Monthly Archives: February 2012

Financial Reporting Challenges for 2012

The following post comes to us from Catherine T. Dixon, member of the Public Company Advisory Group at Weil, Gotshal & Manges LLP, and is based on the introduction of a Weil Gotshal client alert by Ms. Dixon and Ellen J. Odoner, available in full here.

Reflecting the continued uncertainty and volatility of the global economic environment, this year’s financial reporting challenges center around the identification, analysis and disclosure of risks and uncertainties. Those responsible for preparing, certifying, reviewing and/or signing their companies’ forthcoming annual reports on Form 10-K should be aware of recent disclosure guidance issued by the Securities and Exchange Commission (SEC)’s Division of Corporation Finance regarding two specific categories of risk – cyber security threats and exposure to potential European sovereign and private debt defaults. This disclosure guidance is the latest example of how, in this era of change, the SEC and its staff expect companies to apply a principles-based, holistic approach to analysis and disclosure of material risks and uncertainties of all kinds.


Narrative Disclosure and Earnings Performance

The following post comes to us from Kenneth Merkley of the Department of Accounting at Cornell University.

In the paper, Narrative Disclosure and Earnings Performance: Evidence from R&D Disclosures, which was recently made publicly available on SSRN, I examine whether earnings performance relates to the quantity of narrative R&D disclosure that firms provide concurrently in their financial reports. A large body of research examines how managers’ incentives to voluntarily disclose information depend on whether that specific disclosure would reveal good or bad news. This study differs from prior work on the relation between performance and disclosure in that I examine whether earnings performance, a mandatory disclosure, relates to firms’ decisions to provide narrative disclosures – one of the main channels used to convey contextual information about a firm’s operations to investors. While more quantitative disclosures such as earnings guidance have received considerably more attention, narrative information makes up a comparatively large amount of disclosure information and helps to bridge the gap between a firm’s economic reality and its financial statements.


Bebchuk Testifies on Compensation at Large Financial Firms

Editor’s note: Lucian Bebchuk is Professor of Law, Economics, and Finance and Director of the Corporate Governance Program at Harvard Law School. The Program has issued several studies on compensation authored or co-authored by Professor Bebchuk, including Regulating Bankers’ Pay, Paying for Long-Term Performance, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, and How to Fix Bankers’ Pay.

Professor Lucian Bebchuk testified yesterday before the Subcommittee on Financial Institutions and Consumer Protection of the United States Senate Committee on Banking, Housing and Urban Affairs. He participated in a hearing on “Pay for Performance: Incentive Compensation at Large Financial Institutions.” In addition to Bebchuk, the other witnesses testifying in the hearing were Kurt Hyde, Deputy Special Inspector General of the Troubled Asset Relief Program; Professor Robert J. Jackson, Jr., Associate Professor of Law at Columbia Law School; and Michael S. Melbinger, an executive compensation expert appearing on behalf of the Financial Services Roundtable.

In his testimony, Bebchuk explained how compensation practices at financial firms should be reformed to eliminate excessive risk-taking incentives. He described two distinct shortcomings of pay arrangements: first, excessive focus on short-term results; and, second, excessive focus on results for shareholders. He then discussed how pay arrangements should be designed to address each of these problems. In particular, Bebchuk explained how pay structures  should be designed to induce executives to focus on long-term rather than short-term results, as well as to induce such executives to take into account the consequences of their decisions for all those contributing to the bank’s capital (rather than only for shareholders). Bebchuk suggested that the rules proposed by regulators last spring be strengthened to ensure that financial firms provide executives with such incentives. Because of the importance of providing such incentives for financial stability, he concluded, ensuring that financial firms  provide such incentives should be regarded as a regulatory priority.

Bebchuk’s written testimony is available here.

The Outlook for Bank M&A in 2012

Edward Herlihy is a partner and co-chairman of the Executive Committee at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Herlihy, Richard K. Kim, Lawrence S. Makow, Nicholas G. Demmo, David E. Shapiro, Matthew M. Guest, Patricia A. Robinson, and David M. Adlerstein.

