Yearly Archives: 2012

Payout Policy through the Financial Crisis

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, February 6, 2012
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The following post comes to us from Eric Floyd, Nan Li, and Douglas Skinner, all of the Department of Accounting at the University of Chicago Booth School of Business.

Why managers pay dividends remains a puzzle. In our paper, Payout Policy through the Financial Crisis: The Growth of Repurchases and the Resilience of Dividends, which was recently made publicly available on SSRN, we report evidence on the payout policy of US financial and industrial firms over the past 30 years, including through the financial crisis, to shed new light on the why managers pay dividends. There are two specific goals. First, we investigate whether, as would be expected if share repurchases now dominate dividends as a means of paying cash to shareholders, managers used the financial crisis as a convenient excuse to stop paying dividends. Second, we use these data to provide new evidence on whether taxes, and in particular the Tax Relief Act of 2003 (which effectively eliminated the tax disadvantage of dividends) had a first order effect on payout policy.

We find that industrials and financials both increased payouts in the years prior to the crisis, at a pace that was impressive both in absolute terms and relative to earnings. Dividends reach a low point in 2002 but rebound thereafter. Although there is an increase in the fraction of dividend-payers immediately after the Tax Relief Act, we show that this is part of a broader increase in cash payouts that also includes a strong increase in repurchases. In the years after the Tax Relief Act there is no evidence of a shift in the mix of dividends and repurchases towards dividends—if anything, the reverse is true. Nor is there evidence of an increase in dividend payout ratios.

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Say-on-Pay Lawsuits – Is This Time Different?

Posted by Keith L. Johnson, Reinhart Boerner Van Deuren s.c., on
Sunday, February 5, 2012
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Keith L. Johnson heads the Institutional Investor Legal Services team at Reinhart Boerner Van Deuren s.c. This post is based on a Reinhart alert by Mr. Johnson and Kenneth B. Davis; the complete article is available here.

In the aftermath of the first proxy season of shareholder “say-on-pay” votes under the Dodd-Frank Act, shareholders have filed derivative suits against the boards of several of the companies failing to win majority approval. Many observers have been quick to dismiss the plaintiffs’ likelihood of success in these cases, given the well-established principle that decisions on compensation lie within the board’s business judgment. However, while a Georgia court, in the Beazer Homes USA litigation, relied on the business judgment rule to dismiss a say-on-pay shareholder derivative case, at roughly the same time a federal judge in Ohio reached the opposite conclusion, refusing to dismiss a say-on-pay suit involving Cincinnati Bell. [1] In light of these unfolding and conflicting developments, how should directors and compensation committees assess and respond to the risk of suit?

In our view, boards would be ill advised to take too much comfort in the belief that the business judgment rule will always be held to immunize compensation decisions from shareholder attack in the face of a substantial negative say-on-pay vote. The time might be coming for courts to start applying a stricter standard of review in these cases. Analysis of the rationale underlying the courts’ traditional deference to boards on compensation matters reveals that the unique circumstances presented by say-on-pay may lead to a different outcome.

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Implementing the Volcker Rule

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Saturday, February 4, 2012
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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 testimony before the House of Representatives Committee on Financial Services, available here.

Last November, the FDIC, jointly with the Federal Reserve Board of Governors (FRB), the Office of the Comptroller of the Currency (OCC), and the Securities and Exchange Commission (SEC), published a notice of proposed rulemaking (NPR) requesting public comment on a proposed regulation implementing the Volcker Rule requirements of the Dodd-Frank Act. On December 23, the four agencies extended the comment period for an additional 30 days until February 13, 2012. The comment period was extended as part of a coordinated interagency effort to allow interested persons more time to analyze the issues and prepare their comments, and to facilitate coordination of the rulemaking among the responsible agencies. In addition, on January 11, 2012, the Commodity Futures Trading Commission (CFTC) approved the issuance of its NPR to implement the Volcker Rule, with a substantially identical proposed rule text as the interagency NPR. We look forward to receiving comments on the NPR.

In recognition of the potential impacts that may arise from the proposed rule and its implementation, the Agencies have requested comments on whether the rule represents a balanced and effective approach in implementing the Volcker Rule or whether alternative approaches exist that would provide greater benefits or implement the statutory requirements with fewer costs. The FDIC is committed to developing a final rule that meets the objectives of the statute while preserving the ability of banking entities to perform important underwriting and market-making functions, including the ability to effectively carry out these functions in less-liquid markets.

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White Collar and Regulatory Enforcement

Posted by Wayne M. Carlin, Wachtell, Lipton, Rosen & Katz, on
Friday, February 3, 2012
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Wayne Carlin is a partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum.

The last ten years have seen a continuous increase in white collar criminal and regulatory enforcement activity. 2011 was no exception, and we expect the trend to continue in 2012.

