Monthly Archives: June 2013

UK Treasury Releases Draft Alternative Investment Fund Managers Directive

The following post comes to us from Glynn Barwick, counsel in the Business Law Department at Goodwin Procter and member of the firm’s Private Investment Funds and Financial Services Practices, and is based on a Goodwin Procter client alert by Mr. Barwick.

The UK Treasury has recently published a new, and near final, version of the implementing Regulations for the Alternative Investment Fund Managers Directive (the “AIFMD”). (We have commented on the consequences of the AIFMD for EU managers and non-EU managers in our 4 January, 11 January, 27 February and 27 March client alerts.) This updated version of the implementing Regulations represents a considerable improvement for managers compared to the initial draft.

In summary, with effect from the implementation date (22 July 2013), European managers of Alternative Investment Funds (“AIFs”) – essentially:

  • (a) any European manager of a PE, VC, hedge or real estate fund will need to be authorised in its home member state and comply with various requirements regarding the funds that it manages concerning information disclosure and third-party service providers; and
  • (b) any non-European manager of a PE, VC, hedge or real estate fund will need to comply with various marketing and registration restrictions if it wishes to obtain access to European investors.

This post discusses the major changes to the AIFMD implementing Regulations.

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FSOC Proposes the First Three Nonbank SIFIs

The following post comes to us from Charles Horn, partner focusing on banking and financial services matters at Morrison & Foerster LLP, and is based on a Morrison & Foerster client alert by Mr. Horn and Jay G. Baris.

In a June 3, 2013 closed-door meeting, the Financial Stability Oversight Council (“FSOC”) voted to propose the designation of three financial services companies—American International Group (“AIG”), Prudential Financial and GE Capital—as the first systemically significant nonbank financial institutions (“nonbank SIFIs”) under section 113 of the Dodd-Frank Act.

The FSOC decision, announced by the Treasury Secretary, did not identify specific names, but all three companies publicly confirmed their proposed nonbank SIFI status. If these proposed designations become final, these three companies will become the first nonbank SIFIs to be subjected to stringent Federal Reserve Board oversight and supervision, as well as capital and other regulatory requirements, under Title I of the Dodd-Frank Act. In addition, these designations will bring to life the Dodd-Frank Act’s orderly liquidation authority that applies to systemically significant financial firms, in the event that one of these companies may fail or be in danger of failing in the future.

The FSOC’s action to begin the process of designating nonbank SIFIs has been long awaited—some would say long-overdue—and the identities of the three companies that have been proposed for SIFI designation come as no real surprise. Nonetheless, the FSOC’s action marks an important milestone in the implementation of the Dodd- Frank Act’s systemic regulation framework. While the actual significance of these designations likely will emerge more clearly in the coming weeks and months, the FSOC’s action brings into sharper focus the questions and challenges that the designated firms and their regulators will face.

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Delaware Court Decision on Entire Fairness Review for Mergers

The following post comes to us from Robert B. Schumer, chair of the Corporate Department at Paul, Weiss, Rifkind, Wharton & Garrison LLP, and is based on a Paul Weiss client memorandum. 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. Additional reading about In re MFW Shareholders Litigation is available here.

In an important and thoughtful decision that will influence the structure of future going-private transactions by controlling stockholders, Chancellor Strine of the Delaware Court of Chancery applied the business judgment rule—instead of the more onerous entire fairness review—to a going-private merger by a controlling stockholder because the merger was structured to adequately protect minority stockholders. The decision is likely to be appealed, but if affirmed by the Delaware Supreme Court on appeal, the case should provide certainty in an area of the law that has been a source of debate and uncertainty for two decades. The decision, In re MFW Shareholders Litigation, provides a detailed roadmap to obtaining the more favorable business judgment rule review and reducing the considerable litigation costs and risks associated with entire fairness review.

The court in MFW held that if the transaction is (1) negotiated by a fully-empowered special committee of directors who are independent of the controlling stockholder and (2) conditioned on the approval of a majority of the minority stockholders, then entire fairness review will not apply. The court noted the following key elements of the process:

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Demanding Transparency in Clawbacks

This post comes to us from Elizabeth McGeveran, a consultant on corporate governance matters, member of the External Citizens Advisory Panel at ExxonMobil, and former Senior Vice President for Governance & Sustainable Investment at F&C Asset Management, one of the co-filers of Shareholder Proposal No. 8 in Walmart’s 2013 Proxy Statement.