This time last year appeared to hold the promise of increased deal activity, as a series of significant strategic deals were announced in the waning days of 2010 and fundamentals appeared to be aligned. That promise began to manifest itself in the opening months of the year, with several significant deals. As the year wore on, though, deal activity was dampened by several troubling environmental realities: an alarming sovereign debt and bank crisis in Europe, persistent U.S. monetary policy promising sustained low interest rates and a flat yield curve, a weak U.S. housing market and a tricky legal and regulatory landscape.

There were, though, some very bright spots. Leading the way were transformative deals by Comerica, Capital One and PNC. We also witnessed increasingly ambitious efforts by several stronger community banks to intelligently strengthen their franchises through successive smaller acquisitions in strategically important markets. Bank M&A in 2012 will likely remain episodic, as current ongoing business and regulatory conditions and weak equity market valuations will surely take more time to work through. Still, we should see a continued trend of stronger banks making selective, targeted acquisitions focused more on securing their long-term competitive positioning and maintaining balance sheet strength (and less on a short-term boost to quarterly earnings) as well as increasing pressure on smaller banks from several fronts to accept current valuations.


Challenges in Board Leadership

Jeffrey Stein is a partner in the Corporate Practice Group at King & Spalding LLP. This post comes to us from Mr. Stein, Bill Baxley, and Rob Leclerc, and is based on a report from the Lead Director Network, available here.

All directors share the responsibility of helping a board resolve challenging board issues. Lead directors, however, frequently guide the board through critical situations. Although there are many different issues that a board may encounter that are well suited for a lead director’s involvement, a lead director often plays a key role in resolving the following four challenges: (1) handling individual director performance issues, (2) responding to an underperforming CEO, (3) bringing new directors on board, and (4) preparing for lead director succession.

The Lead Director Network (the “LDN”), a group of lead directors, presiding directors and non-executive chairmen from many of America’s leading companies, met on November 1, 2011 to discuss their role as lead directors in these and other challenges. Following this meeting, King & Spalding and Tapestry Networks have published a ViewPoints report here to present highlights of the discussion that occurred at the meeting and to stimulate further consideration of these subjects.

The following provides highlights from the LDN meeting, as described in the ViewPoints report.


Securities Litigation: Recent Supreme Court Decisions and Future Trends

Peter Atkins is a partner of corporate and securities law matters at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a section from Skadden’s 2012 Insights, contributed by Frances Kao, Jay B. Kasner, Christopher P. Malloy, Matthew J. Matule, Peter B. Morrison, Scott D. Musoff, and Susan L. Saltzstein.

Recent and Upcoming Supreme Court Decisions

In 2011, the Supreme Court decided three significant securities cases: Matrixx Initiatives, Inc. v. Siracusano 131 S. Ct. 1309 (2011), regarding statistical significance in the context of securities fraud; Erica P. John Fund, Inc. v. Halliburton Co. 131 S. Ct. 2179 (2011), addressing the relationship between loss causation and class certification; and Janus Capital Group, Inc. v. First Derivative Traders 131 S. Ct. 2296, 2305 (2011), construing the phrase “to make” under the SEC’s Rule 10b-5. Coming up in the term that began in October 2011, the Court will decide Credit Suisse Securities v. Simmonds, to clarify the two-year statute of limitations under Section 16(b) of the Securities Exchange Act.


Comparing Corporate Governance Principles & Guidelines

Holly J. Gregory is a corporate partner specializing in corporate governance at Weil, Gotshal & Manges LLP. This post discusses a Weil Gotshal report by Ms. Gregory and Rebecca C. Grapsas, available here.

Although discussions continue to be robust about effective corporate governance practices, review of the aspirational governance principles and guidelines issued by influential board, management and investor affiliated associations and pension funds indicates significant areas of agreement. Areas of apparent agreement include, for example, the appropriate voting standard in director elections (majority voting in uncontested elections with a director resignation policy, plurality for contested elections), the need for some form of independent board leadership (whether in the form of an independent chair or lead or presiding director) and the importance of formal board evaluation processes.

The Comparison of Corporate Governance Principles & Guidelines from Weil, Gotshal & Manges LLP highlights the convergence in views about effective governance practices and structures, as well as remaining areas of disagreement, by providing a side-by-side look at suggestions for board structure and practice from influential players in the investor, board and management communities. The Comparison shows a range of structures and practices that are generally acceptable, while reflecting general agreement that “one size does not fit all.”


