Monthly Archives: June 2012

Cross-Border Application of Dodd-Frank Swaps Market Reforms

Editor’s Note: Gary Gensler is chairman of the Commodity Futures Trading Commission. This post is based on Chairman Gensler’s remarks before the 2012 FINRA Annual Conference, available here.

I would like to focus my remarks on swaps market reform and specifically on how it fits into the international context.

International Swaps Market – Historically Unregulated

As you all know, with just the click of a mouse, risk can spread around the globe. We surely saw this as the financial system failed in 2008.

As the financial system failed in 2008, most of us learned that the insurance giant AIG had a subsidiary, AIG Financial Products, originally organized in the United States, but run out of London. The fast collapse of AIG, a mainstay of Wall Street, was again sobering evidence of the markets’ international interconnectedness. Sobering evidence, as well, of how transactions booked in London or anywhere around the globe can wreak havoc on the American public.

Swaps, now comprising a $700 trillion notional global market, were developed to help manage and lower risk for commercial companies. But they also concentrated and heightened risk in international financial institutions. And when financial entities fail, as they have and surely will again, swaps can contribute to quickly spreading risk across borders.

Leading up to the financial crisis, swaps were basically not regulated in Asia, Europe or the United States.

There were many reasons put forth as to why swaps should not be regulated. Let me touch upon just three of those reasons, as I believe they are relevant to today’s ongoing debates about the proper role of financial regulation.


Advice for Boards in CEO Selection and Succession Planning

David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz specializing in the areas of mergers and acquisitions and complex securities transactions. This post is based on an article by Mr. Katz and Laura A. McIntosh that first appeared in the New York Law Journal. The views expressed are the authors’ and do not necessarily represent the views of the partners of Wachtell, Lipton, Rosen & Katz or the firm as a whole.

Selecting the chief executive officer and planning for CEO succession are among the most important responsibilities of a company’s board of directors. In ideal circumstances, the succession process will be managed by a successful and trusted incumbent CEO, with the board or a board committee overseeing the process, reviewing the candidates and providing advice throughout. However, in exceptional circumstances, such as when the board lacks full confidence in the incumbent CEO or when a crisis occurs and the normal succession process cannot be utilized, the board will need to take the lead in managing this crucial task. The challenge of CEO turnover is one that boards may face more often than they would like. One source estimates that 40 percent of new CEOs depart within 18 months of their appointment, while 64 percent depart within four years. [1] Nor is the transition inexpensive: The cost of replacing a CEO can range from several million dollars for small-cap firms to tens of millions of dollars for large-cap firms. [2]

In 2011, the CEO turnover rate increased as compared to the previous two years. [3] High-profile resignations and hirings occurred at household-name corporations such as Hewlett-Packard, PG&E, Yahoo!, Costco, and Sara Lee. With the recent publicity surrounding the resignation earlier this month of Yahoo! chief executive Scott Thompson, CEO selection and succession issues have come once again to the fore. Directors facing these challenges should keep in mind that the attitude and smooth functioning of the board are crucial to a sound process and good result, and that the fates of the board and its chosen CEO often are inextricably entwined.


Accounting Discretion, Loan Loss Provisioning and Discipline of Banks’ Risk-Taking

The following post comes from Robert Bushman, Professor of Accounting at the University of North Carolina at Chapel Hill, and Christopher Williams of the Department of Accounting at the University of Michigan.

In our paper, Accounting Discretion, Loan Loss Provisioning and Discipline of Banks’ Risk-Taking, forthcoming in the Journal of Accounting and Economics, we empirically delineate economic consequences associated with differences in accounting discretion permitted to banks under existing regulatory regimes. Policy makers argue that loan loss accounting should allow bank managers’ more discretion to incorporate forward-looking judgments into loan loss provisions. This paper explores potential consequences of such increased discretion for the role of accounting information in supporting outside discipline of bank risk-taking.

Using a large sample of banks from 27 countries, we estimate two distinct constructs of the extent to which discretionary loan provisioning practices within a country reflect a forward-looking orientation. We investigate whether each aspect is associated with stronger or weaker discipline of bank risk-taking. We model risk-taking discipline using two measures: (1) the sensitivity of changes in bank capital to changes in bank risk; and (2) the observed risk-shifting behavior of banks. We find that discretionary provisioning in the form of earnings smoothing dampens disciplinary pressure on risk-taking, consistent with smoothing reducing bank transparency and inhibiting monitoring by outsiders. In contrast, discretionary provisioning practices that increase the extent to which current loan provisions explicitly anticipate future loan portfolio deterioration are associated with enhanced discipline of bank risk-taking.


