Monthly Archives: March 2014

Understanding the Failures of Market Discipline

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, March 18, 2014
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The following post comes to us from David Min of University of California, Irvine School of Law.

Last week, James Kwak (UConn law professor, co-author of 13 Bankers and White House Burning, and blogger at the Baseline Scenario) provided a nice writeup of some of the key issues I identify in my paper, Understanding the Failures of Market Discipline, recently posted to SSRN. But I wanted to take a few words to provide a slightly more detailed explanation of my work.

“Market discipline”—the notion that short-term creditors (such as bank depositors) can efficiently identify and rein in bank risk—has been a central pillar of banking regulation since the 1980s. Obviously, market discipline did not prevent the buildup of bank risk that caused the recent financial crisis, but the general consensus has been that this failure was due to structural impediments to the effective operation of market discipline—such as misaligned incentives, a lack of transparency, or moral hazard caused by implicit guarantees—rather than any problems with the concept itself. As a result, a major point of emphasis in financial regulatory reform efforts has been to improve and strengthen market discipline.

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Toward a Constitutional Review of the Poison Pill: A Reply to Wachtell Lipton

Posted by Lucian Bebchuk, Harvard Law School, and Robert J. Jackson, Jr., Columbia Law School, on
Monday, March 17, 2014
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Lucian Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School. Robert J. Jackson, Jr. is Associate Professor of Law, Milton Handler Fellow, and Co-Director of the Millstein Center at Columbia Law School. They are co-authors of Toward a Constitutional Review of the Poison Pill, a Harvard Law School discussion paper that is forthcoming in the Columbia Law Review, available here and discussed on the Forum here. This post replies to the criticism of their work put forward in a Wachtell, Lipton Rosen & Katz memorandum, posted on the Forum by Martin Lipton here.

We recently placed on SSRN a draft of a new paper, Toward a Constitutional Review of the Poison Pill, which will be published by the Columbia Law Review in the Fall of 2014. Last week, six senior partners of the law firm of Wachtell, Lipton, Rosen & Katz, including founding partner Martin Lipton, published a strongly-worded response, available on the Forum here. In this post, we rebut Wachtell’s criticism.

Wachtell’s response is a twelve-page, single-spaced Memorandum that describes us as “extreme” and “eccentric,” and characterizes our paper as “tendentious,” “misleading,” and “not a work of serious scholarship.” The Memorandum also attempts to offer a substantive rebuttal of the analysis in our paper. Given that Wachtell Lipton prides itself for creating the poison pill, we understand why an article raising doubt about the validity of the state-law rules authorizing the use of poison pills touches a sensitive nerve at the Firm. Wachtell’s response, however, fails to dispel those doubts—and, indeed, shows why there are serious questions about the constitutionality of state-law poison-pill rules today.

Wachtell does not dispute the analysis in our paper showing that state-law poison-pill rules today impose tighter restrictions on tender offers than those that federal courts have viewed as preempted by the Williams Act. Instead, Wachtell’s response asserts that the “true state of the law,” about which there is “no doubt,” is that the Williams Act “governs procedure, not substance,” and that the Act therefore does not preempt any antitakeover devices that states choose to authorize. As we explain below, this is not an accurate description of the state of the law: Wachtell’s view (1) is not established by Supreme Court precedent; (2) gives undue weight to two lower federal court opinions; and (3) discounts or ignores opinions of other lower federal courts that have expressed views that differ from Wachtell’s.

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Delaware Court Endorses Business Judgment Review in Controlling Stockholder Mergers

Posted by Theodore N. Mirvis & Paul Rowe, Wachtell, Lipton, Rosen & Katz, on
Monday, March 17, 2014
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Theodore N. Mirvis and Paul Rowe are partners in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton memorandum by Mr. Mirvis, Mr. Rowe, Igor Kirman, and William Savitt. 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 Supreme Court today affirmed that a going-private transaction may be reviewed under the deferential business judgment rule when it is conditioned on the approval of both a well-functioning special committee and a majority of the minority stockholders. Kahn v. M&F Worldwide Corp., No. 334, 2013 (Del. Mar. 14, 2014).

