Monthly Archives: December 2011

The Spotlight on Boards

Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton firm memorandum by Mr. Lipton.

The focus on the performance of corporate boards prompts a revisiting of what is expected from the board of directors of a major public company – not just the legal rules, but also the aspirational “best practices” that have come to have almost as much influence on board and company behavior.

Boards are expected to:

  • Establish the appropriate “Tone at the Top” to actively cultivate a corporate culture that gives high priority to ethical standards, principles of fair dealing, professionalism, integrity, full compliance with legal requirements and ethically sound strategic goals.
  • Choose the CEO, monitor his or her performance and have a detailed succession plan in case the CEO becomes unavailable or fails to meet performance expectations.
  • Work with management to navigate the dramatic changes in economic, social and political conditions, in order to remain competitive and successful.


Is the Stock Market Just a Side Show?

The following post comes to us from Murillo Campello, Professor of Finance at Cornell University; Rafael Ribas of the Department of Economics at the University of Illinois; and Albert Wang of the Department of Finance at the Chinese University of Hong Kong.

The 2005 split-share reform allowed for restricted stocks worth hundreds of billions of dollars to become tradable over a short period, sharply increasing liquidity in the Chinese stock market. In our paper, Is the Stock Market Just a Side Show? Evidence from a Structural Reform, which was recently made publicly available on SSRN, we use this episode as a way to flesh out links between stock market activity and real business activity.

We evaluate the impact of the 2005 reform exploiting various institutional features associated with its implementation. One of such feature is a pilot experiment conducted at the beginning of the reform schedule. Another is the gradual, large-scale share conversion that took place within a 16-month window. These features are unique and present both opportunities and challenges for our empirical tests. It is possible, for example, that better-managed firms were chosen to participate in the pilot trial that initiates the conversion program because of political motivation to showcase the reform. In addition, after the pilot stage, firms were free to join the reform at the time of their choosing. Thus, the treatment assignment might also be endogenous due to self-selection. To minimize these concerns, our analysis employs quasi-experimental methods that make the outcome variation before and after conversion conditionally independent from the compliance date.


The Increasing Importance of Loss Causation Analysis

John Gould is Senior Vice President at Cornerstone Research. This post is based on a Cornerstone Research article by David Marcus, Greg Eastman, and Marina Martynova, which was first published by Law360. Cornerstone Research was retained by Hoguet Newman Regal & Kenney, counsel for William Tennant in United States v. Anthony Cuti and William Tennant.

The recent court decisions in United States v. Anthony Cuti et al. and United States v. Ferguson et al. highlight the increasing importance of correctly analyzing loss causation in criminal cases. In United States v. Cuti, a New York federal judge applied considerably shorter prison sentences than were recommended by prosecutors for two former executives of Duane Reade Inc. convicted of securities fraud. [1]

In United States v. Ferguson, the U.S. Court of Appeals for the Second Circuit overturned criminal convictions of four former General Re Corporation (Gen Re) executives and a former American International Group Inc. (AIG) executive. [2] Both court decisions were driven by conclusions that prosecutors failed to properly connect the alleged fraud to any actual losses.


CFTC to Impose Position Limits on Some Commodity Derivatives

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 complete publication, including footnotes, is available here.

The Commodity Futures Trading Commission (“CFTC”) adopted interim and final rules on positions limits applicable to option, futures, swap and swaption contracts related to 28 agricultural, metal and energy commodity contracts (the “Final Rules”). The Final Rules impose position limits on a spot-month basis as well as on an all-month and any-month basis. Exemptions are provided from these limits, including a narrow set for bona fide hedging transactions. The Final Rules also exempt certain preexisting positions. Market participants are required to aggregate their interests in commodity contracts across accounts and positions that they control or own, subject to limited exemptions. In addition, the Final Rules impose position visibility requirements with respect to energy and metal contracts. The Final Rules result in radical changes to the CFTC’s long-established position limit regime by, inter alia, taking over responsibility for position limits from the exchanges, expanding limits to include swaps, narrowing exceptions and expanding aggregation requirements.


Corporate Governance Practices of U.S. Initial Public Offerings

Richard J. Sandler is a partner at Davis Polk & Wardwell LLP and co-head of the firm’s global corporate governance group. This post is based on portions of a Davis Polk publication titled Governance Practices for IPO Companies: A Davis Polk Survey; the complete survey, including a discussion of controlled companies which is omitted below, is available here.

