Yearly Archives: 2012

Bidder Hubris and Founder Targets

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, June 18, 2012
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The following post comes to us from Nandu Nagarajan, Frederik Schlingemann and Mehmet Yalin, all of the Katz Graduate School of Business at the University of Pittsburgh, and Marieke van der Poel of the Department of Finance at the Rotterdam School of Management.

The literature on mergers and acquisitions, starting with Roll (1986) has often addressed the issue of managerial hubris leading to overpayment in acquisitions. For example, the observation of statistically and economically significant negative bidder returns for public bidder acquisitions is frequently attributed to the winner’s curse, managerial overconfidence, and thus overpayment. However, in our paper, Bidder Hubris and Founder Targets, which was recently made publicly available on SSRN, we argue that positive bidder gains are not necessarily inconsistent with overpayment, nor are negative bidder returns always a direct consequence of overpayment.

Insofar as managerial hubris leads to overpayment in acquisitions, it is important to note that this overconfidence derives from two non-mutually exclusive sources: (i) the target’s stand-alone value under bidder’s control is overestimated or (ii) synergies from the combined entity are overestimated. To the best of our knowledge, this is the first paper that tries to disentangle these two factors, while not relying on proxies for overconfidence or focusing exclusively on average bidder gains as evidence of managerial hubris. In this paper, we provide a unique test of the first source of overpayment by isolating a part of the target’s ex-ante value that is attributable to a founder CEO and relating this to bidder gains.

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Reform Needed in China’s Fund Business

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Sunday, June 17, 2012
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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 the Financial Times.

I recently returned from a trip to Beijing, where I launched the Mandarin translation of a book that I co-authored with Theresa Hamacher entitled The Fund Industry: How Your Money is Managed.

The book was translated because the Chinese fund industry is expanding rapidly; Chinese mutual funds were introduced in 2001 yet held over $340bn in assets by the end of 2011.

However, the future development of the Chinese fund industry faces a stiff headwind. In China, most retail investors buy mutual funds hoping to score a quick short-term gain, rather than to generate long-term returns. The high turnover is usually costly to investors and stunts the development of the fund industry.

The short-term mentality of Chinese investors is reinforced by the fund industry, which spews forth an incredible number of new funds each year. Though fewer than 1,000 mutual funds exist in China, the industry launched 136 new funds in 2010 alone.

This flood of new funds is partly caused by large up-front commissions on fund sales paid to distributors, who also receive smaller fees on an annual basis. To collect these up-front commissions, distributors hype the new funds and investors rush to buy. But these investors hold for a relatively short time – until the next wave of new funds.

As a result, there are very few large funds in China that attract assets through long-term performance. One helpful reform would be to reduce up-front commissions on fund sales and put more emphasis on annual trailer fees that are collected only as long as shareholders remain in the fund.

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Shadow Banking Index

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, June 17, 2012
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The following post comes to us from Adam Schneider, Executive Director at the Deloitte Center for Financial Services. This post is based on the executive summary of a Deloitte report by Val Srinivas, Mr. Schneider, Don Ogilvie, and John Kocjan. The full report is available here.

Shadow banking may help drive the day-to-day financial system, but it is a concept looking for a hard-and-fast definition.

Despite coming under intense scrutiny following the financial crisis, there have been disparate characterizations of what the shadow banking sector truly entails — with size estimates ranging from $10 to $60 trillion. At the same time, major regulatory efforts have either been enacted or are in the works to help reduce the size of this important sector, with no agreed-upon way to measure their effectiveness.

The purpose of the Deloitte Shadow Banking Index is to define and quantify the sector over time, including its components. This ongoing effort is designed to more closely measure size, importance, effect of market, and impact of regulatory actions, as well as a way to assess the potential impact of shadow banking on regulated markets.

What is shadow banking really? We started by including a multitude of nonbanking entities and activities and then applied specific criteria. For example, we posit that money market mutual funds (MMMFs) are part of shadow banking as they possess the “money-like” attributes of bank deposits. But they do not have bank-like insurance, nor can they access a central bank for liquidity support.

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The Current State of Europe’s Derivative Markets Regulation

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, June 16, 2012
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The following post comes to us from Michael O’Bryan, co-chair of the global M&A Group and a partner in the Corporate Finance Group at Morrison & Foerster LLP, and is based on a Morrison & Foerster Client Alert by Peter Green, Jeremy Jennings-Mares, and Lewis Lee.

After the publication of fifteen revised drafts of the long-awaited Regulation of the European Parliament and Council on OTC Derivatives, Central Counterparties and Trade Repositories (commonly known as “EMIR”), you would be forgiven for thinking that the Europeans were never likely to see a conclusion to legislative attempts to regulate their over-the-counter (“OTC”) derivatives market. However, on 9 February 2012, a trialogue meeting of the European Parliament, the Council and the European Commission at long last reached agreement on the final text of EMIR [1], and since we last provided an update on OTC derivatives reform in the EU [2], the wheels of the legislative process have turned extensively, even if slowly.

