Monthly Archives: September 2013

Rollover Risk: Ideating a U.S. Debt Default

The following post comes to us from Steven L. Schwarcz, Stanley A. Star Professor of Law & Business at Duke University School of Law.

In Rollover Risk: Ideating a U.S. Debt Default, forthcoming in the Boston College Law Review, I systematically examine how a U.S. debt default might occur, how it could be avoided, its potential consequences if not avoided, and how those consequences could be mitigated. The impending debt-ceiling showdown between Congress and the President makes these questions especially topical. The Republican majority in Congress is conditioning any raise in the federal debt ceiling on spending cuts and reforms. Yet without raising the debt ceiling, the government may end up defaulting, perhaps as early as mid-October.

Even without that showdown, however, these questions are important. As the article explains, certain types of U.S. debt defaults, due to rollover risk, are actually quite realistic. This is the risk that the government will be temporarily unable to borrow sufficient funds to repay—sometimes termed, to refinance—its maturing debt.

Because rollover risk is such a concern, one might ask why governments, including the United States, routinely depend on borrowing new money to repay their maturing debt. The answer is cost: using short-term debt to fund long-term projects is attractive because, if managed to avoid a default, it tends to lower the cost of borrowing. The interest rate on short-term debt is usually lower than that on long-term debt because, other things being equal, it is easier to assess a borrower’s ability to repay in the short term than in the long term, and long-term debt carries greater interest-rate risk. But this cost-saving does not come free of charge: it increases the threat of default.

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The Promise of the Enhanced Broker Internet Platform

The following post comes to us from John Endean, President of the American Business Conference.

A breakthrough for improved corporate democracy is languishing at the Securities and Exchange Commission. The breakthrough, called the Enhanced Broker Internet Platform (EBIP) is a technological innovation that would make it vastly easier for shareholders to participate in corporate elections for directors and shareholder resolutions. This is important because the rate of individual or “retail” shareholder voting is pitifully low. For example, in fiscal year 2012, the rate of retail positions voted was less than 14%.

Why is the response rate so low? Unlike public pension funds and other institutional investors, retail shareholders are under no legal obligation to vote, are not much encouraged by anyone to do so, and remain largely unorganized. Work, personal commitments and everything else that crowds each hour of the day can easily make voting a proxy ballot fall off a shareholder’s “to-do” list.

Enter the EBIP proposal. EBIPs would build on individual shareholders’ reliance on brokers’ websites as their primary source for information by also allowing shareholders to vote their positions on those sites. EBIPs would provide a means for reminding shareholders of the importance of voting while affording them a convenient platform for casting informed votes.

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Seasoned Equity Offerings, Corporate Governance, and Investments

The following post comes to us from E. Han Kim and Amiyatosh Purnanandam, both of the Department of Finance at the University of Michigan.

In our paper, Seasoned Equity Offerings, Corporate Governance, and Investments, forthcoming in the Review of Finance, we assess how the strength of governance affects investor confidence about management’s intended uses of the proceeds from SEOs. Our primary tests are conducted using difference-in-differences approaches using the staggered enactments of business combination statutes (BCS) as an exogenous shock weakening external pressure for good governance from the market for corporate control.

These tests are supplemented by two additional analyses, one relying on shareholder-value-reducing acquisitions as an ex post proxy for weak governance; the other relying on top management’s firm-related wealth sensitivity to shareholder value as a proxy for the strength of internal governance. These empirical analyses cover different sample periods spanning 1982 through 2006. Investor reaction to SEOs is positively and significantly related to the strength of governance regardless of which empirical strategy we use and which time period we examine.

The economic magnitudes of governance impacts are surprisingly large, explaining much of the negative stock price reactions to the announcement of SEOs. Absent secondary offerings, investors’ main concern with SEOs is whether management will use the proceeds productively or wastefully. Good governance enhances investor confidence, helping firms raise external equity at lower costs.

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Statement Regarding Joint Rule Reproposal Concerning Credit Risk Retention

Michael S. Piwowar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Piwowar’s statement regarding the SEC’s joint rule reproposal concerning credit risk retention. The views expressed in the post are those of Commissioner Piwowar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

The Securities and Exchange Commission (“SEC” or “Commission”) today approved a joint rule reproposal to implement Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). [1] I am not able to support the release in the form approved because the reproposal does not contain necessary economic analyses and does not adequately consider alternatives to credit risk retention requirements or the interplay between those requirements and other regulatory reforms.

