Monthly Archives: May 2012

Legal Entities as Transferable Bundles of Contracts

The following post comes to us from Kenneth Ayotte, Professor of Law at Northwestern University, and Henry Hansmann, Professor of Law at Yale University.

The large modern business corporation is frequently organized as a complex cluster of hundreds of corporate subsidiaries under the common control of a single corporate parent. General Electric, for example, has over 1500 subsidiaries, most of them wholly-owned. What is the purpose of all these subsidiaries? Do they exist only as a means of avoiding taxation and regulation? Or are there real efficiency gains that subsidiaries can help unlock?

In our paper, Legal Entities as Transferable Bundles of Contracts, which was recently made publicly available on SSRN, we provide new theory and supportive evidence that help explain a relatively unexplored benefit of subsidiaries. We focus, in particular, on the advantages of subsidiary entities in enhancing the transferability of a business unit. The theory not only sheds light on corporate subsidiaries, but illuminates a basic function of all types of legal entities, from partnerships to nonprofit corporations.

Many of the modern firm’s key assets come in the form of bilateral contracts, in which both parties to the contract are exposed to performance risk from the other party. Take, for example, the movie rental company, Redbox, which is a wholly-owned subsidiary of Coinstar. Many of Redbox’s key assets are contractual, including agreements with movie studios to acquire DVDs, and revenue sharing agreements with companies like Wal-Mart that house Redbox kiosks. Real estate, such as corporate headquarters and processing facilities, are frequently acquired through long-term leases.


Delaware Court Expedites Proceedings to Enjoin Enforcement of Advance Notice Bylaw

Editor’s Note: Eduardo Gallardo is a partner focusing on mergers and acquisitions at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson Dunn client alert by Jeffrey Chapman, Brian Gingold, and Rachel Harrison. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

On April 20, 2012, Vice Chancellor Noble of the Delaware Court of Chancery issued an opinion in Icahn Partners LP v. Amylin Pharmaceuticals, Inc. [1] granting a motion to expedite a claim by Carl Icahn that Amylin’s directors breached their fiduciary duties by not waiving Amylin’s advance notice bylaw. Following the passage of the bylaw deadline, Icahn sought to nominate candidates for election to Amylin’s board of directors in the wake of his learning of Amylin’s recent rejection of an unsolicited takeover proposal by Bristol-Myers Squibb Co. Vice Chancellor Noble found that Icahn successfully made a “sufficiently colorable claim” [2] of irreparable injury as a result of the Board’s decisions to reject the Bristol-Myers proposal and his request to waive the advance notice deadline and re-open the nomination process.

The Facts

Amylin’s bylaws contain a fairly customary advance notice provision requiring stockholders to submit director nominations at least 120 days prior to the first anniversary of the preceding year’s annual meeting, unless the meeting date is delayed or advanced by more than 30 days from the anniversary. Given that Amylin’s 2011 annual meeting was held on May 24, 2011 and its 2012 annual meeting was scheduled for May 15, 2012, the cutoff for valid stockholder nominations was January 25, 2012 (the 120th day prior to the first anniversary of the May 24, 2011 meeting). No stockholder nominations were received prior to such date.


Federal Reserve’s Chinese Bank Determination Has Broader Implications

Margaret E. Tahyar is a partner in Davis Polk & Wardwell LLP’s Financial Institutions Group. This post is based on a Davis Polk publication by Ms. Tahyar, Luigi De Ghenghi, Andrew Fei, and other Davis Polk attorneys; the full version is available here.