While not an entirely new phenomenon, the world of white collar and regulatory enforcement appears more politicized than ever. Corporations facing investigations in 2012 can expect extensive press scrutiny, serial leaks about the investigation, and, on occasion, parallel involvement of Congress and others at any stage of the matter. The credit a company can expect to receive for providing cooperation seems ever more uncertain, especially in cases receiving a high level of public focus, notwithstanding government protestations that cooperation will be rewarded. And, it is likely to get harder going forward to shepherd corporate resolutions of these kinds of cases through this politicized landscape. There is no simple solution to these challenges. But, as we discuss below, it remains critical for companies responding to multipronged investigations to keep clear lines of communication open with government investigators, to address questions candidly and with integrity, to correct identified problems promptly, and to build upon and strengthen investments made before the inquiry began in establishing a culture of compliance.

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Decoding Inside Information

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, February 3, 2012
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The following post comes to us from Lauren Cohen and Christopher Malloy, both of Harvard Business School, and Lukasz Pomorski of the Department of Finance at the University of Toronto.

In our paper, Decoding Inside Information, forthcoming in the Journal of Finance, we employ a simple empirical strategy to decode the information in insider trading. Our analysis rests on the basic premise that insiders, while possessing private information, trade for many reasons, and that by identifying ex-ante those insiders whose trades are “routine” (and hence uninformative), one can better isolate the true information that insiders contain about the future of firms. Using simple definitions of routine traders, we are able to systematically and predictably identify insiders as either opportunistic or routine throughout our sample. We show that stripping away the uninformative signals of routine traders leaves a set of information-rich opportunistic trades that are powerful predictors of future firm returns, news, and events.

We show that while the abnormal returns associated with routine traders are essentially zero, a portfolio strategy that instead focuses solely on opportunistic insider trades yields value-weighted (equal-weighted) abnormal returns of 82 basis points per month (180 basis points per month). Similarly, in a regression context the combined differences in the coefficients between opportunistic trades and routine trades translate into an increase of 158 basis points per month in the predictive ability of opportunistic trades relative to routine trades. Further, this effect increases with the strength of the opportunistic signal (as measured by the number of trades or trade-size intensity), but is unrelated to the strength of the routine signal.

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SEC Disclosure Guidance on Exposures to European Sovereign Debt

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, February 3, 2012
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The following post comes to us from Brian V. Breheny, partner at Skadden, Arps, Slate, Meagher & Flom LLP, and is based on a Skadden memorandum by Mr. Breheny and Andrew J. Brady.

On Friday, January 6, 2012, the staff of the SEC’s Division of Corporation Finance issued the fourth installment in its new Disclosure Guidance Topic series. Topic No. 4 focuses on the exposures of registrants to the debt of certain European countries. The staff specifically highlighted its concern about “the risks to financial institutions that are SEC registrants from direct and indirect exposures to” European sovereign debt.

Enhanced Disclosures

The goal of this new guidance is to expand and enhance the disclosures that registrants provide related to sovereign debt exposures, to ensure that investors have transparent and comparable information about the uncertainties of these exposures. This information generally is included in registrants’ disclosures about risk factors, qualitative and quantitative market risks, and management’s discussion and analysis. Bank holding companies and other registrants engaging in similar lending and deposit activities also are required to make the disclosures required by the SEC’s Industry Guide 3 (Statistical Disclosure by Banking Holding Companies).

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Board Focus 2012: Issues and Developments

Posted by Victor I. Lewkow, Cleary Gottlieb Steen & Hamilton LLP, on
Thursday, February 2, 2012
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Victor Lewkow is a partner at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb alert memorandum by Mr. Lewkow, David Becker, Alan Beller, Janet Fisher, Arthur Kohn, and Ethan Klingsberg.

Governance developments in 2011 brought some good news. Shareholder governance proposals were at their lowest level since 2002. Support declined for controversial proposals, such as shareholders’ right to call special meetings or act by written consent, and ISS conceded that its recommendations about written consent proposals should reflect the company’s governance as a whole. Even say-on-pay voting had some worthwhile effects. It gave shareholders the means to express more targeted dissatisfaction, driving a decline in opposition to director incumbents, and it prompted more and better dialogue between many companies and their major shareholders and better disclosure about the business rationale for pay decisions.

But regulators and shareholders remain energized. The SEC brought a record number of enforcement proceedings in 2011, a trend likely to continue, and it and the PCAOB have several important regulatory initiatives underway. For their part, shareholders remain acutely focused on stock performance as the yardstick to evaluate a company’s execution, despite market swings experienced in 2011 that reflected more than anything else fragile economic and political conditions worldwide. The Eurozone crisis and election year politics will keep business prospects extremely challenging and uncertain. In this context, it is critical for boards to frame their deliberative processes in a way that assures the protection of the business judgment rule, while positioning themselves and management to meet expectations of regulators and investors alike. We highlight below some of the issues we believe boards should keep in mind in 2012.