Before discussing these shortcomings, I want to recognize all the hard work the SEC’s staff in the Division of Corporation Finance and the Division of Economic and Risk Analysis (“DERA”) put into developing the joint rule reproposal. I also want to thank them for briefing me on the rulemaking and answering my questions.

While I am not able to vote in favor of the reproposal, I am encouraged that some improvements were made to the original proposal in response to public comments. For example, the reproposal removes the problematic premium capture cash reserve account approach. And, with respect to some classes of asset-backed securities (“ABS”), the reproposal revises various risk retention obligations and allows alternative incentive alignment practices.

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New York Court Upholds Kenneth Cole Going Private Transaction

The following post comes to us from Tariq Mundiya, partner in the litigation department of Willkie Farr & Gallagher LLP, and is based on a Willkie client memorandum by Mr. Mundiya and Sameer Advani.

On September 3, 2013, a New York trial court dismissed a stockholder challenge to a going private transaction in which Kenneth Cole, who held approximately 47% of the Company’s outstanding common stock and controlled 90% of the voting power of Kenneth Cole Productions Inc. (“KCP”), purchased the remaining 53% of the common stock of KCP that he did not already own. Willkie Farr & Gallagher represented Mr. Cole in the underlying going private transaction and the class action litigation that ensued.

The Facts

On February 24, 2012, KCP announced that Mr. Cole had proposed a transaction to take KCP private and to pay the public stockholders $15.00 per share, which reflected a 17% premium to KCP’s unaffected share price. KCP’s board created a special committee of four independent directors to negotiate with Mr. Cole, who conditioned his bid on the approval of the special committee and the affirmative vote of a majority of the minority stockholders. Mr. Cole made it publicly clear that he would not entertain any offers to sell his shares in a third party transaction and was only interested in buying shares from the minority stockholders. After several months of negotiations, Mr. Cole agreed to pay $15.25 per share. 99.8% of KCP’s shares unaffiliated with Mr. Cole that voted ultimately voted in favor of the transaction.

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Will Recent Delaware Court Decisions Curb Excessive M&A Litigation?

The following post comes to us from Andrew J. Noreuil, partner focusing on mergers and acquisitions and corporate governance practice at Mayer Brown LLP, and is based on a Mayer Brown legal update by Mr. Noreuil. 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.

The Delaware Chancery Court has issued three decisions in 2013 that demonstrate the court’s willingness to rein in the excessive and often frivolous litigation challenging public M&A transactions.

Recent trends in shareholder litigation illustrate the magnitude of the litigation issues facing corporations in public M&A transactions. Of the public company acquisition transactions with a value over $500 million that were announced in 2007, 53% were challenged in shareholder litigation. By 2012, 96% of such transactions were subject to shareholder suits, with an average of 5.4 suits filed for each deal. In addition, for Delaware target corporations valued at over $100 million, 65% of the M&A deals announced in 2012 were subject to litigation in Delaware and in at least one other jurisdiction (usually the jurisdiction where the corporation’s principal place of business is located). Finally, for shareholder suits in deals over $100 million that were announced in 2012 and ultimately settled, shareholders received only supplemental disclosures in 81% of such settlements (so-called “disclosure-only settlements”), with plaintiffs’ attorneys fees and expenses being the only cash paid out by defendants in such suits.

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Does the Market for CEO Talent Explain Controversial CEO Pay Practices?

Martijn Cremers is a Professor of Finance at the University of Notre Dame. Yaniv Grinstein is an Associate Professor of Finance at the Johnson Graduate School of Management at Cornell University.

Considerable debate remains among academics and practitioners regarding the economic forces that drive CEO compensation practices in the United States. Some view the market for CEO talent as the main economic force that drives the level and form of CEO compensation (e.g., Rosen, 1992; Gabaix and Landier, 2008). Others argue that these forces have little effect on CEO compensation because of frictions such as managerial entrenchment, asymmetric information, and transaction costs of replacing managers, believing instead that compensation practices are by and large driven by the bargaining power that the CEO has vis-à-vis the board (e.g., Bebchuk and Fried, 2003).

The debate has intensified in recent years due to several controversial compensation practices, a first example of which is the tendency of firms to benchmark CEO compensation to that of other CEOs. While some find benchmarking consistent with competitive compensation (Holmstrom and Kaplan, 2003; Bizjak et al., 2008), others argue it is a way for CEOs to increase their compensation by benchmarking themselves to highly paid CEOs (e.g., Faulkender and Yang, 2010).

