Yearly Archives: 2013

The Effect of Managers’ Professional Experience on Corporate Cash Holdings

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, April 2, 2013
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The following post comes to us from Amy Dittmar of the Department of Finance at the University of Michigan and Ran Duchin of the Department of Finance at the University of Washington.

In our paper, Looking in the Rear View Mirror: The Effect of Managers’ Professional Experience on Corporate Cash Holdings, which was recently made publicly available on SSRN, we study the role of managers’ professional experience in financial decision making, focusing on one of the most debated corporate policies in recent years – cash savings.

We focus our analysis on corporate cash policies because firms hold unprecedented, increasing levels of cash. In 1980, firms held $234.6 billion (in 2011 dollars) in cash, amounting to 12% of assets. By 2011, the amount of cash grew to $1,500 billion, or 22% of assets. The predominant approach to understanding corporate cash holdings is the precautionary savings motive. According to this motive, firms hold liquid assets to hedge against future states of nature in which adverse cash flow shocks, coupled with external finance frictions, may lead to underinvestment or default. While prior research shows that the precautionary savings motive explains much of the cash policy of firms, some suggest that managers are overly conservative in their decision to hold high levels of cash.

Motivated by psychological evidence, which shows that past experience affects individual decision-making, we argue that managers may behave conservatively because they experienced financial difficulties in their professional career. To test this hypothesis, we collect detailed data on managers’ employment histories and construct four measures of experience at firms that faced financial difficulties. These measures capture financial constraints and adverse shocks to cash flows and stock returns. To separate firm and CEO effects, the measures are based on prior employment at other firms.

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Becoming the Fifth Branch

Posted by M. Todd Henderson, University of Chicago Law School, on
Tuesday, April 2, 2013
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M. Todd Henderson is Professor of Law and Aaron Director Teaching Scholar at the University of Chicago Law School, and William A. Birdthistle is Associate Professor of Law and Freehling Scholar at Chicago-Kent College of Law.

In our article Becoming the Fifth Branch, we argue that financial self-regulation has changed dramatically and problematically in the past few years. Financial self-regulatory organizations (SROs), such as FINRA and the Chicago Mercantile Exchange’s regulatory arm, are transforming from “self-regulatory” into “quasi-governmental” organizations. We believe this evolution, moreover, may become a serious problem for the stability and efficiency of our financial system.

To SEC Commissioner Daniel Gallagher’s question, “Is FINRA becoming a ‘deputy SEC?,’” we fear the answer is “yes.” We describe an array of forces that we believe may be driving this change, explain the implications of the loss of true self-regulation, and offer some options for restoring a healthier regulatory balance.

SROs are the primary legislators, regulators, and officers on the beat who monitor our financial system. While corporate theorists tend to focus on Congressional legislation and agency rulemaking, self-regulation is the form of financial governance that most directly governs the daily activities of our financial firms. Nearly one hundred and fifty years before the creation of federal and state securities authorities, the financial industry established its own self-regulatory organizations. The growth of private regulation was initially designed to fill a regulatory void that left brokers unable to signal quality and investors reluctant to participate in the market confidence.

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Swap Trading in the New Regulatory World

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Monday, April 1, 2013
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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 discusses a Davis Polk memorandum, available here; an accompanying timeline is available here.

As a result of the Dodd-Frank Act, the over-the-counter derivatives markets have become subject to significant new regulatory oversight. As the markets respond to these new regulations, the menu of derivatives instruments available to asset managers, and the costs associated with those instruments, will change significantly. As the first new swap rules have come into effect in the past several months, market participants have started to identify risks and costs, as well as new opportunities, arising from this new regulatory landscape.

This memorandum and the accompanying timeline is designed to provide asset managers, and those interested in the activities of asset managers, with background information on key aspects of the swap regulatory regime that may impact their derivatives trading activities. The memorandum highlights practical considerations and potential opportunities for asset managers, as they assess the impact these regulations will have on their trading activities.

In the short term, asset managers should be sure to:

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The New Market in Debt Governance

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, April 1, 2013
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The following post comes to us from Yesha Yadav of Vanderbilt Law School.

Scholars have traditionally assumed that lenders that protect themselves using credit derivatives like credit default swaps (CDS) have limited interest in debt governance. The rationale behind this proposition seems straight-forward. Lenders that have bought credit protection should have little incentive to invest in monitoring and disciplining a borrower where they know they will be repaid under the CDS. Indeed, scholars argue, lenders that have purchased CDS protection have considerable interest in seeing a borrower fail. When this happens, they can easily and cheaply exit their investment by triggering repayment on the CDS.