As an advisor to underwriters and issuers in initial public offerings, we surveyed the corporate governance practices of recent U.S. IPOs to identify current market trends. We focused on the top 50 IPOs of U.S. companies from January 1, 2009 through August 31, 2011 in terms of deal size of the IPO. [*] The deal size of the examined IPOs ranged from $132.0 million to $18.14 billion.

Significant Findings

In doing our research, we compared our findings in this survey to those in our 2009 survey. We found that generally, despite the growing pressure for certain corporate governance provisions in seasoned issuers, the corporate governance practices at the IPO companies that we surveyed in 2011 remained in many ways unchanged from those in our 2009 survey. In both surveys, there were approximately similar results for the existence of classified boards, voting standards in uncontested board elections and the percentage of audit committee independence at the time of the IPO. Indeed, we found many fewer companies separating the role of CEO and Chairman of the board in our 2011 survey—34% as compared with 52% in the 2009 survey.


Why Taxing Executives’ Bonuses Fosters Risk-Taking Behavior

The following post comes to us from Martin Grossmann, Markus Lang, and Helmut Dietl, all of the Department of Business Administration at the University of Zurich. Work from the Program on Corporate Governance on executive compensation includes Paying for Long-Term Performance by Bebchuk and Fried.

In the paper, Why Taxing Executives’ Bonuses Fosters Risk-Taking Behavior, we analyze the effect of a bonus tax on the risk-taking behavior of corporate executives in a principal-agent model. In our paper, the firm value (output) depends on the manager’s behavior in two dimensions. First, the manager can increase the firm value by exerting more effort. Second, the manager can choose a project with specific exposure. A project choice with a higher expected return simultaneously implies a higher risk. Therefore, the project choice influences the expected value as well as the variance in the output. For instance, bank managers dealing with credits face this kind of trade-off.

Credit at low interest rates can be assigned to firms with high ratings. Therefore, the bank has low expected profits but also low risks. Otherwise, credit at higher interest rates can be assigned to a start-up firm operating in a promising area but with high uncertainty. Thus, a higher expected return can be achieved by being exposed to higher risks. We assume that the principal offers a salary package consisting of a fixed salary and an incentive-based component (bonus rate). The bonus rate increases with the manager’s output. As the manager can only influence the output by his effort choice and the degree of exposure, the realization or failure of the project is stochastic.


Self-Fulfilling Credit Market Freezes

Lucian Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School. Itay Goldstein is Associate Professor of Finance at the Wharton School of the University of Pennsylvania. Their recently published article Self-Fulfilling Credit Market Freezes was earlier issued as a discussion paper of the Harvard Law School Program on Corporate Governance.

A recent issue of the Review of Financial Studies featured (as lead article) our study “Self-Fulfilling Credit Market Freezes.” This paper develops a model of a self-fulfilling credit market freezes and uses it to study alternative governmental responses to such a crisis.

We study an economy in which operating firms are interdependent, with their success depending on the ability of other operating firms to obtain financing. In such an economy, an inefficient credit market freeze may arise in which banks abstain from lending to operating firms with good projects because of their self-fulfilling expectations that other banks will not be making such loans. Our model enables us to study the effectiveness of alternative measures for getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of interest rate cuts, infusion of capital into banks, direct lending to operating firms by the government, and the provision of government capital or guarantees to finance or encourage privately-managed lending.

Our analysis provides a framework for analyzing the standard and nonstandard instruments used by authorities during the financial crisis of 2008-2009. This framework, we hope, can be useful for authorities making choices in the face of financial crises in the future. Our analysis also provides testable implications for – and can guide empirical work on – how firms, banks, and economies can be expected to be affected by shocks to the banking system.

We now turn to describing our analysis in a bit more detail: An important aspect of the economic crisis of 2008-2009 has been the contraction or “freezing” of credit to nonfinancial firms. During the crisis, financial firms have displayed considerable reluctance to extend loans to nonfinancial firms (as well as households). Some observers attributed the reluctance of financial firms to lend to irrational fear, while others attributed it to a rational assessment of the fundamentals of the economy, which can be expected to reduce the number of operating firms with good projects worthy of financing.

