Monthly Archives: November 2013

Fact and Fiction in Corporate Law and Governance

The following post comes to us from Michael Klausner, Nancy and Charles Munger Professor of Business and Professor of Law at Stanford Law School.

In a recent article, entitled Fact and Fiction in Corporate Law and Governance, I evaluate two broad elements of corporate governance scholarship—one conceptual and the other methodological. The conceptual element is the “contractarian” framework within which legal academics have analyzed corporate law since the 1980s. My evaluation is not aimed at the characterization of a corporation as a nexus of voluntary associations—a characterization that I think most of us share—but rather at the belief among some legal scholars that market forces lead to optimal governance arrangements within firms, and that a market dynamic leads states to compete to provide value-maximizing corporate law rules. The methodological element that I address is the use of corporate governance indices in empirical studies of corporate governance, an approach that dates back to the 1990s but that became widespread following Gompers, Ishii and Metrick’s development of the G Index in 2003.


Determinants and Performance of Equity Deferral Choices by Outside Directors

The following post comes to us from Christopher Ittner, Professor of Accounting at the University of Pennsylvania; and Francesca Franco and Oktay Urcan, both of the Accounting Area at the London Business School.

In our paper, Determinants and Trading Performance of Equity Deferral Choices by Corporate Outside Directors, which was recently made publicly available on SSRN, we investigate the determinants and trading performance of outside directors’ “equity deferrals,” which represent the choice to convert part or all of the current cash compensation into deferred company stock. Director equity deferrals are interesting for two reasons. First, by deferring, the directors give up a sure amount of cash today for firm stock with an uncertain future value, while at the same time substantially increasing the proportion of their compensation that is tied to future firm performance. Second, the equity deferrals can become a form of insider trading, because directors can use these options as a tax-advantaged alternative to open-market purchases of the firm’s stock.

We examine director equity deferrals using a hand-collected sample of U.S. firms that allowed outside board members to defer their cash compensation into equity between 1999 and 2003. We first focus on the factors affecting director equity deferral choices. Consistent with a certainty equivalent story, we find that directors are more likely to defer cash into equity when they receive higher cash compensation levels and when the plans offer premiums for deferrals made into equity. Deferral likelihood also increases with the size of the taxes that are deferred.


SEC Sanctions Adviser, Broker-Dealer and Their Owner Over ETF Trades

The following post comes to us from Eric R. Fischer, partner in the Business Law Department at Goodwin Procter LLP, and is based on a Goodwin Procter Financial Services Alert by Jackson B. R. Galloway.

The SEC settled claims against a registered investment adviser (the “Adviser”), its affiliated broker-dealer (the “Broker-Dealer”), and the founder, owner, and president of each (the “CEO”) that related to (1) investments in Class A shares of underlying funds made by funds managed by the Adviser (the “Funds”) and (2) commissions paid by the Funds to the Broker-Dealer for trades in exchange-traded funds (“ETFs”). Without admitting or denying its findings, the Respondents agreed to the settlement order (the “Order”), available here, which this post summarizes.


Achieving High Quality Audits to Promote Integrity and Investor Protection

The following post comes to us from Jeanette M. Franzel, board member of the Public Company Accounting Oversight Board. This post is based on Ms. Franzel’s remarks at the NACD 2013 Board Leadership Conference, available here. The views expressed in this post are those of Ms. Franzel and should not be attributed to the PCAOB as a whole or any other members or staff.

I want to commend the NACD on its mission to “advance exemplary board leadership” with the compelling vision of aspiring to “a world where businesses are sustainable, profitable, and trusted; shareowners believe directors prioritize long-term objectives and add unique value to the company; [and] directors provide effective oversight of the corporation and strive to deliver exemplary board performance.”

Audit committees are instrumental in achieving this vision and maintaining public trust and investor protection through their oversight of corporate financial reporting and auditing. I would also like to recognize the important role and difficult jobs that each of you have as audit committee members in these oversight functions, as well as the many other areas that are being assigned to audit committees during a time of ever increasing business complexity and risk.


