Monthly Archives: May 2012

Regulatory Complexity and Uncertainty: The Capital Requirements Directive IV

The following post comes to us from Vincent O’Sullivan, member of the FS Regulatory Centre of Excellence, PwC, UK, and Stephen Kinsella, Lecturer in Economics at the Kemmy Business School, University of Limerick.

Regulation is the most important factor influencing strategic change at financial institutions and is the second largest threat – after economic uncertainty – to growth prospects, according to PwC’s Annual Global CEO Survey [1]. The survey, which is in its fifteenth consecutive year, canvassed CEOs at over 250 financial institutions in 42 countries late last year and provides a good barometer on market sentiment. The significance of regulation as a change driver in the financial sector has grown steadily since the recent crisis. Based on PwC’s face-to-face interviews with CEOs of some of the world’s largest financial institutions, it is clear, though, that it is not simply regulatory change, but regulatory complexity and uncertainty that are really dampening confidence in growth.

Upgrading the European Union (EU) prudential regime for banks in line with the Basel III proposals is an excellent example of both regulatory complexity and uncertainty. In July 2011, the European Commission [2] released two proposals to introduce the new regime. The bulk of the existing EU prudential regime, with the amendments necessary to introduce Basel III, is recast into a regulation – the Capital Requirements Regulation (CRR) – amongst other things to support the parallel EU goal of harmonising and deepening the internal market through a single rule book. In addition, a Directive – Capital Requirements Directive IV (CRD IV) – sets out requirements in a limited number of areas where Member State discretion is still necessary, for example in relation to corporate governance.


CFTC and SEC Adopt Final Definitions for Swap Participants

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, available here. Slides from Davis Polk concerning the swap participant definitions are available here.

On April 18, 2012, the CFTC and SEC adopted final rules [1] to further define the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.” [2] The rules initially establish the threshold for the de minimis exclusion from SD registration requirements at $8 billion for swaps connected with dealing activity effected in a 12-month period for CFTC-regulated swaps and all credit default swaps and $400 million for other SBS. [3] Importantly, the rules also exclude from the scope of dealing activity swaps between majority-owned affiliates. The Commission also excluded certain hedging activity from the SD registration analysis.

The Commissions generally declined to adopt exclusions from the definition of SD and MSP for categories of persons, including for sovereign wealth funds, agricultural cooperatives and employee benefit plans. Furthermore, the Commissions confirmed that absent a limited purpose designation, an SD registration applies to the entire legal entity and to all of such person’s swaps or SBS, whether or not such swaps or SBS are entered into in a dealing capacity. The final rules do not address the extraterritorial application of Title VII, including whether a limited designation would be available for a U.S. branch of a foreign bank or to separate U.S.-facing activities from non-U.S.-facing activities; instead, the Commissions stated that they will address such issues in future releases.

With the adoption of these rules, there remains one step – the issuance of final swap product definition rules – before the start of the countdown for swap dealer and MSP provisional registration. The swap entity definition rules will be effective 60 days after they are published in the Federal Register, which is expected to occur shortly. For further information regarding the CFTC’s expected compliance timetable, see the last section of this memorandum.


Campaign Contributions and Governmental Financial Management

The following post comes to us from Craig Brown of the Department of Finance at the National University of Singapore.

In the paper, Campaign Contributions and Governmental Financial Management: Evidence from State Bond Pricing, which was recently made publicly available on SSRN, I study campaign-finance agency costs related to pricing in the $2.9 trillion state and local government bond market. By selecting a contributing underwriter directly, the government could incur significant costs with respect to government bond underpricing. There is no comparable impact when an underwriter is chosen through an auction. Through the use of a control function approach, I show that the decision to select a contributing underwriter is endogenous to first-day returns. When underpricing is expected, the government’s propensity to choose a contributing underwriter decreases as expected underpricing increases. This evidence supports the idea that there are significant agency costs associated with campaign contributions and the evidence remains robust after a battery of checks.

This paper’s results lend support to the political agency cost model. Consistent with the common assertion that the election is the primary disciplining mechanism for political executives in a political agency cost model (Besley, 2006), the likelihood that a contributing underwriter is chosen is decreasing in the closeness to the next election. Consistent with the idea that laws can discipline politicians directly and through taxpayer monitoring, the likelihood that the government does not choose an auction to select an underwriter is decreasing in the quality of conflict-of-interest laws and freedom-of-information laws; the likelihood that the government chooses a contributing underwriter is decreasing in the quality of freedom-of-information laws.


Seventeen Boards of S&P 500 Companies Already Declassified Following Agreements with SRP-Represented Investors

Editor’s Note: Professor Lucian Bebchuk is the Director of the Shareholder Rights Project (SRP), and Scott Hirst is the SRP’s Associate Director. Any views expressed and positions taken by the SRP and its representatives should be attributed solely to the SRP and not to Harvard Law School or Harvard University.

Already at this stage of the current proxy season, seventeen charter amendments declassifying boards of S&P 500 companies have been adopted following agreements entered into with investors represented by the Shareholder Rights Project (SRP). Details about these early results, as well as about the large number of agreed-upon management proposals to declassify expected to go to a vote at other S&P 500 companies later on, are provided below.

