Monthly Archives: March 2012

The Political Economy of Dodd-Frank

The following post comes to us from John C. Coffee Jr., Adolf A. Berle Professor of Law at Columbia University Law School.

For a number of years, commentators have noted that securities “reform” legislation seems to be passed only in the wake of major stock market crashes, with this pattern dating back to the South Sea Bubble. Some have argued that this pattern demonstrates the undesirability of such legislation, arguing that laws passed after a market crash are invariably flawed, result in “quack corporate governance” and “bubble laws,” and should be discouraged. Recently, this criticism has been directed at both the Sarbanes-Oxley Act and the Dodd-Frank Act. The forthcoming Cornell Law Review article, The Political Economy of Dodd-Frank: Why Financial Reform Tends to be Frustrated and Systemic Risk Perpetuated, presents a rival perspective. Investors, it argues, are naturally dispersed and poorly organized and so constitute a classic “latent group” (in Mancur Olson’s terminology). Such latent groups tend to be dominated by smaller, but more cohesive and better funded special interest groups in the competition to shape legislation and influence regulatory policy. This domination is interrupted, however, by major crises, which encourage “political entrepreneurs” to bear the transaction costs of organizing latent interest groups to take effective action. But such republican triumphs prove temporary, because, after the crisis subsides, the hegemony of the better organized interest groups is restored.


Shining a Light on Expenditures of Shareholder Money

Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on remarks by Commissioner Aguilar at the Practising Law Institute’s SEC Speaks in 2012 Program; the full remarks, including footnotes, are available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff. Work from the Program on Corporate Governance about corporate political spending includes Corporate Political Speech: Who Decides? by Lucian Bebchuk and Robert Jackson, discussed on the Forum here. A committee of law professors co-chaired by Bebchuk and Jackson submitted a rulemaking petition to the SEC concerning corporate political spending; that petition is discussed here.

The Commission’s core mission is to protect investors. William O. Douglas, a former chairman of the Securities and Exchange Commission, who went on to serve as a Supreme Court Justice, described the SEC’s role by contrasting it with a well-represented industry. Chairman Douglas said: “We’ve got broker’s advocates, we’ve got exchange advocates, we’ve got investment banker advocates, and we [the SEC] are the investor’s advocate.”

Not much has changed since Chairman Douglas spoke those words at his first press conference as SEC Chairman in 1937. The industry, with its lobbyists and spokespeople, remains the loudest voice – in fact, one could say that things have gotten much worse. As a result, investors need an advocate today more than ever.


Corporations and Political Spending: A New Lobbying Focus in the 2012 Proxy Season

The following post comes to us from Heidi Welsh, Executive Director of the Sustainable Investments Institute (Si2), and Julie Fox Gorte, Senior Vice President for Sustainable Investing at Pax World Funds. This post discusses a Si2/IRRC Institute report, “Corporate Governance of Political Expenditures: 2011 Benchmark Report on S&P 500 Companies,” available here. Work from the Program on Corporate Governance about corporate political spending includes Corporate Political Speech: Who Decides? by Lucian Bebchuk and Robert Jackson, discussed on the Forum here. A committee of law professors co-chaired by Bebchuk and Jackson submitted a rulemaking petition to the SEC concerning corporate political spending; that petition is discussed here.

We are on the cusp of the 2012 spring corporate annual meeting season, where the headline issue is political spending in this election year. The primary focus for investor activists until now has been campaign spending, but this year investor activists also want more transparency about lobbying, in a big new development. This speaks to the allegations of undue corporate influence on politics and the economy raised by the Occupy Wall Street movement. Companies are providing more oversight and disclosure of their political spending, as we discuss below, but the investor appetite for more is huge, evidenced by both high votes on shareholder resolutions and the sheer number of proposals. Nine votes last year earned more than 40 percent support from investors, a highwater mark. And these resolutions now make up one-third of the approximately 350 social policy shareholder resolutions that have been filed for 2012, up from 23 percent of the total in 2011 and only 15 percent in 2010.


Earnings Management from the Bottom Up

The following post comes to us from Felix Oberholzder-Gee and Julie Wulf, both of the Strategy Unit at Harvard Business School.