Court of Chancery Reaffirms Validity of Forum Selection Charter Provision

Theodore N. Mirvis is a partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. The following post is based on a Wachtell Lipton memorandum by Mr. Mirvis, David A. Katz, William Savitt, and Ryan A. McLeod. 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 Court of Chancery recently determined that forum selection provisions in corporate charters—much like forum selection bylaws—are presumptively valid, and provided guidance on the appropriate procedure to enforce such provisions against a stockholder who files suit in violation of them. Edgen Grp. Inc. v. Genoud, C.A. No. 9055-VCL (Del. Ch. Nov. 5, 2013) (Trans.).

The dispute arose after the Edgen Group announced that it had agreed to sell itself in a premium, all-cash, sales transaction to an unrelated third party. Edgen’s certificate of incorporation includes a provision that provides that any claim of breach of fiduciary duty by an Edgen stockholder must be filed in Delaware. Nevertheless, a putative class action challenging the merger was filed in Louisiana state court. In response, Edgen filed suit against the stockholder in Delaware, asking the Court of Chancery to enjoin him from proceeding in Louisiana.


Regulatory Agencies Re-Propose Risk-Retention Rules for Securitizations

The following post comes to us from Anthony R.G. Nolan, partner in the Finance practice at K&L Gates LLP, and is based on a K&L Gates publication by Mr. Nolan, Sean P. Mahoney, and Drew A. Malakoff.

On August 28, 2013, a consortium of U.S. banking, housing and securities regulators (the “Agencies”) [1] re-proposed the joint regulations (the “Re-Proposed Rules”), to implement Section 15G of the Securities Exchange Act of 1934. Section 15G requires the Agencies to prescribe joint regulations to require “any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells or conveys to a third party.” [2] This has popularly been referred to as a “skin in the game” requirement intended to align the interests of those originating or aggregating loans with the interests of investors in securitizations of those loans. The Re-Proposed Rules are the Agencies’ second attempt at rulemaking under Section 15G, the first coming with proposed joint regulations released on April 14, 2011 (the “Initial Proposed Rules”). [3]

Both the Initial Proposed Rules and the Re-Proposed Rules would generally require a “securitizer” to retain at least 5 percent of the credit risk associated with the assets backing a securitization transaction, subject to various exemptions and offsets. The Initial Proposed Rules prescribed some basic forms of risk-retention that could be used in any type of securitization, as well as some forms of risk-retention that would apply only to specific types of securitizations (such as those involving revolving asset master trusts, which are common to credit-card and automobile floorplan securitization, CMBS transactions, certain federal agency securities issuances, and ABCP conduits). [4] The Re-Proposed Rules appear to be dramatically simpler than the Initial Proposed Rules and address many of the more significant issues presented by the Initial Proposed Rules. Nevertheless, the Re-Proposed Rules present a number of issues of their own.


Do Fraudulent Firms Engage in Disclosure Herding?

The following post comes to us from Gerard Hoberg of the Department of Finance at the University of Maryland and Craig Lewis of the Finance Area at Vanderbilt University.

In our paper, Do Fraudulent Firms Engage in Disclosure Herding?, which was recently made publicly available on SSRN, we present two new hypotheses regarding the strategic qualitative disclosure choices of firms involved in potentially fraudulent activity. First, these firms have incentives to herd with industry peers in order to escape detection. Second, these firms have incentives to locally anti-herd with the same peers on specific aspects of disclosure consistent with achieving fraud-driven objectives. We use text-based analysis of firm disclosures and compare disclosures across firms involved in SEC enforcement actions to benchmarks based on industry, size and age, and also to each firm’s own disclosure before and after SEC alleged violations.

