Monthly Archives: June 2019

Weekly Roundup: June 7–13, 2019

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This roundup contains a collection of the posts published on the Forum during the week of June 7–13, 2019.

French Legislation on Corporate Purpose

A New Era of Extraterritorial SEC Enforcement Actions

Ten Years of Say-on-Pay Data

New DOJ Compliance Program Guidance

Board Diversity by Term Limits?

EVA, Not EBITDA: A Better Measure of Investment Value

CFO Gender and Financial Statement Irregularities

Corporate Governance by Index Exclusion

Precluding Pre-Merger Communications in Post-Merger Dispute

Stakeholder Capitalism for Long-Term Value Creation

Steve W. Klemash is Americas Leader; Jamie C. Smith is Associate Director; and Rani Doyle is Executive Director, all at the EY Center for Board Matters. This post is based on their EY memorandum. Related research from the Program on Corporate Governance includes The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law by Leo E. Strine (discussed on the Forum here); and The Uneasy Case for Favoring Long-Term Shareholders by Jesse Fried (discussed on the Forum here).

Boards can strengthen their oversight role by guiding management to focus on the long-term, understand stakeholder objectives and communicate the many ways their companies create value.

Transformation of business, society and governments has accelerated over the last decade. Disruption, especially in business, is an increasing challenge for governments, society and companies to navigate and manage. In this environment, a growing and increasingly diverse group of market participants is supporting greater corporate focus on creating long-term value for multiple stakeholders.

As companies consider why and how to address such considerations, a consensus is emerging about how companies can redefine and communicate corporate value through an expanded lens. There is an ongoing shift from the view that the primary purpose of companies is to enhance and protect value for shareholders (shareholder capitalism) to the view that corporations are better able to deliver long-term value to shareholders when they understand and address the needs of their customers, employees, investors, regulators and other key stakeholders (stakeholder capitalism).

As boards examine these changing dynamics and expectations, they should consider recent market-driven approaches and regulatory views on measuring and communicating corporate value with an expanded and longer-term perspective.


Should Retail Investors’ Leverage Be Limited?

Rawley Heimer is Assistant Professor at the Boston College Carroll School of Management and Alp Simsek is Rudi Dornbusch Career Development Associate Professor of Economics at Massachusetts Institute of Technology. This post is based on their recent article, forthcoming in the Journal of Financial Economics.

Financial markets feature considerable speculative trading that can harm uninformed investors. Consequently, financial market regulators have long grappled with how to prevent investors from making harmful speculative trades, while preserving markets for useful trades. Leverage is a major catalyst for speculative trading. Our article examines the impact of leverage limits on the retail foreign exchange (forex) market. We find that leverage limits result in smaller losses for the most aggressive traders without harming market liquidity. Further, the policy improves belief-neutral welfare and reduces excessive financial intermediation. Our approach can be applied to other markets, and will be a useful framework for regulators as they try to curb speculation without impeding well-functioning markets.

The retail forex market is an ideal venue for our analysis because leverage limits in this market are new (introduced in 2010, compared to e.g. the market for U.S. equities, which has had a leverage limit of 2:1 since 1934). In October 2010, under the authority of the Dodd-Frank Act, the Commodity Futures Trading Commission (CFTC) capped the amount of leverage brokers can provide to U.S. traders at 50:1 on all major currency pairs and 20:1 on others. Meanwhile, European regulators did not impose any leverage limits, and the maximum leverage available almost always exceeded 50:1. These market features—time-series variation in available leverage and a suitable control group of unregulated traders—allow us to use a difference-in-differences design to evaluate the costs and benefits of the leverage-constraint policy.


Sometimes Silence is Golden: “Dell Compliance” Following Aruba III

Michael Kass is Portfolio Manager at BlueMountain Capital Management, LLC. This post is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Using the Deal Price for Determining “Fair Value” in Appraisal Proceedings (discussed on the Forum here) and Appraisal After Dell, both by Guhan Subramanian.

The frequently discussed but generally unwritten story underlying the three judicial opinions in Verition Partners v. Aruba Networks involves a dispute between two luminaries of the Delaware Corporate Law—Vice Chancellor Travis Laster and Chief Justice Leo Strine.

