Monthly Archives: January 2012

What’s Over the Horizon for OTC Derivatives?

Posted by David Felsenthal, Clifford Chance LLP, on
Saturday, January 14, 2012
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David Felsenthal is a partner at Clifford Chance LLP focusing on financial transactions. This post is based on a Clifford Chance client memorandum by Mr. Felsenthal, Jeremy Walter, and Caroline Dawson.

European and US market participants are having to prepare for the introduction of OTC derivatives legislation and clearing reforms, despite continuing uncertainty about the exact nature of significant elements of the new rules. Given the ‘sea of change’ engulfing the sector it’s important to focus on the practical effects of new regulation from a clearing member or market participant perspective.

Mapping the ‘sea of change’

Before going into any detail on individual areas of concern, it is worth very briefly sketching out the regulatory framework. In the US, the mechanism for implementing OTC derivatives regulations and clearing reforms is contained in the Dodd-Frank Act, while in Europe, the main legislation is the European Market Infrastructure Regulation (EMIR – as below), supported by further reforms in the Markets in Financial Instruments Directive (MiFID) and the Capital Requirements Directive 4 (CRD4). These changes are in response to the financial crisis, which highlighted a lack of information on positions and exposures of individual firms in OTC derivatives. This issue was seen to have prevented regulators from getting a clear view of the inherent risks building up in the system. It was also judged to have impeded accurate assessment of the consequences of a default and, as described by a recent European Commission impact assessment, “helped fuel suspicion and uncertainty among market participants during a crisis”.

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The Martin Act and Common-Law Claims

Posted by William Savitt, Wachtell, Lipton, Rosen & Katz, on
Friday, January 13, 2012
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William Savitt is a partner in the Litigation Department of Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum from Mr. Savitt, Herbert M. Wachtell, John F. Savarese, Jonathan M. Moses, David B. Anders, and Jasand Mock.

In a decision troublesome to the business community, the New York Court of Appeals has now determined that the New York Martin Act does not preempt private plaintiff lawsuits based solely upon traditional common-law causes of action such as negligence and breach of fiduciary duty — even where there may be overlap with statutory claims reserved to the New York Attorney General. From the fact that the Act itself had been held years ago not to give rise to a private cause of action, numerous rulings from both New York State and Federal courts held that the Act preempted non-fraud common-law tort claims. Deeming itself unable to find anything in either the text of the statute or its legislative history that would support such preemption, the Court affirmed a more recent ruling by the Appellate Division, First Department, and ruled the doctrine out. Assured Guarantee (UK) Ltd. v. J.P. Morgan Investment Management Inc., No. 227 (N.Y. Dec. 20, 2011).

In doing so, the Court nevertheless reaffirmed its prior rulings that the Martin Act itself creates no private right of action and that preemption would continue to exist where the claim is entirely dependent upon a violation of the Martin Act or its implementing regulations, including certain specific real estate provisions that are part of the Act.

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Analyzing Speech to Detect Financial Misreporting

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, January 13, 2012
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The following post comes to us from Jessen Hobson of the Department of Accountancy at the University of Illinois at Urbana-Champaign and William Mayew and Mohan Venkatachalam, both of the Department of Accounting at Duke University.

In our paper, Analyzing Speech to Detect Financial Misreporting, forthcoming in the Journal of Accounting Research, we examine whether nonverbal vocal cues elicited from speech are useful in detecting intentional deception in financial reporting. Detecting deceptive financial reporting is an increasingly important concern for auditors, regulators, investors, and the various constituents that interact with corporations. High profile accounting scandals such as Enron, WorldCom, Tyco, and Satyam have cost market participants several billions of dollars and eroded confidence in published financial statements. These events call into question the ability to uncover financial misstatements by auditors who review and provide an opinion on the financial statements (PCAOB [2007], [2010]). Even sophisticated market participants such as institutional investors and analysts have been remarkably unsuccessful at detecting financial fraud (Dyck et al. [2010]).