We hypothesize that firms involved in potentially fraudulent activity face tensions when providing qualitative disclosures to the Securities and Exchange Commission, the agency tasked with enforcing anti-fraud laws. Our focus is on the Management’s Discussion and Analysis section of the 10-K, which is where managers have a high level of discretion to describe the key issues facing their firms and to describe their performance in detail. A primary motive is to escape detection, and managers who assume that the SEC is less likely to scrutinize disclosures that resemble industry peers, or that such disclosure is less likely to raise red flags, have incentives to herd with industry peers. On the other hand, the same objectives that lead managers to commit fraud may also provide incentives to anti-herd in their disclosure from industry peers. However, these latter incentives are likely more localized, and anti-herding would be predicted only on disclosure dimensions that might help managers to achieve these objectives.


Court Finds No Breach of Fiduciary Duties in Proxy Contest

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.

In Red Oak Fund, L.P. v. Digirad Corp., the Delaware Court of Chancery held that the Digirad board of directors did not breach its fiduciary duties or create an unfair election process where: (i) preliminary election results that showed the incumbents in the lead were accidentally disclosed to a large stockholder; (ii) certain preliminary proxy reports inaccurately reported a large lead by management; (iii) the company delayed disclosure of negative financial results until after the election; and (iv) management proxy materials did not disclose that the board was considering a stockholder rights plan (a “poison pill”).

Plaintiff, owner of 5.6% of Digirad’s outstanding common stock, nominated a slate of five directors to replace the company’s incumbent board, but lost the ensuing proxy contest. Plaintiff filed suit, alleging that the incumbent directors breached their fiduciary duties and created an unfair election process.

The court found no breach of fiduciary duties and no valid claim of an unfair election process, holding that:


Read Before Whistleblowing: What Every Lawyer Needs to Know

The following post comes to us from Robert J. Malionek, partner and member of the Litigation Department at Latham & Watkins LLP, and is based on a Latham Client Alert by Mr. Malionek and Keith A. Cantrelle.

In wake of ethics opinion, lawyers in New York—if not elsewhere—must think hard before considering whether to participate in the Dodd-Frank Whistleblower Award Program.

A recent SEC whistleblower award of $14 million may offer a persuasive incentive for lawyers to blow the whistle on a client’s perceived wrongdoing. However, a subsequent ethics opinion from the Committee on Professional Ethics of the New York County Lawyers’ Association will give lawyers pause. As the SEC whistleblower award program gains momentum, New York lawyers may be well-advised to wait for the courts to determine whether the SEC’s rules can pre-empt state rules of professional conduct.


Is the Independent Director Model Broken?

The following post comes to us from Roberta S. Karmel, Centennial Professor of Law at Brooklyn Law School, and is based on Professor Karmel’s paper, forthcoming in the Seattle University Law Review.

At common law, an interested director was barred from participating in corporate decisions in which he had an interest, and therefore “disinterested” directors became desirable. This concept of the disinterested, director developed into the model of an “independent director” and was advocated by the Securities and Exchange Commission (SEC or Commission) and court decisions as a general ideal in a variety of situations. The SEC’s view of the need for independent directors should be understood in the context of Adolph Berle’s theory of the 1930s that shareholders had abdicated control of public corporations to corporate managers, and fiduciary duties needed to be imposed upon corporate boards in order to compensate for this loss of shareholder control. Berle’s writings laid the foundation for shareholder primacy as the theory of the firm, a theory embraced by the SEC, which viewed itself as a surrogate for investors.

The SEC has generally succeeded in imposing its corporate governance views in the wake of scandals. Following the sensitive payments enforcement program of the 1970s, the SEC embarked on an activist corporate governance reform program. During the merger and acquisition frenzy of the 1980s, the SEC used the Williams Act to foster the view that the market for corporate control constrained incompetent managers. After the bursting of the technology bubble in 2000, and the financial reporting scandals that ensued, the SEC was able to incorporate its views on independent directors into the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). Following the financial crisis of 2008, the SEC further enforced its views on the requirements for independent directors in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).

The composition and behavior of securities markets and investors has changed drastically since the SEC was established in 1934. Yet, the SEC has persisted in its path-dependent view that independent directors, ever more stringently defined, should dominate the boards of public companies.


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