The Federal Reserve’s decision this week to confer Comprehensive Consolidated Supervision (“CCS”) status to three state-owned Chinese banks has been long awaited and paves the way for major Chinese banks to enter retail commercial banking in the United States by acquiring U.S. banks. We view the Federal Reserve’s decision, which is the first CCS determination with respect to a major jurisdiction in nearly 10 years, as encouraging for banks from other emerging economies that wish to expand their activities in the United States by acquiring U.S. banks or electing to become financial holding companies (“FHCs”). Since many developed economies have attained CCS status, the key markets that might, over time, indirectly benefit from the China CCS determination include Dubai, India, Malaysia, Saudi Arabia, Singapore and South Africa. Brazilian and Mexican banks already benefit from earlier CCS determinations. There are, however, a few lessons to be learned from the Chinese experience, which we take to mean that CCS determinations will require patience and persistence. These lessons are:

  • A willingness on the part of the Chinese government and major Chinese banks to make the CCS determination a policy priority across a range of trade, economic and strategic relationships;
  • A willingness to invest in smaller U.S. community and regional banks by Chinese banks with a traditional commercial banking profile;
  • A strong, reciprocal desire by U.S. financial institutions to enter or expand their presence in the Chinese market;
  • A determined effort on the part of the Chinese government and Chinese regulatory authorities to enhance their overall supervisory framework, as well as their anti-money laundering controls; and
  • An appreciation that, in today’s environment, CCS determinations may be incremental and more likely to be made on a bank-by-bank basis (or at least with respect to similar banks in the same country).


Toward Effective Governance of Financial Institutions

Lord Adair Turner is chairman of the United Kingdom Financial Services Authority. This post is excerpted from a report from the Group of Thirty, titled Toward Effective Governance of Financial Institutions, available here. The Group of Thirty is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia.

What is meant by “governance” in the context of a financial institution (FI)? [1] Corporate governance is traditionally defined as the system by which companies are directed and controlled. The OECD Principles of Corporate Governance (2004) defines corporate governance as involving

“a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.” [2]

In the case of financial institutions, chief among the other stakeholders are supervisors and regulators charged with ensuring safety, soundness, and ethical operation of the financial system for the public good. They have a major stake in, and can make an important contribution to, effective governance.

Good corporate governance requires checks and balances on the power and rights accorded to shareholders, stakeholders, and society overall. Without checks, we see the behaviors that lead to disaster. But governance is not a fixed set of guidelines and procedures; rather, it is an ongoing process by which the choices and decisions of FIs are scrutinized, management and oversight are strengthened and streamlined, appropriate cultures are established and reinforced, and FI leaders are supported and assessed.


Skin in the Game and Moral Hazard

The following post comes to us from Gilles Chemla, Professor of Finance at the Imperial College Business School, and Christopher Hennessy, Professor of Finance at the London Business School.

Formulation of optimal regulation of asset-backed securities (ABS) markets has been hindered by the inability to identify specific market failures as well as the absence of well-defined social welfare objectives. In our paper, Skin in the Game and Moral Hazard, which was recently presented at Harvard University, we develop a tractable framework for analyzing social welfare in both regulated and unregulated ABS markets, accounting for moral hazard at the origination stage, private information at the distribution stage, and asymmetric information across ABS investors. We show originators operating in unregulated markets fail to internalize the costs they impose on investors if they utilize a common ABS structure (e.g. zero retentions) rather than credibly signaling positive information to the market via higher retentions. Further, originator effort incentives are reduced since those developing high value assets must either signal via high retentions or otherwise face underpricing of their securities. Mandated retentions have the potential to raise welfare by increasing originator effort incentives in an efficient way, accounting for investor-level spillovers.

The first important policy implication to emerge from the model is that regulators must choose between a “one-size scheme” under which all originators are forced to hold the same retention size (e.g. 5%) or a “menu scheme” under which originators must choose amongst multiple retention sizes (e.g. 4% or 8%). Both schemes can restore effort incentives. However, the menu scheme carries the added social benefit of allowing originators to signal positive information to investors via the choice of a larger retention. Signaling promotes efficient sharing of risks by mitigating the adverse selection problem confronting uninformed ABS investors. The weakness of the menu scheme is that it generally results in higher average retentions, resulting in lower originator fundraising.