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2011 Annual Corporate Governance Review

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, January 12, 2012
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The following comes to us from David Drake, President of Georgeson Inc, and is based on the executive summary of Georgeson’s 2011 Annual Corporate Governance Review by Mr. Drake, Rhonda L. Brauer, Rajeev Kumar, Steven Pantina, and Rachel Posner. The full review is available for download here.

The past decade has been a whirlwind for corporate governance in America. Since 2001, we have witnessed a myriad of scandals, epic corporate failures and legislative and regulatory attempts to prevent more of the same. Early on it was the failure of firms such as Enron, WorldCom and Global Crossing. More recently, the failure of financial stalwarts like Lehman Brothers, Bear Stearns and AIG nearly pushed our markets to the brink of collapse. These failures have ushered in a new era of shareholder activism and corporate governance initiatives, including extensive legislative reform efforts and new rules by the Securities and Exchange Commission (SEC), the New York Stock Exchange (NYSE) and the Financial Industry Regulatory Authority (FINRA).

While many of the proxy-related reforms have focused on enhanced disclosure requirements (the SEC has approved expansive new rules around director experience and qualifications, board leadership structure, board risk oversight responsibilities and Compensation Disclosure and Analysis (CD&A) disclosure), new regulations have been put in place that fundamentally shift what issues are considered by shareholder at annual meetings in the United States.

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Executive Compensation: What Will 2012 Bring?

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, January 12, 2012
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This post comes to us from John J. Cannon, a partner in the Executive Compensation and Employee Benefits Group at Shearman & Sterling LLP, and is based on a memorandum by Linda Rappaport.

Executive compensation continues to command the center stage in public discourse about corporate governance. In the context of a troubled worldwide economy, the focus on pay in the financial services industry— most prominently evidenced by the Occupy Wall Street movement— has led to increased scrutiny of executive compensation at all companies.

As 2011 draws to a close, boards of directors of U.S. public companies are subject to conflicting pressures in making executive pay decisions for this year and in designing compensation programs for 2012. There is a widespread public sentiment that senior executives of large U.S. corporations are paid too much, and there are newly enacted laws and regulations that emphasize the importance of paying for performance and guarding against excessive risk-taking. Corporate directors, however, continue to have an obligation to foster the future profitability of their corporations, and they see compensation as a key motivating tool.

Against this backdrop, it is helpful to look forward to major legal themes that will be likely to affect incentive compensation in 2012 and the effect those themes may have on decision-making in U.S. corporate boardrooms.

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Proposed Federal Rules Regarding Alternatives to Credit Ratings

Posted by H. Rodgin Cohen, Sullivan & Cromwell LLP, on
Wednesday, January 11, 2012
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H. Rodgin Cohen is a partner and senior chairman of Sullivan & Cromwell LLP focusing on acquisition, corporate governance, regulatory and securities law matters. This post is based on the executive summary of a Sullivan & Cromwell publication by Andrew Gladin and Joel Alfonso; the complete publication is available here.

The Federal banking agencies have recently issued three notices of proposed rulemaking (and applicable related guidance) in connection with the implementation of Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Section 939A generally requires that all Federal agencies remove from their regulations references to and requirements of reliance on credit ratings and replace them with appropriate alternatives for evaluating creditworthiness.

Market Risk Capital NPR:

The Office of the Comptroller of the Currency (the “OCC”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the Federal Deposit Insurance Corporation (the “FDIC” and, together with the Federal Reserve and the OCC, the “agencies”) issued a joint notice of proposed rulemaking (the “Market Risk Capital NPR”) concerning their market risk capital rules applicable to certain U.S. banking organizations with significant trading operations by proposing standards of creditworthiness to be used in place of credit ratings when calculating the specific risk capital requirements for covered debt and securitization positions, including the following:

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The Risk-Shifting Hypothesis

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, January 11, 2012
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The following post comes to us from Augustin Landier, Professor of Economics at the Toulouse School of Economics; David Sraer of the Department of Economics at Princeton University; and David Thesmar, Professor of Finance at HEC.