This paper, the New Market in Debt Governance, recently made available on SSRN, challenges this consensus and proposes a new theory of governance in the context of credit derivatives trading. While scholars have traditionally focused on lenders that protect themselves using CDS, they overlook the role of financial firms that sell this credit protection and thereby assume economic risk on the underlying borrower. These protection sellers take on the risk of a borrower defaulting, but possess no legal tools with which they can discipline the borrower to stave off default. As a result, unlike ordinary lenders, protection sellers have no direct means to control a borrower’s risk-taking. They possess no legal powers to influence how much leverage a borrower takes on, its use of collateral, cash reserves or its acquisitions and enterprise strategy. Given this precarious position, it follows that protection sellers possess powerful incentives to seek out ways to influence how a borrower company is run to better control how risky it is allowed to become.

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A New Playbook Part 2 — Global Securities Enforcement Stepping Up

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, April 1, 2013
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The following post comes to us from Paul A. Ferrillo, counsel at Weil, Gotshal & Manges LLP specializing in complex securities and business litigation, and is based on an article by Mr. Ferrillo, Robert F. Carangelo, and Hannah Field-Lowes. [1]

About a year ago, we published A New Playbook for Global Securities Litigation and Regulation, in which we detailed dramatic changes in the global securities regulatory and litigation arena driven by various factors, including not only the financial crisis of 2007-2008, but also changes in tolerance in the United States to litigation brought by foreign investors against public companies listed on non-U.S. exchanges.

One year later, the regulatory environment continues to revamp with new rules being issued constantly in the United States to conform to the legislative mandates set forth in the Dodd Frank Act. The United Kingdom and European Union also seek to reinforce previous global initiatives to reform and strengthen the Pan-European financial markets.

What is more ever-present, however, is the marked increase in global enforcement activities by regulators in the United Kingdom, Canada, and the European Union, which are attempts to give teeth to the global financial reforms each jurisdiction felt necessary to potentially prevent a “repeat” of the financial crisis. This article seeks to address the increase in global securities enforcement activity and concludes that continued cooperation and coordination in enforcement activities will be required to seamlessly address the desire to strengthen global regulatory initiatives aimed at harmonizing and centralizing international securities regulation to create safer, more fundamentally sound financial markets for investors.

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Shareholder Proxy Access in Small Publicly Traded Companies

Posted by J.W. Verret, George Mason University School of Law, on
Sunday, March 31, 2013
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J.W. Verret is an Assistant Professor at George Mason University School of Law.

In Business Roundtable v. SEC, the DC Court of Appeals struck down the proxy access rule giving certain shareholders access to the corporate proxy on the grounds that the SEC failed to adequately fulfill its requirement to consider the impact of new rules on “efficiency, competition, and capital formation.” The Court offered a blistering critique of the SEC’s economic analysis in the rule. Criticism of the opinion followed and also led to a series of Congressional hearings on the SEC’s process for weighing the economic costs and benefits of new rules. Many of the critics of the opinion, and indeed of cost-benefit analysis itself, have argued that it is simply too difficult to guide rulemaking, or that costs are easier to measure than benefits and so the approach trends against the status quo.

I counter that critique of Business Roundtable by way of example in an article co-authored with Thomas Stratmann in the Stanford University Law Review, Does Shareholder Proxy Access Damage Share Value in Small Publicly Traded Companies? We suggest a question the SEC might itself have investigated about its approach, if it had submitted a rule proposal first and if it was committed to economic analysis of its rules. We consider a natural experiment provided by the rule’s differential impact on small and large firms above and below the arbitrary $75 million market capitalization separation. We measure the impact of the market’s frustrated expectation of a permanent exemption for small firms, an expectation stemming from prior SEC implementation of other controversial rules and strong language in the Dodd-Frank Act, against a control group represented by large firms who expected application of the rule and for whom the new rule’s impact was largely capitalized into their value.

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Board Composition and Firm Value — Lessons from Lawyer-Directors

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, March 30, 2013
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The following post comes to us from Charles K. Whitehead, Professor of Law at Cornell Law School.