As described on the SRP’s website, during the 2011-12 proxy season, the SRP has been representing and advising several institutional investors – Illinois State Board of Investment (ISBI), the Los Angeles County Employees Retirement Association (LACERA), the Nathan Cummings Foundation (NCF), the North Carolina State Treasurer (NCDST), and the Ohio Public Employees Retirement System (OPERS) – in connection with the submission of precatory shareholder proposals to more than eighty S&P 500 companies that have classified boards. The proposals urge repealing the classified board and moving to annual elections, which are widely viewed as corporate governance best practice.

Through active engagement with companies receiving declassification proposals, negotiated outcomes have been obtained with forty-four S&P 500 companies receiving proposals from the SRP-represented investors (about half of the companies receiving such proposals). These forty-four companies have entered into agreements committing them to bring management proposals to declassify their boards. Overall, the forty-four companies that have entered into such agreements represent about one-third of the S&P 500 companies that had staggered boards as of the beginning of this proxy season, and have an aggregate market capitalization that exceeds (as of April 1, 2012) half a trillion dollars.

Of the forty-four agreed-upon management proposals, twenty-three management proposals have already gone to a shareholder vote. Of these twenty-three proposals, seventeen have passed, resulting in declassification of the board. The table below provides information concerning the agreed-upon management proposals that passed. As the table indicates, these proposals obtained average support of 99.08% of votes cast and 81.01% of votes outstanding.

The six management proposals to declassify that did not pass (detailed here) did receive a majority of the votes (95.51% of the votes cast on average, and 67.22% of the votes outstanding on average). However, the proposals did not pass due to the presence of high supermajority requirements.

Agreed-upon management proposals to declassify are expected to go to a vote at other S&P 500 companies later on. A list of such companies that have already made public filings that disclose the planned management proposals is available here.


Proxy Season 2012: The Year of Pay for Performance

Matteo Tonello is managing director of corporate leadership at the Conference Board. This post is based on an issue of the Conference Board’s Director Notes series, by James D.C. Barrall, Alice M. Chung, and Julie D. Crisp, all of Latham & Watkins LLP. The original report, including footnotes, is available here. Work from the Program on Corporate Governance on executive compensation includes the paper Paying for Long-Term Performance, and the book Pay without Performance, both by Bebchuk and Fried.

As in 2011, executive compensation is the single most important corporate governance issue for companies, boards, and investors for the 2012 proxy season. This Director Notes discusses the evolving analytics and issues around pay for performance (P4P) and suggests ways for companies and their boards to analyze the alignment of P4P, counter negative recommendations by proxy advisers, and draft their proxies to obtain shareholder support for their pay programs.

In 2011, approximately 3,000 companies held their first mandatory shareholder say on pay (SOP) and say on frequency votes; approximately 1,500 “smaller reporting companies” are not required to do so until January 21, 2013. Overall, 42 companies that held SOP votes in 2011 received less than 50 percent shareholder support. More than 90 percent of companies received shareholder support of 70 percent or higher, and more than 70 percent received shareholder support of 90 percent or higher. On the issue of say on frequency, shareholders at more than 75 percent of companies supported annual SOP votes, while shareholders at a majority of the remaining companies supported triennial votes, and a few supported biennial votes. Following the votes, the vast majority of companies adopted the vote frequency preference supported by a plurality of their shareholders.

One unexpected development during the 2011 proxy season was the large volume of publicly filed disputations between public companies and Institutional Shareholder Services (ISS) and Glass Lewis, the two most influential U.S. proxy advisers, over their negative SOP recommendations. While some of the negative recommendations and the controversies that followed were related to pay practices labeled “problematic” or “egregious” by the proxy advisers, most of the negative recommendations and controversies stemmed from negative recommendations based on those proxy advisers’ P4P voting policies.


SEC Not Pursuing Mandatory Proxy Access at this Time

Andrew R. Brownstein is a partner in the Corporate Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Brownstein, Trevor S. Norwitz, and S. Iliana Ongun. Work on proxy access from the Program on Corporate Governance includes Private Ordering and the Proxy Access Debate by Bebchuk and Hirst.

Testifying recently before a House Financial Services subcommittee, SEC Chairman Mary Schapiro stated that, because of capacity constraints, proposing a revised mandatory rule on shareholder access to company proxy materials is “not on the Commission’s immediate agenda.” She noted, however, that the issue is one that the SEC will “continue to look at over time.”

Last summer, the D.C. Circuit Court of Appeals vacated the SEC’s Rule 14a-11, finding that the SEC had “acted arbitrarily and capriciously” in adopting the rule without adequately assessing its economic effects. At the time, the SEC said that it was considering its options but noted that its changes facilitating private ordering in proxy access were not impacted by the Court’s decision.

In the current 2012 proxy season, less than two dozen companies have received proxy access proposals. This modest level of activity is in part explained by activist shareholders waiting to learn whether or not the SEC would be re-promulgating a mandatory rule. Because it is now clear that this will not happen, at least not for the 2013 proxy season, we can expect the focus on private ordering through shareholder proposals to continue and increase.


