Monthly Archives: January 2012

Corporate Governance and Capital Structure Dynamics

The following post comes to us from Erwan Morellec, Professor Finance at Ecole Polytechnique Fédérale de Lausanne; Boris Nikolov of the Department of Finance at the University of Rochester; and Norman Schürhoff, Professor of Finance at the University of Lausanne.

In our paper, Corporate Governance and Capital Structure Dynamics, forthcoming in the Journal of Finance, we examine the importance of manager-shareholder conflicts in capital structure choice and characterize their effects on the dynamics and cross section of corporate capital structure. To this end, we develop a dynamic tradeoff model that emphasizes the role of agency conflicts in firms’ financing decisions. The model features corporate and personal taxes, refinancing and liquidation costs, and costly renegotiation of debt in distress. In the model, each firm is run by a manager who sets the firm’s financing, restructuring, and default policies. Managers act in their own interests and can capture part of free cash flow to equity as private benefits within the limits imposed by shareholder protection. Debt constrains the manager by reducing the free cash flow and potential cash diversion (as in Jensen, 1986, Zwiebel, 1996, or Morellec, 2004). In this environment, we determine the optimal leveraging decision of managers and characterize the effects of manager-shareholder conflicts on target leverage and the pace and size of capital structure changes.

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The ISS 2012 Policy Updates: Another View of the Cathedral

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.

Companies looking ahead to the 2012 proxy season should be aware of the recently updated corporate governance policies of Institutional Shareholder Services (ISS). [1] While maintaining its formal policy of issuing “case-by-case” evaluations in many areas, ISS has issued numerous revisions of prior policies as well as new policies on certain types of shareholder proposals that had not been previously addressed. The key areas of interest for companies preparing for 2012 are likely to be proxy access, say-on-pay, pay-for-performance, and risk oversight.

Proxy Access

Shareholder proposals on proxy access are likely to be a topic of importance next year due to the Securities and Exchange Commission’s (SEC) amendment to Rule 14a-8, effective September 20, 2011. The rule now provides that companies may not exclude proposals for proxy access procedures from their proxy statements on the basis that they relate to the nomination or election of directors. Proponents must meet the current eligibility requirements of Rule 14a-8, which require that the shareholder have owned at least the lesser of $2,000 in market value, or 1 percent, of company shares for at least one year. (Companies may, of course, ask for noaction relief from the SEC to exclude such proposals on other grounds. [2])

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FTSE Announces Change to Minimum Free Float Requirements

The following post comes to us from Glen M. Scarcliffe, partner at Cleary Gottlieb Steen & Hamilton LLP, and is based on a Cleary Gottlieb Alert Memorandum.

On December 14, 2011, the FTSE Group published the results of its market consultation on the minimum free float [1] requirements for inclusion of premium London-listed companies [2] in the FTSE UK Index Series – one of the most recognized indices in the world, which includes the FTSE 100 Index. The key outcome of the consultation is that, as of January 1, 2012, the minimum free float required for UK-incorporated companies will increase from 15% to 25%, with grandfathering of existing FTSE companies until January 1, 2014.

I. Current Free Float Requirements

Under the FTSE Ground Rules, companies that wish to be included in the FTSE UK Index Series must maintain a minimum free float:

  • of at least 50%, if not incorporated in the UK; or
  • of at least 15% (or 5% where the relevant company’s market capitalization exceeds US $5 billion), if incorporated in the UK.

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January 2012 Dodd-Frank Progress Report

The following post comes to us from Margaret E. Tahyar and Gabriel D. Rosenberg of the Financial Institutions Group at Davis Polk & Wardwell LLP. This post discusses a Davis Polk report which is available here. A post about the previous progress report is available here. Other posts about the Dodd-Frank Act are available here.

