Monthly Archives: April 2012

April 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 April 2012 Davis Polk Dodd-Frank Progress Report, is the thirteenth 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 April 2, 2012, a total of 222 Dodd-Frank rulemaking requirement deadlines have passed. Of these 222 passed deadlines, 155 (69.8%) have been missed and 67 (30.2%) have been met with finalized rules.
  • In addition, 100 (25.5%) of 393 total required rulemakings have been met with finalized rules. Rules have not yet been proposed to meet 138 (35.1%) rulemaking requirements.

Investor Horizons and Corporate Cash Holdings

The following post comes to us from Jarrad Harford, Professor of Finance at the University of Washington; and Ambrus Kecskés and Sattar Mansi, both of the Department of Finance at Virginia Tech.

It is well known that the separation of ownership and control in public firms causes tension between investors and managers. These so-called “agency problems” are particularly pronounced in the use of corporate cash holdings because it is both easy for managers to misuse cash and hard for investors to evaluate the appropriateness of mangers’ use of cash. Moreover, cash holdings account for a substantial proportion of corporate assets (about 25% of total assets in recent years). Therefore, since firms with better internal corporate governance tend to use their cash holdings more for the benefit of their investors rather than their managers, it is not surprising that investors are willing to pay a higher price for them.

In the paper, Investor Horizons and Corporate Cash Holdings, which was recently made publicly available on SSRN, we study how the investment horizons of a firm’s institutional investors affect the agency costs of corporate cash holdings. It is widely recognized that monitoring by institutional investors of managers increases firm value. However, not all institutional investors are created equal, and, one important way in which they differ is their investment horizons. Differences in investment horizons arise, for example, because of differences in investment strategies (e.g., short-term hedge funds) and/or differences in the maturity of liabilities (e.g., long-term pension funds).

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Learning and the Disappearing Association between Governance and Returns

Lucian Bebchuk, Alma Cohen, and Charles C.Y. Wang are all affiliated with Harvard Law School’s Program on Corporate Governance.

The Journal of Financial Economics has recently accepted for publication our study, Learning and the Disappearing Association between Governance and Returns. The paper, which was earlier issued as a working paper of the Program on Corporate Governance, is available here.

Our study seeks to explain a pattern that has received a great deal of attention from financial economists and capital market participants: during the period 1991-1999, stock returns were correlated with the G-Index based on twenty-four governance provisions (Gompers, Ishii, and Metrick (2003)) and the E-Index based on the six provisions that matter most (Bebchuk, Cohen, and Ferrell (2009)). We show that this correlation did not persist during the subsequent period 2000-2008. Furthermore, we provide evidence that both the identified correlation and its subsequent disappearance were due to market participants’ gradually learning to appreciate the difference between firms scoring well and poorly on the governance indices. Consistent with the learning hypothesis, we find that:

(i) The disappearance of the governance-return correlation was associated with an increase in the attention to governance by a wide range of market participants;
(ii) Until the beginning of the 2000s, but not subsequently, stock market reactions to earning announcements reflected the market’s being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms;
(iii) Stock analysts were also more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms until the beginning of the 2000s but not afterwards;
(iv) While the G-Index and E-Index could no longer generate abnormal returns in the 2000s, their negative association with Tobin’s Q and operating performance persisted; and
(v) The existence and subsequent disappearance of the governance-return correlation cannot be fully explained by additional common risk factors suggested in the literature for augmenting the Fame-French-Carhart four-factor model.

Here is a more detailed account of our analysis:

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Hedge Fund Activism in Technology and Life Science Companies

This post is based on a Latham & Watkins LLP commentary by Nicholas O’Keefe, available here.

Hedge fund activism has received a lot of attention in the legal and financial communities since the middle of the last decade, and has been identified as a major threat to U.S. public companies. Some of the early literature suggested that hedge funds avoid companies with high levels of R&D (such as technology and life science companies), in part because their businesses are more complicated and it takes longer for efforts of the hedge funds to be appreciated by the investment community and to generate returns. There has also been an assumption among legal practitioners that many technology and life science companies are dependent on the skills of their founders, and thus a hedge fund campaign faces the risk that the main assets of the company may walk out the door. However, a review of campaigns of 33 hedge funds from 2005 through the end of 2011 indicates that hedge fund activism is not only a significant risk that technology and life science companies face, but one that may disproportionately target them relative to companies in other industries. This Commentary summarizes some of the findings regarding the funds involved and their campaigns, and makes recommendations to technology and life science companies on how to address the risks.

