Monthly Archives: September 2012

Hedge Funds and Risk-Decoupling — The Empty Voting Problem in the EU

The following post comes to us from Wolf-Georg Ringe, Professor of International Commercial Law at Copenhagen Business School.

In my paper, Hedge Funds and Risk-Decoupling — The Empty Voting Problem in the European Union, I address the implications of negative risk-decoupling, otherwise known as empty voting, for corporate governance and corporate finance, and I develop suggestions for a regulatory response. These suggestions are framed for the European context, but the underlying policy considerations may prove useful for other regulators worldwide, including the SEC.

Empty voting is a popular strategy amongst hedge funds and other activist investors. In short, it is the attempt to decouple the economic risk from the share’s ownership position, retaining in particular the voting right without risk. This paper uses three perspectives to analyze the problems created by such negative risk-decoupling: an agency costs approach, an analysis of information costs, and a perspective from corporate finance. It shows how risk-decoupling is a type of market behavior that creates significant costs for market participants, in particular existing shareholders and potential investors. Risk-decoupling strategies create both agency and information costs for investors. Furthermore, they generate challenges for traditional categories of corporate finance, aiming to extract the “best of both worlds”, debt and equity.


Breaking Up the Big Banks: Is Anybody Thinking?

Editor’s Note: Peter J. Wallison is a senior fellow at the American Enterprise Institute. This post is based on an article by Mr. Wallison; the full article, including footnotes, is available here.

Breaking up the biggest banks is said to have growing support in Congress, but the idea’s supporters—even those who are respected commentators—do not appear to have given it any deep thought. Without any serious discussion, it should come as no surprise that the idea has bipartisan support among the American people. But Martin Baily of Brookings, always levelheaded in his judgments, calls it “nuts.”

Obviously, for the United States to break up its largest banks would be a very consequential step with significant implications for our economy and financial system. Before proceeding, we should have a reasoned debate on the costs and benefits. Instead, what we have had thus far is a surprising chorus of commentators calling for breaking up the banks without seeming to give any attention to the most elementary issues such a step would entail.

This article will lay out some of those issues. These are not technical matters; they are the simple, first-order questions that ought to occur immediately to anyone who supports the idea of breaking up the largest banks—and they have been largely ignored. Ultimately, this is a depressing commentary on how our discourse on important matters of financial regulation and financial structure has descended—in this era of 24/7 media and instant reaction—to the level of slogans and bumper-strip opinionating.


Ten Myths of “Say on Pay”

David Larcker is the James Irvin Miller Professor of Accounting at Stanford University.

In the paper, Ten Myths of “Say on Pay”, my co-authors (Allan McCall, Gaizka Ormazabal, and Brian Tayan) and I review many widely held misconceptions regarding the shareholder voting practice called “say on pay.” “Say on pay” is a prominent issue today, given its unique position at the intersection of executive compensation and shareholder democracy—two topics which themselves are of deep interest to investors, stakeholder, regulators, and the media. Despite this interest, several misconceptions have developed which continue to be commonly accepted. Fortunately, academics have devoted considerable effort studying “say on pay,” shareholder democracy, and executive compensation. As a result, a lengthy empirical record exists against which “say on pay” can be examined. Our intention is to review “say on pay” in light of the scientific evidence so that practitioners have a better understanding of the limits and consequences of granting shareholders the right to vote on executive compensation.


A Better Alternative to Basel Capital Rules

Editor’s Note: The following post comes to us from Thomas M. Hoenig, director of the Federal Deposit Insurance Corporation. This post is based on Director Hoenig’s remarks at the American Banker Regulatory Symposium, available here.


I have been involved in central banking and financial supervision my entire career. I understand the importance of having the right market conditions and regulatory framework for an economic system to thrive. And most certainly I know that the foundation of a strong financial system is strong capital. For these reasons I wish to add my perspective on the discussion regarding Basel III. After reading the entire 1,000-plus page proposal, I would encourage the Basel Committee and the international regulatory community to step back and rethink the Basel capital standards.

