Monthly Archives: October 2012

Redrawing the Public-Private Boundaries in Entrepreneurial Capital-Raising

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, October 26, 2012
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The following post comes to us from Robert Thompson and Donald Langevoort, Professor of Business Law and Professor of Law, respectively, at the Georgetown University Law Center.

In our article, Redrawing the Public-Private Boundaries in Entrepreneurial Capital Raising, we examine what the JOBS Act (enacted earlier this year) tells us about the division between the public and private spheres in securities regulation. On its face the JOBS Act broadly expands the private realm as defined by our national securities laws. It provides two new exemptions from registration (crowdfunding and Regulation A+) and will broadly expand the reach of the most-used existing exemption from registration by removing the ban on general solicitation from exempt offerings made pursuant to Rule 506, provided they are made only to accredited investor. Yet legislative reform has done little to shore up the shaky foundation of existing theory that guides how we have thought about dividing public from private obligations in this area of the law. For the Securities Act of 1933 Act, the part of securities regulation that regulates the capital-raising, the changes spotlight a lingering identity crisis: Given the ever-expanding presence of Securities Exchange Act of 1934 Act regulation over the last half-century (e.g. integrated disclosure, shelf registration), is there any place left for the additional regulation traditionally provided by the ’33 Act?

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Delaware Court Finds Dissident Director Breached Duty of Loyalty

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, October 26, 2012
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The following post comes to us from Steven M. Haas, partner focusing on mergers and acquisitions, corporate law and corporate governance at Hunton & Williams LLP. 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.

In an October 1, 2012, ruling in Shocking Technologies, Inc. v. Michael, the Delaware Court of Chancery held that a dissident director breached his fiduciary duty of loyalty by sharing confidential information with a third party and trying to discourage that third party from investing in the company. The court’s post-trial ruling came in spite of the director’s claim that he acted in good faith and believed his actions would address certain governance disputes that he had with the other directors. The court observed that “fair debate” is an important issue in corporate governance, but there are clear limits on director conduct in trying to resolve disagreements. Among other things, the court’s decision serves as a reminder to stockholders who sit on boards or otherwise have board representation that directors’ duties run to all stockholders.

Background

The decision involved a dissident director who was the sole board representative of two series of preferred stock. Over time, significant disagreements between the director and the other board members arose over executive compensation and whether there should be increased board representation for the preferred stock. The director argued that the company’s governance problems needed to be resolved before it could attract additional equity funding. The company alleged, however, that these disagreements were pretext for the director’s desire to increase his influence and control over the board at a time when the company faced financial difficulties.

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Financial Stability Regulation

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, October 25, 2012
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Editor’s Note: Daniel K. Tarullo is a member of the Board of Governors of the Federal Reserve System. This post is based on Governor Tarullo’s recent remarks at the University of Pennsylvania Law School; the full speech, including footnotes, is available here. The views expressed in this post are those of Governor Tarullo and do not necessarily reflect those of the Federal Reserve Board, the other Governors, or the Staff.

As one would expect of a piece of legislation that has sixteen titles and runs 849 pages in the Statutes at Large, the Dodd-Frank Wall Street Reform and Consumer Protection Act ranges widely in addressing problems both directly and indirectly associated with the financial crisis. Taken as a whole, though, the primary aim of those 849 pages can fairly be read as a reorientation of financial regulation towards safeguarding “financial stability” through the containment of “systemic risk,” phrases that both recur dozens of times throughout the statute. The law, explicitly in many provisions and implicitly in many others, directs the bank regulatory agencies to broaden their focus beyond the soundness of individual banking institutions, and the market regulatory agencies to move beyond their traditional focus on transaction-based investor protection.

This emphasis on financial stability and systemic risk is hardly surprising in light of the damage done by the financial crisis and the ensuing Great Recession, from which we continue to recover only slowly. Indeed, concern about financial stability and systemic risk has at times been a crucial impetus for financial reform in the United States. Much of the New Deal legislation that defined the financial regulatory structure for more than 40 years was in direct response to what we would today call systemic concerns, including banking panics and excessive leverage in equity markets. Twenty years before the New Deal, the creation of the Federal Reserve had been intended at least as much as a financial stability measure as an instrument of monetary policy.

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Controlled Companies in the S&P 1500: Performance and Risk Review

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, October 25, 2012
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Editor’s Note: The following post comes to us from Sean Quinn, vice president of Institutional Shareholder Services, Inc. This post is based on a report by ISS and the Investor Responsibility Research Center Institute; the full publication is available here.

Executive Summary

At most U.S. firms, ownership is dispersedly-­held and voting power is proportionate to capital at risk. At a minority of firms, however, a significant amount of the vote is controlled by one party through a sizeable ownership stake or, alternately, through a multiclass capital structure created specifically to allow voting power to be disproportionate to capital commitment. These controlling parties often include company founders and/or insiders whose interests may or may not conflict with those of unaffiliated shareholders.