Although the publication of the legislation finally puts in place the broad regulatory framework to govern the OTC derivatives market and establishes common rules for central counterparties and trade repositories, much of the real detail has yet to be drafted. The European Securities and Markets Authority (“ESMA”) now has responsibility for putting the flesh on the bones, in the form of drafting scores of technical standards to implement the EMIR provisions.

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June 2012 Dodd-Frank Progress Report

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, June 15, 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 June 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 June 1, 2012, a total of 221 Dodd-Frank rulemaking requirement deadlines have passed. Of these 221 passed deadlines, 148 (67.0%) have been missed and 73 (33.0%) have been met with finalized rules.
  • In addition, 110 (27.6%) of the 398 total required rulemakings have been finalized, while 144 (36.2%) rulemaking requirements have not yet been proposed.

The Volcker Rule Distraction

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, June 15, 2012
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The following post comes to us from Nicole Gelinas, Searle Freedom Trust Fellow at the Manhattan Institute, and is based on a Manhattan Institute report by Ms. Gelinas, available here.

Since JPMorgan Chase announced a trading loss of at least $2 billion, reporters, analysts, and politicians have focused anew on the Wall Street Reform and Consumer Protection Act. President Obama signed this financial-regulation law, known as Dodd-Frank, into law nearly two years ago, on July 21, 2010.

Recently, observers have placed most of their attention on Dodd Frank’s Section 619: “The Volcker Rule.” The Volcker Rule, when it goes into effect as early as July 2012, will prohibit banks such as JPMorgan from engaging in “proprietary trading,” or speculation.

In the aftermath of the JPMorgan Chase announcement, the Volcker Rule proponents’ position has been as follows. Were the Volcker Rule in place already, the rule would have prevented JPMorgan from engaging in the trading that resulted in the loss, as such trading, they say, was “proprietary.” Although details are unclear, JPMorgan appears to have taken its loss in using “excess deposits” to invest in debt securities and attempt to hedge those investments. (“Excess deposits” are the difference between the amount of money a bank has taken in from depositors and the amount of money it has loaned out to borrowers.) As Sen. Carl Levin (D-MI), who helped write the Volcker Rule language, said four days after the bank’s announcement, the Volcker Rule would have prohibited such activities: “If this law were in effect when they made these trades, I believe that these trades violated or were inconsistent with Dodd-Frank, yes.” [1]

Yet it is far from clear that the Volcker Rule would have prevented JPMorgan from engaging in the activities that led to its loss. Among other things, the Volcker Rule allows banks to engage in securities and derivatives trading to hedge risk, as JPMorgan claims this particular activity was intended to do. Moreover, it is far from clear that preventing financial-industry losses—even losses that lead to financial-firm failure—should be the goal of financial regulation. Instead, the goal should be for financial firms to be able to fail without endangering the broader economy.

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JPMC, Dimon, Hedging, and Volcker

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, June 14, 2012
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Editor’s Note: Jeffrey Gordon is the Richard Paul Richman Professor of Law at Columbia Law School.

I think that folks are missing the implications of the JPMorgan Chase (JPMC) London losses, including FDIC board member Thomas Hoenig in this Monday’s Wall Street Journal. The JPMC situation illustrates the problems that derive from the shift in “banking” from a limited form of credit intermediation, namely, commercial banking, into the general form of credit intermediation, including methods that used to be the province of investment banks. Meaning: Banks now provide credit by holding market-traded instruments that are marked to market (unlike commercial loans), and thus want (need?) to hedge exposure to minimize earnings volatility and solvency threats. This is what “London” was mostly about for JPMC.

What counts as “banking” (credit intermediation) these days can take many forms: banks can extend credit by originating and holding, by originating and distributing (bond issuances and structured finance), and by purchasing and holding debt securities originated by others. What are the implications? First, this understanding illustrates the conceptual gap in the Volcker Rule. The Rule, in its focus on market making and hedging, imagines that the bank is taking a long position for customer accommodation and needs to hedge it. That’s what a broker-dealer does, but it’s not what a bank does. A bank takes a long credit position for its own account, which it wants to (partly) hedge. Banks are always adjusting their credit position in light of their views about credit risk, in deciding who to extend credit to and their mix of assets. We want banks to do this to assure their solvency. The Volcker Rule’s focus on proprietary trading simply misses this underlying reality: extending credit and holding credit risk is a proprietary business and it’s hard to limit hedging such activity in a mechanical way. Because the hedged position is the bank’s, this hedging activity will be, at its core, “proprietary.”

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Proxy Voting Fact Sheet

Posted by Matteo Tonello, The Conference Board, on
Thursday, June 14, 2012
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Matteo Tonello is managing director of corporate leadership at the Conference Board. This post is based on the May 2012 issue of the Conference Board’s Proxy Voting Fact Sheet series, authored by Mr. Tonello and Melissa Aguilar, researcher at the Conference Board. The original report is available here (registration required). This memo mentions the Shareholder Rights Project (SRP); posts about the SRP can be found here.

The declassification of the board of directors is emerging as one of the key highlights of the 2012 proxy season, as shareholder proposals on the subject continue to receive overwhelming support. This and other data from nearly 500 annual general meetings (AGMs) held at Russell 3000 companies in the January 1-April 30 period are discussed in the new edition of Proxy Voting Fact Sheet—the periodic report issued by The Conference Board in collaboration with FactSet Research.