Rulemaking Petition on Disclosure of Corporate Political Spending Attracts Massive Support from over 250,000 Comments Filed with the SEC

Editor’s Note: Lucian Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School. Robert J. Jackson, Jr. is Associate Professor of Law at Columbia Law School. This post is related to an SEC rulemaking petition available here and discussed on the Forum here. Bebchuk and Jackson are co-authors of Corporate Political Spending: Who Decides?, discussed on the Forum here and here.

Last July, we co-chaired a committee of ten corporate and securities law experts that submitted a rulemaking petition to the Securities and Exchange Commission urging the Commission to develop rules to require public companies to disclose their political spending. As of today, the petition has attracted massive support from a record number of comments filed with the SEC.

Altogether, as is indicated on the SEC’s webpage for comments filed on the petition, the SEC has received more than a quarter of million comments on the petition. An analysis of the comment file indicates that all except eight were supportive of the petition.

Of the filed comments, 259,801 came from individuals who expressed their views through one of six common types of letters received by the Commission. The submission of comments by such a large number of individuals was partly due to the work of the Corporate Reform Coalition, a group that includes institutional investors and public officials. While the 259,801 comments used standard form letters, each of them was separately submitted by one or more individuals who presumably were interested enough in the subject to file a comment with the SEC.

In addition to the 259,801 comments using form letters, the SEC received 487 “unique” comments on the petition. Of these comments, 5 came from institutional investors; 7 were submitted by government officials; 12 were submitted by researchers and nonprofits; 3 were submitted by other organizations such as religious groups; and 460 comments came from individuals who did not indicate an affiliation. Within this group of 487 unique comments, all but eight comments expressed support for the petition.


Lehman Bankruptcy Court Interprets Safe Harbor Protections

The following post comes to us from James L. Bromley, partner and a leader of the global restructuring and insolvency practice at Cleary Gottlieb Steen & Hamilton LLP, and is based on a Cleary Gottlieb alert memorandum.

On April 19, 2012, the United States Bankruptcy Court for the Southern District of New York granted in part a motion to dismiss claims asserted by Lehman Brothers Holdings Inc. (together with its debtor-affiliates, “Lehman”) against JPMorgan Chase Bank, N.A (“JPMorgan”). [1] The claims at issue arose from JPMorgan’s efforts in the months leading up to Lehman’s bankruptcy to mitigate its exposure as Lehman’s primary clearing bank by requiring Lehman to post a significant amount of additional collateral and expand the scope of the obligations secured by that collateral. Lehman and its creditors’ committee challenged these transactions under the avoidance provisions of the Bankruptcy Code and asserted other causes of action, including common law claims for unjust enrichment and invalidation of the contractual amendments that improved JPMorgan’s position.

The decision applies the safe harbor protections of Section 546(e) to dismiss Lehman’s preference and constructive fraud claims. However, the court rejected JPMorgan’s efforts to apply Section 546(e) more broadly, allowing Lehman’s parallel common law claims to proceed even where they are based on similar allegations. The decision also applies a relaxed pleading standard to Lehman’s claims for actual fraud, under which it found that Lehman had adequately alleged facts to state a claim under Section 548(a)(1)(A). The decision thus provides support for a literal application of the safe harbor protections to dismiss certain claims at the pleading stage. However, the decision also suggests that even where a transaction falls within the scope of Section 546(e), artful pleading may permit plaintiffs to survive a motion to dismiss. The decision thus underscores the importance of considering potential litigation risks and costs when analyzing transactions with distressed counterparties.


The Dangers of Dual Share Classes

The following post comes to us from Kimberly Gladman, Director of Research and Risk Analytics at GovernanceMetrics International, and is based on a GMI Ratings report by Ms. Gladman and Beth M. Young, available here.

Executive Summary

Recent issues related to dual share classes with disparate voting rights have sparked controversy at Google, News Corp, and perhaps most dramatically, radio broadcaster Emmis Communications. These examples demonstrate the dangers to investors that result when voting power does not align with economic interest—a risk indicator GMI Ratings has identified at over 200 publicly traded companies in the Russell 3000.