The issue of control has received much attention since the initial public offerings of LinkedIn Corp., Zynga Inc., Groupon Inc., and Facebook Inc. While these firms were taken public amid great fanfare and high expectations, the results have been mixed. As of Aug. 31, 2012, the market price of LinkedIn Corp. had risen over 138 percent from its Sept. 16, 2011, initial public offering but Zynga Inc., Groupon Inc., and Facebook Inc. had fallen 72.0 percent, 79.3 percent, and 52.5 percent, respectively, from their IPO prices. A common feature of these firms is a capital structure that allows founders to control a majority of the voting stock while holding a comparatively small portion of their firm’s economic value.

Supporters of these structures claim that control of a firm’s voting power enables management to govern with minimal outside interference and focus on long-term business growth, ultimately delivering shareholders higher returns in exchange for control rights. Detractors, however, claim that control mechanisms misalign interest between affiliated and external shareholders and allow insiders to operate without the normal accountability mechanisms. This study attempts to contribute to that debate by examining the prevalence, characteristics, and relative performance of controlled companies listed on exchanges in the United States.

Key findings of the study include:

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For Whom Golden Parachutes Shine

Posted by Lucian Bebchuk, Harvard Law School, on
Wednesday, October 24, 2012
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Lucian Bebchuk is a Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance at Harvard Law School. This post is based on a column by Professor Bebchuk published today in the New York Times DealBook, available here. The column discusses his study with Alma Cohen and Charles Wang, titled “Golden Parachutes and the Wealth of Shareholders,” available here.

Golden parachutes, those packages that reward top executives if their company is acquired, have attracted much attention from investors and public officials for more than two decades. Defenders of golden parachutes believe that they provide executives with incentives to facilitate a sale of their companies. While the evidence confirms this, it indicates that golden parachutes have significant costs as well and might fail to serve the interests of shareholders over all.

Shareholder resolutions opposing golden parachutes have often received substantial support over time. Congress adopted tax rules aimed at discouraging large golden parachutes, and the rules created during the financial crisis precluded companies receiving government support from providing golden parachute payments to top executives. Subsequently, the Dodd-Frank Act mandated advisory shareholder votes on all future adoptions of golden parachutes.

Many companies and financial economists, however, continue to believe that golden parachutes are an important and beneficial element of executive pay. Because top executives typically give up independence and control when their companies are acquired, executives that do not have a golden parachute might be excessively reluctant to sell — and often can impede or even derail an acquisition they dislike.

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Guide to Public ADR Offerings in the U.S.

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, October 24, 2012
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The following post comes to us from Cleary Gottlieb Steen & Hamilton LLP. This post is based on the introduction of a Cleary Gottlieb memorandum by Leslie Silverman and Jorge Juantorena, titled “Guide to Public ADR Offerings in the United States;” the full publication is available here.

I. Introduction

In the United States, the shares of many foreign corporations are traded in the form of American Depositary Shares (“ADSs”) that represent the underlying foreign shares on a share-for-share, partial-share or multiple-share basis. ADSs are usually issued by a U.S. commercial bank (the “Depositary”), which holds the underlying foreign shares directly or through a foreign correspondent (the “Custodian”). ADSs historically have been referred to by the negotiable certificates evidencing the ADSs, known as American Depositary Receipts (“ADRs”). [1]

The issuance of ADRs may be either “sponsored” or “unsponsored.” “Unsponsored” ADRs are issued by a Depositary for already outstanding foreign shares, without an agreement with the issuer of the shares. An ADR facility for an issuer’s shares, however, cannot be established unless the issuer either (i) is subject to the periodic reporting requirements under the Securities Exchange Act of 1934 (the “1934 Act”), or (ii) is exempt from these reporting requirements pursuant to Rule 12g3-2(b) under the 1934 Act. [2] Consequently, in the case of an issuer that does not meet either of these two conditions, a Depositary cannot create an unsponsored ADR facility without the issuer’s cooperation. [3]

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Managerial Overconfidence and Accounting Conservatism

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, October 24, 2012
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The following post comes to us from Anwer S. Ahmed, Ernst & Young Professor of Accounting at Texas A&M University, and Scott Duellman, Assistant Professor of Accounting at Saint Louis University.

In our paper, Managerial Overconfidence and Accounting Conservatism, forthcoming at the Journal of Accounting Research, we provide evidence on the relation between CEO overconfidence, an important managerial trait, and the aggressiveness of financial reporting. Building on a growing literature in finance which shows that overconfidence can distort investment, financing, and dividend policies, we demonstrate that firms with overconfident CEOs make more aggressive financial reporting choices than other firms.

