Yearly Archives: 2011

Present and Future Challenges for the Banking Industry and the FDIC

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Sunday, October 9, 2011
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Editor’s Note: Martin Gruenberg is Acting Chairman of the Federal Deposit Insurance Corporation. This post is based on Chairman Gruenberg’s remarks to the American Banker Regulatory Symposium, available here.

Condition of the Banking Industry

The FDIC and the banking industry are only now emerging from the most severe financial crisis since the 1930s. The latest data, released by the FDIC in its Quarterly Banking Profile last month, indicate that banks have continued to make gradual but steady progress in recovering from the financial market turmoil and severe recession that unfolded from 2007 through 2009.

The economic recovery, now entering its third year, has been marked by continued distress in real estate markets and a slow, painful process of balance-sheet repair by households, financial institutions, small businesses, and, now, governments at all levels. The result has not only been sub-par growth compared with previous recoveries, but also a persistent uncertainty about the future prospects for the economy, for jobs, and for the banking industry.

All of these trends are, of course, of concern to policymakers and to the public. The FDIC remains alert to these challenges going forward.

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Broker-Dealers Respond to Dodd-Frank and FINRA

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, October 8, 2011
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The following post comes to us from Michael Patterson, Principal, Financial Services at Ernst & Young LLP, and is based on an Ernst & Young publication.

We recently conducted a survey of broker-dealer compliance officers to gather perspectives and practices around new regulatory initiatives and amendments that will likely have a material impact on financial institutions: the Dodd-Frank Act and FINRA’s know-your customer (KYC) and suitability rules.

We thought it would be useful to understand how firms and their compliance functions are responding.

The survey consisted of 12 questions focused on 4 specific initiatives:

  • 1. The uniform fiduciary standard under Dodd-Frank Title IX
  • 2. Regulation of the over-the-counter (OTC) derivatives markets under Dodd-Frank Title VII
  • 3. The Volcker Rule regulating proprietary trading under Dodd-Frank Title VI
  • 4. FINRA’s new KYC and suitability rules (FINRA Rules 2090 and 2111)

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Institutional Investors: The Next Frontier in Corporate Governance

Posted by Benjamin W. Heineman, Jr., Harvard Law School, and Stephen M. Davis, Yale University, on
Friday, October 7, 2011
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Ben W. Heineman, Jr. is a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government. Stephen M. Davis is the Executive Director of Yale University School of Management’s Millstein Center for Corporate Governance and Performance. This post is based on a paper by Mr. Heineman and Mr. Davis, available here or here.

Although institutional investors play a major role in our public equity markets, far less is known about the governance of those investor entities than about investee corporations. These investors are critical to individuals, equity markets, publicly held companies, the economy — and to the troubling (and conceptually difficult) issue of good versus bad short-termism in investor and investee behavior. Put simply, the fundamental issue is whether institutional investors are part of the problem or part of the solution within the current state of market capitalism. By institutional investors we mean, at a minimum, pension funds, mutual funds, insurance companies, hedge funds and endowments of non-profit entities like universities and foundations. Recent developments in public policy treat shareholders (primarily institutional investors) as part of the “solution.” The Dodd-Frank Act in the United States and the Stewardship Code in the United Kingdom, for instance, essentially place big bets that institutions can and will police the market with new powers and responsibilities. While this is a worthy objective, it rests on unexamined and unsophisticated assumptions.

In a new paper, Are Institutional Investors Part of the Problem or Part of the Solution?, we attempt to outline major descriptive and prescriptive issues relating to these institutional investors (the paper is available from Yale’s Millstein Center here, and from the Committee for Economic Development here). We call for much greater intellectual and institutional effort in addressing these vital but under-analyzed questions. Set out below is the essence of our argument for much more sophisticated analysis of the governance of institutional investors — based on development of much more robust data bases about the critical elements of investor governance and performance.

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Complexity, Innovation and the Regulation of Modern Financial Markets

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, October 7, 2011
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The following post comes to us from Daniel Awrey of the University of Oxford Faculty of Law.