In classified boards, members are divided into classes with directors in each class serving staggered terms (typically three years) so that only one class stands for election each year. Classification is used as a defensive measure to prevent hostile takeovers: when a board is staggered, hostile bidders must win more than one proxy contest at successive shareholder meetings to exercise control of the target. Proposals on declassification seek to discontinue this board structure in favor of a system of annual election for all members. The Fact Sheet reports that across the 17 proposals on declassification that went to a vote in the first four months of the year, the average support level was 75.9 percent of votes cast. The most notable examples included the 85.2 percent approval at Johnson Control, a 78.7 percent vote at F5 Networks, and the 77.2 percent vote at Emerson Electric.

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Thirty-Three Declassification Proposals Win Approval with Average Support of 82%

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, June 13, 2012
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Editor’s Note: Professor Lucian Bebchuk is the Director of the Shareholder Rights Project (SRP), and Scott Hirst is the SRP’s Associate Director. Any views expressed and positions taken by the SRP and its representatives should be attributed solely to the SRP and not to Harvard Law School or Harvard University.

With the current proxy season moving toward its final stage, this post provides an updated report about the outcome of precatory declassification proposals that investors represented by the Shareholder Rights Project (SRP) submitted to S&P 500 companies. At this stage of the proxy season, thirty-three precatory declassification proposals submitted to S&P 500 companies by SRP-represented investors won approval, with an average support of 82% of votes cast. These results, as well as the proposals still expected to go to a vote at other S&P 500 companies this season, are described further below.

As described in detail on the SRP’s website, during the 2011-12 proxy season, the SRP has been representing and advising several institutional investors – including the Illinois State Board of Investment (ISBI), the Los Angeles County Employees Retirement Association (LACERA), the Nathan Cummings Foundation (NCF), the North Carolina State Treasurer (NCDST), and the Ohio Public Employees Retirement System (OPERS) – in connection with the submission of precatory shareholder proposals to more than eighty S&P 500 companies that have classified boards. The proposals urge repealing the classified board and moving to annual elections, which are widely viewed as corporate governance best practice.

Through active engagement with companies receiving declassification proposals, forty-four S&P 500 companies have entered into agreements committing them to bring management proposals to declassify their boards (information about these negotiated outcomes is available here). In many of the companies receiving proposals, however, negotiated outcomes were not forthcoming, and as a result, shareholder proposals submitted by the SRP-represented investors have been going to a vote at a number of annual meetings. In particular, such proposals have already gone to a vote at thirty-five companies.

Of the thirty-five proposals voted on so far, thirty-three passed. The table below provides information concerning the precatory declassification proposals that passed. As the table indicates, these proposals obtained average support of 82.16% of votes cast.

Of the thirty-five shareholder proposals to declassify that went to a vote, only two proposals (detailed here) did not pass. Although these proposals failed to gain majority support, they received an average support of 48.55% of votes cast.

We hope that all or most of the thirty-three companies where declassification proposals passed will follow the strongly expressed preferences of their shareholders and bring management proposals to declassify to a vote at their 2013 annual meeting.

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“Limit Up-Limit Down” Plan and Circuit Breakers Approved

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Wednesday, June 13, 2012
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Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former commissioner at the U.S. Securities and Exchange Commission. This post is based on a Davis Polk client memorandum by Ms. Nazareth, Gerard Citera, Susan C. Ervin, Lanny A. Schwartz, and Jeffrey T. Dinwoodie.

On May 31, 2012, the SEC approved two proposals submitted by the national securities exchanges and FINRA that are designed to dampen volatility in the stock market following the May 6, 2010 flash crash: the establishment of a “limit up-limit down” plan that would temporarily prevent trading in a particular listed stock in the event of rapid price swings, and the modification of existing market-wide circuit breakers. Both proposals are scheduled to go into effect on a one-year pilot basis on February 4, 2013.

Limit Up-Limit Down Plan

The new limit up-limit down plan, which is intended to replace the current single-stock circuit breaker pilot, requires exchanges, alternative trading systems, broker-dealers and other trading centers to establish policies and procedures that prevent the execution of trades and the display of offers outside of a specified price band. Price bands for each security will be set (and reset throughout the trading day) at a percentage above and below the security’s average price over the prior five minutes of trading, but will not be reset if price movements within the period are one percent or less. The price band for most stocks in the S&P 500 Index and the Russell 1000 Index, as well as certain exchange-traded funds and notes that have been designated in the SEC’s release (collectively, “Tier 1 NMS stocks”), will be 5%. The price band for most other listed stocks and certain other exchange-traded instruments will be 10%. Price bands will be doubled during opening and closing periods, and broader price bands will apply at all times for listed stocks and exchange-traded instruments priced at or below $3.00. If bid or offer quotations are at the far limit of the price band for more than 15 seconds, trading in that security will be subject to a five-minute trading pause. During its first six-months of operation, the limit up-limit down plan will apply only to Tier 1 NMS stocks. Thereafter, it will apply to all covered stocks.

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