As described in our previous memo, the case arose out of a stockholder challenge to a merger in which MacAndrews & Forbes acquired the 57% of M&F Worldwide it did not already own. Then-Chancellor Strine granted summary judgment in favor of the defendants, finding that the record established the transaction was approved by both an independent special committee that functioned effectively and had the power to say no and the fully-informed vote of a majority of the unaffiliated stockholders, thus entitling them to business judgment review.

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SEC v. Contorinis: SEC gets Powerful New Tool—For Now

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, March 16, 2014
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The following post comes to us from Paul N. Monnin, partner in the Litigation and Regulatory practice at DLA Piper LLP, and is based on a DLA Piper publication by Mr. Monnin and Zachary LeVasseur.

The Second Circuit Court of Appeals has broadened the Securities and Exchange Commission’s power to seek civil disgorgement of profits from insider trading violations even where an individual did not personally profit from the illegal trades.

In its panel opinion in SEC v. Contorinis, decided on February 18, the Second Circuit upheld a trial court order requiring that Joseph Contorinis, the former managing director of the Jeffries Paragon Fund, disgorge more than US$7 million in unlawful profits obtained by the fund as a result of Contorinis’s trading on material nonpublic information. This is despite the fact that he did not trade with his own personal assets and his personal compensation from the trades amounted to only US$427,875.

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Supreme Court Hears Arguments in Halliburton

Posted by Robert Giuffra, Sullivan & Cromwell LLP, on
Saturday, March 15, 2014
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Robert Giuffra is a partner in Sullivan & Cromwell’s Litigation Group. The following post is based on a Sullivan & Cromwell publication by Jeffrey B. Wall. The Supreme Court’s reconsideration of Basic is also discussed in a Harvard Law School Discussion Paper by Professors Lucian Bebchuk and Allen Ferrell, Rethinking Basic, discussed on the Forum here.

On March 5, 2014, the U.S. Supreme Court heard oral argument in Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317, which presents whether to overrule or significantly limit plaintiffs’ ability to rely on the legal presumption that each would-be class member in a securities fraud class action relied on the statements challenged as fraudulent in the lawsuit. Without this so-called fraud-on-the-market presumption of classwide reliance, putative class action plaintiffs would face substantial barriers in maintaining securities fraud class actions. The Court’s decision in Halliburton, which is expected by June 2014, could lead to a significant change in the conduct of securities class actions. Even if the Court ultimately retains some formulation of the fraud-on-the-market presumption of reliance, the Court could increase defendants’ ability to contest what in practice has evolved into a virtually irrebuttable presumption.

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Fixing Merger Litigation

Posted by Steven Davidoff, Ohio State University College of Law, Jill Fisch, University of Pennsylvania, and Sean Griffith, Fordham University, on
Friday, March 14, 2014
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Steven M. Davidoff is Professor of Law and Finance at Ohio State University College of Law. As of July 2014, Professor Davidoff will be Professor of Law at the University of California, Berkeley School of Law. Jill E. Fisch is Perry Golkin Professor of Law and Co-Director of the Institute for Law & Economics at the University of Pennsylvania Law School. Sean J. Griffith is T.J. Maloney Chair in Business Law at Fordham University School of Law. 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 the US, every M&A deal of any significant size generates litigation. The vast majority of these lawsuits settle, and the vast majority of these settlements are for non-pecuniary relief, most commonly supplemental disclosures in the merger proxy.