This posting, the January 2012 Davis Polk Dodd-Frank Progress Report, is the tenth in a series of Davis Polk presentations that illustrate graphically the progress of the rulemaking work that has been done and is yet to occur under the Dodd-Frank Act. The Progress Report has been prepared using data from the Davis Polk Regulatory Tracker™, an online subscription service offered by Davis Polk to help market participants understand the Dodd-Frank Act and follow regulatory developments on a real-time basis.

In this report:

  • As of the end of 2011, deadlines for half of Dodd-Frank’s rulemaking requirements have passed.  25.5% of the passed deadlines have been met with finalized rules.
  • Major rulemaking activity this month included a Federal Reserve proposal on enhanced prudential standards and CFTC final rules on swap data recordkeeping and reporting.
  • In 2011, the CFTC, FDIC, Federal Reserve and SEC held 1720 reported meetings with the public on Dodd-Frank. The Progress Report includes each regulator’s top five topics of discussion at those meetings.

The Case for Intervening in Bankers’ Pay

The following post comes to us from John Thanassoulis of the Department of Economics at the University of Oxford. Work from the Program on Corporate Governance about bankers’ pay includes Regulating Bankers’ Pay by Bebchuk and Spamann, and How to Fix Bankers’ Pay by Bebchuk.

In the paper, The Case for Intervening in Bankers’ Pay, forthcoming in the Journal of Finance, I model banker remuneration in the context of competition between banks, thereby allowing financial regulation to be assessed in the light of its impact on the default risk arising from remuneration. Bonuses are important to banks—more so than purely for their incentive effects. Bonuses have much better insurance properties than wages do as the remuneration payment is better connected with the realized state of investments, while wages add to banks’ fixed costs. If investment returns are poor then the required bonus remuneration payments shrink—just when the danger of a default event is present.

Competition between banks for bankers creates a negative externality which drives banks’ default risk upwards. Each bank bids up bonuses on teams of bankers who they do not ultimately hire. This pushes up remuneration costs for the bank which does hire any given team. For 1 in 10 financial institutions on the NYSE, these remuneration costs can represent over 80% of the shareholder equity. Remuneration payments of this size increase the risk of default of the institution significantly: a default event occurs even at smaller investment losses. Hence, the banks are forced to incur higher costs due to the increased chance of the costs of a default event (forced asset sales, higher costs of capital) being incurred.

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Proxy Access Heats Up for 2012

Francis H. Byrd is Senior Vice President, Corporate Governance & Risk Practice Leader at Laurel Hill Advisory Group. This post is based on a Laurel Hill newsletter by Mr. Byrd. Work from the Program on Corporate Governance about proxy access includes Private Ordering and the Proxy Access Debate by Bebchuk and Hirst; more posts about proxy access can be found here.

As we prepare to bring down the curtain on 2011 and look ahead to a new year and proxy voting season, the fallout from the governance scandals, risk control and business failures continue to rain down upon executives, boards and shareholders providing lessons for each.

Although the final word on the individual problems spotlighted at the above mentioned companies has yet to be stated, the lessons and the actions they will result in are fairly clear. Without casting judgments on the companies and individuals involved we’ll comment, in this week’s and our final Byrd Watch for 2011, on what we believe the key lessons are and how market participants (investors, senior executives and corporate directors among them) may react going forward.

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New Dodd-Frank Regulatory Framework for Thrift Institutions

The following post comes to us from Dwight C. Smith, partner focusing on bank regulatory matters at Morrison & Foerster LLP, and is based on the executive summary of a Morrison & Foerster publication, Thrift Institutions After Dodd-Frank: The New Regulatory Framework, which is available in full here.

On July 21, 2011, thrift institutions entered a new regulatory structure, with the transfer of regulatory responsibility for these institutions from the Office of Thrift Supervision (“OTS”) to the other federal banking agencies and with other changes under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank” or the “Act”). [1] Dodd-Frank and related reforms, including new international capital standards, will, over time, shape the operations of savings and loan holding companies (“SLHCs”) and their subsidiary thrifts. For the most part, the changes will bring the thrift and bank charters closer together, and SLHCs will be treated nearly the same as bank holding companies (“BHCs”). Reinforcing the similarity in treatment are various amendments Dodd-Frank has made to the same provisions in the thrift statute and the banking statutes. Some important distinctions nevertheless will remain, including a slightly greater range of activities for thrift institutions and the qualified thrift lender test.

