(Editor’s Note: This post by our Guest Contributors John Armour of the University of Oxford and Brian Cheffins of the University of Cambridge was published today on ft.com.)

The current credit crisis has many reaching for their history books, seeking to find out what lessons might be drawn from previous financial disasters. There is a rich history of bank failures. What can history tell us about the $2,000bn world of hedge funds?

Some say the turmoil in financial markets could be a boon for shrewd hedge fund managers, allowing them to pick up assets on the cheap from distressed sellers. Others argue hedge funds are in a potential death spiral, with redemption demands from investors prompting asset sales which lock in losses, in turn prompting further redemptions and so on.

While hedge funds seem to capture perfectly the zeitgeist of contemporary capitalism, they actually have parallels in investment companies that flourished on Wall Street in the late 1920s. By 1929 a new investment company was being launched every day amidst frenzied demand from investors. These investment companies had a number of similarities to modern hedge funds.

First, the marketing of investment companies was based on promises investors would benefit from the investment expertise of highly skilled professional managers and advisers. Various investment companies even recruited noted economists and finance professors to provide investment expertise.

Second, investment companies, as with hedge funds but unlike modern day mutual funds, regularly had access to borrowed capital that enabled them to turbocharge their equity investors’ returns.

Third, investment companies were free to compensate their managers on the basis of high-powered incentive contracts, and often did so. The senior Goldman Sachs partners who managed the market leader in the late 1920s – the Goldman Sachs Trading Corporation – contracted to receive 20 per cent of any net profits above 8 per cent.

Fourth, restrictions were frequently imposed on the ability of investors to withdraw capital. Pre-crash investment companies typically operated as “closed-ended” funds, meaning investors had no discretion to demand redemption of their investments. Hedge funds typically impose on investors fixed minimum investment periods and redemption penalties, and have begun during the current market crisis to “close the gates” – put caps on redemptions.

Fifth, the investment companies of the late 1920s, as with today’s hedge funds, operated in great secrecy, revealing little about their trading strategies or manager remuneration.

The 1929 Wall Street crash prompted dramatic changes for the investment companies.

The investors who piled into the sector typically suffered devastating losses. Shares in closed-ended investment companies traded at a premium to underlying asset values prior to the crash but when share prices fell, liquidity dried up. Since investors could not force redemptions, they had no option but to sit and watch as their investments plummeted in value. The bitter experience meant closed-ended investment companies were shunned and new investment funds had to be marketed on an open-ended basis permitting redemption at any time.

Regulation also followed. Following Congressional investigations of investment companies in the 1930s, the Investment Company Act of 1940 and the Investment Advisers Act of 1940 regulated investment companies, or “mutual funds” as they came to be known. Mutual funds were, amongst other things, subjected to prudential regulations that inhibited their ability to use leverage. A requirement of a fairness review by the Securities and Exchange Commission for self-dealing transactions also impeded the use of high-powered incentive compensation for their managers.

However, all was not doom and gloom in the investment company sector in the 1930s. There was money to be made by those able to spot the right opportunities amidst the market wreckage. Floyd Odlum became a multimillionaire by buying control of 22 investment companies – including the Goldman Sachs Trading Corporation – at prices substantially less than the value of the securities they owned.

The basic themes of the investment company story resonate for today’s exemplars of the free-wheeling leveraged collective investment vehicle. First, a prolonged downturn in returns could prompt hedge funds to market themselves to bruised investors afresh, with steps such as downplaying their use of leverage, cutting fees and offering more attractive exit arrangements.

Second, new regulatory controls cannot be far off. Hedge funds may cater almost entirely to sophisticated investors but they will not be able to sidestep fresh regulation when they trade assets in ways that potentially affect the viability of the entire financial system.

Third, there no doubt are present-day Floyd Odlums among the current crop of hedge fund managers. Those with the right combination of courage, skill and timing will have a golden opportunity to turn today’s turmoil into tomorrow’s profits.

Recently, in the Law, Economics, and Organization Seminar here at the Law School, I presented my paper, co-authored with Rodney Ramcharan, entitled Landed Interests and Financial Underdevelopment in the United States.

