Yearly Archives: 2021

No-Fault Default, Chapter 11 Bankruptcy, and Financial Institutions

Posted by Robert C. Merton (MIT) and Richard T. Thakor (University of Minnesota) , on
Thursday, February 4, 2021
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Robert Merton is Professor of Finance at the MIT Sloan School of Management and Richard T. Thakor is Assistant Professor of Finance at the University of Minnesota Carlson School of Management. This post is based on their recent paper, forthcoming in the Journal of Banking and Finance.

The existing Chapter 11 bankruptcy process is time-consuming and financially costly for firms, which causes many firms that file for bankruptcy to eventually liquidate due to the value dissipation during bankruptcy (see, e.g., Morrison (2007) and Hotchkiss et al. (2008)). This leads to significant social and private costs, and reduces the documented tax-shield and agency-cost-reduction benefits of corporate leverage. In No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions, we propose and theoretically analyze the idea of a “no-fault-default” structure for corporate debt, which facilitates harvesting the benefits of leverage without the associated deadweight costs of bankruptcy.

The main idea of no-fault-default debt is to enable the firm to transform its debt claims into equity claims upon default on the debt, thus allowing a reallocation of control rights to bondholders with minimal disruption of the business operations of the firm. Put differently, when a bondholder demands payment at maturity, the company can choose to make the payment or surrender equity in the company. If the company does not have enough funds to make the promised payment to the bondholders, the bond converts automatically into equity—a transaction not requiring bankruptcy—and the firm also issues new debt with a longer maturity in exchange for the old debt. If the current shareholders wish to maintain corporate control, then they would need only to put up additional cash needed to buy the new equity. As with normal debt, other features like covenant restrictions—such as provisions which trigger early payment to the bondholders—can be included. We also show that no-fault-default debt remains feasible, with some modifications (such as adding a conversion option) even in the presence of well-known frictions like risk-shifting moral hazard.

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US Sanctions on Chinese Company Securities: Further Developments

Posted by Gary Stein, Betty Santangelo, Hannah M. Thibideau, Schulte Roth & Zabel LLP, on
Thursday, February 4, 2021
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Gary Stein is partner, Betty Santangelo is an attorney with the firm, and Hannah M. Thibideau is an associate at Schulte Roth & Zabel LLP. This post is based on a Schulte Roth & Zabel memorandum by Mr. Stein, Ms. Santangelo, Melissa G.R. Goldstein, and Ms. Thibideau. Related research from the Program on Corporate Governance includes Alibaba: A Case Study of Synthetic Control, (discussed on the Forum here); and China and the Rise of Law-Proof Insiders (discussed on the Forum here), both by Jesse M. Fried and Ehud Kamar.

During the first half of January, the Trump Administration continued to expand the ban on trading related to the public securities of designated Communist Chinese military companies (“CCMCs”). Meanwhile, the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) issued additional guidance on how the ban applies to U.S. investors and other market participants. This post describes these actions, reflected in additional designations of CCMCs, amendments to the original Executive Order issued on Nov. 12, 2020 (“Executive Order”), new Frequently Asked Questions (“FAQs”) published by OFAC, and two OFAC General Licenses.

The sanctions against trading in CCMC securities, as set forth in the original Executive Order, took effect on Jan. 11, 2021. As of that date, U.S. persons are prohibited from engaging in transactions in “publicly traded securities, or any securities that are derivative of, or are designed to provide investment exposure to such securities” (“CCMC securities”), of the CCMCs initially designated on Nov. 12, 2020. For additional CCMCs designated after Nov. 12, 2020, the trading ban takes effect 60 days after the date of the designation. As described in SRZ’s prior Alerts, the trading ban encompasses not only the CCMC public securities themselves, but also indices and ETFs that include one or more CCMCs as components, as well as various derivatives and other financial instruments that reference CCMC securities.

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The End of the Anonymous Shell Company in the United States

Posted by Robert Appleton, Olshan, Frome & Wolosky LLP, on
Thursday, February 4, 2021
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Robert Appleton is a partner at Olshon, Frome & Wolosky LLP. This post is based on his Olshan memorandum.