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The Independent Board Requirement and CEO Connectedness

The following post comes to us from E. Han Kim, Professor of Finance and International Business at the University of Michigan, and Yao Lu of the School of Economics and Management at Tsinghua University.

In our paper, The Independent Board Requirement and CEO Connectedness, which was recently made publicly available on SSRN, we investigate unintended consequences of the independent board requirement.  Following highly publicized corporate scandals in 2001 and 2002, firms listed on the NYSE and NASDAQ are required to have a majority of independent directors. The intent is to better protect shareholders by making boards more independent from managerial influence and thereby more effective monitors. However, the majority requirement represents a ceiling on the percentage of dependent directors a firm may have.

If board composition is endogenous, the quota may trigger reactions by firms affected by the regulation. Board composition is but one of many facets of governance. Imposition of a quota on one governance mechanism may spillover to other governing bodies as firms find ways to counteract it. This paper attempts to identify the spillover effects, analyze their consequences, and answer several questions: How do CEOs react to a regulation that may reduce their influence over the board? How do the reactions, if any, manifest in the softer side of governance, namely, CEO connectedness with other key players in governing the firm? How do the spillover effects impact the regulatory intent?

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Activism and the Move toward Annual Director Elections

The following post comes to us from Tom Nohel, Associate Professor of Finance at Loyola University, and is based on a Conference Board Director Note by Mr. Nohel, Re-Jin Guo of the University of Illinois at Chicago, and Timothy Kruse of Xavier University. Work from the Program on Corporate Governance on staggered boards includes The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence & Policy by Bebchuk, Coates and Subramanian, and Staggered Boards and the Wealth of Shareholders: Evidence from Two Natural Experiments by Bebchuk, Cohen and Wang.

Staggered boards, a structure under which the board is divided into classes, with one class of directors standing for re-election annually, are perhaps the most consequential takeover defense. They also are a favorite target of activist shareholders and governance experts. The effect of collective pressure to move to annual elections for all directors has been dramatic: the proportion of public companies with staggered boards has fallen from 60 percent in 2002 to less than half in 2011 (and less than one-third among S&P 500 companies). Non-binding shareholder proposals have been an important catalyst in the move away from staggered boards. [1] More recently, activist hedge funds have emerged as an alternate and better-financed vehicle to channel shareholder displeasure. This report documents the extent to which activism of any type continues to push corporations to implement annual director elections and compares the influence different forms of activism have had on this governance practice.

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ISS’ New Pay-for-Performance Evaluation Methodology

Carol Bowie is Executive Director at ISS. An ISS white paper detailing the methodology discussed below is available here.

Escalating CEO pay packages in the last few decades have stirred much debate, culminating in mandated advisory shareholder votes on executive compensation under the Dodd-Frank Act of 2010. The first year of widespread “say-on-pay” votes in the U.S. suggests that investors are taking a conservative approach – about 40 proposals at Russell 3000 index companies received less than majority support from votes cast for and against, and fewer than 200 received support from less than 70 percent. The advent of say on pay in the U.S. has highlighted pay-for-performance as the most significant factor driving investors’ voting decisions on the issue, however.

Doubts about the strength of pay and performance alignment arise from perceptions of “agency problem” conflicts of interest, weak board oversight and aggressive pay benchmarking; from demonstrated abuses such as options backdating; and most recently, from concern that pay practices at some firms likely contributed to the financial meltdown that triggered the latest economic and market malaise.  Further, while executive pay has increased at a fairly rapid pace since the 1980s, investor portfolios have experienced multiple market swings – booms and busts that often appear disconnected from individual executives’ impact — adding to skepticism about long-term pay and performance alignment.

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