In our paper, we explore how the structure of banking across counties in the United States was shaped in the early part of the twentieth century by local landowners, who wanted to limit free access to credit. We focus on banks because they were, and in many areas, still are, the most important source of local finance. Likewise, we focus on the influence of landowners because agriculture was still a key sector at that time in the U.S. economy, and agricultural interests were a powerful political constituency. From a research design standpoint, this focus is also appropriate because we believe we can isolate exogenous factors that determined the nature of land holdings. Specifically, counties varied in the extent to which land holdings were concentrated or widely distributed. In part, the distribution of land holdings was driven by rainfall, with large-scale plantation-like agriculture being favored in areas with high rainfall, and small scale farming in areas with moderate rainfall. Therefore, in some counties, a few large farmers held much of the land, while in other counties land was widely dispersed among many smaller farmers. Large, wealthier landowners had reasons to restrict access to credit by limiting the spread of banks, and had the economic and political power to implement those interests.

We find that landed interests appeared to be an important influence in constraining bank competition and thus limiting access to finance. We provide a variety of tests showing that their impact was most pronounced in situations where they had the greatest incentive and ability to exert influence. We also argue that our results cannot be easily explained as resulting from the supply of banking services responding to the underlying demand. Finally, we show these constraints on financial development persisted long after the interest groups driving them faded away.

While our paper is on financial development, it has broader implications. A recent trend in explaining the underdevelopment of nations has been to attribute it to the historical weakness in their political institutions such as democracy and constitutional checks-and-balances. While U.S. political institutions in the 1920s were far from perfect, they were also far from the coercive political structures that are typically held responsible for persistent underdevelopment. Yet even in the United States, we find large variations in the development of enabling economic institutions such as banking between areas that had different constituencies but were under the same political structures. The significant, and potentially adverse, influence of constituencies even in such environments suggests that fixing political institutions alone cannot be a panacea for the problem of underdevelopment.

The full paper is available for download here.

My forthcoming book, Corporate Governance, Promises Made, Promises Broken, presents my views about what corporate governance is all about and what sorts of corporate governance institutions and mechanisms work best. Corporate governance consists of a farrago of legal and economic devices that induce the people in charge of companies with publicly owned and traded stock to keep the promises they make to investors. This book develops three original insights about corporate governance. These insights can be succinctly summarized:

1. Corporate Governance is about promises. I believe that it is more accurate to characterize corporate governance as being about promises than it is to characterize corporate governance as being about contracts. One reason I believe this is because the relationship between public shareholders and the corporations is so attenuated than it is misleading to characterize their relationship with the corporation as contractual in nature, rather than promissory. Shareholders have almost no contractual rights and virtually no contractual rights to corporate cash flows. Shareholders’ investments are based on trust. This trust, in turn is based on the belief that the managers who run corporations will keep the promises that they make to investors. Another reason why I believe that corporate governance is about promise is because the idea of promise captures the primordial fact that trust rather than reliance on the prospect of enforcement is the focal point of a successful system of corporate governance.

2. Since corporate governance is about promise, then it stands to reason that the various institutions and mechanisms of corporate governance can be evaluated on the basis of how well they facilitate the keeping of promises by corporate managers. The bulk of this book analyzes various devices and mechanisms of corporate governance for the purpose of determining which ones work well and which do not work so well.

…continue reading: Corporate Governance, Promises Made, Promises Broken

(Editor’s Note: This post comes to us from Qiang Cheng at the University of Wisconsin-Madison and David B. Farber at the Trulaske College of Business at the University of Missouri-Columbia.)

In our forthcoming Accounting Review paper entitled Earnings Restatements, Changes in CEO Compensation, and Firm Performance, we provide insights into the design and efficacy of chief executive officer (CEO) compensation contracts following an earnings restatement.

Using a sample of 289 restatements and the year prior to restatement announcement as the benchmark year, we find that while total CEO compensation does not significantly change by the second year after the restatement announcement, there is a significant shift from option-based compensation to salary over this period. In univariate tests, we find that the proportion of the value of option grants to total compensation declined by 5.6 percentage points for the restatement firms, while control firms experienced an increase of 2.6 percentage points in this proportion over the same period. The analyses indicate that the number of option grants also declines for restatement firms compared to control firms. The reduction in the use of option grants for restatement firms holds after we control for the level of stock and option holdings as well as other determinants of option-based compensation, such as firm size, growth opportunities, leverage, idiosyncratic risk, R&D intensity, stock returns, cash compensation, and industry and year fixed effects. Because about half of the restatement firms experienced CEO turnover after restatements, we also investigate the change in option grants separately for extant and new CEOs. We find that our results hold for both extant and new CEOs.