The story goes that Vice Chancellor Laster, fuming over his “rebuke” in Dell, a decision not written but generally attributed to the Chief Justice, sought to force acknowledgement of the faults in that decision by adopting an extreme view of its logic and interpreting it reductio ad absurdum for a “result that no litigant would even ask for”. He did so by (i) finding an odious transaction process involving rampant conflicts of interest, negotiating negligence and selective disclosure to be sufficiently reliable to evidence fair value (“FV”) because its record of defects was, in his view, no worse than the one in Dell, while, nevertheless, (ii) ruling that the cleanest measure of FV was the Company’s so-called unaffected stock price (“USP”), a metric that was neither argued by any party at trial nor particularly well suited to the FV measurement objective, given strong evidence of conflicts of interest and the exploitation of material non-public information found in the trial record. Similar to the first holding, on process sufficiency (or what was subsequently coined by Vice Chancellor Glasscock as “Dell Compliance” in AOL), the latter holding on “USP Relevance” was grounded in the Vice Chancellor’s comparison of the factual record of Aruba against those in Dell and DFC, and the Delaware Supreme Court’s heavy deference to observable market measures of value in those cases. Not to be outdone by this deft, “hoisted on your own petard” tactic by the Vice Chancellor, the Chief Justice returned the favor in a manner that only a superior tribunal can—by (a) reversing the Chancery Court on the USP Relevance holding via a scathing criticism of its reductionist argumentation, (b) affirming its Dell Compliance holding with virtually no discussion on the merits of the Chancery Court’s adjudication of that issue, and (c) directing a verdict in reliance on the Dell Compliance holding—notwithstanding obvious conflicts in the trial record on the quantification of deductible synergies that, absent judicial gloss, would have frustrated such implementation. While motives remain opaque, the twin effects of this directed verdict are to establish finality (i.e., ensure there will be no Aruba IV or, more importantly, Aruba V) and, by implication, to set in stone the Vice Chancellor’s findings of fact that implicitly sanction as “reliable” a very, very dirty deal.


Precluding Pre-Merger Communications in Post-Merger Dispute

John Mark Zeberkiewicz is director and Daniel E. Kaprow is an associate at Richards, Layton & Finger, P.A. This post is based on a Richards Layton memorandum by Messrs. Zeberkiewicz, Kaprow, Rudolf Koch and Robert Greco, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Allocating Risk Through Contract: Evidence from M&A and Policy Implications (discussed on the Forum here); and M&A Contracts: Purposes, Types, Regulation, and Patterns of Practice, both by John C. Coates, IV.

In Shareholder Representative Services LLC v. RSI Holdco, LLC, C.A. No. 2018-0517-KSJM (Del. Ch. May 29, 2019), the Delaware Court of Chancery upheld a provision in a private-company merger agreement precluding a buyer from using the seller’s privileged emails against the seller in post-closing litigation. Following the guidance from the decision in Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP, 80 A.3d 155 (Del. Ch. 2013), the RSI Court held that under the terms of the parties’ merger agreement, pre-merger communications between the target company’s owners and representatives and the target company’s counsel could not be used by the buyer in a post-closing dispute.

In September 2016, RSI Holdco, LLC (“Buyer”) acquired Radixx Solutions International, Inc. (“Radixx”). Radixx and its counsel negotiated for a so-called “Great Hill provision” in the merger agreement—i.e., one providing that certain pre-merger privileged communications would not pass to the Buyer at the effective time. In essence, the merger agreement provided that the pre-merger privileged communications between the sellers and company counsel would survive the merger and be assigned to the stockholders’ representative, and prevented the Buyer from using or relying on any such privileged communications. Despite the clear language of the merger agreement, the Buyer sought to use approximately 1,200 pre-merger emails that it had acquired by virtue of the merger in post-closing litigation. Although it acknowledged that the emails were presumably privileged at the time they were made, the Buyer argued that because the sellers did not take steps to excise or segregate the privileged communications from the email servers, the privilege had been waived.


Corporate Governance by Index Exclusion

Scott Hirst is an Associate Professor of Law at the Boston University School of Law, and Director of Institutional Investor Research at the Harvard Law School Program on Corporate Governance. Kobi Kastiel is Assistant Professor of Law at Tel Aviv University, and a Research Fellow at the Harvard Law School Program on Corporate Governance. This post is based on their recent article, forthcoming in the Boston University Law Review. Related research from the Program on Corporate Governance includes The Untenable Case for Perpetual Dual-Class Stock (discussed on the Forum here), and The Perils of Small-Minority Controllers (discussed on the Forum here), both by Lucian Bebchuk and Kobi Kastiel, and the keynote presentation on The Lifecycle Theory of Dual-Class Structures.

Investors have long been unhappy with certain governance arrangements adopted by companies undertaking IPOs, such as dual-class voting structures. Traditional sources of corporate governance rules—the Securities and Exchange Commission, state law, and exchange listing rules—do not constrain these arrangements. As a result, investors have turned to a new source of governance rules: index providers.

Our recent article, forthcoming in the Boston University Law Review, provides a comprehensive analysis of index exclusion rules, their likely effects on insider decision-making, and their ability to serve as investors’ new gatekeepers. We show that efforts to portray index providers as the new sheriffs of the U.S. capital markets are overstated. Index providers face complex and conflicting interests, which make them reluctant regulators, at best. This reluctance to regulate is clearly reflected in the dual-class exclusion rules they adopted. We also analyze, theoretically and empirically, the efficacy of index exclusions in preventing disfavored arrangements and show that their efficacy is likely to be limited, but not zero (as some scholars argue). We conclude by examining the lessons from this important experiment and the way forward for corporate governance.

A more detailed overview of our analysis follows:


What’s New on the SEC’s new RegFlex Agenda?

Cydney S. Posner is special counsel at Cooley LLP. This post is based on a Cooley memorandum by Ms. Posner.

