Yearly Archives: 2012

Allocating Risk Through Contract: Evidence from M&A and Policy Implications

Posted by John Coates, Harvard Law School, on
Friday, September 14, 2012
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John Coates is the John F. Cogan, Jr. Professor of Law and Economics at Harvard Law School.

Risk allocation provisions (RAPs) are an important part of M&A contracts. In a new research paper, Allocating Risk Through Contract: Evidence from M&A and Policy Implications, I analyze those provisions in the contracts for a representative sample of deals for US targets, and find both wide variation but also clear patterns in when they are used and how they are designed. The patterns I observe reflect multiple economic theories: they show that RAPs are used and designed in light of the information different parties to a deal are likely to have, their incentives during and after the deal, and also transaction costs, especially the costs of enforcing contracts. Despite these patterns, the contracts also show enormous variation in how risk is allocated — and some of this residual variation correlates with the experience of deal lawyers — suggesting that some choices are better than others. Practitioners can benefit from better understanding economic theories, and academics can benefit from better understanding how varied and complex real-world contracts are.

Among the basic patterns I find are the following:

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September 2012 Dodd-Frank Progress Report

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, September 14, 2012
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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 September 2012 Davis Polk Dodd-Frank Progress Report, is one 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 September 4, 2012, a total of 237 Dodd-Frank rulemaking requirement deadlines have passed. Of these 237 passed deadlines, 145 (61.2%) have been missed and 92 (38.8%) have been met with finalized rules.
  • In addition, 131 (32.9%) of the 398 total required rulemakings have been finalized, while 132 (33.2%) rulemaking requirements have not yet been proposed.
  • Major rulemaking activity this month included the Federal Reserve final rule on risk management standards for financial market utilities and the SEC final rules on conflict minerals and the disclosure of payments by resource extraction issuers. Additionally, the OCC, Federal Reserve, NCUA, FHFA and CFPB released a proposed rule on appraisals for higher-risk mortgage loans.

Does Macropru Leak? Evidence from a UK Policy Experiment

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, September 13, 2012
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The following post comes to us from Shekhar Aiyar, Senior Economist at the International Monetary Fund; Charles Calomiris, Henry Kaufman Professor of Financial Institutions at the Columbia University Graduate School of Business; and Tomasz Wieladek, MPC Adviser, External MPC Unit, Bank of England.

How can governments limit excessive and unstable credit growth? Should they raise capital requirements for banks? In our recent NBER working paper, Does Macropru Leak? Evidence from a UK Policy Experiment, we address these questions using evidence from a policy experiment in the UK. The minimum capital ratio requirements that national regulatory authorities impose on banks have two sets of objectives: (i) so-called ‘micro-prudential’ motives, to ensure the safety and soundness of individual banks; and (ii) ‘macro-prudential’ goals, especially to influence the aggregate supply of credit. Micro-prudential regulation has a long pedigree, but the focus on macro-prudential regulation has increased sharply in the wake of the global financial crisis. This sharpened focus underlies recent changes in the international regulatory regime for banks. Basel III, as the new regime is called, establishes a “countercyclical capital buffer”, under which national regulators would vary banks’ required capital-to-risk-weighted assets ratio over time, thereby helping smooth the credit cycle. For variation in minimum capital requirements to be effective in regulating the aggregate supply of credit, three conditions must be satisfied:

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Investing in Good Governance

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, September 12, 2012
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Editor’s Note: 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 an op-ed article by Professor Bebchuk published today in the New York Times DealBook, available here. The op-ed builds on a forthcoming article with Alma Cohen and Charles Wang, titled “Learning and the Disappearing Association Between Governance and Returns.”

The New York Times published today my column Investing in Good Governance. The column discusses a study by Alma Cohen, Charles Wang, and myself about the correlation between governance and returns. The study, Learning and the Disappearing Association between Governance and Returns, forthcoming in the Journal of Financial Economics, is available here.