If the reduction in option-based compensation is a result of unwarranted negative public perception of option usage, we would expect a decrease in firm performance as firms deviate from optimal contracting. However, if restatements result from too high a level of incentive compensation and the reduction in option compensation after the restatement better aligns managerial incentives with those of shareholders, we would expect to observe improved firm performance. Overall, our results imply that economic benefits accrue to restatement firms that reduce their CEOs’ option-based compensation, indicating that the reduction in option grants helps adjust managers’ equity incentives toward optimal levels. A natural question that follows is if reducing option usage is associated with improved firm performance, why is it that all restatement firms do not do so? To help answer this question, we conduct a within-sample analysis. We find that the likelihood of a reduction in options usage is positively related to the level of option grants prior to the restatement and in some specifications, this likelihood is higher for income-decreasing restatements.

The full paper is available for download here.

In this memorandum, a team composed of experts in my firm’s financial institutions, corporate governance, real estate, capital markets, executive compensation, hedge fund, private equity, asset management, white collar defense and litigation departments discusses our collective view on the likely interpretation of the Emergency Economic Stabilization Act’s most important provisions, the key ambiguities and questions that will have to be resolved by the Treasury Secretary, and the policy issues that will shape not only the implementation of the Act, but also the future of the US financial regulatory system.

The memorandum is available here.

(Editor’s Note: For a related piece published in the San Francisco Chronicle by Professor Jesse Fried, the author of this post, see here.)

Warren Buffett aptly called the credit-related derivatives invented, marketed, and held by Wall Street firms “financial weapons of mass destruction.” These weapons have now gone off, putting the economy at risk. The Bush administration has cobbled together a $700 billion taxpayer-financed plan to bail out Wall Street firms and, it is hoped, avoid a larger economic disaster.

Unfortunately, While Wall Street executives have already pocketed large profits from the reckless business decisions that made the bailout necessary in the first place. Over the last two years, Wall Street financiers took home more than $60 billion in bonuses, much of it in cash. Lehman Bros. alone shelled out almost $6 billion in bonuses in 2007; it recently filed for bankruptcy.

If the government ends up losing money on the bailout, it should make a serious effort to “claw back” at least part of the bonuses paid to Wall Street executives before the meltdown. The cost of cleaning up this mess must not fall entirely on taxpayers’ shoulders; those who profited from the derivatives casino should chip in directly. Clawing back executives’ bonus pay will also make future decision-makers think twice before taking similar financial gambles, reducing the likelihood that another generation of Americans will be asked to bail out Wall Street.

The challenge would be finding legal authority to recover pre-meltdown bonuses. If a bailed-out firm were to file for bankruptcy, several provisions of the Bankruptcy Code could be used to recover pre-bankruptcy bonus payments to its executives. But if the rescue plan is successful, most of these bailed-out firms won’t be forced to file for bankruptcy. Is there a way to attack the bonuses paid by the firms that, thanks to government assistance, are able to steer clear of bankruptcy?

One possible source of authority is New York’s “fraudulent conveyance” statute, which applies to all firms in that state, including those that have not filed for bankruptcy. The statute gives creditors the right to recover a payment to an insider if, for example, the paying firm (1) did not receive fair consideration for the payment and (2) at the time had unreasonably small capital for its business operations. Some courts have held that managerial services do not constitute fair consideration for purposes of this type of statute. The statute may thus permit the government, to the extent it is considered an unpaid creditor of a bailed-out firm, to recover a bonus payment to one of that firm’s executives.

Will the federal government be able to recoup bonuses paid to Wall Street executives before the meltdown? We won’t know for sure until the government litigates these cases. But if the government loses money on the bailout, bringing these cases is the least the government can do for taxpayers - both those on the hook for the $700 billion rescue plan and those who may be asked to pay for a future bailout.