The engine that drives this litigation is the concept of “corporate benefit.” Under judge-made law, litigation that produces a corporate benefit allows the court to order plaintiffs’ attorneys’ fees to be paid directly by the defendants provided that the outcome of the litigation is beneficial to the corporation and its shareholders. In a negotiated settlement, plaintiffs will characterize supplemental disclosures in the merger proxy as producing a corporate benefit, and defendants will typically not oppose the characterization, as they are happy to pay off the plaintiffs’ lawyers and get on with the deal. The supposed benefits of these settlements thus are rarely tested in adversarial proceedings. Knowing this creates a strong incentive for plaintiffs’ attorneys to file claims, put in limited effort, and negotiate a settlement consisting exclusively of corrective disclosures. But is there any real value to these settlements?

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A Response to Bebchuk and Jackson’s Toward a Constitutional Review of the Poison Pill

Posted by Martin Lipton, Wachtell, Lipton, Rosen & Katz, on
Thursday, March 13, 2014
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Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton memorandum by Mr. Lipton, Theodore N. Mirvis, George T. Conway III, Jeffrey M. Wintner, and William Savitt. This post responds to a recent Harvard law School Discussion paper by Lucian Bebchuk and Robert Jackson that is forthcoming in the Columbia Law Review. The paper, Toward a Constitutional Review of the Poison Pill, is available here and a blog post describing it is available here.

In a recent paper, Professors Lucian Bebchuk and Robert Jackson have extended Professor Bebchuk’s extreme and eccentric campaign against director-centric governance into a new realm—that of the Constitution of the United States. They claim that “serious questions” exist about the constitutionality of the poison pill—or, more precisely, “about the validity of the state-law rules that authorize the use of the poison pill.” It is likely, they argue, that these state-law rules violate the Supremacy Clause of the Constitution, and are thus preempted, because they frustrate the purposes of the Williams Act, the 1968 federal statute that governs tender-offer timing and disclosure.

Bebchuk and Jackson cite leading academic textbooks and articles that either recognize the preeminence of the poison pill in takeover defense or demonstrate the weakness of preemption challenges to state takeover statutes. The scholars authoring these books and articles, we are told, “overlooked” or “ignored” the obvious fact that poison pills may delay tender offers for lengthy periods of time. Bebchuk and Jackson profess “surpris[e]” that the constitutional issue they discuss “has received little attention, or even notice, from commentators,” and assert that it is rather a shocking “oversight” that, despite a “large literature” on Williams Act preemption, “commentators and practitioners” have devoted “little attention to the question of whether the state-law rules with the most powerful antitakeover effect—the rules authorizing use of the poison pill—are preempted.”

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Remarks on the Halliburton Oral Argument (3): The Consistency of a Fraudulent Distortion Approach with Not Resolving Merit Issues at Class Certification

Posted by Lucian Bebchuk and Allen Ferrell, Harvard Law School, on
Thursday, March 13, 2014
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Lucian Bebchuk is William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance, Harvard Law School. Allen Ferrell is Greenfield Professor of Securities Law, Harvard Law School. They are co-authors of Rethinking Basic, a Harvard Law School Discussion Paper forthcoming in the May 2014 issue of The Business Lawyer, that is available here. This post is the third in a three-part series in which they remark on the oral argument at the Halliburton case; the first two posts are available here and here.

As we discussed in our first two posts, the Halliburton oral argument (transcript available here), provided encouraging signs that a number of the Justices might choose to avoid making a judgment on the state of efficient market theory and to focus on the presence of fraudulent distortion (sometimes also referred to as price impact). In this post, we respond to arguments that the adoption of such an approach would be inconsistent with or at least in tension with the Court’s earlier rulings that merit issues should not be resolved at the class certification case.

In Rethinking Basic, we explain that class-wide reliance should depend not on the “efficiency” of the market for the company’s security but on the existence of fraudulent distortion of the market price, and that focusing on fraudulent distortion would provide a coherent and implementable framework for identifying class-wide reliance in appropriate circumstances. We also go on to explain that, in contrast to some claims to the contrary, determining fraudulent distortion would not usurp the merits issues of materiality and loss causation.