Dual Share Classes and Governance Risk

Recently, both Google and News Corp have been in the news for issues related to dual share classes with disparate voting rights. Google has announced that as part of a stock split, it will issue a new class of stock that has no voting rights for current shareholders. The plan will further solidify the power of the company’s leadership, which already controls two-thirds of the voting power through special Class B shares. At News Corp, meanwhile, non-US domiciled Class B shareholders have recently seen their voting power reduced as a means of remedying the company’s non-compliance with US regulations on foreign ownership of broadcasters. This step has relatively minor impact on voting at the company, since the Murdoch family already determines the outcome of any matter through its ownership of 40% of the voting stock.


Dynamic CEO Compensation

The following post comes to us from Alex Edmans of the Department of Finance at the Wharton School, University of Pennsylvania; Xavier Gabaix, Professor of Finance at New York University; Tomasz Sadzik of the Department of Economics at New York University; and Yuliy Sannikov, Professor of Economics at Princeton University.

In our paper, Dynamic CEO Compensation, which is forthcoming in the Journal of Finance, we present a fully dynamic model of CEO pay that incorporates many complex features of real-life contracting settings. In particular, it considers multiple periods, risk aversion, private saving, and short-termism. In such settings, the optimal contract is typically very complicated and can only be solved numerically, which makes it difficult to see the intuition and understand which features of the setting are driving which aspects of the contract. Our main methodological contribution is to achieve a surprisingly tractable optimal contract. The model’s closed-form solutions lead to transparency, clarity, and simplicity — they allow the economic forces behind the contract to be transparent, its economic implications to be clear, and in particular practical guidelines on how to reform compensation to address issues that manifested in the recent financial crisis. In particular, we propose a compensation structure based on a system that escrows compensation for a set period of years stretching into the executive’s retirement. The longer time frame is designed to prevent the executive from taking short-term actions that may enrich the manager at the expense of the firm’s future profits. The plan also provides a rebalancing mechanism to maintain a constant percentage of compensation in cash and stock, so that the executive always has sufficient equity in the firm to provide performance incentives — even if the stock price falls.


Changes and Challenges at the SEC

Editor’s Note: Mary Schapiro is Chairman of the U.S. Securities and Exchange Commission. This post is based on Chairman Schapiro’s testimony before the U.S. House Committee on Financial Services, which is available (including footnotes) here. The views expressed in this post are those of Chairman Schapiro and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

The past three years have been a period of enormous change and challenge for the SEC. The aftermath of the financial crisis, the passage of legislation that imposes extensive new responsibilities on the agency, and the growth in the size and complexity of the financial markets have demanded that the SEC become more efficient, creative and productive to achieve its mission. While we have made significant progress in many areas, much work remains to be done. My testimony today will highlight a number of the actions we have taken over the past three years to reform and improve SEC operations. In addition, I will describe our progress on implementation of financial reform legislation, upcoming challenges, and the agency’s FY13 appropriations request.

Operational Improvements and Recent Accomplishments

As you know, the SEC has responsibility for approximately 35,000 entities, including direct oversight of about 12,600 investment advisers, 9,900 mutual funds and exchange traded funds (ETFs), and over 4,500 broker-dealers with more than 160,000 branch offices. We have responsibility for reviewing the disclosures and financial statements of more than 9,100 reporting companies and also oversee approximately 450 transfer agents, 15 national securities exchanges, eight active clearing agencies, and nine nationally recognized statistical rating organizations (NRSROs), as well as the Public Company Accounting Oversight Board (PCAOB), Financial Industry Regulatory Authority (FINRA), Municipal Securities Rulemaking Board (MSRB), and the Securities Investor Protection Corporation (SIPC). Due to recent changes in the law, smaller investment advisers will transition from SEC to state oversight during 2012, but with the corresponding addition of advisers to private funds, we estimate that the agency will still oversee approximately 10,000 investment advisers with about $48 trillion in assets under management. During FY 2012 and FY 2013, we also expect to fully implement our new oversight responsibilities with respect to municipal advisors and entities registering with us in connection with the security-based swap regulatory regime.


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