Monthly Archives: May 2012

Search for Auditors; Don’t Rotate

Editor’s Note: Robert Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. This post is based on an article by Mr. Pozen that originally appeared in Pensions & Investments.

In March, the Public Company Accounting Oversight Board held hearings about whether to require public companies to change — or “rotate” — their external auditor periodically. Meanwhile, the European Union is proposing to require mandatory rotation every six or 12 years, and the lower house of the Dutch Parliament recently voted to require auditor rotation every eight years.

At the PCAOB hearings, various investor advocates and pension funds argued in favor of mandatory rotation. They found fault with the lengthy relationships between many auditors and the companies they audit — the auditors of almost 36% of all companies in the Russell 1000 have held that position for 21 years or more. According to the supporters of auditor rotation, this coziness creates a potential conflict of interest: an auditor’s desire to maintain a good relationship with its client could conflict with its duty to rigorously question the client’s financial statements.

Mandatory auditor rotation could reduce this conflict. Since auditors would know that their engagement would come to an end after a fixed period, they would have less incentive to curry favor with management. At the same time, mandatory rotation could encourage existing auditors to perform more thorough audits, because the firm would fear that a new auditor would expose any previous errors or omissions.


Federal Reserve Clarifies Deadline for Volcker Rule Compliance

Bradley Sabel is partner and co-head of Financial Institutions Advisory & Financial Regulatory practice group at Shearman & Sterling LLP. This post is based on a Shearman & Sterling client publication from Mr. Sabel and Donald N. Lamson, available here.

The Federal Reserve issued a statement last week clarifying that it will interpret the Volcker Rule to afford banking entities the full two-year period provided by the statute to conform their activities and investments to the Rule’s prohibitions and restrictions. The financial services industry should welcome this alternative to curtailing trading and investment activities earlier than the statute on its face would have required, but inevitably some questions remain. The Federal Reserve still has not given any indication whether it may extend this period. As compliance activities progress and we gain greater insight into the effect of the Rule on the economy, the public may seek even clearer guidance on this aspect of the Federal Reserve’s discretion.


The Volcker Rule added a new section 13 (“Section 13”) to the Bank Holding Company Act of 1956 imposing prohibitions and requirements on a banking entity that engages in proprietary trading and has investments in or certain relationships with a hedge fund or private equity fund. [1] The Rule also provides that a non-bank financial company supervised by the Federal Reserve that engages in proprietary trading or makes hedge fund investments must comply with certain other requirements, including supplemental capital requirements or quantitative limitations. [2] The Rule takes effect on the earlier of two years after the date of its enactment, July 21, 2012, or 12 months after the date of issuance of rules implementing that section. Because the Agencies did not issue implementing rules by July 21, 2011, the effective date will be July 21, 2012.


The Role of Institutional Investors in Voting

The following post comes to us from Reena Aggarwal, Professor of Finance at Georgetown University; Pedro Saffi of the Cambridge Judge Business School at the University of Cambridge; and Jason Sturgess of the Department of Finance at Georgetown University.

In the paper, The Role of Institutional Investors in Voting: Evidence from the Securities Lending Market, which was recently made publicly available on SSRN, we use a unique setting to examine if institutional investors influence firm-level corporate governance through proxy voting. Understanding institutional investor preferences regarding corporate governance is important for firms trying to attract new investors as well as policy makers considering the regulation of different governance mechanisms. The activities of institutional investors in the securities lending market provide one of the few opportunities to directly examine the behavior of institutional investors in influencing firm-level governance.

To study the securities lending market for U.S. firms during the period 2007-2009, we use a proprietary data set comprising shares available to lend (supply), shares borrowed (demand), and loan fees. The data covers more than 85% of the securities lending activity for these firms and allows for a comprehensive analysis during a period of tremendous growth in that market. In the past, understanding the securities lending market has been limited partly due to the lack of transparency in this fragmented market. We find that on average, 22.48% of a firm’s market capitalization is available for lending, 3.44% is actually borrowed, and the annualized loan fee is 35 basis points. The supply of lendable shares shows great variation, with minimum and maximum values of 0.01% and 74.38% of market capitalization. We find that more lending supply is available for firms with larger institutional ownership and strong corporate governance. There is considerable interest in some stocks and almost 100% of the available supply of such stocks is actually borrowed and on loan. The annual fee can be quite high, with the maximum at 745 bps. During 2007-2009, 10% of the stocks were very expensive to borrow and had a fee greater than 100 basis points. 2007 was the peak year for the securities lending market, with activity dropping off after the financial crisis.


Benefit Corporations vs. “Regular” Corporations: A Harmful Dichotomy

The following post comes to us from Mark A. Underberg, retired partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP.

