Yearly Archives: 2011

Banking Entity Trading Under the Volcker Rule

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, July 6, 2011
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The following post comes to us from Christopher Laursen, Vice President, NERA Economic Consulting and Co-Regional Director, Professional Risk Managers’ International Association’s (PRMIA) Washington, DC Chapter.

Looking back to the fall of 2007, it is clear from SEC filings that significant financial company losses resulted from proprietary positions booked in trading accounts. More specifically, a large amount of trading losses came from holdings of mortgage-backed and asset-backed bonds that had been afforded high credit ratings (e.g., AAA) by Nationally Recognized Statistical Rating Organizations (NRSROs). Rapid mark-to-market losses on these and other trading positions contributed significantly to the financial crisis and ultimately led legislators to develop the Volcker Rule, section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

With the Volcker Rule, legislators aim to reduce banking entity exposure to proprietary trading and thereby enhance bank’s ability to maintain their more traditional functions during market crises. The Rule, depending on how it is interpreted and enforced by regulators, has the potential to significantly change the scope and scale of proprietary trading within federally insured depositories and their affiliates.

This article discusses the relevant background of the Volcker Rule trading restrictions and offers insights on likely regulatory interpretations and banking entity responses. Specifically, the article addresses the designation of customer-initiated trades, increased expectations related to trading risk systems and limits, and the identification of material conflicts of interest.

The original article can be found at the following link on NERA’s website: http://www.nera.com/67_7328.htm.

Can the Treasury Exempt its Own Companies from Tax? The $45 Billion GM NOL Carryforward

Posted by Mark Ramseyer, Harvard Law School, on
Tuesday, July 5, 2011
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Mark Ramseyer is a Professor of Japanese Legal Studies at Harvard Law School.

Year after year, General Motors lost money – enormous sums of money. It designed cars. It built cars. But no one wanted to buy the cars it designed and built. Over time, it accumulated huge operating losses (“net operating losses,” or NOLs). The tax code let GM carry forward these NOLs into the future. It let the firm save them for that day in the future when it would once again sell cars that people wanted.

The day never came. Instead, in June 2009 GM (or “Old GM”) declared bankruptcy. It filed under Chapter 11 of the Bankruptcy Code and sold its assets to a new shell (New GM) in a transaction under Sec. 363 of the Code. Old GM’s shareholders were not part of New GM, and the firm’s creditors took stock: the US Treasury, the auto unions, and Canada swapped debt claims against Old GM for equity stakes in New GM. With 61 percent, the Treasury took the largest share among this group. Other Old GM creditors acquired a 10 percent stake in New GM as well. In the fall of 2010, Treasury re-sold a large amount of its New GM shares to the public, and cut its share to 26%.

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Lessons of the Financial Crisis: The Dangers of Short-Termism

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, July 4, 2011
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Editor’s Note: Sheila Bair is the Chairman of the Federal Deposit Insurance Corporation. This post is based on Chairman Bair’s remarks to the National Press Club, available here.

As I prepare to close out my term, I cannot help reflect on the challenges we have faced over the past five years and some of the lessons we have learned in the process. Our nation has suffered its most serious financial crisis and economic downturn since the Great Depression. The after effects will be felt for years to come.

There are many causes of this crisis, some of which I will address in my remarks today. But, in my opinion, the overarching lesson of the crisis is the pervasive short-term thinking that helped to bring it about. Short-termism is a serious and growing problem in both business and government. I would like to devote my remarks to explaining what I mean by this, and discussing how I think it plays into the policy challenges arising from the crisis.

The Challenge Posed by Short-Termism

What is short-termism, and why does it arise? Short-termism refers to the long-observed tendency – which we all share, to one degree or another – to unduly discount outcomes that occur far in the future.

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The Information Content of Annual Earnings Announcements and Mandatory Adoption of IFRS

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, July 4, 2011
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The following post comes to us from Wayne Landsman, Professor of Accounting at the University of North Carolina at Chapel Hill; Edward Maydew, Professor of Accounting at the University of North Carolina at Chapel Hill; and Jacob Thornock of the Department of Accounting at the University of Washington.

In the paper, The Information Content of Annual Earnings Announcements and Mandatory Adoption of IFRS, forthcoming in the Journal of Accounting & Economics as published by Elsevier, we examine whether the information content of earnings announcements increased in countries that mandated adoption of IFRS compared to countries that retained domestic accounting standards. We address this research question using a sample of 20,517 earnings announcements from 16 countries that mandated adoption of IFRS and 11 countries that retained domestic accounting standards. We measure information content of earning announcements based on abnormal trading volume and return volatility around firms’ earnings announcements.