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A New Playbook for Global Securities Litigation and Regulation

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, February 2, 2012
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The following post comes to us from Paul A. Ferrillo, counsel at Weil, Gotshal & Manges LLP specializing in complex securities and business litigation, and is based on a Weil Alert by Mr. Ferrillo, Robert F. Carangelo and Catherine Y. Nowak.

Key developments in both the litigation and regulatory context are compelling multinational corporations to reassess their global securities litigation and regulatory compliance strategies. In the litigation context, recent U.S. Supreme Court activity has limited the ability of overseas plaintiffs to bring securities class action claims within the United States. As such, plaintiffs have shifted litigation to more flexible jurisdictions in Europe and overseas, thereby forcing global firms listed on multiple exchanges to increasingly defend against securities class action claims and regulatory investigations in numerous jurisdictions. At the same time, governments around the world have responded to the recent financial crisis by bolstering their regulatory capability. Governments have not only adopted more robust legislative regimes with respect to securities regulation, but they have also invested heavily in stronger enforcement protocols.

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A Blueprint for Contingent Convertible Securities?

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, February 2, 2012
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The following post comes to us from Michael O’Bryan, co-chair of the global M&A Group and a partner in the Corporate Finance Group at Morrison & Foerster LLP, and is based on a Morrison & Foerster Client Alert by Peter Green and Jeremy Jennings-Mares.

It has probably not escaped the attention of the reader that European banks, and their ability to meet their continuing funding needs, have been some of the principal victims of the continuing uncertainty surrounding the future of the Eurozone, due to their exposures to Eurozone sovereign debt. As part of its general efforts to increase market confidence in European banks, the European Banking Authority (EBA) published a Recommendation [1] on 8 December 2011 as to the creation and maintenance of temporary capital buffers by European banks.

The EBA recommends that European banks should have created, by 30 June 2012, a temporary capital buffer by attaining a Core Tier 1 capital ratio of at least 9 percent.

The Core Tier 1 capital ratio is to be calculated by comparing a bank’s Core Tier 1 capital to its risk-weighted assets. “Core Tier 1 capital” is defined to include ordinary shares or similar instruments, but also newly-issued contingent convertible instruments if their terms comply with a new common term sheet for such instruments (“Buffer Convertible Capital Securities” or “BCCS”) set out by the EBA in Annex III to the Recommendation. This represents the first time that a European banking authority has laid down in such detail the core terms that such an instrument should possess in order to count as Tier 1 capital. Existing convertible capital instruments of European banks will not be counted towards the 9 percent ratio, unless they convert into Core Tier 1 capital by the end of October 2012.

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Executive Pay and the Financial Crisis

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, February 1, 2012
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Editor’s Note: Lucian Bebchuk is Professor of Law, Economics, and Finance and Director of the Corporate Governance Program at Harvard Law School. This post is the opening statement in an online debate at a World Bank forum between Lucian Bebchuk and René Stulz on the question: Has executive compensation contributed to the financial crisis? The moderator’s introduction to the debate is available here, Lucian Bebchuk’s statement is available here, and René Stulz’s opening statement is available here, with responses by Bebchuk and Stulz expected next week. Bebchuk’s post refers to several studies on the subject issued by the HLS Program on Corporate Governance, including Regulating Bankers’ Pay, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, and Paying for Long-Term Performance.

Yes, there is a good basis for concern that executive pay arrangements have contributed to excessive risk-taking during the run-up to the financial crisis. To be sure, other factors were clearly at work: the environment within which firms operated grew riskier due to asset bubbles generated by macro policies and global factors, and regulatory constraints on risk-taking and capital requirements were too lax. As financial economists generally recognize, however, for any given environment and outside constraints, the performance and risk choices of firms depend substantially on the incentives of firms’ executives. Unfortunately, rather than provide incentives to avoid excessive risk-taking, the design of pay arrangements in financial firms encouraged such risk-taking.

Of course, despite incentives to take excessive risks, some executives might have avoided doing so due to professional integrity, reputational concerns, or fiduciary duty norms. And some executives taking excessive risks might have done so due to their under-estimation of the risks taken. But economics and finance teach us that incentives often matter. Thus, to the extent that pay arrangements provided significant incentives to take excessive risks, the possibility that such incentives in fact contributed materially to the excessive risks taken in the run-up to the crisis should be seriously considered.

In fact, pay arrangements did provide substantial incentives for excessive risk-taking. Under the standard design of pay arrangements, executives were fully exposed to the upside of risks taken but enjoyed substantial insulation from part of the downside of such risks. As a result, executives had incentives to increase risk-taking beyond optimal levels.

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