Yearly Archives: 2011

Derivatives Market’s Payment Priorities in Bankruptcy

Posted by Mark Roe, Harvard Law School, on
Thursday, May 5, 2011
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Mark Roe is a professor at Harvard Law School, where he teaches bankruptcy and corporate law.

Stanford Law Review recently published my article, The Derivatives Market’s Payment Priorities as Financial Crisis Accelerator, in which I analyze the Bankruptcy Code’s role in undermining the stability of systemically-vital financial institutions.

Chapter 11 bars bankrupt debtors from immediately repaying their creditors, so that the bankrupt firm can reorganize without creditors’ cash demands shredding the bankrupt’s business. Not so for the bankrupt’s derivatives counterparties, who, unlike most other secured creditors, can seize and immediately liquidate collateral, readily net out gains and losses in their dealings with the bankrupt, terminate their contracts with the bankrupt, and keep both preferential eve-of-bankruptcy payments and fraudulent conveyances they obtained from the debtor, all in ways that favor them over the bankrupt’s other creditors.

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Risk and Incentive: An Event Study Approach

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, May 4, 2011
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The following post comes to us from Zhonglan Dai of the Accounting and Information Management Department at the University of Texas at Dallas, Li Jin of the Finance Unit at Harvard Business School, and Weining Zhang of the Department of Accounting at the National University of Singapore.

In the paper, Risk and Incentive: An Event Study Approach, which was recently made publicly available on SSRN, we take an event study approach to reexamine the standard principal-agent model prediction with respect to executives who have likely experienced an exogenous risk shock. Existing empirical studies of the relationship between risk and incentives provide mixed results, some positive, some negative, and some showing no relationship. We analyze not only the relation between level of pay-performance-sensitivity and firm risk subsequent to a litigation event, but also incremental incentives (changes in pay-performance-sensitivity embedded in executives’ annual compensation) occasioned by a litigation event.

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Moving toward Board Declassification in Fourteen S&P 500 Companies

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, May 3, 2011
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Editor’s Note: This post relates to two press releases issued by the American Corporate Governance Institute (the “ACGI”), an organization that Lucian Bebchuk and Scott Hirst are affiliated with. One press release, issued jointly by the ACGI and the Florida State Board of Administration is available here; the other press release, issued jointly by the ACGI and the Nathan Cummings Foundation, is available here.

During this proxy season, the American Corporate Governance Institute (the “ACGI”), an organization with which we are affiliated, assisted two institutional investors in the submission of shareholder declassification proposals. This post reports on the success that these shareholder declassification proposals had in contributing to board declassification in 14 S&P 500 companies.  The declassification of the boards of these companies would produce a 10% reduction in the number of S&P 500 companies with a classified board (currently standing at 139).

The ACGI assisted the Florida State Board of Administration (the “Florida SBA”) in the submission of shareholder declassification proposals for a vote at the 2011 annual meeting of a number of companies. The Florida SBA and the ACGI subsequently negotiated and reached agreements with seven companies, pursuant to which each company will bring a management proposal to declassify its board of directors.

The ACGI also assisted the Nathan Cummings Foundation (the “Foundation”) in the submission of shareholder declassification proposals to a number of companies. The Foundation and the ACGI subsequently negotiated and reached agreements with six companies, pursuant to which each company will bring a management proposal to declassify its board of directors. In addition, following the submission of one of the Foundation’s proposals (to Watson Pharmaceuticals, Inc.), the company announced a plan to bring a declassification proposal to a vote at its 2011 annual meeting.

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Concentrating on Governance

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, May 2, 2011
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The following post comes to us from Dalida Kadyrzhanova of the Finance Department at the University of Maryland and Matthew Rhodes-Kropf of the Entrepreneurial Management Unit at Harvard Business School.

In our paper, Concentrating on Governance, forthcoming in the Journal of Finance, we develop a unified account of the costs and benefits of external governance and explore the economic determinants of the resulting trade-offs for shareholder value. The importance of corporate governance is broadly recognized, but there is a great deal of disagreement on whether existing governance mechanisms ultimately benefit or hurt shareholders. Our novel perspective explains shareholder governance trade-offs, why they arise, and how they vary across firms and industries.