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Shadow Banking and Financial Instability

Editor’s Note: Lord Adair Turner is chairman of the United Kingdom Financial Services Authority. This post is based on a speech delivered by Lord Turner at the Cass Business School; the speech and accompanying slides are available here.

In autumn 2008 the developed world’s banking system suffered a severe crisis. In response the world’s regulators and central banks have focused on building a more stable banking system for the future: less leveraged, more liquid, better supervised and with even the largest banks able to be resolved without taxpayer’s support. The implementation of that bank-focused regulatory agenda is still unfinished, but much progress has been made.

Looking back to the year 2007/08, however, it’s striking that the crisis did not at first look like a traditional banking crisis, but rather one related to a new phenomenon: shadow banking. Initially the problems seemed concentrated in the US, where the development of non-bank credit intermediation was most advanced, and many of the events which marked the developing crisis related to non-bank institutions and markets.

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Insider Trading Restrictions and Insiders’ Supply of Information

The following post comes to us from Ivy Zhang of the Department of Accounting at the University of Minnesota and Yong Zhang of the Department of Accounting at Hong Kong University of Science and Technology.

In our paper, Insider Trading Restrictions and Insiders’ Supply of Information: Evidence from Reporting Quality, which was recently made publicly available on SSRN, we exploit a natural experiment involving first-time enforcement of insider trading laws around the world in order to examine the impact of insider trading restrictions on insiders’ supply of information. Following the existing literature, we measure the quality of financial reporting along four dimensions: earnings smoothing, earnings management towards positive earnings, loss recognition, and value relevance.

Empirical analyses indicate that reporting quality improves following a country’s first-time enforcement of insider trading laws only in countries with strong macro governance infrastructure, suggesting that a country’s legal infrastructures play an important role in determining earnings quality. Consistent with the prediction that firm-level governance structures significantly affect insiders’ incentives and their responses to regulations, we also find that the improvement in earnings quality is concentrated in less closely held firms.

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Nonprofit Corporate Governance: The Board’s Role

Lesley Rosenthal is the general counsel of Lincoln Center for the Performing Arts and the author of Good Counsel: Meeting the Legal Needs of Nonprofits. Bart Friedman, senior partner at Cahill Gordon & Reindel LLP, contributed to this post.

Governing boards in the for-profit and nonprofit contexts share many legal precepts: the oversight role, the decision-making power, their place in the organizational structure, and their members’ fiduciary duties. But in the nonprofit setting, misconceptions about corporate governance abound. Are board members primarily fundraisers? Cheerleaders? A rubber stamp to legitimize the actions and decisions of the executives? Do they run the organization to the extent staff is unable? Are they window-dressing to spruce up the organization’s letterhead? If they are rich or famous, must they attend board meetings? How do they know whether they are doing a good job, or when it is time to go? Despite the common ancestry and legal underpinnings, nonprofit corporate governance places heightened demands on trustees: a larger mix of stakeholders, a more complex economic model, and a lack of external accountability. This post explores how substituting a charitable purpose for shareholders’ interests affects the board’s role.

In organizations of all kinds, good governance starts with the board of directors. The board’s role and legal obligation is to oversee the administration (management) of the organization and ensure that the organization fulfills its mission. Good board members monitor, guide, and enable good management; they do not do it themselves. The board generally has decision-making powers regarding matters of policy, direction, strategy, and governance of the organization.

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Analyzing Global Proxy Voting Practices

Michael McCauley is Senior Officer, Investment Programs & Governance, of the Florida State Board of Administration (the “SBA”). This post is based on an excerpt from the SBA’s 2012 Corporate Governance Report by Mr. McCauley, Jacob Williams and Lucy Reams. Mr. Williams and Ms. Reams are Corporate Governance Manager and Senior Corporate Governance Analyst, respectively, at the SBA.

Fiscal year 2011 witnessed the SBA’s shift from domestic and foreign asset classes, to a combined global equity portfolio, with a heavier international equity weighting and a more balanced U.S. exposure. With the recent structural changes, the proportion of SBA assets invested in foreign equity markets will continue to rise, and a significant proportion may be managed internally. In 1998, for foreign equities was 7.6 percent, rising to 12.7 percent by 2003, and 18.8 percent by the end of fiscal year 2010. Upon completion of the transition to a combined global equity asset class, foreign equities composed 33 percent of FRS assets as of October 2011. As a percent of the equity asset class, foreign shares account for 56 percent and U.S. shares for 44 percent.