Shareholder Activism Focused on Political Spending and Lobbying

James R. Copland is director of the Manhattan Institute’s Center for Legal Policy. This post is based on a memorandum from the Proxy Monitor project; that memo is 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.

The 2012 shareholder meeting cycle, in which publicly traded U.S. companies convene to consider corporate business, is reaching an end. One hundred fifty of the 200 largest American companies (by revenues) as ranked by Fortune magazine have held their annual meetings as of May 29, and most of the remainder will do so by the end of June.

2012’s annual meetings have been notable for various shareholder protests, organized by labor unions and their allies in the “Occupy” movement, at various large companies, particularly in the financial sector. [1] This year, as discussed in earlier findings and reports, [2] activists who attempt to influence corporate management through the shareholder voting process have focused their efforts on proposals to increase disclosure of or to limit companies’ political spending and other political activities, as well as proposals to separate companies’ chief executive and chairman positions. Activists have also targeted certain companies’ executive compensation packages, now subject to advisory shareholder votes at all public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. [3]


FDIC’s Orderly Liquidation Authority

Editor’s Note: Martin Gruenberg is acting chairman of the Federal Deposit Insurance Corporation. This post is based on Chairman Gruenberg’s remarks at the Federal Reserve Bank of Chicago Bank Structure Conference, available here.

I would like to take the opportunity to discuss one of those challenging issues – the orderly resolution of systemically important financial institutions ( SIFIs). The Dodd-Frank Act provided important new authorities to the FDIC to resolve SIFIs. Prior to the recent crisis, the FDIC’s receivership authorities were limited to federally insured banks and thrift institutions. There was no authority to place the holding company or affiliates of an insured institution or any other non-bank financial company into an FDIC receivership to avoid systemic consequences. The lack of this authority severely constrained the ability of the government to resolve a SIFI.

This authority has now been provided to the FDIC under the Dodd-Frank Act. The question is whether the FDIC can develop the operational capability to utilize this authority effectively and a credible strategy under which an orderly resolution of a SIFI can be carried out without putting the financial system itself at risk. These key challenges have been the focus of the FDIC’s efforts since the enactment of the Dodd-Frank Act in July 2010. I would like to focus my comments today on the progress we have made in meeting these important challenges.


Shareholder Activism and the Bank Holding Company Act

Victor Lewkow is a partner at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by John McGill.

The ongoing battle between Floyd, Virginia-based Cardinal Bankshares Corporation (Cardinal) and activist investor Douglas Schaller raises interesting questions with respect to whether an activist shareholder entity can wage a proxy contest to replace a majority of directors on the board of a bank holding company (BHC) without the activist entity being considered a BHC under the Bank Holding Company Act (BHCA).


Cardinal is the holding company of the Bank of Floyd, which provides banking services in five counties of Virginia. Cardinal is publicly-traded and has a market capitalization of approximately $22 million.

In a February 7, 2011 Schedule 13D filing with the Securities and Exchange Commission (SEC), entities associated with Douglas Schaller (Schaller Equity Partners, Schaller Equity Management, Inc. and Schaller Investment Group Incorporated) disclosed an 8.3% ownership stake in Cardinal. Over the following 12-month period the Schaller entities filed several amended Schedule 13Ds, reflecting an ownership stake in Cardinal that eventually increased to 9.8%. Beginning in June 2011, Schaller and Cardinal engaged in a war of words, largely carried on in open letters and in the press. Schaller first pushed for Cardinal to explore a sale and later appeared to back off that position, instead arguing for management changes. Cardinal resisted Schaller and has maintained that Schaller is only interested in selling Cardinal. While the letters between Schaller and Cardinal are not the focus of this article, they make for interesting reading and can be found in SEC filings by Schaller and Cardinal.


Processing Fluency and Investors’ Reactions to Disclosure Readability

The following post comes to us from Kristina Rennekamp of the Department of Accountancy at the University of Illinois at Urbana-Champaign.

Recent work in the archival accounting literature investigates disclosure readability (Li [2008], You and Zhang [2009]) and its effects on the behavior of small investors (Miller [2010]). In my paper, Processing Fluency and Investors’ Reactions to Disclosure Readability, forthcoming in the Journal of Accounting Research, I use a controlled experiment to provide complementary evidence and to address questions that cannot be answered with archival data. I find that, holding constant length and information content, more readable disclosures lead to stronger reactions from investors, so that changes in investors’ valuation judgments are more positive when news is good and more negative when news is bad. Consistent with prior literature in psychology, I find that participants are more likely to feel as though they can rely on a disclosure that is more readable, and that this effect is mediated by processing fluency. Processing fluency represents how easy it feels to process a given piece of information, and is often subconsciously treated as a heuristic cue that information can be relied upon when making related judgments. In my study, the greater reliance on news (be it good or bad) helps to explain the stronger reactions to more readable disclosures that I observe, even though readability does not lead to significant differences in the actual information that participants are able to gather from the press release. Counter to my predictions, I do not find that disclosure readability directly affects perceptions of management credibility. However, I do find evidence of an indirect effect operating through feelings of processing fluency.