Banks and the Global Credit Crisis

The following post comes to us from Andrea Beltratti, Professor of Finance at the Università Bocconi, and René Stulz, Professor of Finance at Ohio State University.

In our paper, The Credit Crisis Around the Globe: Why Did Some Banks Perform Better?, forthcoming in the Journal of Financial Economics, we investigate the determinants of the relative stock return performance of large banks across the world during the period from the beginning of July 2007 to the end of December 2008. Our study does not focus on why the crisis happened. Rather, it is an investigation of the validity of various hypotheses advanced in the literature and the press as to why banks performed so poorly during the crisis.

Analyses of the crisis that emphasize the fragility of banks financed with short-term funds raised in the money markets are strongly supported by our empirical work, as are analyses that emphasize the role of bank capital. We find that large banks with more Tier 1 capital, more deposits, and less funding fragility performed better. Banks from countries with current account surpluses fared significantly better during the crisis, while banks from countries with banking systems more exposed to the U.S. fared worse. These latter results show that macroeconomic imbalances and the traditional asset contagion channel are related to bank performance during the crisis.


Executive Pay and the Financial Crisis: A Response to René Stulz

Editor’s Note: Below is the response by Professor Lucian Bebchuk to the opening statement of Professor René Stulz in an online debate between the two of them at a World Bank forum. The debate focused on the question: Has executive compensation contributed to the financial crisis? The moderator’s introduction to the debate is available here; Lucian Bebchuk’s opening statement is available here; René Stulz’s opening statement is available here; Lucian’s Bebchuk’s response is available here; and René Stulz’s response is available here. Bebchuk’s response refers to two studies on the subject issued by the Harvard Law School Program on Corporate Governance, Regulating Bankers’ Pay and Paying for Long-Term Performance.

In his opening statement, René Stulz relies on the results of the Fahlenbrach-Stulz study (FS study) to reject the view that executive compensation has contributed to the financial crisis. Stulz argues that the evidence in his study is “inconsistent with the view that banks performed poorly because CEOs had poor incentives.” However, as explained below, the FS study does not provide a good basis for rejecting the poor incentives view.

The FS study attempts to test the “poor incentives” hypothesis by examining whether banks whose CEOs had larger equity holdings performed better during the crisis. Failing to find such an association – and indeed finding that such banks performed worse – the FS study rejects the poor incentives hypothesis. But the poor incentives view does not attribute poor risk-taking incentives to relatively low equity holdings, and the analysis in the FS study does not supply an adequate test of this view.

As I explained in my opening statement, the poor incentives view does not regard large equity holdings as the way to ensure good risk-taking incentives and does not view poor incentives as rooted in insufficient equity holdings. Rather, as I explained, poor incentives have resulted from (i) design of equity compensation (as well as bonus compensation) that rewarded executives even for short-term results that were subsequently reversed, and (ii) linking executive payoffs only to payoffs for shareholders and not also to payoffs for other contributors of capital to financial firms (such as bondholders).


CFTC Rule on Protection of Swap Collateral

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former Commissioner at the U.S. Securities and Exchange Commission. This post is based on a Davis Polk client memorandum.

In adopting final rules on the treatment of cleared swap customer collateral, the CFTC has taken a major step in defining the architecture of market-wide swap clearing, a key pillar of the Dodd-Frank Act’s derivatives reform. After receiving intense arguments for divergent types of collateral protection, the CFTC adopted the “legal segregation, operational commingling” (“LSOC”) model.

The LSOC model is designed to eliminate the “fellow customer risk” to which futures customers are exposed. Under the LSOC model, if a customer of a futures commission merchant (“FCM”) defaults on a cleared swap margin obligation and the FCM is not able to satisfy the defaulting customer’s obligations, the derivatives clearing organization (“DCO”) has no recourse to funds of the FCM’s non-defaulting customers. Therefore, LSOC is intended to provide additional protection, albeit at an additional cost, to cleared swap customers beyond the current futures DCO model. In contrast, under the futures DCO model, any FCM customers’ swap collateral is available to the DCO upon a default of both the FCM and one of its futures customers. The CFTC has not extended the LSOC model to futures at this time, but will consider doing so.


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