My firm is pleased to provide a section-by-section analysis of the Emergency Economic Stabilization Act of 2008 as passed by the Senate, by a vote of 74-25, on October 2, 2008. The section-by-section analysis includes commentary from experts on Gibson, Dunn & Crutcher LLP’s Financial Markets Crisis Group. We hope you find it useful as you work through the challenges and opportunities posed by the market crisis and the government’s response.

On a procedural note, the Senate used H.R. 1424, which was a resolution to amend the Employment Retirement Security Act to include mental health parity provisions, as a vehicle to pass the Emergency Economic Stabilization Act. As passed by the Senate, the bill also included energy and tax extender provisions. We have not included those provisions in this analysis.

The analysis is available here.

(Editor’s Note: The article below, just published in The Deal, came to us from its author David Marcus.)

Leo E. Strine Jr. doesn’t have any time to waste as he settles in behind the lectern for his first mergers and acquisitions class of the year at Harvard Law School. He’s tackling three classic Delaware cases today. Most law school professors excerpt cases. Strine does not. “If a judge thought something was important enough to put in the opinion,” he tells the class, “you might want to entertain the notion that it’s worth thinking about why it’s there.”

The first case treats T. Boone Pickens’ 1985 hostile bid for Unocal Corp. Strine ranges far beyond the opinion to explore the legal and business context in which then-Delaware Supreme Court Chief Justice Andrew G.T. Moore II wrote. Strine notes that Unocal’s board met for eight or nine hours to consider Pickens’ offer — a response to Smith v. Van Gorkom, a case decided a few months before Unocal in which Moore’s court found board members personally liable for not thoroughly considering a bid.

“They definitely learned the lesson of Van Gorkom. They were not going to be accused of a lack of process,” Strine tells the class of 75. Unocal’s board answered Pickens’ offer by making one of its own to all shareholders except Pickens. Delaware’s Court of Chancery enjoined the Unocal bid, but Moore reversed.

…continue reading: Leo Strine’s Marvelous Adventures

The Harvard Law School Program on Corporate Governance is pleased to announce the availability of the video of its event on transactional practice. The event, which was held earlier this month, is the second of the Program’s series entitled Introduction to Corporate Practice. The series’ aim is to expose students to leading practitioners and their perspective on corporate practice—What do they enjoy about their jobs? What issues do they deal with? And what does it take to succeed in their field? The videos are made public as a resource for law students and young lawyers everywhere who are considering corporate practice.

The three panelists at the transactional practice event were:

• Eileen T. Nugent, co-head of the Private Equity group at Skadden Arps.
• Matthew J. Gardella, co-chair of the Public Offerings & Public Company Counseling practice group at Edwards Angell Palmer & Dodge LLP.
• Christopher L. Mann, a partner in the New York office of Sullivan & Cromwell.

Each member of the panel gave introductory remarks, followed by Q&A. One of the main topics of discussion was how the panelists came to find and love transactional practice. Chris Mann said he had always wanted to be involved in business deals, and got off to a very quick start when he was sent to Papua New Guinea for a finance project three weeks into his job at Sullivan & Cromwell. Project finance is still one of his major areas of practice today. By contrast, Matt Gardella admitted that he had originally wanted to become a defense attorney. He eventually moved into securities work because he valued the long-term client relationship, in which the attorney can take a proactive advisory role. Eileen Nugent discovered her passion for deals as an in-house counsel, and only later moved to Skadden Arps to pursue it. All three emphasized the business orientation of transactional lawyering. The panel also offered their perspectives on career planning issues, including working for law firms or other players in the transactional world, and the types of characteristics they felt were central to the success of associates.

A video of the panel discussion is available for download here.

Directorship magazine issued its second annual Directorship 100 list – a list of the 100 “most influential people on corporate governance.” The list includes such well-known figures as Chairman Barney Frank, Chairman Ben Bernanke, Treasury Secretary Henry Paulson, SEC Chair Christopher Cox, Goldman Sachs CEO Lloyd Blankfein, activist investor Carl Ichan, and Blackstone CEO Steve Schwarzman. The blog is pleased to announce the significant representation that members of the Harvard Program on Corporate Governance have on the Directorship 100 list:

• Lucian Bebchuk, the program’s director, was selected in the “professors” category. Bebchuk was also included in the Directorship 100 list last year, when the magazine first issued this list.