We analyze in this paper another factor that may contribute to the contraction of credit in such circumstances. In particular, we show how coordination failure among financial institutions can lead to inefficient “credit markets freeze” equilibria. In such equilibria, financial institutions rationally avoid lending to nonfinancial firms (operating firms) that have projects that would be worthy if banks did not withdraw from the lending market en masse. They do so out of self-fulfilling fear, validated in equilibrium, that other financial institutions would withhold loans and that operating companies would not be able to succeed in an environment in which other operating firms fail to obtain financing.


The Case Against the Dodd-Frank Act’s Living Wills

The following post comes to us from Nizan Geslevich Packin of the University of Pennsylvania Law School.

In the paper, The Case Against the Dodd-Frank Act’s Living Wills: Contingency Planning Following the Financial Crisis, forthcoming in the Berkeley Business Law Journal, I focus on the Dodd-Frank Act’s “living will” requirement that mandates that systemically important financial institutions (SIFIs) develop business strategic analyses, and submit plans for reorganization or resolution of their operations to regulators. The goal of this regulation is to mitigate risks to the financial stability of the US and encourage last-resort planning – in order to enable a rapid and efficient response in the event of an emergency – for multinational financial institutions that are so large that their insolvency could shake the entire financial system and the economy. Nearly everyone believes that living wills are just about the perfect solution to the problems highlighted in the recent financial crisis; regulators from all over the world strongly support the concept and have been advocating for its implementation. Nevertheless, I argue that this solution is ill-designed to address the too-big-to-fail problem, and that living wills are not the silver bullet that regulators seem to think they are. My paper shows that there are a lot of open issues concerning living wills, and that there are real questions as to how effective they can be.


UK Special Administration Regime

The following post comes to us from Lawrence V. Gelber, partner at Schulte Roth & Zabel LLP, and is based on a Schulte Roth & Zabel client alert by Mr. Gelber and Ron Feldman.

The UK Financial Services Authority (“FSA”) confirmed on 31 Oct. 2011 that MF Global UK Limited (“MF Global UK”) will be subject to the new Special Administration Regime (“SAR”). [1] This is the first time that the new regime, set out in The Investment Bank Special Administration Regulations 2011 (“SAR Regulations”) [2] has been invoked.


The SAR Regulations were made under the powers set out in Sections 233 and 234 of the Banking Act 2009. They came into effect on Feb. 8, 2011 and are supplemented by The Investment Bank Special Administration (England and Wales) Rules 2011 [3] (“SAR Rules”) which came into force on 30 June 2011.

The purpose of the new SAR is to address perceived deficiencies in the UK insolvency regime in the case of the collapse of an investment bank and highlighted by the collapse of Lehman Brothers in 2008 such as: [4]

  • Ascertaining which assets are client assets and which firm assets;
  • Interpreting the effect of, and the interrelationship between, various contracts and master agreements such as prime brokerage agreements, futures agreements, stock lending agreements and ISDA master agreements;
  • Establishing the extent of any right of use; and
  • Determining and allocating any shortfalls in client omnibus accounts.


Comparing Regulation for Domestic Firms in Different Countries

The following post is based on the executive summary of Doing Business 2012: Doing Business in a More Transparent World, a co-publication of the World Bank and the International Finance Corporation. The lead author of the report is Sylvia Solf, program manager of the Doing Business project; more information about the team can be found here. The complete report, including omitted footnotes and figures from the summary, is available here.

Over the past year a record number of governments in Sub-Saharan Africa changed their economy’s regulatory environment to make it easier for domestic firms to start up and operate. In a region where relatively little attention was paid to the regulatory environment only 8 years ago, regulatory reforms making it easier to do business were implemented in 36 of 46 economies between June 2010 and May 2011. That represents 78% of economies in the region, compared with an average of 56% over the previous 6 years.

Worldwide, regulatory reforms aimed at streamlining such processes as starting a business, registering property or dealing with construction permits are still the most common. But more and more economies are focusing their reform efforts on strengthening legal institutions such as courts and insolvency regimes and enhancing legal protections of investors and property rights. This shift has been particularly pronounced in low- and lower-middle-income economies, where 43% of all reforms recorded by Doing Business in 2010/11 focused on aspects captured by the getting credit, protecting investors, enforcing contracts and resolving insolvency indicators.


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