In our paper, Earnings Management from the Bottom Up: An Analysis of Managerial Incentives below the CEO, which was recently made publicly available on SSRN, we analyze all components of compensation packages for CEOs and for managers at levels below that of the CEO. Pay-for-performance contracts are a critical instrument to align the interests of principals and agents (Jensen and Meckling, 1976). While it can be optimal to make the agent the residual claimant of the firm’s profit, under numerous conditions principals are better off employing weaker incentives. These include situations with poor measures of performance and multitasking environments, when agents reduce their motivation in response to financial incentives, and when principal and agent have differing priors.

Another cost of high-powered incentives is that they provide managers with incentives to manipulate the firm’s reported earnings. For example, equity incentives can entice managers to boost reported earnings just before they exercise options or sell stock. There are now a number of academic studies – and many anecdotes – that document this link between the structure of chief executive officer (CEO) compensation and various measures of earnings manipulation (e.g., Beneish and Vargus, 2002; Bergstresser and Philippon, 2006; Peng and Roell, 2008). These papers generally focus on one component of compensation for the top position—equity incentives for the CEO. In this paper, we extend this literature by analyzing all components of compensation packages for CEOs and for managers at lower levels. To our knowledge, this study is the first that analyzes the relationship between CEO, division manager, and chief financial officer (CFO) compensation and earnings management in a large sample of firms.


Custom-Made Material Adverse Effect Provisions

Daniel Wolf is a partner at Kirkland & Ellis LLP focusing on mergers and acquisitions. This post is based on a Kirkland & Ellis M&A Update by Mr. Wolf, David B. Feirstein, and Joshua M. Zachariah.

Regardless of the state of the deal market, Material Adverse Effect, or MAE/MAC, provisions remain among the most hotly contested negotiating points for dealmakers. Contemporary purchase and merger agreements almost invariably contain some form of an MAE, defined generally as events or changes that have (or, in some cases, would or could reasonably be expected to have) a material adverse effect on the target company, subject to negotiated exceptions. MAE clauses typically serve two main purposes — they are used to qualify representations and warranties (and in some cases, covenants), and act as a condition to closing for the benefit of the buyer (i.e., the buyer is not required to close if the target has suffered an MAE between signing and closing).


Internal Corporate Governance, CEO Turnover, and Earnings Management

The following post comes to us from Jonathan Karpoff, Professor of Finance at the University of Washington, and Sonali Hazarika and  Rajarishi Nahata, both of the Department of Finance at Baruch College, City University of New York.

In our paper, Internal Corporate Governance, CEO Turnover, and Earnings Management, forthcoming in the Journal of Financial Economics, we examine whether executives who manage earnings increase the risk of losing their jobs. We find that earnings management is strongly associated with the subsequent likelihood of forced CEO turnover, but is not significantly related to voluntary turnover. This basic result holds through several test specifications, including multinomial logistic regressions and competing risks hazard models. In the short run, aggressive earnings management in any given year is associated with an increased likelihood of forced ouster the next year. And in the long run, a CEO’s job tenure is negatively related to earnings management over the time he or she is in the CEO position. Similar results hold when we examine the forced turnover of CFOs. A large battery of sensitivity tests reported in the Internet Appendix indicate that these results are robust to alternate measures of earnings management and different model specifications.


A Path Forward for Bank Acquisitions

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. A related memo from Sullivan & Cromwell LLP on bank mergers and acquisitions is available here.

The Federal Reserve’s approval recently of Capital One’s application to acquire ING Bank, fsb, taken together with its December approval of PNC’s proposed acquisition of RBC Bank (USA), marks a path forward for bank acquisitions. Despite broad industry concerns about unrealistic capital expectations by the regulators and Dodd-Frank’s mandate that the Federal Reserve consider financial stability risk factors in M&A applications, Capital One and PNC demonstrate that with advance preparation and thoughtful structuring, it is possible for large banks to navigate the regulatory process and make strategic acquisitions. However, the regulatory process has clearly changed post-crisis, and larger banks should be prepared for a more extended and thorough vetting of their acquisitions by the regulators.

The Federal Reserve processing of the Capital One and PNC filings took approximately seven months and four-and-a-half months, respectively. The Capital One processing was extended as a result of a large number of internet-based protests organized by certain community groups, three public hearings and the Federal Reserve’s refinement of its framework for evaluating financial stability risk. Going forward, acquirors should expect renewed regulatory focus on consumer and CRA compliance matters and inquiries concerning all allegations raised by community groups and others, even those that may be regarded as non-substantive. Acquirors will need to demonstrate the sufficiency of their compliance and other risk-management systems, including in connection with their expanded operations and increased size.