Over a veto of President Trump, on January 1, 2021, the Corporate Transparency Act (“CTA”) went into effect as part of the National Defense Authorization Act (“NDAA”). The CTA, many years in the making, introduces major changes to transparency requirements of entities registered in the United States. No longer can anonymous shell companies, limited liability companies, and the like hide the identities of their owners. In aiming to end this phenomenon, which resulted in the United States becoming a leading “safe haven” jurisdiction for those seeking anonymity of ownership, the CTA establishes a central database of beneficial owners of corporations, LLCs, and other corporate entities, available to law enforcement agencies (but not the public), and an affirmative obligation on the entity to identify and report its ownership. The CTA requires, with very limited exceptions, all U.S. registered corporations, LLCs, or similar entities to report beneficial ownership information to the U.S. Department of Treasury’s Financial Crimes Enforcement Network (“FinCEN”). The new registry will collect the names, dates of birth, addresses, and identification documents of individuals who own at least a 25 percent equity stake in the entity, or exercise substantial control over the entity, which will more directly tie the responsibility of the entity’s conduct to specific individuals.

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Don’t Let the Short-Termism Bogeyman Scare You

Posted by Lucian Bebchuk (Harvard Law School), on
Wednesday, February 3, 2021
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Lucian Bebchuk is the James Barr Ames Professor of Law, Economics, and Finance, and Director of the Program on Corporate Governance, at Harvard Law School. This post is based on his article in the current issue of the Harvard Business Review. Related Program research on short-termism includes The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here), The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), and Should Short-Term Shareholders Have Less Rights? by Lucian Bebchuk and Doron Levit.

The current issue of the Harvard Business Review contains an article I wrote entitled Don’t Let the Short-Termism Bogeyman Scare You.

The current issue of the Harvard Business Review also includes, as many prior issues have included, an article decrying the perils of short-termism and supporting measures for insulating corporate leaders from the outside pressures that allegedly make them myopic. The aim of my article is to show that, despite the alarming rhetoric of arguments supporting such measures, they are short on empirical evidence or economic logic. Furthermore, these arguments overlook substantial benefits that outside investor oversight produces and that such measures would sacrifice.

Harvard Business Review readers have been warned about the dangers of short-termism for at least four decades. In their 1980 article “Managing Our Way to Economic Decline,” Robert Hayes and William Abernathy argued that the short-term focus of corporate managers was to blame for a “marked deterioration of competitive vigor.” Similarly, in his 1992 article “Capital Disadvantage: America’s Failing Capital Investment System,” Michael Porter claimed that short-termism was causing underinvestment in long-term R&D projects and was the reason that “the competitive position of important U.S. industries has declined relative to other nations, notably Japan and Germany.”

Although short-termism has not produced the predicted demise during the decades that have passed since, calls to protect corporate leaders from pressures that could induce short-termism have persisted if not intensified. Indeed, such arguments have long been advanced as a key reason for supporting measures—such as takeover defenses, staggered boards, dual-class share structures, and dual-class recapitalizations—that limit the power of shareholders and insulate corporate leaders.

Unfortunately, the superficial appeal of such arguments has won over many institutional investors and public officials. It is important that they and others recognize the shortcomings of the short-termism claims. My article seeks to highlight these shortcomings, and below I note several elements of my analysis:

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Corporate Political Contributions

Posted by H. Rodgin Cohen and Melissa Sawyer, Sullivan & Cromwell LLP, on
Wednesday, February 3, 2021
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H. Rodgin Cohen and Melissa Sawyer are partners at Sullivan & Cromwell LLP. This post is based on a Sullivan & Cromwell memorandum by Mr. Cohen, Ms. Sawyer, Francis Aquila and Marc Treviño. Related research from the Program on Corporate Governance includes Corporate Political Speech: Who Decides? by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here); Shining Light on Corporate Political Spending by Lucian Bebchuk and Robert J. Jackson Jr., (discussed on the Forum here); The Untenable Case for Keeping Investors in the Dark by Lucian Bebchuk, Robert J. Jackson Jr., James David Nelson, and Roberto Tallarita (discussed on the Forum here); and The Politics of CEOs by Alma Cohen, Moshe Hazan, Roberto Tallarita, and David Weiss (discussed on the Forum here).