It may be helpful here to recall how Basel has evolved. Following the implementation of Basel I, many in economics and finance and many of the world’s largest banks wanted a more sophisticated and flexible risk-based capital standard. The U.S. chaired the Basel II Committee then and with others agreed that such change was necessary for the largest firms to remain globally competitive. Basel II and III were also given the task of satisfying various national interests, adding more complexity. As a result, the number of Basel risk weights evolved from five to thousands.


The Rise of the General Counsel

Editor’s Note: Ben W. Heineman, Jr. is a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government. This post is based on an article that appeared in the Harvard Business Review online.

In a special New York Times section on business and law, Andrew Ross Sorkin opines: “As regulations change and the threat of litigation rises, the importance of lawyers has never been greater.” He, and writers in the rest of the section, then go on to talk about the downward pressures on private law firms to sustain profits per partner and the burgeoning crisis in private practice, symbolized by the collapse of Dewey & LaBoeuf and the exodus of young associates.

But from a business person’s point of view, Sorkin and other writers in the section don’t even discuss one of the most important developments of the last 25 years: the rise in the role, status and importance of the general counsel and other inside lawyers employed directly by the corporation. The following two critical trends for major companies in the U.S. — and increasingly in Europe and Asia — are not mentioned:


Delaware Supreme Court Rules on Excess Insurer’s Coverage Obligations

Warren Stern is Of Counsel at Wachtell, Lipton, Rosen & Katz, where he concentrates on corporate and securities litigation. This post is based on a Wachtell Lipton memorandum by Mr. Stern, Martin J.E. Arms and Caitlin A. Donovan. 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 September 7, 2012, the Supreme Court of Delaware, applying California law, ruled that an excess insurer of Intel had no payment obligation even after Intel’s out-of-pocket defense costs, combined with Intel’s prior settlement with an underlying insurer, exceeded the underlying insurer’s policy limits — notwithstanding a provision in the excess insurer’s policy providing that coverage would apply when “the insured or the insured’s underlying insurance has paid or is obligated to pay the full amount” of the underlying insurer’s policy limits. Intel Corp. v. Am. Guar. & Liab. Ins. Co., et al., No. 692, 2011 (Del. Sept. 7, 2012).

This dispute arose from antitrust litigation that was brought against Intel and for which Intel sought reimbursement for defense costs from its insurers. A small primary policy was quickly exhausted and Intel then entered into coverage litigation with XL, its first excess insurer, that was ultimately settled for $27.5 million of XL’s $50 million policy limits. Having incurred significantly more than $50 million in defense costs, Intel then turned to its second excess insurer, American Guarantee & Liability Insurance Company (“AGLI”), for reimbursements for defense costs in excess of XL’s policy limits. AGLI refused coverage and litigation followed.


Executive Superstars, Peer Groups and Over-Compensation

Charles M. Elson is the Edgar S. Woolard, Jr. Chair in Corporate Governance and Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. This post is based on a paper he co-authored with Craig Ferrere, Research Fellow at the Weinberg Center.

In the paper, Executive Superstars, Peer Groups and Over-Compensation — Cause, Effect and Solution, which was recently made publicly available on SSRN, we develop a pragmatic approach to understanding the run-up in CEO compensation over the past several decades. Rather than looking to markets or captured boards for the explanation, we argue that the actual mechanical process of peer benchmarking by which pay is set is the cause of the present controversy. From this perspective, we present what we believe will be an effective solution; additionally and collaterally, some interesting lessons about executive recruitment, particularly the CEO “superstar” culture, may be gleaned from our findings. We thank the Investor Responsibility Research Center Institute, which has long funded compensation research, for their financial support and helpful assistance in the development of this paper.

The piece makes a contribution to the executive compensation literature as it offers a novel explanation for the perpetual rise in CEO pay and suggests a significantly different solution to the compensation controversy. As boards have typically looked outside the organization to set CEO pay, we argue that this approach, known as “peer grouping,” is seriously flawed as it relies on the notion of an easy transferability of executive talent which empirically, is incorrect. Therefore, boards should look within the organization itself rather than to external comparators to create an appropriate CEO pay structure. We suggest that this approach should begin to resolve the CEO compensation problem.