May 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 May 2012 Davis Polk Dodd-Frank Progress Report, is the fourteenth 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 May 1, 2012, a total of 221 Dodd-Frank rulemaking requirement deadlines have passed. This is 55.5% of the 398 total rulemaking requirements, and 78.9% of the 280 rulemaking requirements with specified deadlines.
  • Of these 221 passed deadlines, 148 (67%) have been missed and 73 (33%) have been met with finalized rules. Regulators have not yet released proposals for 21 of the 148 missed rules.
  • Of the 398 total rulemaking requirements, 108 (27.1%) have been met with finalized rules and rules have been proposed that would meet 146 (36.7%) more. Rules have not yet been proposed to meet 144 (36.2%) rulemaking requirements.
  • This month, in a major Title VII rulemaking development, the CFTC and SEC approved final rules further defining the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant.” In addition, the FDIC and Treasury released a final rule that will govern the maximum obligation the FDIC may incur in liquidating a covered financial company.

Board Structure and Monitoring

The following post comes to us from Lixiong Guo and Ronald Masulis, both of the Department of Finance at the Australian School of Business.

In the paper, Board Structure and Monitoring: New Evidence from CEO Turnover, which was recently made publicly available on SSRN, we provide new evidence on the potential benefits of SOX and ensuing new exchange listing rules and the effectiveness of monitoring by independent directors. Although many researchers, regulators and investors believe that increasing the representation of independent directors on corporate boards can improve quality of board oversight, empirical evidence has been mixed and inconclusive. Recent research even raises doubt about the effectiveness of independent directors in monitoring CEOs.

Using the change in NYSE and Nasdaq listing rules following the passage of the Sarbanes-Oxley Act as a source of exogenous variation, we provide the first statistically convincing evidence on a causal relation between board (committee) independence and the sensitivity of forced CEO turnover to firm performance. Specifically, we find that firms that after SOX moved to a majority of independent directors or to a fully independent nominating committee experience increased sensitivity of forced CEO turnover to performance. This evidence suggests that quality of board monitoring is positively related to board independence and nominating committee independence and the causation goes from board structure to quality of board monitoring.


Harvard M&A Roundtable Meets to Discuss the State of Delaware Corporate Law

The Harvard Law School Program on Corporate Governance hosted a meeting of the M&A roundtable last Thursday, May 10. The M&A Roundtable, which is supported by the Corporation Service Company, brought together many of the country’s leading M&A experts and practitioners. Participants in the Roundtable engaged in a discussion with Chancellor Leo Strine of the Delaware Court of Chancery (who is also a Senior Fellow of the Program on Corporate Governance) on the state of Delaware corporate law.

Among the issues discussed were confidentiality provisions and their effect on mergers and acquisitions in light of the decision in Martin Marietta Materials v. Vulcan Materials; dual-class share structures and director accountability; go-shop provisions and deal protection devices; process issues in approving mergers and appropriate remedies; the use of poison pills following Airgas v. Air Products; and trends in shareholder litigation, including multiple forum issues and the fragmentation of shareholder litigation. The participants in the M&A Roundtable included:


“Toehold” Stakes in Target Firms

David Fox is a partner at Kirkland & Ellis LLP, focusing on complex mergers and acquisitions as a member of the firm’s Corporate Group. This post is based on a Kirkland & Ellis M&A Update by Mr. Fox, Daniel E. Wolf, Joshua M. Zachariah, and David B. Feirstein.

Whether or not to acquire a minority or “toehold” stake in a public company as a preliminary step towards a future business combination has been the subject of tactical debate for many years. Proponents argue that a toehold can be used by a potential bidder to convey its serious intent or, if necessary, as a platform to quietly or publicly put the target in play. In addition, the position could advantage a buyer in a subsequent sale process by reducing its average cost (by acquiring shares before a deal premium attaches) or acquiring a meaningful voting position in the target; at the very least, the profit on the toehold that the acquirer can collect if another buyer succeeds with a higher bid may cover, or exceed, the costs the acquirer incurs in pursuing the target. On the flip side, demurrers point out the risk of being perceived as employing strong-arm tactics when a velvet glove approach is more likely to win over the “hearts and minds” of the target. Moreover, many a target board may reflexively react in an unduly defensive manner, for example by enacting a poison pill, complicating an attempt to reach a negotiated outcome at a desirable price.

The debate has recently sharpened with comments from at least one Delaware judge who has taken the view that the failure to acquire a stake before approaching a target conveys a lack of seriousness about making a potential bid and is evidence of being a “stupid acquirer.” A small stake (even as little as 100 shares) in a potential target represents a low-cost option for better positioning the acquirer in the event of litigation if a sale process does not unfold in the way the buyer would like (e.g., the target board refuses to engage with the buyer or agrees to a sale to another buyer). Only by owning a stake will the buyer have “standing” as a shareholder of the target to bring legal claims against the target or its board, a need that may not become apparent until it is too late to rectify.


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