The classical agency view is that it is costly for shareholders to yield power to managers because managers pursue private benefits of control whenever their jobs are protected from takeovers or shareholder initiatives. A challenge to the agency view comes from the alternative bargaining view, which suggests that it is in the interest of shareholders to yield power to managers, a popular argument among M&A lawyers and practitioners.

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Promising Steps on Bank Pay Reforms

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Sunday, May 1, 2011
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Editor’s Note: 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. This post is based on an article that recently appeared in the Butterworths Journal of International Banking and Financial Law, which is available here. The Program on Corporate Governance has published several recent papers on pay at financial institutions, including How to Fix Bankers’ Pay, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, and Regulating Bankers’ Pay.

Despite greater regulatory oversight and smaller payouts, compensation in the financial sector continues to attract scrutiny and criticism. Yet, an examination of pay reforms at some banks suggests a strengthening alignment of interest among executives, their firms, and wider society.

First, owing to new regulations, a greater proportion of bankers’ pay is exposed to longerterm performance outcomes of their firms. Last December, the Committee of European Banking Supervisors (‘CEBS’) finalised rules requiring 40-60 per cent of executives’ variable pay to be deferred for three to five years and at least 50 per cent of it to be in stock. Equally, CEBS regulations limit upfront cash payments to 20-30 per cent of total remuneration.

Although US regulators have historically been reticent to regulate executive pay, the Federal Deposit Insurance Corporation is proposing to introduce similar requirements at US financial institutions.

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Comments on the SEC’s Proposal for Beneficial Ownership Reporting and Security-Based Swaps

Posted by Theodore Mirvis, Wachtell, Lipton, Rosen & Katz, on
Saturday, April 30, 2011
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Theodore Mirvis is a partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum.

Recently we filed a comment letter with the Securities and Exchange Commission regarding its proposal to readopt existing rules to preserve the “status quo” with respect to the treatment of security-based swaps under the beneficial ownership reporting rules. Our letter reiterates our belief, as reflected in the rulemaking petition we filed In March with the Commission, that modernization of the beneficial ownership reporting rules is needed in order to compel timely, accurate and complete disclosure of the accumulation of control stakes in public companies. We urge the Commission to undertake a complete overhaul of the rules as promptly as reasonably practicable. Chief among the failings in need of correction are the outdated ten-day reporting window and the overly narrow definition of “beneficial ownership,” which excludes a host of derivative products commonly used by investors to acquire the characteristics of ownership while currently evading reporting requirements.

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The Supreme Court Considers Loss Causation at Time of Class Certification

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, April 29, 2011
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The following post comes to us from Jonathan K. Youngwood, a partner in the Litigation Department at Simpson Thacher & Bartlett LLP, and is based on a Simpson Thacher report by Mr. Youngwood and Christopher R. Kelly. Oral arguments in the Supreme Court case discussed below, Erica P. John Fund, Inc. v. Halliburton Co., are available here.

The Supreme Court heard oral arguments recently in Erica P. John Fund, Inc. v. Halliburton Co., No. 09-1403, a private securities fraud case in which the Court is expected to address whether a class may be certified even where plaintiffs fail to establish that the alleged misstatements had an impact on the price of the securities at issue. The Court’s decision will likely resolve a split concerning whether courts should require plaintiffs to prove loss causation at the time of class certification. The Fifth Circuit in Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 487 F.3d 261 (5th Cir. 2007), has expressly allowed defendants to rebut the fraud-on-the-market presumption by disproving loss causation at the class certification stage. The Third and Seventh Circuits have explicitly rejected the Fifth Circuit’s approach in In re DVI, Inc., Sec. Litig., No. 08-8033, 08-8045, 2011 WL 1125926 (3d Cir. Mar. 29, 2011), and Schleicher v. Wendt, 618 F.3d 679 (7th Cir. 2010), respectively. The Second Circuit also rejected analyzing loss causation as a class certification requirement in In re Salomon Analyst Metromedia Litig., 544 F.3d 474 (2d Cir. 2008).