In the wake of recent events in Washington, D.C., several companies have come under fire for making contributions to candidates who opposed the certification of the U.S. Presidential election. In addition, several large corporations have announced that they are pausing the making of political donations altogether. These actions coincide with a general trend of intense scrutiny of corporate political donations and lobbying, and may be viewed as an extension of institutional investors’ heightened focus on environmental, social and governance (“ESG”) issues. The combination of these events is creating increased focus on corporate political spending and suggests that issuers should review carefully their corporate political contribution policies and disclosures ahead of the upcoming proxy season.

In Citizens United, [1] the U.S. Supreme Court ruled that a corporation’s political spending is a form of protected speech. In the years that followed that decision, corporate political spending through political action committees (“PACs”) tripled. However, scrutiny of corporate political spending has also increased. This scrutiny takes several forms: (1) the development of related voting guidelines by proxy advisory firms ISS and Glass Lewis; (2) the proxy voting guidelines of large passive investors; and (3) the rise of shareholder proposals related to political contributions and lobbying.

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The Ethics of Diversity

Posted by Deborah Gilshan, The 100% Club, on
Wednesday, February 3, 2021
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Deborah Gilshan is an Independent Advisor in Investment Stewardship & ESG and Founder of The 100% Club. This post is based on an Institute of Business Ethics report. Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite by Alma Cohen, Moshe Hazan, and David Weiss (discussed on the Forum here).

This post presents an overview of a recent report from the UK’s Institute of Business Ethics, entitled The Ethics of Diversity, published on 17th December 2020. It is based on comments I made at the webinar to launch the report, of which I am lead author.

The Ethics of Diversity provides a practical guide as to why diversity matters for boards, companies and their stakeholders. There are important ethical dimensions in the framing of diversity in terms of the questions asked and the solutions presented. The report seeks to provide boards with a framework for understanding these ethical dimensions and addressing them systematically.

The report reflects on what has been achieved from the ten years of sustained efforts in the UK to improve gender diversity and the lessons learned from the multi-stakeholder approach. It looks forward and considers initiatives to improve other dimensions of diversity. Academic and practitioner research on the various proof points for diversity are examined, including the business case and in how board governance can be enhanced, and the risk of groupthink lessened, through improved board diversity.

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OFAC Will See You Now

Posted by Amber Vitale and Eric J. Rudolph, FTI Consulting, on
Tuesday, February 2, 2021
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Amber Vitale is Managing Director and Eric J. Rudolph is Senior Director at FTI Consulting. This post is based on their FTI memorandum, and is part of the Delaware law series; links to other posts in the series are available here.

The September Memorandum of Understanding (MOU) entered into between the U.S. Office of Foreign Assets Control (OFAC) and the Delaware Department of Justice (DOJ) could be a game changer for both domestic and foreign corporations.

The MOU appears to be the first of its kind ever entered into between OFAC and a state law enforcement agency. (Previous OFAC MOUs concerned primarily federal and state banking and financial service regulators.) As such, it appears that OFAC and the State of Delaware are gearing up to increase scrutiny of entities registered in Delaware.

The Treasury Department’s press release regarding the MOU indicates several reasons for collaboration between OFAC and Delaware. They include improving transparency into corporate structures, promoting sharing of critical information, facilitating coordinated sanctions investigations, protecting national security, and disrupting illicit activity that is inconsistent with U.S. foreign policy (i.e.,“entities that should not be operating in the United States”). READ MORE »

Corporate Social Responsibility and Imperfect Regulatory Oversight: Theory and Evidence from Greenhouse Gas Emissions Disclosures

Posted by Jean-Etienne de Bettignies (Queen's University), Hua Fang Liu (Brandon University), and David T. Robinson (Duke University), on
Tuesday, February 2, 2021
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Jean-Etienne de Bettignies is Professor, and Distinguished Professor of Business Economics, at Queen’s University Smith School of Business; Hua Fang Liu Assistant Professor of Business Administration at Brandon University; and David T. Robinson is James and Gail Vander Weide Distinguished Professor at Duke University’s Fuqua School of Business. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here);  For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here); and Toward Fair and Sustainable Capitalism by Leo E. Strine, Jr (discussed on the Forum here).