The working paper, Complexity, Innovation and the Regulation of Modern Financial Markets, which was recently made publicly available on SSRN, was motivated by two observations.

First, the perfect market assumptions underpinning the canonical theories of financial economics – modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model, and the efficient market hypothesis – are increasingly unreflective of how many modern financial markets work in practice.  More specifically, these theories share a common and highly stylized view of financial markets, one characterized by perfect information, the absence of transaction costs and rational market participants.  Yet in reality, of course, financial markets rarely (if ever) strictly conform to these assumptions.  Information is costly and unevenly distributed; transaction costs are pervasive, and market participants frequently exhibit cognitive biases and bounded rationality.  Despite these seemingly uncontroversial facts, however, the empirically (con)testable assumptions of conventional financial theory have been transformed into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society’s resources.

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Bankruptcy Court Decision May Impact Claims Trading and Plan Negotiation

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, October 6, 2011
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The following post is based on a Davis Polk & Wardwell LLP client newsletter by Damian Schaible, Donald Bernstein, and Marshall S. Huebner from the Insolvency and Restructuring Practice at Davis Polk.

On September 13, 2011, Judge Mary Walrath of the United States Bankruptcy Court for the District of Delaware surprised many parties in interest and observers of the case by issuing an opinion denying confirmation of the modified proposed plan of reorganization of Washington Mutual, Inc. (“WMI”) and its affiliated debtors. The modified plan incorporated certain changes Judge Walrath had indicated were necessary in a January 2011 opinion denying confirmation of a prior version of the plan, and many expected that these changes would be sufficient to ensure confirmation of the modified plan. Although the decision turned primarily on the rate of post-petition interest awarded to certain creditors of WMI, the Court’s extensive discussion of allegations of “insider trading” raised against certain claims purchasers is likely to attract the most attention. Judge Walrath’s findings on these allegations may have a significant impact on claims trading and negotiation dynamics in complex chapter 11 cases going forward.

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Say on Pay Drives Compensation Program Changes

Posted by Matteo Tonello, The Conference Board, on
Thursday, October 6, 2011
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Matteo Tonello is Director of Corporate Governance for The Conference Board, Inc. This post is based on a Conference Board Director Note by Russell Miller and Yonat Assayag of ClearBridge Compensation Group.

The arrival of say-on-pay (SOP) votes has renewed the focus of directors and senior management on striking the right balance between designing an effective executive compensation program that supports the company’s strategic business objectives and one that is sensitive to shareholder perspectives. As a result, many companies made changes to their compensation programs this year, aimed at enhancing the relationship between pay and performance in preparation for their first SOP votes. This report examines the changes made by some Fortune 500 companies and includes recommendations for companies to consider in their 2012 compensation decision-making.

An analysis of the first 100 proxy filings by Fortune 500 companies (First 100) subject to shareholder advisory votes under the Dodd-Frank Wall Street Reform and Consumer Protection Act demonstrates some of the real effects SOP has had on executive compensation. [1] A key learning from those filings is that companies that perform and successfully demonstrate that their pay programs support and drive performance are more likely to win shareholder SOP votes.

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Delaware Court’s New Chancellor Provides Guidance on M&A

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, October 5, 2011
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The following post comes to us from Bradley W. Voss, partner in the Commercial Litigation Practice Group of Pepper Hamilton LLP, and is based on a Pepper Hamilton publication. 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.

During a recent hearing on a motion to expedite litigation involving Validus Holdings’s hostile bid to acquire Transatlantic Holdings, Judge Leo E. Strine, Jr., recently promoted to Chancellor of the Delaware Court of Chancery, made several observations worthy of note by deal lawyers, bankers, and corporate litigators.