Coinciding with this shift, the SBA realigned its international proxy voting practices, bringing foreign voting decisions ”in-house” to match domestic SBA voting practices.

Previously, external asset managers were responsible for voting international proxies associated with SBA shares held in their funds. Since the SBA assumed this responsibility, votes are now cast by SBA staff—based on our own Corporate Governance Principles & Proxy Voting Guidelines and meeting specific research from our proxy research providers.

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CFTC Proposes Block Size Rules for Swaps

The following post comes to us from David J. Gilberg, partner at Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication from Mr. Gilberg and Kenneth M. Raisler; the full publication, including footnotes, is available here.

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) added Section 2(a)(13)(A) to the Commodity Exchange Act (the “CEA”), which requires the Commodity Futures Trading Commission (the “CFTC” or the “Commission”) to prescribe rules concerning the real-time reporting of swap transaction and pricing data. These rules are intended to provide transparency and enhance price discovery for swap contracts while protecting liquidity in the market as well as counterparty anonymity. On December 20, 2011, the Commission adopted rules concerning the “Real-Time Public Reporting of Swap Transaction Data” (the “Real-Time Reporting Rules”). At that time, the Commission chose not to adopt the provisions proposed in connection with these rules that concerned the procedures for determining minimum block sizes. Less than fifty days after adopting the Real-Time Reporting Rules, the Commission has re-proposed rules concerning procedures to establish appropriate minimum block sizes for large notional off-facility swaps and block trades (the “Proposed Rules”). If a trade size of a swap is greater than the appropriate minimum block size, whether executed on- or off-facility, the swap transaction and pricing data is subject to a reporting time delay. The Proposed Rules would provide a means for separating swaps into categories within five asset classes (the interest rates, credit, foreign exchange, equity and other commodity asset classes). Further, the Proposed Rules would establish prescribed initial appropriate minimum block sizes as well as methods for determining post-initial minimum block sizes. If the trade size of a swap is greater than the appropriate minimum block size, the swap transaction and pricing data is subject to a reporting time delay. The minimum block sizes in the Proposed Rules will be important not only for reporting purposes, but also may determine the size of trades that can be traded off-facility. The Proposed Rules would replace the interim cap sizes adopted in the Real-Time Reporting Rules with initial cap sizes and methods for determining post-initial cap sizes. In the release accompanying the Proposed Rules (the “Proposing Release”), the Commission offers a number of alternatives for categorizing swaps in each asset class as well as alternatives to the method for determining the appropriate minimum block size and cap size; the Commission would consider adopting any of these alternatives as a final rule.

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Mandatory IFRS Reporting and Changes in Enforcement

The following paper comes to us from Hans Christensen of the Department of Accounting at the University of Chicago; Luzi Hail of the Department of Accounting at the University of Pennsylvania; and Christian Leuz, Sondheimer Professor of International Economics, Finance and Accounting at the University of Chicago.

In our paper, Mandatory IFRS Reporting and Changes in Enforcement, which was recently made publicly available on SSRN, we examine the underlying sources of the capital-market benefits around the introduction of mandatory IFRS reporting. Prior work finds significant capital market benefits and also shows that the effects around IFRS adoption are significantly stronger in countries with stricter and better functioning legal systems, and that they are stronger in the EU than in other regions of the world. We argue that this evidence is consistent with several interpretations and that it is still an open question to what extent these positive effects around mandatory IFRS adoption are indeed attributable to the switch to arguably better, more capital-market oriented, and globally harmonized accounting standards.

We focus on market liquidity and rely on within- and across-country variation in the timing of IFRS adoption and of other institutional changes to disentangle several possible explanations. Specifically, we explore whether (i) the switch from local GAAP to IFRS reporting played a primary role for the observed capital-market benefits; (ii) the introduction of IFRS had capital-market benefits, but only in countries with strong institutions and legal enforcement; or (iii) the switch to IFRS reporting itself had little or no effect and, instead, concurrent changes to countries’ institutions drive the observed capital-market benefits.

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