Second Circuit Clarifies Standards for Insider Trading Claims

Alan L. Beller is a partner focusing on complex securities, corporate governance and corporate matters at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum.

In the latest of a string of litigation victories it has scored in the Second Circuit, the Securities and Exchange Commission convinced a panel of the Second Circuit on September 6, 2012, to vacate a district court’s grant of summary judgment to the defendants in Securities and Exchange Commission v. Obus, No. 10 Civ. 4749. In so doing, the Circuit clarified, and to some extent modified, the standards for tipper/tippee insider trading under the misappropriation theory.

The SEC alleged that Thomas Strickland, an employee of General Electric Capital Corporation (“GE Capital”), tipped a friend of his, Peter Black, who worked for a hedge fund, about a planned acquisition of Sunsource, Inc., by Allied Capital Corporation, that GE Capital was financing. The SEC alleged that Black relayed the tip to his boss, Nelson Obus, who then traded on the information. The SEC argued that all three participants were liable under the misappropriation theory, alleging that Strickland owed a fiduciary duty to GE Capital to keep the information about the acquisition confidential, that he breached this duty by disclosing the information to Black, and that Black and Obus knew or should have known that Strickland was breaching a duty by providing the tip.


Blockholder Disclosure, and the Use and Abuse of Shareholder Power

The following post comes to us from Adam O. Emmerich, Eric S. Robinson, Theodore Mirvis and William Savitt, attorneys in the corporate and litigation departments at Wachtell, Lipton, Rosen & Katz. This post is based on a paper they co-authored, titled “Fair Markets and Fair Disclosure: Some Thoughts on The Law and Economics of Blockholder Disclosure, and the Use and Abuse of Shareholder Power,” available here. The paper responds to a forthcoming article by Lucian Bebchuk and Robert Jackson Jr., titled “The Law and Economics of Blockholder Disclosure,” that is available here and discussed on the Forum here.

In our article Fair Markets and Fair Disclosure: Some Thoughts on The Law and Economics of Blockholder Disclosure, and the Use and Abuse of Shareholder Power forthcoming in Harvard Business Law Review, Spring 2012, and available at SSRN, we discuss the debate that has ensued following the March 2011 petition by our law firm, Wachtell, Lipton, Rosen & Katz, to the Securities and Exchange Commission to modernize the blockholder reporting rules under Section 13(d) of the Securities Exchange Act of 1934.

The petition sought to ensure that the reporting rules would continue to operate in a way broadly consistent with the statute’s clear purposes that an investor must promptly notify the market when it accumulates a block of publicly traded stock representing more than 5% of an issuer’s outstanding shares, and that loopholes that have arisen by changing market conditions and practices since the statute’s adoption over forty years ago could not continue to be exploited by stockholder activists, to the detriment of market transparency and fairness to all security holders. Among other things, the petition proposed that the time to publicly disclose such block acquisitions be reduced from ten days to one business day, given activists’ current ability to take advantage of the ten-day window to accumulate positions well above 5% prior to any public disclosure, in contravention of the clear purposes of the statute.


Regulating IPOs: Evidence from Going Public in London and Berlin

The following post comes to us from Carsten Burhop of Max Planck Institute for Research on Collective Goods; David Chambers of Cambridge Judge Business School at University of Cambridge; and Brian Cheffins, Professor of Corporate Law at the University of Cambridge.

The role that regulation should play in the development of securities markets is much debated and a persistent lull in initial public offerings helped to prompt some deregulation through the enactment of the 2012 Jumpstart Our Business Startups (JOBS) Act. While the appropriate scope of public regulation of securities markets is a contentious issue and while the market for newly listed firms can be a bellwether for the development of public equity markets, the empirical literature on regulation of IPOs is small and generally inconclusive. In our paper, Regulating IPOs: Evidence from going public in London and Berlin published on SSRN, we use history to offer insights concerning regulation of IPOs and the development of public equity markets. In particular, we draw upon hand-collected Initial Public Offering (IPO) datasets to undertake a comparative study of the London and Berlin stock markets between 1900 and 1913, a period that coincides with the apogee of an era of global financial development unmatched until the end of the 20th century.


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