices

Paul Rowe is a Partner in the Litigation Department at Wachtell, Lipton, Rosen and Katz. This post is based on a Wachtell Lipton memorandum by Mr. Rowe, Jeannemarie O’Brien, and Jeremy Goldstein. 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 dismissing a wide-ranging stockholder challenge to compensation practices at Goldman Sachs, the Delaware Court of Chancery has issued a strong reaffirmation of traditional principles of the common law of executive compensation.  The decision emphasizes that boards are free to encourage and reward risk-taking by employees and that Delaware law protects directors who adopt compensation programs in good faith.  In re The Goldman Sachs Group, Inc. Shareholder Litigation (Oct. 12, 2011).

Shareholders of Goldman Sachs brought suit on a variety of theories, claiming that Goldman’s compensation policies, which emphasized net revenues, rewarded employees with bonuses for taking risks but failed to penalize them for losing money; that the directors allocated too much of the firm’s resources to individual compensation versus investment in the business; that while the firm adopted a “pay for performance” philosophy, actual pay practices failed to align stockholder and employee interests; and that the board should have known that the effect of the compensation practices was to encourage employees to engage in risky and/or unlawful conduct using corporate assets.  In dismissing the claims, the Court relied on basic principles of Delaware law.

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Does It Matter Who Pays for Bond Ratings?

The following post comes to us from John (Xuefeng) Jiang, Associate Professor of Accounting at Michigan State University; Mary Stanford, Professor of Accounting at Texas Christian University; and Yuan Xie, Assistant Professor of Accounting at Fordham University.

In our paper, Does It Matter Who Pays for Bond Ratings? Historical Evidence, forthcoming in the Journal of Financial Economics, we examine whether charging issuers for bond ratings is associated with higher credit ratings employing the historical setting wherein S&P switched from an investor-pay to an issuer-pay model in 1974, four years after Moody’s made the same switch.

Many commentators and policy makers claim that charging bond issuers for ratings introduces conflicts of interest into the rating process. For corporate bonds issued between 1971 and 1978, we find that, for the same bond, Moody’s rating is higher than S&P’s rating prior to 1974 when only Moody’s charges issuers. After S&P adopts the issuer-pay model in July 1974, the evidence indicates that S&P’s ratings increase to the extent that they no longer differ from Moody’s ratings. Because we use Moody’s ratings for the same bond as our benchmark, we can conclude that this increase in S&P’s ratings is not due to general changes affecting bond ratings.

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Two New Corporate Forms to Advance Social Benefits in California

John Olson is a founding partner of Gibson, Dunn & Crutcher’s Washington, D.C. office and a visiting professor at the Georgetown Law Center. This post is based on a Gibson Dunn alert by David M. Hernand and Stewart L. McDowell.

On October 9, 2011, California Governor Jerry Brown signed into law competing bills that create two new corporate forms in California — a “flexible purpose corporation” and a “benefit corporation” — intended to allow entrepreneurs and investors the choice of organizing companies that can pursue both economic and social objectives. The new corporate forms differ from traditional for-profit corporations that are organized to pursue profit (and not social purposes) and non-profit corporations that must be used solely to promote social benefits. These laws will take effect on January 1, 2012.

The flexible purpose corporation is created by California Senate Bill 201 (“SB 201”), which adds Division 1.5 to Title 1 of the California Corporations Code (the “Code”) and amends other related sections of the Code, and the benefit corporation is created by California Assembly Bill 361 (“AB 361”), which adds Part 13 to Division 3 of Title 1 of the Code. State Senator Mark DeSaulnier authored SB 201, and a full copy is available here. AB 361 was authored by Assemblyman Jared Huffman, and a full copy is available here. Both new laws take effect January 1, 2012.

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EU Proposed Financial Transaction Tax – Fortune or Folly?

The following post comes to us from Thomas A. Humphreys, head of the Federal Tax Practice Group as well as co-chair of the Tax Department at Morrison & Foerster LLP, and is based on a Morrison & Foerster bulletin by Mr. Humphreys, Peter J. Green, Jeremy C. Jennings-Mares, and Richard Jerman.

Since the financial crisis, there has been frequent talk of the introduction of a financial transaction tax. This tax, often referred to as “Tobin tax” after its original advocator, James Tobin, in the 1970s, would impose a levy on individual transactions undertaken by a financial institution. The subject has been discussed at G20 summits since Pittsburgh in 2009, [1] and the European Commission (the “Commission”) has made no secret of its desire to implement the taxation across its 27 Member States.

On Wednesday 28 September in the annual State of the Union address, José Manuel Barroso, President of the Commission, announced the long anticipated proposal for a European financial transaction tax. The tax, if implemented, would impact financial transactions between financial institutions from 2014, charging 0.1% against the exchange of shares and bonds and 0.01% across derivative contracts. The Commission believes the tax, with the potential to raise 57 billion euros per year, would “ensure that the financial sector makes a fair contribution at a time of financial consolidation” [2] noting, among other things, the significant government bailouts to support the financial sector during the crisis.

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Endogenous Information Flows and the Clustering of Announcements

Viral Acharya is a Professor of Finance at New York University.

One of the most important ingredients to the process of price discovery in financial markets is the flow of new information, particularly apparent during times of market “crisis,” when it often seems that bad news is being reported simultaneously from multiple sources. While it is not surprising that firms’ news are affected by market and sector conditions (given the correlation of their cash flows), the timing of the announcements is suggestive that these disclosure decisions are not made independently. Indeed, recent empirical work suggests that corporate earnings warnings within an industry are clustered and that firms speed up their warnings in response to poor market conditions. Interestingly, however, such clustering is asymmetric in that good news does not generate such clustering, only bad news does. In the paper, Endogenous Information Flows and the Clustering of Announcements, forthcoming in the American Economic Review, my co-authors (Peter DeMarzo and Ilan Kremer, both of Stanford University) and I provide a theoretical explanation for this asymmetry.

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