In our paper, The Risk-Shifting Hypothesis: Evidence from Sub-Prime Organizations, which was recently presented at Harvard, we provide evidence consistent with risk-shifting in the lending behavior of a large subprime mortgage originator (New Century Financial Corporation) starting in 2004. This change follows the monetary policy tightening implemented by the Fed in the spring of 2004, which resulted in an adverse shock to the large portfolio of loans New Century was holding for investment. New Century reacted to this shock by massively resorting to deferred amortization loan contracts (“interest-only” loans).

Financial institutions, when in distress, may take excessive risk. Because they do not bear the losses in case of failure, shareholders of distressed banks have a natural preference for risky lending, fueling asset bubbles, banking crises and prolonged recessions. Our goal in this paper is to provide direct evidence of risk shifting in a large financial institution. To this end, we use the internal records of a major subprime originator, New Century Financial Corporation (NC). NC is a good candidate to study risk-shifting: in 2004, its payout ratio went up from 5% to 90%, consistent with textbook asset substitution. Against this background, our project-level (loan-level) data allows us to accurately characterize the distortion in risk preferences induced by financial distress.

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Bebchuk Leads SSRN’s 2011 Rankings

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, January 10, 2012
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Statistics released by the Social Science Research Network (SSRN) indicate that Professor Lucian Bebchuk continued in 2011 to lead SSRN ranks as he has done in each of the preceding four years. As of December 2011, Bebchuk ranked first among all law school professors (in all fields) in terms of both the number of citations to his work and the number of downloads of his work on SSRN. (SSRN’s rankings in terms of citations are available here and SSRN’s rankings in terms of downloads are available here.) Bebchuk’s papers (available on his SSRN page here) have attracted a total of more than 3,500 citations and about 170,000 downloads.

Bebchuk’s top ten papers in terms of citations are as follows:

SSRN is the leading electronic service for social science research, and its electronic library contains (as of December 2011) over 307,000 full-text documents by more than 176,000 authors.

Say-on-Pay Year Two: a Planning Primer

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Monday, January 9, 2012
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Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP. This post is based on a Davis Polk client memorandum by Ning Chiu, Edmond T. FitzGerald, William M. Kelly, Richard J. Sandler, and Ron M. Aizen.

For most companies 2011 was the first year for say-on-pay. The good news is that most emerged from the process unscathed. Only a relative handful (38 of the Russell 3000, including eight in the S&P 500) failed to receive majority support as of October, and those companies are part of a small number (157 and 42, respectively) that received less than 70% of the votes cast.

Shareholders also displayed a strong preference for annual votes, which means that year two is almost upon us. Companies with failed or close votes in 2011 know that they will face heightened scrutiny, particularly as to whether changes were made in response to the vote. But all public companies should consider the lessons learned from year one and make say-on-pay assessment part of their regular annual planning process.

Here are some suggestions to keep in mind.

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The Consequences of Private Meetings with Investors

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, January 9, 2012
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The following post comes to us from David Solomon of the Department of Finance at the University of Southern California and Eugene Soltes of the Accounting and Management Unit at Harvard Business School.

Private meetings between executives and investors consume a significant amount of managerial time and offer investors a potentially unique window into a firm’s operations. In our paper, What Are We Meeting For? The Consequences of Private Meetings with Investors, which was recently made publicly available on SSRN, we investigate which funds meet privately with management and the consequences of these interactions.

We find that certain types of investors are more likely to privately meet with management including those with more assets, greater turnover, closer physical proximity to the firm, and greater holdings of the firm. We also find that hedge funds are also more likely to meet with management. These findings are consistent with the incentives of both sell‐side analysts (who arrange meetings for investors that offer the greatest revenue opportunities for the sell‐side analysts’ firm) and investors who have the most to gain from meetings with management.

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