After the horrifying collapse of a factory in Bangladesh killed over 1,100 workers, companies like H&M are moving to strengthen supplier standards and audits, as they should. We have seen similar responses to other compliance meltdowns in the past. Banks trumpet new checks and balances to help prevent excessive risk taking, massive trading losses and robo-foreclosures. Walmart points to changes in its compliance policies in response to front-page allegations of bribery and corruption in Mexico. Companies are quite happy to tell investors, employees, and the public how such changes will prevent the same problems from recurring.

This public disclosure about change for the future is commendable. But such reforms must be accompanied by measures to hold executives accountable for major compliance failures in the past. And here, beyond the occasional news report that a CEO volunteered to forego a bonus, companies tell us very little.

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Measuring Intentional Manipulation: A Structural Approach

The following post comes to us from Anastasia Zakolyukina of the University of Chicago Booth School of Business.

In the paper, Measuring Intentional Manipulation: A Structural Approach, which was recently made publicly available on SSRN, I suggest a structural model of a manager’s manipulation decision that allows me to estimate his costs of manipulation and to infer the amount of undetected intentional manipulation for each executive in my sample. The model follows the economic approach to crime (Becker, 1968) and incorporates the costs and benefits of manipulation decisions. The model is a dynamic finite-horizon problem in which the risk-averse manager maximizes his terminal wealth. The manager’s total wealth depends on his equity holdings in the firm and his cash wealth. The model yields three predictions. First, according to the wealth effect, managers having greater wealth manipulate less. Second, according to the valuation effect, the current-period bias in net assets increases in the existing bias. Third, the manager’s risk aversion, the linearity of his terminal wealth in reported earnings, and the stochastic evolution of the firm’s intrinsic value produce income smoothing. Furthermore, the structural approach allows partial observability of manipulation decisions in the data; hence, I am able to estimate the probability of detection as well as the loss in the manager’s wealth using the data on detected misstatements (i.e., financial restatements).

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Quadratic Vote Buying, Square Root Voting, and Corporate Governance

The following post comes to us from Eric Posner, Kirkland & Ellis Distinguished Service Professor of Law and Aaron Director Research Scholar at the University of Chicago, and E. Glen Weyl, Assistant Professor in Economics at the University of Chicago.

Imagine that a corporation holds a shareholder vote on a project like a merger, and, under the corporation’s bylaws, each shareholder can cast a number of votes equal to the square root of the number of shares that he holds. This might seem like a gimmick, but it actually provides a natural, smooth form of minority shareholder protection without the external intervention of the courts. In fact, under reasonable conditions square root voting (SRV) ensures that the project is approved if and only if it maximizes the value of the firm and thus achieves the efficiency goals of minority shareholder protection without the messy legal procedures that usually accompany them.

To see why, suppose that a corporation proposes a merger. An investor believes that the merger will increase the value of the corporation by $1000 per share, and that a vote in favor of the merger increases the probability of approval by 0.01. Thus, the marginal benefit from buying a share is $10. The investor can buy shares of the corporation at an opportunity cost of $1 (in the sense that she would rather use her money in another way and she incurs brokerage fees, but can otherwise sell the share for net expected profit of $0 if the merger is not approved). Because of the square-root rule, however, she must buy the square of the number of shares for every vote she casts. Thus, if she wants to cast 1 vote, she must buy 1 share at a cost of $1; if she wants to cast 2 votes, she must buy 2 shares at a cost of $4; if she wants to buy 3 shares, she must pay $9; and so on.

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Striving to Restructure Money Markets Funds to Address Potential Systemic Risk

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s statement at a recent open meeting of the SEC; the full text is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Today [June 5, 2013], the Commission considers amending the rules that govern money market funds to address potential systemic risks. Before I begin, I would like to recognize the efforts of the staff throughout the SEC, especially the Division of Investment Management and the Division of Risk, Strategy, and Financial Innovation. I acknowledge and appreciate the staff’s good work in examining the 2010 amendments to Rule 2a-7 and the staff’s report, which concluded that, among other things, the 2010 amendments would not have been adequate to prevent the systemic risks that we saw in 2008. This report has resulted in the much-improved proposal that is before us today.