Banker Conflicts and Fairness Opinions

Validus’s hostile takeover bid came after Transatlantic signed a friendly deal with Allied World. In the process leading to the Allied World agreement, Transatlantic was advised by Goldman Sachs. Apparently in response to a potential Goldman conflict, Transatlantic obtained a fairness opinion from another bank. Chancellor Strine said, “I don’t understand the idea of a banker running a process … and not having to back it up with a fairness opinion. It in no way addresses the conflict for the person who plays the operative role to not actually have to put the fairness opinion on the line. In fact, it would seem more vital when someone acts in a conflicted basis to make them render a fairness opinion.” Where one banker performs important tasks like “testing the market” and “giving strategic advice,” Chancellor Strine thought it “a very strange cure” to a conflict to hand off the job of giving a fairness opinion to another banker who is not compensated as highly. Referencing Smith v. Van Gorkom, Chancellor Strine emphasized the importance of financial advisors in deals and that “conflicts of interest” in the deal process are “taken seriously.”

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Agency Costs in the Era of Economic Crisis

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, October 5, 2011
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The following post comes to us from Mira Ganor of The University of Texas School of Law.

In the paper, Agency Costs in the Era of Economic Crisis – The Enhanced Connection between CEO Compensation and Corporate Cash Holdings, which was recently made publicly available on SSRN, I examine the evolution of the practice of cash hoarding following the Great Recession. The results suggest that managerial behavior, as evidenced by the elasticity of cash holdings as a function of total director compensation, has changed significantly in 2008 with economically meaningful implications. The effect was somewhat diminished the following year, which may be attributed to the growth and stimulus of the second half of 2009, but peaked again in 2010. In particular, I find that following the Great Recession managerial compensation has become positively correlated with the level of corporate cash holdings, suggesting that agency costs contribute to cash retention in times of financial distress.

It is possible that high managerial compensation influences the managers to be more risk averse and thus affects the managers’ decision to retain cash. Since diversified shareholders are likely to be less risk averse than the managers at times of financial crisis, when it is harder to find a comparable alternative job and the probability of complete failure increases, it may well be that the cash hoarding practice is at a suboptimal level and comes at the expense of shareholder value. Thus, the influence of the size of the managerial compensation on the manager’s risk tolerance should be taken into account when evaluating managerial pay.

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For Directors, A Wake-Up Call from Down Under

Posted by David A. Katz, Wachtell, Lipton, Rosen & Katz, on
Tuesday, October 4, 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 an article by Mr. Katz and Laura A. McIntosh that first appeared in the New York Law Journal.

Earlier this summer, the Federal Court of Australia handed down an important corporate law decision that would appear to have a substantial impact on the way that the statutorily defined responsibilities of directors are understood in Australia. [1] In Australian Securities and Investments Commission v. Healey, the entire board of directors (consisting of seven non-executive directors and the chief executive officer) was found to have breached its duty in failing to notice a significant error in the financial statements, an error that also went uncorrected by the outside auditors and internal employees. The directors were subject to possible financial penalties and bans as a result of the decision, though in the penalty phase of the case, the court determined that the liability judgment itself, with its associated embarrassment and reputational damage, was adequate punishment and deterrence. [2] Though the case involved interpretation of an Australian corporation law statute and was necessarily fact-specific, nonetheless it is worth careful scrutiny, as it serves as a powerful reminder to directors that their role is an active one and, further, may signal the direction in which the understanding of the role of directors generally could be headed.

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Proposed American Jobs Act Would Tax Carried Interest Tax as Ordinary Income

Posted by David S. Huntington, Paul, Weiss, Rifkind, Wharton & Garrison LLP, on
Tuesday, October 4, 2011
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David Huntington is a partner in the Capital Markets and Securities Group at Paul, Weiss, Rifkind, Wharton & Garrison LLP. This post is based on a Paul Weiss client memorandum.

On September 12, 2011, the Obama administration submitted statutory language for the proposed American Jobs Act to Congress. The Administration’s proposal contains a number of revenue offsets, including an updated proposal to tax carried interest as ordinary income. The carried interest proposal is similar to and based on earlier versions of the proposed legislation that have passed the House of Representatives a number of times over the past several years, but have not passed the Senate. The Administration’s proposal, however, makes some significant changes as compared to earlier versions.

In General. The legislation continues to recharacterize carried interest income and gain as ordinary income, and would apply to interests in traditional hedge funds, private equity funds, venture capital funds, and real estate funds that were the focus of the original legislation. It would also continue to treat gain on the sale of such interests as ordinary income.

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