Harvard Law School Corporate Faculty Contribute Five Most-Cited Law Review Articles

Five articles on corporate law subjects by Harvard Law School faculty appear in the list of the most-cited law review articles (in all legal fields) just published in a study on the subject by Fred R. Shapiro and Michelle Pearse in the Michigan Law Review. The study is available here.

This study updates two classic earlier studies from 1985 and 1996 by Fred Shapiro, and uses new research tools and databases to create accurate lists. The study includes two lists: A list of the 100 most-cited articles of all time, and a list of the 100 most-cited articles from the last twenty years, consisting of a list of the five most-cited articles for each year.

An examination of these two lists indicates that there are five articles on corporate law topics authored or coauthored by Harvard Law School faculty:

Mid-Season Update on the 2012 Proxy Season

Richard J. Sandler is a partner at Davis Polk & Wardwell LLP and co-head of the firm’s global corporate governance group. This post is based on a Davis Polk client memorandum by Mr. Sandler, Ning Chiu, William M. Kelly, Kyoko Takahashi Lin, and Elizabeth S. Weinstein. This memo mentions the Shareholder Rights Project (SRP); posts about the SRP can be found here.

The 2012 proxy season in the United States, forecast by some to feature significant turmoil and change, has in fact been less tumultuous than expected. It’s been all quiet on the regulatory front, owing to the SEC’s highly deliberate approach to rulemaking and the D.C. Circuit’s interventionist reaction to the proxy access rules. With new rules, for once, not in motion, change is occurring incrementally, as activists continue old campaigns and launch new ones, institutional shareholders express their support on both the issues and the circumstances of particular companies, and the companies themselves decide when to resist and when to negotiate.

Continued Support for Say-on-Pay Votes

Obtaining say-on-pay support continues to be a nonissue for many companies. Of the 639 large accelerated filers to report results as of May 18th, only 2% failed their say-on-pay votes, the same percentage that we saw in 2011. Less than 16% of large accelerated filers reported say-on-pay results below the 80% approval level and less than 10% reported results below the 70% approval level. The continued high pass rates may reflect not only the tactical judgment of shareholders to force the issue at only a handful of companies, but also the retreat at many companies from practices that had drawn the most criticism, such as tax gross-ups and excessive severance. Many companies also increased their engagement with shareholders and have done a better job of explaining their pay practices.


Warning to Lenders that Do Business with Distressed Companies

The following post comes to us from Harold S. Novikoff, partner in the Restructuring and Finance Department at Wachtell, Lipton, Rosen & Katz, and is based on a Wachtell Lipton memorandum by Mr. Novikoff, David C. Bryan, and Emil A. Kleinhaus.

In a significant decision for lenders to distressed companies, the United States Court of Appeals for the Eleventh Circuit has reinstated a decision by the Bankruptcy Court for the Southern District of Florida to unwind a secured loan transaction on fraudulent transfer grounds. In re TOUSA Inc., No. 11-11071 (11th Cir. May 15, 2012).

As discussed in our prior memos (Bankruptcy Court Voids Subsidiary Guaranties and Liens as Fraudulent Transfers, November 2, 2009, and Controversial Fraudulent Transfer Ruling Reversed on Appeal, February 18, 2011), TOUSA involved a parent company that in July of 2007 caused certain of its subsidiaries to guarantee and secure $500 million in new secured debt, which was used to fund a litigation settlement with a pre-existing unsecured lender group to which the parent had been obligated but the subsidiaries had not. The bankruptcy court determined that the transaction was a fraudulent transfer as to both the new lenders and the lenders who were repaid, concluding that the subsidiaries had not received “reasonably equivalent value” for securing and guaranteeing loans used to repay parent company debt. In the view of the bankruptcy court, because the challenged transaction made it “inevitable” that the subsidiaries would file for bankruptcy, as they ultimately did in January 2008, the subsidiaries did not receive value from the transaction, even though it permitted them to forestall an immediate bankruptcy that would have resulted from an adverse judgment against the parent company triggering defaults on over $1 billion of debt that the subsidiaries had guaranteed. See In re TOUSA, Inc., 422 B.R. 783 (Bankr. S.D. Fla. 2009).


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