SEC Chair Jay Clayton has repeatedly made a point of his intent to take the Regulatory Flexibility Act Agenda “seriously,” streamlining it to show what the SEC actually expected to take up in the subsequent period. (Clayton has previously said that the short-term agenda signifies rulemakings that the SEC actually planned to pursue in the following twelve months. See this PubCo post and this PubCo post.) The SEC’s Spring 2019 short-term and long-term agendas have now been posted, reflecting the Chair’s priorities as of March 18, when the agenda was compiled. What stands out is not so much the matters that show up on the short-term agenda—although there are plenty of significant proposals to keep us all busy—but rather the legislatively mandated items that have taken up protracted residency on the long-term (i.e., the maybe never) agenda.

On the short-term agenda:

Extending the Testing the Waters Provision to Non-Emerging Growth Companies—Corp Fin is considering recommending that the SEC adopt amendments to extend the test-the-waters provision to non-emerging growth companies. These amendments were proposed in February and are now considered to be in the final rule stage. New Rule 163B would allow a company (and its authorized representatives, including underwriters) to engage in oral or written communications, either prior to or following the filing of a registration statement, with potential investors that are, or are reasonably believed to be, qualified institutional buyers (QIBs) or institutional accredited investors to determine whether they might be interested in the contemplated registered offering. The proposed new rule was designed to allow the company to gauge market interest in the deal before committing to the time-consuming prospectus drafting and SEC review process or incurring many of the costs associated with an offering. (See this PubCo post.)


Help! I Settled With an Activist!

Kai Haakon E. Liekefett is a partner and Leonard Wood is an associate at Sidley Austin LLP. This post is based on their recent publication in the 2019 Spring Edition of Ethical Boardroom. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); Dancing with Activists by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch (discussed on the Forum here); and Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System by Leo E. Strine, Jr. (discussed on the Forum here).

Public companies in the US and around the world are increasingly signing settlement agreements as a means to put shareholder activist campaigns to rest.

While companies are allured by the prospect of a quick end to the public side of an activist campaign, settlement agreements often invite new disruptions inside the boardroom and interrupt a board’s ability to concentrate on executing a long-term strategy. Moreover, settlement agreements are of increasingly shorter duration, meaning that the peace boards bargained for often becomes merely a fleeting respite from what is, in fact, a multi-year campaign of the activist.

The anatomy of a settlement agreement

At first sight, settlement agreements with activists have much to offer. The downside for the incumbent board is nearly always that one or more activist designees will join the board, often immediately. If the activist had leverage in the negotiations, it will have successfully pushed for “replacement rights”—the right of the activist to designate a replacement for any of its designees on the board who leave for ostensibly unforeseen reasons. Replacement rights create the possibility that an activist can replace a “good cop” that it first designated to the board with a “bad cop” who will push his or her agenda harder in the boardroom. Often, the activist designees are principals or employees of the activist fund. Regularly, settlement agreements provide that activist designees on the board will occupy seats on key committees.


CFO Gender and Financial Statement Irregularities

Vishal Gupta is associate professor and Sandra Mortal is associate professor of Economics, Finance, & Legal Studies at the University of Alabama Culverhouse College of Commerce. This post is based on an article, forthcoming in Academy of Management Journal, by Professor Gupta; Professor Mortal; Bidisha Chakrabarty, Edward Jones Endowed Professor of Finance at St. Louis University; Xiaohu Guo, PhD Candidate in Finance at The University of Alabama; and Daniel B. Turban, Emma S. Hibbs/Harry Gunnison Brown Chair of Business and Economics at the University of Missouri.

Our research examines whether CFO gender affects the likelihood of irregularities in a firm’s financial statements. In the current climate of increased focus on women leaders, especially in corporate positions, an intriguing question of academic and popular interest is whether male and female managers are associated with different firm decisions and behaviors. We examine this in the context of financial statements, which are an important part of the firm’s communications with its stakeholders. Because information presented in financial statements informs the investment decisions of capital market participants, the accuracy of said statements is critical to the effective functioning of the economy. Unfortunately, irregularities in financial statements are commonplace, with some estimates suggesting that at least 5% of the annual revenues of US-based firms are lost to fraud.


EVA, Not EBITDA: A Better Measure of Investment Value

Bennett Stewart is a Senior Advisor at Institutional Shareholder Services, Inc. This post is based on his ISS memorandum.

There’s no doubting the popularity of EBITDA—earnings before interest taxes depreciation and amortization—as a measure of investment value. Analysts like EBITDA because it removes the vagaries of depreciation and taxes and is unaffected by company leverage ratios. EBITDA is certainly a useful indicator of the gross cash operating profit performance of a business. But is it a reliable way to measure the value of a company?

The short answer is, no, not at all. EBITDA is far less correlated to market value than is commonly thought, and it is riddled with omissions and distortions that make it a highly unreliable guide to how well a company is performing. There also is a much better valuation and performance assessment metric, so much better that investment managers should consider adopting it to replace—or at a minimum, augment—EBITDA in their equity evaluation processes.

In this post, we explore the shortcomings of EBITDA by comparing it with EVA (Economic Value Added), which measures a firm’s true economic profit after deducting a full, weighted-average cost-of-capital interest charge on the net assets used in the business.


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