Overconfident managers are defined as managers who overestimate future returns from their firms’ investments and systematically overestimate the probability of good performance. Our first hypothesis predicts that overconfident managers will tend to overvalue net assets as well as delay recognition of losses. In other words, we expect overconfident managers to make more aggressive (or less conservative) financial reporting decisions than other managers. Furthermore, we investigate whether this relation is affected by governance mechanisms. To the extent that governance mechanisms, such as boards of directors or institutional shareholders, view conservative reporting as desirable, external monitoring could constrain the negative effect of managerial overconfidence on conservative reporting. Thus, our second hypothesis predicts that the negative relation between overconfidence and accounting conservatism will be constrained for firms with strong external monitoring.

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Contributing to the Declassification of 21 S&P 500 Companies: Final Tally of the Results of the ACGI’s 2011 Work

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, October 23, 2012
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Editor’s Note: Lucian Bebchuk is Professor of Law, Economics and Finance at Harvard Law School, and Scott Hirst is a Lecturer on Law at Harvard Law School; both were affiliated with the American Corporate Governance Institute (ACGI) during the period discussed in this post. Their earlier posts about the work of the ACGI are available here. Subsequent work in connection with declassification proposals was undertaken in 2012 by the Shareholder Rights Project (SRP), and has been discussed in posts available here.

This post provides a final tally of the results from the work of the American Corporate Governance Institute (ACGI) during 2011. As described in more detail below, this final tally shows that the 2011 work of the ACGI and ACGI-represented investors contributed to board declassification at 21 S&P 500 companies – about 15% of the S&P 500 companies that had a staggered board as of the beginning of 2011. [1]

During the 2011 proxy season, the ACGI worked on behalf of two institutional investors — the Florida State Board of Administration (SBA) and the Nathan Cummings Foundation (NCF) — in connection with the submission of shareholder declassification proposals for presentation at the 2011 annual meetings of certain S&P 500 companies. The ACGI assisted the SBA and the NCF with selecting companies for proposal submission, designing proposals, engaging with companies, negotiating and executing agreements by companies to bring management declassification proposals, and presenting proposals at annual meetings.

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Innovation and Institutional Ownership

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, October 23, 2012
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The following post comes to us from Philippe Aghion, Professor of Economics at Harvard University; John Michael Van Reenen, Professor of Economics at the London School of Economics; and Luigi Zingales, Professor of Entrepreneurship and Finance at the University of Chicago.

In our forthcoming American Economic Review paper, Innovation and Institutional Ownership, we examine the incentives to innovate at the firm level by studying the relationship between innovation and institutional ownership. Innovation is the main engine of growth. But what determines a firm’s ability to innovate? Innovating requires taking risk and forgoing current returns in the hope of future ones. Furthermore, while any type of financing is plagued by moral hazard and adverse selection, the financing of innovation is probably the most vulnerable to these problems (Arrow, 1962) since the information that needs to be conveyed is hard to communicate to outsiders. This paper is an attempt at analyzing the corporate governance of innovation and more specifically the role of institutional owners in fostering (or hindering) innovation.

While the ability to diversify risk across a large mass of investors makes publicly traded companies the ideal locus for innovation, managerial agency problems might undermine the innovation effort of these companies. In publicly traded companies, the pressure for quarterly results may induce a short-term focus (Porter, 1992). And the increased risk of managerial turnover (Kaplan and Minton, 2008) might dissuade risk-averse senior managers from this activity. Finally, innovation requires effort and “lazy” managers might not exert enough of it. Hence, it is especially important to study the governance of innovation in publicly traded companies, which account for a large share of the private investments in research and development (R&D).

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Disclosure of Certain Iran-Related Activities

Posted by Brian Breheny, Skadden, Arps, Slate, Meagher & Flom LLP, on
Tuesday, October 23, 2012
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Brian V. Breheny is a partner at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a Skadden, Arps memorandum by Mr. Breheny, Marc S. Gerber, and Samuel Scrimshaw.

On August 10, 2012, President Obama signed the Iran Threat Reduction and Syria Human Rights Act of 2012 (ITR Act) into law. Section 219 of the ITR Act (Section 219) requires companies that file public reports with the U.S. Securities and Exchange Commission (SEC) to disclose certain additional information in their annual and quarterly reports, including whether they or any of their affiliates knowingly have engaged in certain activities that are sanctionable pursuant to the Iran Sanctions Act of 1996 (1996 Act) or the Comprehensive Iran Sanctions, Accountability and Divestment Act of 2010 (2010 Act) or knowingly have engaged in any unlicensed transaction with the government of Iran or with persons designated for sanctions pursuant to certain executive orders (a group that includes most Iranian banks and many large commercial enterprises).

The provisions of Section 219 do not require SEC rulemaking to become effective. As a result, the disclosure requirements of Section 219 will take effect with respect to periodic reports on Forms 10-K, 10-Q, 20-F and 40-F that are required to be filed with the SEC on or after February 6, 2013.

New disclosure requirements. Section 219 requires an SEC reporting company to disclose whether, during the period covered by a periodic report, it or its affiliates knowingly engaged in:

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