In less than two years, seven states, including New York, New Jersey and California, have enacted laws creating a new hybrid type of corporation designed for businesses that want to simultaneously pursue profit and benefit society. Advocates for this new type of entity—typically called a benefit corporation, or B Corp– say that it fills a gap between traditional corporations and non-profits by giving social entrepreneurs flexibility to achieve the dual objectives of doing well and doing good. [1]

At first glance, the B Corp seems a welcome addition to the corporate governance landscape, that promises to advance the cause of socially responsible business. Indeed, B Corp proponents have been remarkably successful in making their case to lawmakers; the statutes were passed without a single dissenting vote in both houses of the New York and New Jersey legislatures last year, and similar proposals are pending in four additional states. Meanwhile, hundreds of businesses, most notably the outdoor clothing company Patagonia, have chosen to organize under the B Corp banner.

But viewed from a broader corporate governance perspective, the B Corp initiative—however well-intentioned–has troubling implications. The problem is that its primary rationale rests on the mistaken, though widely-held, premise that existing law prevents boards of directors from considering the impact of corporate decisions on other stakeholders, the environment or society at large. This crabbed view of directorial fiduciary duties perpetuates the unfortunate misconception that existing law compels companies to single-mindedly maximize profits and share price, and in so doing undermines the very values that corporate governance advocates should seek to promote: responsible, sustainable corporate decision-making by companies of any stripe.


The Need for Improved Cost-Benefit Analysis of Dodd-Frank Rulemaking

The following post comes to us from Jacqueline McCabe, Executive Director for Research at the Committee on Capital Markets Regulation, and is based on testimony given by Ms. McCabe before the US House Oversight and Government Reform Committee (available here).

Thank you for permitting me to testify before you today on cost-benefit analysis conducted by the Securities Exchange Commission (SEC). I am speaking today on behalf of the Committee on Capital Markets Regulation (Committee), of which I am the Executive Director for Research. The Committee has, since its 2006 Interim Report, [1] strongly supported improved cost-benefit analysis by both the SEC and other agencies. Today, the need for improved cost-benefit analysis is particularly evident in the agencies’ respective rulemakings under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). We are deeply concerned that the inadequate cost-benefit analysis in the vast majority of rulemakings under Dodd-Frank could expose these rules to judicial challenge, prevent important rules from taking effect, and contribute to uncertainty in our markets over their fate.

The broad scope of new regulation under Dodd-Frank, issued by agencies including the SEC, Commodity Futures Trading Commission (CFTC) and others, will result in fundamental changes across the financial industry. Sound cost-benefit analysis must be a part of this process, to ensure that in each case, the proposed rule is optimal among all reasonable alternatives. In light of the ruling last July by the U.S. Court of Appeals for the D.C. Circuit in Business Roundtable v. Securities and Exchange Commission, [2] and a current lawsuit seeking to strike down the CFTC’s recently promulgated position limits rule, [3] we believe many of the rules under Dodd-Frank could be subject to successful challenge in court. It would be an unfortunate outcome if, after the Dodd-Frank rulemaking process has run its course for several years, important rules are invalidated because of inadequate analysis. Even if such rules are not eventually invalidated, prolonged uncertainty around their fate threatens to hamper economic activity.


CEO Succession Practices

Matteo Tonello is Managing Director of Corporate Leadership at The Conference Board, Inc. This post relates to a Conference Board report led by Dr. Tonello, Jason D Schloetzer of Georgetown University, and Melissa Aguilar of The Conference Board. For details regarding how to obtain a copy of the report, contact [email protected].

In our study, CEO Succession Practices (2012 Edition), which The Conference Board recently released, we document and analyze 2011 cases of CEO turnover at S&P 500 companies. The study is organized in four parts.

Part I: CEO Succession Trends (2000-2011) illustrates year-by-year succession rates and examines specific aspects of the succession phenomenon, including the influence on firm performance on succession and the characteristics of the departing and incoming CEOs.

Part II: CEO Succession Practices (2011) details where boards assign responsibilities on leadership development, the role performed within the board by the retired CEO, and the extent of the disclosure to shareholders on these matters.

Part III: Notable Cases of CEO Succession (2011) includes summaries of 10 episodes of CEO succession that made headlines in the past two years and that were carefully chosen to highlight key circumstances of the process.

Part IV: Shareholder Activism on CEO Succession Planning (2011) reviews examples of companies that have recently faced shareholder pressure in this area.


JOBS Act Applies to Debt-Only Issuers

John Olson is a founding partner of Gibson, Dunn & Crutcher’s Washington, D.C. office and a visiting professor at the Georgetown Law Center. This post is based on a Gibson Dunn alert.

On April 5, 2012, President Obama signed the Jumpstart Our Business Startups Act (“JOBS Act” or the “Act”) into law. While the Act and recent commentary have focused primarily on common equity issuances by “Emerging Growth Companies” (or “EGCs”), the JOBS Act also impacts companies that have issued only debt securities in registered transactions, typically pursuant to an “A/B” exchange for privately offered high-yield debt securities. Many of these companies subsequently become “voluntary filers” of SEC Exchange Act reports to comply with on-going debt covenants.