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Elevating Board Performance

Posted by Simon Wong, Northwestern University School of Law, on
Sunday, July 3, 2011
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Simon Wong is a Partner at Governance for Owners, an Adjunct Professor of Law at the Northwestern University School of Law, and a Visiting Fellow at the London School of Economics and Political Science.

The global financial crisis has prompted debate once again on how to improve the effectiveness of the board of directors at listed companies. Despite considerable reforms over the past two decades, boards – particularly at financial institutions – have been criticized recently for failing to properly guide strategy, oversee risk management, structure executive pay, manage succession planning, and carry out other essential tasks.

This article argues that the lack of attention to behavioral and functional considerations – such as director mindset, board operating context, and evolving human dynamics – has hampered the board’s effectiveness.

To reach their potential, the article recommends that – alongside establishing core building blocks such as appropriate board size, well-functioning committees, proficient company secretarial support, and professionally-administered board evaluation – boards and their members focus on the following:

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Sixth Circuit Upholds Tortious Interference Verdict Against Auction Loser’s Overbid

Posted by Trevor Norwitz, Wachtell, Lipton, Rosen & Katz, on
Saturday, July 2, 2011
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Trevor Norwitz is a partner in the Corporate Department at Wachtell, Lipton, Rosen & Katz, where he focuses on mergers and acquisitions, corporate governance and securities law matters. This post is based on a Wachtell Lipton firm memorandum by Mr. Norwitz and Robin Panovka, and relates to the U.S. Appeals Court decision in Ventas, Inc. v. HCP, Inc., available here.

The U.S. Court of Appeals for the Sixth Circuit has affirmed a District Court judgment holding an interloper that breached its standstill agreement liable for tortious interference to the winning bidder in an auction. The interloper is required to pay the winner the incremental amount – over $100 million – that it took to secure shareholder approval for its deal, and may also be liable for punitive damages. In addition to providing important guidance on tortious interference claims in the M&A context, the case offers useful reminders for buyers, sellers and would-be over-bidders in the art of running, winning and “topping” an auction for a public company.

The case stems from a four-year old transaction in which, after our client Ventas won an auction to buy Sunrise REIT, losing bidder Health Care Property Investors (“HCP”) went public with a topping bid at a 20% premium, even though this was prohibited by its standstill agreement with the target. The public announcement of the topping bid did not disclose that it was conditional or that it violated the standstill. Ventas demanded that Sunrise REIT enforce HCP’s standstill agreement as required by the merger agreement. Both the Ontario trial and appellate courts ordered Sunrise REIT to do so, upholding a selling board’s prerogative to structure an auction in a manner that the board believes will maximize shareholder value (including by requiring “best and final” offers from participants and agreeing to enforce a standstill obligation against a losing bidder).

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The Changing Information Environment and Disclosure De-regulation

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, July 1, 2011
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The following post comes to us from Nemit Shroff of the Department of Accounting at MIT, Amy Sun of the Department of Accounting at Pennsylvania State University, Hal White of the Department of Accounting at the University of Michigan, and Weining Zhang of the Department of Accounting at the National University of Singapore.

In July 2005, the Securities and Exchange Commission (SEC) announced the enactment of the Securities Offering Reform (Reform), which, among other things, relaxes restrictions—known as ‘gun jumping’ provisions—on firms’ forward-looking disclosures prior to public equity offerings. The SEC argues that in recent years, the information environment has become much richer through marked improvements in mandated disclosure quality and both broader and timelier dissemination of information, rendering gun jumping provisions “unnecessary and outdated,” as these rules restrict valuable information flow to investors around a highly important corporate event (SEC [2005]). However, opponents of the Reform argue that the restrictions are meant to protect investors from managers conditioning the market (i.e., hyping the stock price) before incentive-rich corporate events such as equity offerings, and the relaxation of these restrictions will increase market conditioning.

In our paper, The Changing Information Environment and Disclosure De-regulation: Evidence from the 2005 Securities Offering Reform, which was recently made publicly available on SSRN, we examine the impact of the Reform on management forecasting behavior before equity offerings. To provide a broader context in which to evaluate this impact, we also investigate the effect of the recently improved information environment on market conditioning. Thus, this paper is comprised of three main analyses. First, using the enactment of SOX in 2002 as the shift in the information environment, we examine whether managers generally attempt to mislead the market using forecast announcements in the pre-SOX period. Using a difference in differences design, we find that there is a statistically significant increase in the propensity and magnitude of good news disclosures by SEO firms via management forecasts in the period before the SEO, as compared to those of non-SEO firms in the same industry and of similar size, growth, and performance. Moreover, we observe a negative association between the pre-SEO good news disclosure activity and long-term abnormal returns following the SEO. This suggests that in the less rich information environment pre-SOX, managers use forecast announcements to hype the stock price in the months prior to equity offerings.