• Vice-Chancellor Leo Strine, Jr., a senior fellow of the program, was selected in the “regulators and rule makers” category.

• Finally, the Directorship magazine, in recognition of the success and influence of the Harvard Law School Corporate Governance blog, included in its list the two current co-editors of the blog, Jim Naughton and myself, in “the media” category. Others listed in this category are Alan Murray and Joann Lublin of the Wall Street Journal, Andrew Ross Sorkin of the New York Times, Fox news CEO Roger Ailes, Maria Bartiromo of CNBC, and Jim Cramer of TheStreet dot com. This selection would not have been possible, of course, but for the many contributors posting their insights and work on the blog and for the loyalty of our readers, and we would like to express our thanks to them all.

The Directorship article, which includes the full Directorship 100 list, as well as a description of the methodology used and substantial effort invested in putting together the list, is available here.

In “To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance”, which I co-wrote with Joel F. Houston and Jennifer W. Tucker, and which was recently accepted for publication in Contemporary Accounting Research, we investigate the importance of quarterly earnings guidance. Quarterly earnings guidance—managers’ public forecasts of forthcoming earnings—is widespread yet highly controversial. Arguments for ending the practice of guidance are made by purists, who claim that managers should tend to their business and leave securities valuation and the underlying forecasts of future performance to investors and analysts, and by pragmatists, lawyers in particular, who caution managers that guidance increases litigation exposure. Regulators and commentators are often concerned that a previously issued forecast will motivate managers to meet the guidance even if doing so would require costly changes in real activities, such as cutting capital expenditures or R&D, and sometimes induce them to manage earnings toward the forecast. On the pro-guidance side, managers often claim that the practice is necessary to keep analysts’ earnings forecasts—issued with or without corporate guidance—within a reasonable range to avoid large earnings surprises and the consequent high stock price volatility and investors’ heightened risk perceptions.

We empirically examine in this study a sample of 222 U.S. firms that ceased to provide quarterly earnings guidance during 2002 through the first quarter of 2005, after having routinely done so. Only a few of these “stoppers” publicly announced and rationalized their decision, whereas the majority just ceased to provide guidance. We first examine the determinants of the stopping decision with particular reference to the pro and con arguments made by challengers and supporters of the practice. Although managers often cite reducing short-termism as the motive for stopping guidance, an unstated reason could be poor performance and repeated consensus misses. We then examine the post-stoppage changes in the stoppers’ long-term investments, in their complementary disclosures, and in their information environment. Using a control sample of 676 guidance “maintainers,” along with the 222 stoppers, we find that poor performance is the main reason for guidance cessation. Our stoppers are characterized by (1) a decline in earnings before stopping, (2) a poor record of meeting or beating analyst consensus forecast, and (3) a deterioration of anticipated earnings. Additionally, we document that guidance cessation is associated with (1) a change in top management, likely ushering in new management philosophy, (2) a relatively low frequency of guidance by industry peers, and (3) past as well as anticipated difficulties in predicting earnings. In addition, we do not find that stoppers enhance investment in capital expenditure and research and development after guidance cessation. Contrary to the claim that firms would provide more alternative, forward-looking disclosures in lieu of the guidance, we find that such disclosures are curtailed. We also find a deterioration in the information environment of guidance stoppers in the form of increased analyst forecast errors and forecast dispersion and a decrease in analyst coverage. Taken together, our evidence indicates that guidance stoppers are primarily troubled firms and stopping guidance does not benefit either the stoppers or their investors.

The full paper is available for download here.

A Congressional section-by-section summary of the bailout bill to be voted on shortly by Congress is available here. The full draft of the bill is available here.

In the recent decision of U.S. v. Stein, the US Court of Appeals for the Second Circuit upheld the dismissal of all charges against thirteen former partners and employees of KPMG, holding that the government had violated defendants’ Sixth Amendment rights by pressuring KPMG to cut off payment of their legal fees. The court affirmed the central findings that US District Court Judge Lewis A. Kaplan reached two years ago: absent the Thompson Memo (the Principles of Federal Prosecution of Business Organizations then-in-effect) and the actions of the US Attorney’s Office, KPMG would have paid the legal fees of all of its partners and employees without regard to cost. KPMG’s decision not to advance legal fees “followed as a direct consequence of the government’s overwhelming influence, and that KPMG’s conduct therefore amounted to state action.” The Court held that “the government thus unjustifiably interfered with defendants’ relationship with counsel and their ability to mount a defense, in violation of the Sixth Amendment, and that the government did not cure the violation.” The case perhaps represents a decisive victory to the defendants in this high-profile matter.