September 2020 marked the 50th anniversary of Milton Friedman’s famous New York Times Magazine article, in which he summarized and expanded on an earlier argument that “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game” (Milton Friedman, Capitalism and Freedom, p.133). This argument was controversial then and remains so today. In his view, it is the regulator’s job to ensure the appropriate behavior of profit-maximizing firms by setting proper rules and regulations, rather than firms’ responsibility to determine and implement their notion of socially responsible behavior. Implicit in this argument is the assumption that the government or regulatory body is able to ensure appropriate behavior by firms. But what happens if the regulator is unable to monitor firm behavior effectively? What if the regulator doesn’t know whether the firm is staying within the rules of the game?

To put the question slightly differently, would a self-interested, profit-maximizing entrepreneur ever find it optimal to engage in corporate social responsibility (CSR) when regulatory oversight was imperfect? More generally, how is the quality of oversight connected to the prevalence of CSR? How does this change how we view Friedman’s admonition?

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The 2021 Boardroom Agenda

Posted by Debbie McCormack and Robert Lamm, Deloitte LLP, on
Tuesday, February 2, 2021
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Debbie McCormack is a managing director and Robert Lamm is an independent senior advisor at the Center for Board Effectiveness, Deloitte LLP. This post is based on their Deloitte memorandum.

Introduction: A year of consequence

It seems likely that 2020 will be viewed as one of the most consequential years in recent memory. In addition to dealing with an ongoing global pandemic and the massive economic and social dislocations it caused, the United States has had to address natural disasters such as major hurricanes and wildfires, racial unrest, and a lengthy and challenging political campaign, among other things.

While the challenges of any year often influence boardroom agendas for the following year, the impact of 2020 on 2021 board agendas will almost certainly be extraordinary. At the same time, boards will need to deal with many perennial areas of board oversight, including strategy, financial reporting, compliance, and culture.

This post discusses some of the many issues, old and new, that boards will likely have to contend with in the coming year.

Risk: Crisis management, disruption, and business continuity

Crisis management, disruption, and business continuity have long been key elements of risk management and related board oversight. However, the meanings of these terms and the severity of the challenges they posed in 2020 entail a much broader range of considerations. For example, the issues contemplated by the term “crisis management” have often been short-term and/or relatively limited in scope, such as the sudden death or incapacity of an executive or damage to a production facility.

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The Domains of Loyalty: Relationships Between Fiduciary Obligation and Intrinsic Motivation

Posted by Deborah DeMott (Duke University), on
Monday, February 1, 2021
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Deborah A. DeMott is David F. Cavers Professor of Law at Duke University School of Law. This post is based on her recent paper, forthcoming in the William & Mary Law Review.

By imposing obligations of loyalty, does fiduciary law “crowd out” the force of intrinsic motivations to act loyally? Or does fiduciary law reinforce (and thereby “crowd in”) intrinsic motivations to trust and to act in a trustworthy fashion? This paper examines relationships between the formal domain of fiduciary law and other factors that shape conduct, including intrinsic motivation and markets for professional services, as well as the force of reputation in  a market or an industry. The paper demonstrates that looking across domains—from the legal to the extra-legal and back to the legal—places the distinctiveness of fiduciary law into sharp relief. The relationships to which this body of law applies are ones that necessarily make one party vulnerable to the other to some degree; the prospectively vulnerable party “has to trust” that the other will prove trustworthy. Fiduciary law undergirds intrinsic motivations to repose trust by addressing the risk of betrayal intrinsic to relationships in which one party must to some degree trust the other; the law also addresses the risk of aversion to the prospect of being duped or made a chump by reposing trust in another. Surveying relevant behavioral research, the paper examines its significance for fiduciary law, which the paper argues is invulnerable to critique on crowding-out grounds.

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