Earlier research has shown that, during the 1990s, trading strategies based on the Governance Index (Gompers, Ishii, and Metrick (2003)) and the Entrenchment Index (Bebchuk, Cohen, and Ferrell (2009)) would have produced abnormally high returns in the 1990s. Our study shows that the correlation between governance and stock returns in the 1990s did not subsequently persist. The study also provides evidence that both the correlation in the 1990s and its subsequent disappearance were due to market participants’ gradually learning to appreciate the difference between firms scoring well and poorly on the governance indices. Finally, the study establishes that, although the governance indexes could no longer generate abnormal returns in the 2000s, their negative association with operating performance and firm value persists. After discussing these findings, the DealBook column comments on whether there are any ways left for investors to make money from governance.

The DealBook column is available here.

Private Investment Funds Perspective on Permitting General Solicitation and Advertising

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, September 12, 2012
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The following post comes to us from Alan Klein, partner in the Corporate Department at Simpson Thacher & Bartlett LLP, and is based on a Simpson Thacher memorandum.

On April 5, 2012, the U.S. Congress enacted The Jumpstart Our Business Startups Act (the “JOBS Act”), a package of capital access reforms intended, among other things, to facilitate the ability of companies to raise capital in private offerings without registration with the Securities and Exchange Commission (the “SEC”). The JOBS Act directed the SEC to amend its rules to permit general solicitation or general advertising in connection with private offerings of securities under Rule 506 of Regulation D (“Rule 506”) [1] under the Securities Act of 1933 (the “Securities Act”) provided that that all purchasers of the securities are accredited investors (because either they fall within one of the categories of persons who are accredited investors or the issuer reasonably believes that they meet one of the categories at the time of sale) and the issuer had taken reasonable steps to verify that all purchasers of the securities are accredited investors. [2]

On August 29, 2012, the SEC proposed rules (the “Proposed Rules”) to implement these provisions of the JOBS Act. [3] The SEC seeks public comments on the Proposed Rules for 30 days following the date of their publication in the Federal Register. Following the review of comments by the SEC, the final rules will be issued. Since private investment funds typically rely on Rule 506 in connection with their fundraisings in the United States, we anticipate that the final rules, assuming that they are substantially similar to the Proposed Rules, will allow for greater flexibility in the United States fundraising process by relaxing existing regulatory requirements on publicity. This memorandum focuses on the aspects of the proposed changes to Rule 506 that are relevant for private investment funds.

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Evidence from SEC Enforcement Against Broker-Dealers

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, September 12, 2012
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This post comes to us from Stavros Gadinis, an Assistant Professor of Law at University of California, Berkeley.

My recent article “The SEC and the Financial Industry: Evidence from Enforcement Against Broker-Dealers,” just published at the Business Lawyer (Vol. 67, p. 679, May 2012), provides an empirical account of the agency’s enforcement record against investment banks and brokerage houses in the period right before the 2007-2008 crisis. At the time, the SEC was the target of severe criticism from diverse quarters, ranging from scholarly commentators to the popular press and Congress. This article provides a systematic examination of the SEC enforcement record up to April 2007 and finds that defendants associated with big firms fared better in SEC enforcement actions, as compared to defendants associated smaller firms.

As this data suggests, the SEC faces three key decisions when formulating an enforcement action. One decision concerns whether to focus on the violations of individual employees of financial institutions, pursue the corporate entity that employs them, or charge them both. In two well-publicized rulings, Judge Rakoff chastised the SEC’s decision to direct its action exclusively against the firm and avoid individual liability. The article reveals that actions against big broker-dealers were more likely to target solely the corporate entity, without any further action against either frontline employees or high-level supervisors. More specifically, 40 percent of all actions against broker-dealers involved exclusively corporate liability, compared to just 10 percent for smaller firms.

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Breakup Fees — Picking Your Number

Posted by David Fox, Kirkland & Ellis LLP, on
Tuesday, September 11, 2012

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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, David B. Feirstein, and Joshua M. Zachariah.

During the course of negotiations of every public company deal, inevitably the conversation will turn to the amount of the breakup fee payable by a target company to a buyer if the deal is terminated under certain circumstances. Because U.S. corporate law generally requires a target company to retain the ability to consider post-signing superior proposals, a breakup fee is an important element of the suite of deal protection devices (including “no-shop” restrictions, matching rights, etc.) that an initial buyer implements to seek to protect its position as the favored suitor. Speaking broadly, a breakup fee will increase the cost to a topping bidder as it will also need to cover the expense of the fee payable to the first buyer. However, with respect to deal protection terms in general, as well as the amount of breakup fees in particular, courts have indicated that they cannot be so tight or so large as to be preclusive of a true superior proposal. Starting from this somewhat ambiguous principle, the negotiations therefore turn to the appropriate amount for the breakup fee given the particular circumstances of the deal at hand.