The attached chart summarizes how certain JOBS Act provisions apply to these debt-only issuers. As indicated in the chart, they may benefit from a number of JOBS Act provisions with regard to their Securities Act registration statements and Exchange Act reports, including:

  • potentially indefinite EGC status, assuming the $1 billion revenue, $1 billion debt issuance every three years, and certain other thresholds are never crossed;
  • the option to submit to the SEC confidential drafts of Securities Act registration statements for any offering prior to the issuer’s first sale of its common equity securities pursuant to an effective Securities Act registration statement;
  • the option to comply with new accounting standards applicable to public companies on the schedule that is applicable to private issuers; and
  • the option to provide scaled back executive compensation disclosure.

In addition, after the SEC adopts implementing rules, companies that issue debt securities privately will be permitted to engage in general solicitation and general advertising in connection with offerings made in reliance on Rule 506 of Regulation D and Rule 144A under the Securities Act, just as they will be able to do with respect to equity offerings.


Short Sellers, News, and Information Processing

The following post comes to us from Joseph Engelberg of the Department of Finance at UC San Diego, Adam Reed of the Department of Finance at the University of North Carolina, and Matthew Ringgenberg of the Department of Finance at Washington University in St. Louis.

There is strong evidence that high levels of short selling are associated with lower future returns and this return predictability suggests that short sellers, on average, have an information advantage over other traders (e.g., Senchack and Starks, 1993; Asquith, Pathak, and Ritter, 2005; Boehmer, Jones, and Zhang, 2008). However, while return predictability suggests that short sellers have an information advantage, it says little about the source of this advantage. In our forthcoming Journal of Financial Economics paper, How Are Shorts Informed? Short Sellers, News, and Information Processing, we ask how short sellers obtain an information advantage.

During the financial crisis in 2008, some regulators and journalists accused short sellers of illegitimate trading practices. In fact, the Securities and Exchange Commission (SEC) suggested that short sellers spread “false rumors” in an effort to manipulate firms “uniquely vulnerable to panic.” However, in contrast to this manipulation hypothesis, we find that a substantial portion of short sellers’ trading advantage comes from their ability to analyze publicly available information. These findings suggest that, on average, short sellers do not manipulate prices, but rather, they help prices incorporate pertinent information.


Delaware Court Issues Guidance about M&A Confidentiality Agreements

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 Mr. Gallardo, Robert Little, and Travis Souza. 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 May 4, 2012, Chancellor Strine of the Delaware Court of Chancery issued an opinion finding that Martin Marietta Materials, Inc. breached two confidentiality agreements with Vulcan Materials Company when it commenced a $5.5 billion hostile bid for Vulcan in December 2011. Despite the absence of an explicit standstill provision in either confidentiality agreement, which were signed by the parties in the spring of 2010 in connection with then-friendly discussions about a possible merger, the Court enjoined Martin Marietta for four months from pursuing its bid for Vulcan. We expect the Court’s decision to influence the negotiation of M&A confidentiality agreements. See Martin Marietta Materials, Inc. v. Vulcan Materials Co., No. 7102-CS (Del. Ch. May 4, 2012).

The Court concluded that Martin Marietta breached the confidentiality agreements by using confidential information in determining whether to launch a hostile bid and disclosing extensive details regarding the confidential merger discussions and other confidential information in its securities filings and other communications. The Court’s opinion highlights a number of considerations that M&A practitioners should bear in mind when drafting and negotiating confidentiality agreements:


Hedge Funds Need More Accountability

Editor’s Note: Jay Eisenhofer is co-founder and managing director of Grant & Eisenhofer P.A. This post is based on a commentary from Pensions & Investments magazine by Mr. Eisenhofer.

In the past few years, hedge funds have moved into the mainstream of the U.S. economy. Once restricted to a small number of super-wealthy “sophisticated investors,” they now receive hundreds of billions of dollars from public and private pension plans acting as fiduciaries for school teachers, truck drivers, construction workers, first responders and others whom we have lately come to call “the 99 percent,” who share little in common with fund managers stocking the Forbes 400 list. Surfing upon this incoming tide of money, some individual funds now manage enough assets to exert significant influence in the markets.

But the widespread acceptance of hedge funds among institutional investors has not been matched by commensurate improvements in their level of transparency, accountability and corporate governance. In recent months, we’ve witnessed the dismal result: a parade of inside-trading scandals evoking the fraud-riddled implosions of Worldcom, Tyco, Enron and Global Crossing that rocked corporate America a decade ago. It’s time for hedge funds to be brought into the 21st century and reflect their new broader role and fiduciary responsibilities. This means the legal regime that sets the rules for hedge funds must change.

Without question, the profile of the average hedge fund investor has changed in the past few years. Battered by the financial crisis that erased billions of dollars in stock market value just a few years before the first baby boomers were scheduled to retire, many pension funds started investing with hedge funds in the hope of making up lost ground by taking advantage of their customized, often quant-driven investing strategies and promises of “absolute returns” regardless of the markets’ direction.


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