In responses to our paper (see, e.g., Kevin LaCroix of D&O blog’s thoughtful post here http://www.dandodiary.com/2014/01/articles/securities-litigation/dump-fraud-on-the-market-yet-preserve-securities-plaintiffs-ability-to-establish-reliance/) and in reactions to the oral argument in Halliburton, commentators raised the possibility that adopting a fraudulent distortion approach would create tension with some recent Supreme Court rulings.

In particular, questions were raised as to (1) whether a finding of fraudulent distortion would necessarily imply a finding of materiality, an issue that the Court held in Amgen to be a merits issue?, and (2) whether such a finding would necessarily imply a finding of loss causation, an issue that the Court in the earlier Halliburton case held also to be a merits issue?

As we explain below, based on our analysis in Rethinking Basic, the answer to both questions is no. We first address the question of materiality and then turn to loss causation.

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Do-It-Yourself Activism

Posted by Kobi Kastiel, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, March 13, 2014
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The following post comes to us from Gerry Hansell, senior partner and managing director at The Boston Consulting Group, and is based on a BCG publication by Mr. Hansell, Tawfik Hammoud, Alexander Roos, and Vinay Shandal. Recent work from the Program on Corporate Governance about hedge fund activism includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon P. Brav, and Wei Jiang.

Many corporate executives and board members view activist investors as little more than bullies with calculators: they seem to hunt in packs, force disruptive and risky changes, and use simplistic benchmarks as their call to action.

Yet their ranks have grown rapidly, and activist investors now attack even the largest and most successful companies. Worldwide, the assets managed by activist investors have increased sevenfold over the past decade, from $12 billion to $85 billion. Since 2005, the number of activist campaigns in the U.S. has increased 15 percent per year, reaching a total of 144 in 2012. These investors have pushed for the return of excess cash to shareholders at Apple; urged restructuring through spinoffs and divestitures at PepsiCo, Sony, Timken, and McGraw-Hill; and called for the replacement of senior management or board members at Abercrombie & Fitch, Yahoo, and Sotheby’s.

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Remarks on the Halliburton Oral Argument (2): Implementing a Fraudulent Distortion Approach

Posted by Lucian Bebchuk and Allen Ferrell, Harvard Law School, on
Wednesday, March 12, 2014
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Lucian Bebchuk is William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance, Harvard Law School. Allen Ferrell is Greenfield Professor of Securities Law, Harvard Law School. They are co-authors of Rethinking Basic, a Harvard Law School Discussion Paper forthcoming in the May 2014 issue of The Business Lawyer, that is available here. This post is the second in a three-part series in which they remark on the oral argument at the Halliburton case; the first post is available here.

In our first post on the Halliburton oral argument (transcript available here), we discussed the encouraging signs that a number of the Justices might choose to avoid making a judgment on the state of efficient market theory and to focus on the presence of fraudulent distortion (sometimes also referred to as price impact). In this post, we remark on how a fraudulent distortion approach could be implemented should the Court indeed adopt such an approach. In particular, we discuss the financial econometric tools for assessing the presence or absence of fraudulent distortion and we explain that these tools are not limited to event studies at the time of the misrepresentation.

In Rethinking Basic, we present a detailed case for using a fraudulent approach and explain why it would provide a conceptually superior framework than a focus on market efficiency. We go on, however, to show that an approach focusing on fraudulent distortion would have significant administrability and implementation advantages over the federal courts’ practice in this area.

Because the courts have thus far had to provide a yes/no answer to whether the market for a given security is efficient, significant problems of over- and under-inclusion have arisen (as has been noted by the Supreme Court in its Amgen decision). Focusing on the presence of fraudulent distortion in the case at hand would avoid these significant problems. Furthermore, as we describe in Rethinking Basic, there are standard and sound methods drawn from the academic finance and accounting literature for ascertaining the presence of a distortionary price impact (a toolkit that should displace the current exclusive focus on the Cammer factors, which test for market efficiency). Without attempting to be comprehensive, we discuss below three tools that are potentially available for implementing a fraudulent distortion approach.

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