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Don’t Run Away from the Evidence: A Reply to Wachtell Lipton

Lucian Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School. Alon Brav is Professor of Finance at Duke University. Wei Jiang is Professor of Economics and Finance at Columbia Business School. This post responds to two Wachtell Lipton memoranda posted by Martin Lipton, available on the Forum here and here. These memoranda criticize the recently-issued empirical study by Bebchuk, Brav, and Jiang on the long-term effects of hedge fund activism. The study is available here, and its results are summarized in a Forum post and in a Wall Street Journal op-ed article.

In two recent memoranda by the law firm of Wachtell Lipton (Wachtell), The Bebchuk Syllogism (Syllogism memo) and Current Thoughts about Activism (Current Thoughts memo), the firm’s founder Martin Lipton and several other senior Wachtell lawyers strongly criticize our recent study, The Long-Term Effects of Hedge Fund Activism. Our study empirically disproves the myopic activists claim that interventions by activist hedge funds are in the long term detrimental to the involved companies and their long-term shareholders. This post responds to the main criticisms of our work in Wachtell’s memos. Below we proceed as follows:

  • First, we discuss the background of how our study meets a challenge that Wachtell issued several months ago;
  • Second, we highlight how Wachtell’s critiques of our study fail to raise any questions concerning the validity of our findings concerning long-term returns, which by themselves are sufficient to undermine the myopic activists claim that Wachtell has long been putting forward;
  • Third, we explain that the methodological criticisms Wachtell directs at our findings concerning long-term operating performance are unwarranted;
  • Fourth, we show that Wachtell’s causality claim cannot provide it with a substitute basis for its opposition to hedge fund activism;
  • Finally, we explain why Wachtell’s expressed preference for favoring anecdotal evidence and reports of experience over empirical evidence should be rejected.

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Accuracy in Proxy Monitoring

The following post comes to us from Heidi Welsh, Executive Director at the Sustainable Investments Institute (Si2), and is based on a Si2 report. This post relates to reports by Proxy Monitor, the most recent of which was discussed on the Forum here.

Shareholder activists are meeting now to consider what proposals they will file for the 2014 proxy season and the results are largely in from the 2013 proxy season, with analysis coming from all the different proponent groups, the proxy advisory firms and others interested in what happened this year. Si2’s own report in August showed that the upward climb of investor support for social and environmental policy proposals continued this year, with average support hitting a record level of 21.3 percent and requests for more board and workplace diversity, sustainability reporting and corporate political activity disclosure got the highest levels of support. (More information on these overall findings and overall trends, illustrated with charts, appears here.)

One group that reports on proxy season findings is Proxy Monitor, a project of the Manhattan Institute’s Center for Legal Studies. It focuses on resolutions that go to votes at the 250 largest U.S. firms, reporting on the vote results and presenting analysis of the trends on its website. The group’s analyses of proxy season results trends have some significant blind spots that are not always apparent to the novice proxy analyst, but its reports nonetheless are widely quoted in the press. As such, they deserve some scrutiny, which this post offers. Si2 took a look at all the shareholder resolutions filed since 2010 and compared the results to the Proxy Monitor database to see precisely how PM reaches its conclusions.

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Executive Pay Disparity and the Cost of Equity Capital

The following post comes to us from Zhihong Chen of the Department of Accountancy at City University of Hong Kong, Yuan Huang of the School of Accounting and Finance at Hong Kong Polytechnic University, and K.C. John Wei, Professor of Finance at Hong Kong University of Science & Technology (HKUST).

In our paper, Executive Pay Disparity and the Cost of Equity Capital, forthcoming in the Journal of Financial and Quantitative Analysis, we investigate the association between executive pay disparity and the cost of equity capital. Understanding the association is important because the cost of capital is one of the key considerations for managers in their capital budgeting and corporate financing decisions. In fact, the cost of capital is a more direct yardstick of corporate investment and financing decisions than firm valuation. A higher cost of capital means fewer positive net present value (NPV) projects, leading to fewer growth opportunities. In addition, the cost of capital summarizes an investor’s risk-return tradeoff in his resource allocation decision (Pástor, Sinha, and Swaminathan (2008)).

In general, there are two perspectives on executive pay disparity. The tournament perspective views the large pay gap between the CEO and other executives as the prize for a tournament in which players compete for the CEO position (Lazear and Rosen (1981); Kale, Reis, and Venkateswaran (2009)). A large pay disparity motivates non-CEO senior executives to work hard and to invest in firm-specific human capital. This, in turn, helps build a large pool of skilled internal candidates for the CEO position. The availability of skilled internal candidates not only reduces the entrenchment of the incumbent CEO by increasing the bargaining power of the board, but also reduces CEO succession risk. Therefore, this perspective predicts a negative association between executive pay disparity and the cost of capital.

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