Within the standard framing, directors monitor managers in order to help align shareholder-manager interests and minimize the agency costs that arise within public companies. A principal goal has been to reinforce director independence in light of the conventional wisdom that independent directors are the most effective monitors. Directors, however, are more than just agency-cost-reducers. As managers, they also bring to bear different perspectives and judgments that are important in formulating business strategies. In addition, their training, expertise, and experience in problem-solving are valuable in managing a business, as well as their knowledge of markets and practices that may be less familiar to firm executives.

The board’s managing function has been under-evaluated by law and finance academics. In our working paper, Lawyers and Fools: Lawyer-Directors in Public Corporations, my co-authors, Lubomir Litov and Simone Sepe, and I offer new insight into how boards operate. Specifically, we analyze the effect on firm value of directors with legal training (“lawyer-directors”) who sit on the boards of public, non-financial corporations.

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Court: Disclosure of SEC Investigation Insufficient to Plead Loss Causation

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, March 29, 2013
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The following post comes to us from Adam Hakki, partner and global head of the Litigation Group at Shearman & Sterling LLP, and is based on a Shearman & Sterling client publication.

The US Court of Appeals for the Eleventh Circuit recently issued an important decision that addresses two types of allegations that plaintiffs routinely rely on to plead loss causation in federal securities fraud cases. In Meyer v. Greene, 2013 US App. LEXIS 4187 (11th Cir. Feb. 25, 2013), the Eleventh Circuit appears to have become the first federal court of appeals to rule definitively that the mere announcement of an investigation by the US Securities and Exchange Commission (“SEC”) followed by a decline in a company’s stock price is insufficient to plead loss causation. The Court also ruled, consistent with decisions from other federal circuits, that a negative third-party analyst presentation is not a corrective disclosure for purposes of pleading loss causation if the presentation is based on publicly available information.

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Governance Buffett Style

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, March 29, 2013
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The following post comes to us from Lawrence A. Cunningham, Henry St. George Tucker III Research Professor of Law at George Washington University Law School. This post is based on and adapted from The Essays of Warren Buffett: Lessons for Corporate America (3d ed. 2013) by Professor Cunningham.

In Warren Buffett’s model of corporate governance, managers are stewards of shareholder capital. The best managers think like owners in making business decisions. They have shareholder interests at heart. But even first-rate managers will sometimes have interests that conflict with those of shareholders. How to ease those conflicts and to nurture managerial stewardship have been constant objectives of Buffett’s long career and a prominent theme of his shareholder letters that I began collecting two decades into the stand-alone book, The Essays of Warren Buffett: Lessons for Corporate America, the third edition of which was released in March 2013.

The essays address some of the most important governance problems. The first is the importance of forthrightness and candor in communications by managers to shareholders. Buffett tells it like it is, or at least as he sees it, and laments that he is in the minority. Berkshire’s annual report is not glossy; Buffett prepares its contents using words and numbers people of average intelligence can understand; and all investors get the same information at the same time. Buffett and Berkshire avoid making predictions, a bad managerial habit that too often leads other managers to make up their financial reports.

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The Board, Social Media and Regulation FD

Posted by David A. Katz, Wachtell, Lipton, Rosen & Katz, on
Thursday, March 28, 2013
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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 full article, including footnotes, is available here.

The widespread use of social media in today’s global marketplace presents opportunities and challenges for all financial market participants, including boards of directors, investors and regulators. While social media outlets provide unprecedented pathways for companies to engage actively with investors, both large and small, as well as with reporters, analysts, customers, suppliers and other members of the corporate community, there are regulatory restrictions that public companies need to heed. Releasing information via Twitter, Facebook, and similar channels must be done with caution to avoid violating Securities and Exchange Commission (SEC) Regulation FD as it currently stands. Moreover, companies are vulnerable to negative publicity that can be quickly and widely disseminated over social media networks, even if they are not active participants in such channels.

As public companies increasingly use and rely upon the new avenues of communication provided by social media, it is correspondingly important for directors to be aware of the manner and extent of their companies’ use of social media and have a basic understanding of the risks and benefits of corporate participation. At the same time, it may be incumbent upon the SEC to revisit Regulation FD. The immediacy and availability of communications made through social media suit the purpose of Regulation FD far better than anything available at the time of its passage in 2000; by failing to update Regulation FD, the SEC may find that the rule is impeding rather than furthering its stated goals. Fundamentally, the interests of all market participants are aligned when it comes to encouraging companies to use social media consistently, effectively, and legally, as enhanced transparency and increased engagement generally benefit the market as a whole.

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