The staff’s work is a testament as to why the SEC should take the helm of matters that are within its jurisdiction. I appreciate that the Financial Stability Oversight Council (“FSOC”) recently said as much in its 2013 Annual Report. [1] The SEC’s expertise brings a clear-eyed experience and practical knowledge that can target needed change, while being mindful of unintended consequences.

I am supportive of the staff’s recommendations and will first put the proposed amendments in context, and then highlight a few items.

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Only the Right CEO Can Create a Culture of Integrity

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 Corporate Counsel.

Corporate Counsel recently ran an article entitled “Bringing Compliance to the C-Suite,” based on a Rand Corporation conference of a similar name and previewing a subsequent report-out. The focus of the conference, as reflected in papers presented there and referenced in the article, is that a variety of pressures cause CEOs to act badly or, at the least, to be indifferent to issues of corporate integrity. This is, of course, an important perspective.

But, despite the headlines, many CEOs, supported by boards of directors and top company leaders, are trying to do the right thing. Indeed, how a corporation fuses high performance with integrity—from the CEO to the shop or trading floor—is a venerable topic. And, despite important roles for the board and top company leaders like finance, legal, compliance, and HR officers, the profound reality, in my view, is that only the right CEO can create a robust culture of integrity.

Given the often-dour public perception of CEOs and given the contrasting reality of their centrality in a company’s fusion of performance with integrity, I thought it worth re-emphasizing core principles of private-ordering that can serve as practical ideals for CEOs and for companies seeking to do the right thing. These core principles should be kept in view as various discrete problems about aberrant CEO behavior are discussed in venues like the Rand conference, and it is helpful to think of them as arising in two dimensions of corporate governance.

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Incentive Schemes for Nominees of Activist Investors

The following post comes to us from Neil Whoriskey, partner focusing on mergers and acquisitions at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by Mr. Whoriskey, titled “Golden Leashes, Honest Brokers, Risk Tolerances and Market Imperfections: Incentive Schemes for Nominees of Activist Investors.”

Golden leashes – compensation arrangements between activists and their nominees to target boards – have emerged as the latest advance (or atrocity, depending on your point of view) in the long running battle between activists and defenders of the long-term investor faith. Just exactly what are we worried about?

With average holding periods for U.S. equity investors having shriveled from five years in the 1980s to nine months or less today, the defenders of “long-termism” would seem to have lost the war, though perhaps not the argument. After all, if the average shareholder is only sticking around for nine months, and if directors owe their duties to their shareholders (average or otherwise), then at best a director on average will have nine months to maximize the value of those shares. Starting now. Or maybe starting nine months ago.

But this assumes that the directors of any particular company have a real idea of just how long their particular set of “average” shareholders will stick around, and it also assumes that the directors owe duties primarily to their average shareholders, and not to their Warren Buffett investors (on one hand) or their high speed traders (on the other). So, in the absence of any real information about how long any then-current set of shareholders will invest for on average, and in the absence of any rational analytical framework to decide which subset(s) of shareholders they should be acting for, what is a director to do?

Here is what I think directors do, in one form or fashion or another:

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Corporate Funding: Who Finances Externally?

The following post comes to us from B. Espen Eckbo, Professor of Finance at Dartmouth College, and Michael Kisser of the Department of Finance at the Norwegian School of Economics.

In our paper, Corporate Funding: Who Finances Externally?, which was recently made publicly available on SSRN, we provide new information on security issues and external financing ratios derived from annual cash flow statements of publicly traded industrial companies over the past quarter-century. Our use of cash flow statements permits us to differentiate between competing forms of internal financing, including operating profits, cash draw-downs, reductions in net working capital, and sale of physical assets. Unlike leverage ratios which dominate the focus of the extant capital structure literature, our cash-flow-based financing ratios are measured using market values (cash) and are unaffected by the firm’s underlying asset growth rate.

The empirical analysis centers around three main issues, the first of which is to establish the importance of external finance in the overall funding equation. In our pool of nearly 11,000 (Compustat) non-financial firms, the net contribution of external cash raised (security issues net of repurchases and dividends) was negative over the sample period. Moreover, the average (median) firm raised merely 12% of all sources of funds externally. Also, annual funds from total asset sales contributed more to the overall funding equation than net proceeds from issuing debt.

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