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SEC Adopts New Rules to Encourage Whistleblowers

Posted by Martin Lipton, Wachtell, Lipton, Rosen & Katz, on
Thursday, June 30, 2011
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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, Steven A. Rosenblum, John F. Savarese, Wayne M. Carlin and Karessa L. Cain.

Recently, the SEC adopted controversial new rules that create significant financial incentives for whistleblower employees to report suspected securities law violations directly to the SEC, potentially circumventing company compliance programs in the process. Under the new rules, which were adopted pursuant to Section 922 of the Dodd-Frank Act, the SEC will pay awards to whistleblowers who voluntarily provide the SEC with original information about a violation of securities laws that leads to a successful enforcement action brought by the SEC and that results in monetary sanctions exceeding $1 million.

The size of potential bounty payments may range from 10% to up to 30% of the total monetary sanctions collected in successful SEC and related actions. In some cases, this could result in multimillion dollar cash payments to whistleblowers. The final rules set forth the SEC’s methodology for determining awards, with specified factors weighing in favor of an increase in the reward size and others weighing in favor of a reduction in the reward size. In addition, the rules provide that various persons will not be eligible for whistleblower payments, including compliance and internal audit personnel, but an exception is provided for such personnel if they believe disclosure “may prevent substantial injury to the financial interest or property” of the company or investors, and at least 120 days have elapsed since the whistleblower reported the information internally at the company or became aware of information that was already known to the company.

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Janus Capital Group v. First Derivative Traders: Only the Supreme Court can “Make” a Tree

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, June 29, 2011
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Editor’s Note: Jeffrey Gordon is the Alfred W. Bressler Professor of Law at Columbia Law School. This post discusses the Supreme Court decision in Janus Capital Group v. First Derivative Traders, available here; a post from Gibson, Dunn & Crutcher LLP concerning this case is available here.

The Supreme Court decision in Janus Capital Group v. First Derivative Traders is one of those cases that takes your breath away. The case astonishingly holds that an investment advisor is not liable for fraud in the prospectus of a sponsored mutual fund because the investment advisor is not the “maker” of those statements – even though the fund’s officers are all employees of the advisor (and paid for that service by the advisor) and the advisor prepares, files, and distributes the prospectus. Nevertheless, says the Supreme Court majority, the advisor did not “make” the fraudulent statement, because the fund, a legally separate entity, had “ultimate authority over the statement, including its content and whether and how to communicate it.”

Okay, we get that the Supreme Court is hostile to the implied private right of action under Rule 10b-5 yet seems to regard its existence as a “super-precedent.” But Janus Capital Group does real damage. First, the Court seems willfully to deny what it should have learned about the functioning of mutual funds in last term’s advisory fee case, Jones v. Harris Associates. A mutual fund is hardly a free-standing entity bargaining at arm’s length with a supplier of advisory services, notwithstanding the “independence” of the fund’s directors. At a time when an increasingly large share of investment activity occurs through large pools of capital, the decision exacerbates the problem of “agency capitalism” – the tendency of the managing agents to pursue their own objectives at the expense of the ultimate beneficiaries. Why strain to find ways to insulate wrong-doers from accountability systems?

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External Networking and Internal Firm Governance

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, June 29, 2011
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The following post comes to us from Cesare Fracassi of the Department of Finance at the University of Texas at Austin and Geoffrey Tate of the Department of Finance at the University of California, Los Angeles.

In our paper, External Networking and Internal Firm Governance, forthcoming in the Journal of Finance, we use panel data on S&P 1500 companies to identify external network connections between directors and CEOs. We observe network connections stemming from shared external board seats, prior employment in other firms, education, or charitable and leisure activities. We test whether these ties affect firm policies and performance.

A well-functioning board of directors provides both valuable advice to management and a check on its policies. An effective director should not just rubber stamp management’s actions, but should take a contrarian opinion when management’s proposals are not in the interest of the firm’s shareholders. Thus, it is important to identify director characteristics which affect their ability or willingness to bring valuable new information into the firm and to properly perform their monitoring role. Our results suggest that having directors with external network ties to the CEO may undermine the effectiveness of corporate governance.

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