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Mergers, Spin-offs, and Employee Incentives

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, April 29, 2011
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The following post comes to us from Paolo Fulghieri, Professor of Finance at the University of North Carolina, and Merih Sevilir of the Finance Department at Indiana University.

Many mergers are driven by the desire to reduce competition in the product market and to develop new products to enter into new markets. In our paper, Mergers, Spin-offs, and Employee Incentives, forthcoming in The Review of Financial Studies, we argue that these two motives may be in conflict with each other in that mergers reducing product market competition have a negative effect on employee incentives to innovate and develop new products.

On one hand, mergers reduce the product market competition and increase expected payoffs from employee innovations. On the other hand, by reducing the number of firms in the product market, mergers limit employee ability to go from one firm to another with a negative effect on incentives. Moreover, mergers create internal competition between the employees of the post-merger firm, with an additional negative effect on incentives to innovate. When the negative effects of the merger on incentives are sufficiently large, firms are better off competing in the product market and competing for employee human capital rather than merging and eliminating competition. In other words, firms prefer not to merge and bear competition in the product market to maintain stronger employee incentives. In this way, our paper is consistent with the recent concerns voiced in the context of the AT&T and T-mobile merger, whereby practitioners have suggested that it will hamper incentives to innovate, as we argue in this paper.

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The Volcker Rule and Goldman Sachs

Posted by Andrew Tuch, Fellow, Harvard Law School Program on Corporate Governance, on
Thursday, April 28, 2011
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Andrew Tuch is a Fellow of the Program on Corporate Governance and a John M. Olin Fellow at Harvard Law School, as well as a senior lecturer in the Faculty of Law at the University of Sydney.

In its recently issued report, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, the Senate Permanent Subcommittee on Investigations considered the conduct of Goldman Sachs in several transactions, including the ABACUS 2007-AC1 collateralized debt obligation. The report “examines Goldman’s conduct in the context of the law prevailing in 2007,” [1] and it asserts that the Volcker Rule provisions of the Dodd-Frank Act, “if well implemented, will protect market participants from the self-dealing that contributed to the financial crisis.” [2] But what justification exists for the conflict of interest restrictions in the Volcker Rule provisions, and how would the Volcker Rule provisions have applied to the ABACUS CDO had the provisions been in force at the time?

In my paper, Conflicted Gatekeepers: The Volcker Rule and Goldman Sachs, I consider the conflict of interest restrictions in the Volcker Rule provisions. These provisions, namely Sections 619 and 621 of the Dodd-Frank Act, purport to impose fiduciary-like standards on banks in their arm’s length relationships with sophisticated counterparties. Section 619 generally prohibits banks from engaging in proprietary trading and affiliating with certain private funds; it permits some activities as exceptions to this general prohibition, but subjects such activities to the requirement that they not give rise to material conflicts of interest, including conflicts between banks and their “counterparties.” Section 621 purports to ban material conflicts of interest between banks (in their capacity as underwriters) and investors in offerings of asset-backed securities.

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The Destructive Ambiguity of Federal Proxy Access

Posted by Jill Fisch, University of Pennsylvania, on
Wednesday, April 27, 2011
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Jill Fisch is a Professor of Law at the University of Pennsylvania. The Program on Corporate Governance has issued several papers concerning proxy access, including Private Ordering and the Proxy Access Debate and The Harvard Law School Proxy Access Roundtable.

The paper, The Destructive Ambiguity of Federal Proxy Access, forthcoming in the Emory Law Journal, demonstrates the tension between the federal requirements for the exercise of shareholder nominating rights and the state law principles upon which the SEC purports to ground those rights. The paper unpacks the ambiguities in the SEC’s conception of which shareholders should nominate director candidates. And it highlights the ambiguity resulting from the SEC’s failure to confront, in adopting its rule, the appropriate allocation of power between shareholders and management and the effects of proxy access on that balance.

Under U.S. corporate law, the shareholders elect the board of directors. In most cases, however, those shareholders do not nominate director candidates. Instead, the nominating committee of the board chooses a slate of candidates, and those candidates are submitted to the shareholders for approval. Absent the infrequent phenomenon of an election contest, shareholders do not participate in the nomination process.

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