Draft French Financial Transaction Tax

The following post comes to us from Gauthier Blanluet, partner focusing on tax, mergers and acquisitions, and capital markets at Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication by Mr. Blanluet and Nicolas de Boynes.

Following the outline released by France’s and Germany’s Ministers of Finance on September 9, 2011, and the publication of a draft directive by the EU Commission on September 28, 2011, draft legislation to introduce a financial transaction tax (the “FTT”) in France was presented by the French government on February 8, 2012. This proposal will now be discussed by the French Parliament.

The scope of the FTT would not be as broad as that of the EU proposal. First, the FTT would be applicable on acquisitions of equity instruments only. Second, the FTT would be due if the equity instrument is issued by a French-listed company with a market capitalization of at least €1bn. The FTT would amount to 0.1% of the value of the equity instrument. The French government estimates that the revenues from the FTT would amount to €1.1bn per year.

Two other specific taxes would also be introduced by the same finance bill: a 0.01% tax would apply to high frequency trading operations located in France (the tax basis would be equal to the value of cancelled orders), and another 0.01% tax would apply to the notional amount of credit default swaps on EU sovereign bonds that are acquired by entities established or individuals domiciled in France.

In addition, the finance bill would repeal the recent reform of French transfer tax rules applicable to transfers of shares.


Permanently Reinvested Earnings and the Profitability of Foreign Cash Acquisitions

The following post comes to us from Alexander Edwards of the Rotman School of Management at the University of Toronto, Todd Kravet of the Naveen Jindal School of Management at the University of Texas at Dallas, and Ryan Wilson of the Tippie College of Business at the University of Iowa.

Prior research has documented that current U.S. corporate tax laws create incentives for some U.S. multinational corporations (MNC) to delay repatriation of foreign earnings in order to defer taxation on those earnings and hold greater amounts of cash abroad. The current financial accounting treatment for taxes on foreign earnings under ASC 740 potentially exacerbates this issue and increases the incentive to avoid the repatriation of foreign earnings by allowing firms to designate foreign earnings as permanently reinvested and to defer the recognition of the U.S. tax expense related to foreign earnings for financial reporting purposes. In our paper, Permanently Reinvested Earnings and the Profitability of Foreign Cash Acquisitions, which was recently made publicly available on SSRN, we predict and document that the combined effect of these tax and financial reporting incentives likely lead to significant agency costs. Namely, managers of U.S. MNCs with high levels of both permanently reinvested earnings and cash holdings are more likely to make value-destroying acquisitions of foreign target firms. Our findings are consistent with anecdotal evidence from the popular press. For example it has been suggested that a significant determinant of Microsoft’s decision to acquire Skype for $8.5 billion was that Skype was a foreign company with headquarters in Luxemburg, enabling Microsoft to use foreign cash “trapped” overseas to make the acquisition (Bleeker 2011).


Developments in M&A Shareholder Litigation

John Gould is Senior Vice President at Cornerstone Research. This post is based on a Cornerstone Research report prepared in cooperation with Professor Robert Daines of Stanford Law School. The report, titled Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions, is available here. For more information, contact Mr. Gould or Olga Koumrian. An updated version of the report is available here.

Shareholder litigation challenging merger and acquisition (M&A) deals has increased substantially in recent years. To study this increase and characterize the recent litigation, Cornerstone Research and Professor Robert Daines of the Stanford Law School reviewed reports of M&A shareholder litigation in Securities and Exchange Commission (SEC) filings related to acquisitions of U.S. public companies valued over $100 million and announced in 2010 or 2011. [1] We found that almost every acquisition of that size elicited multiple lawsuits, which were filed shortly after the deal’s announcement and often settled before the deal’s closing. Only a small fraction of these lawsuits resulted in payments to shareholders; the majority settled for additional disclosures or, less frequently, changes in merger terms, such as deal protection provisions. Interestingly, while requiring additional disclosures is a common outcome, we have not encountered a case in which shareholders rejected the deal after the additional disclosures were provided.

In this report, we provide statistics on recent M&A shareholder lawsuits, describing their prevalence, filing timelines, venue choices, outcomes, and settlement terms.


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