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SEC Requirements under the Iran Threat Reduction and Syria Human Rights Act

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, September 10, 2012
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The following post comes to us from Larry Sonsini, chairman of Wilson Sonsini Goodrich & Rosati. This post is based on a WSGR alert.

Overview

On August 10, 2012, President Obama signed the Iran Threat Reduction and Syria Human Rights Act into law. The act is available at http://www.gpo.gov/fdsys/pkg/BILLS-112hr1905enr/pdf/BILLS-112hr1905enr.pdf.

The purpose of the act is to expand U.S. sanctions against Iran in order to compel Iran to stop pursuing a nuclear weapons program and other controversial initiatives.

Public companies, however, may have new disclosure obligations as a consequence of the act. Among other things, the act requires that companies subject to the reporting requirements of the Securities Exchange Act of 1934 (Exchange Act) make certain disclosures relating to activities that they and their worldwide affiliates knowingly engage in involving Iran in their quarterly and annual reports filed with the Securities and Exchange Commission (SEC). This provision of the act does not require additional rulemaking by the SEC in order to be effective. As a consequence, public reporting companies must comply with the new reporting obligations under the act by February 6, 2013.

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Ownership Dispersion and the London Stock Exchange’s “Two-Thirds Rule”

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, September 10, 2012
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The following post comes to us from David Chambers of Cambridge Judge Business School at University of Cambridge; Brian Cheffins, Professor of Corporate Law at the University of Cambridge; and Dmitri K Koustas of University of California, Berkeley.

In contrast to most other countries, in both Britain and the United States, a hallmark of corporate governance is a separation of ownership and control in major business enterprises. Various theories that have been advanced to account for why patterns of ownership and control differ across borders, with the most influential being that the “law matters” in the sense that ownership dispersion is unlikely to become commonplace in public companies unless company law provides substantial protection to outside investors. As one of us has argued elsewhere, these theories do not explain effectively why a separation of ownership and control became the norm in the UK. In our paper “Ownership Dispersion and the London Stock Exchange’s ‘Two-Thirds Rule’: An Empirical Test”, recently published on SSRN we analyze a different law-related hypothesis concerning the evolution of ownership patterns and show that it similarly lacks substantial explanatory power.

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The Relationship between Corporate Social Responsibility, Reputation, and Activist Targeting

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, September 9, 2012
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The following post comes to us from Brayden King of the Kellogg School of Management at Northwestern University and Mary-Hunter McDonnell of the Northwestern University School of Law.

The global market has created a complex political environment for corporations. On the one hand, they seem less beholden to state control, but on the other hand they have become more concerned with brand, image, and reputation as assets used to gain customer loyalty, stakeholder support, and regulatory freedom (Klein 1999). Their reliance on reputation as an asset has meant that they have become more committed to impression management tactics, like philanthropic activity and improving firm environmental standards, in order gain the approval of the stakeholders that matter most.

Having a good reputation has numerous positive consequences for firms. In our study, Good Firms, Good Targets: The Relationship between Corporate Social Responsibility, Reputation, and Activist Targeting, which was recently made publicly available on SSRN, we suggest that it also creates certain liabilities. Belonging to the top tier of most reputable firms and engaging in reputation-building actions, like announcing prosocial activities, exposes a firm to activist attention, making them more likely targets of boycotts. Activists, ever eager for media coverage and the agenda-setting influence attached to it, use firms’ reputation-seeking as a weapon against the firm. By targeting firms that are already committed to reputation-building, they put those firms in a position where they must react by conceding or by doing more CSR activities if they wish to maintain their lofty status in the field. Our findings suggest that scholars who have asserted that CSR and other reputation-building activities have insurance-like properties that protect a firm from future activist challenges may be wrong. Rather than serving as a form of insurance against future criticism, CSR may in fact just make firms more attractive targets. Insofar as activists are eager to target companies that the media and other stakeholders will notice, companies that built reputations for being socially conscious are certainly on their radar. Such companies offer a visible stage for activists.

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