My colleague David B. Anders and I have written a memo, available here, on the decision as well as the DOJ’s policies regarding its evaluation of corporations in the course of criminal investigations. The Court’s opinion may be accessed here.

(Editor’s Note: This post comes to us from Belén Villalonga of Harvard Business School.)

Recently, in the Law, Economics, and Organization Seminar here at the Law School, I presented my paper, co-authored with Raphael Amit, entitled Family Control of Firms and Industries. In our study, we use the variation in the prevalence of family control within and across industries in the United States to test the two broad explanations for family control, which we refer to as “competitive advantage” and “private benefits of control”, and to identify which characteristics distinguish family controlled firms and industries from their non-family counterparts.

We construct two different tests of the two broad explanations. First, we analyze the relative sensitivity of family and non-family firms to industry profit shocks. We allow for firms’ responses to be asymmetric across positive and negative shocks. A lower sensitivity of family control to positive shocks would be consistent with a tunneling (i.e., private benefits appropriation) explanation. On the other hand, a lower sensitivity to negative shocks would be consistent with a “propping” explanation, suggesting that families do not always act in their own self-interest but instead, and seek to maximize value for the firm as a whole as implied by the competitive advantage explanation. As a second test, we estimate a propensity-score matching model of the effect of family control on the family premium, defined as the excess value of family firms relative to non-family firms in each industry. We use this model to test whether family firms dominate where they are valued the most (as a competitive advantage explanation would suggest) or the least (as a private benefits explanation would suggest).

We find that, just like in the cable and newspaper industries, the combination of competitive advantage and private benefits explanations to family control is the norm across our sample. We then analyze which factors, specifically, are driving our results. Consistent with the competitive advantage hypothesis, firms and industries are more likely to remain under family control when their efficient scale and capital intensity are smaller (the value-maximizing size argument), when the environment is more noisy (the control potential argument), and when the difference between long and short-term profitability is larger (the investment horizon argument). Consistent with the private benefits of control hypothesis, families are more likely to stay in control when there is dual-class stock in their firms. Overall, our findings suggest that family control results in net value creation for all of the firm’s shareholders, and not in a sheer transfer of value from outside investors to the founding family.

The full paper is available for download here.

(Editor’s Note: The post below is an op-ed piece published by Lucian Bebchuk in the Wall Street Journal this morning. This op-ed piece is based on his discussion paper, A Plan for Addressing the Financial Crisis, which was just issued by the Harvard Law School Program on Corporate Governance and is available here.)

Treasury Secretary Henry Paulson is seeking authorization to spend $700 billion of taxpayers’ money on “troubled assets” owned by financial firms. We’re told his plan is the only way to stabilize the financial markets. But the plan, as proposed to Congress, can be improved to be both less costly and a better stabilizing force for the markets.

The redesign should have three elements. First, the Treasury should only buy troubled assets at fair market value. Second, the Treasury should be allowed to purchase, again at fair market value, new securities issued by financial institutions needing additional capital. Third, to ensure that asset purchases are made at fair market value, the Treasury should buy them through multibuyer competitive processes with appropriate incentives.

If troubled assets are purchased at fair market value, taxpayers might get an adequate return on their investment. And the Treasury’s official statements say that “The price of assets purchased will be established through market mechanism where possible, such as reverse auctions.”

But the draft legislation grants the Treasury full authority to pay higher prices, potentially conferring massive gifts on private parties. The final bill should not permit this.

Adding this fair market constraint by itself may leave us with concerns about the stability of some financial firms. Because falling housing prices depressed the value of troubled assets, some financial firms might still be seriously undercapitalized even after selling these assets at today’s fair market value. That is, of course, why the Treasury wants the power to overpay. It wants to be able to improve the capital position of firms with troubled assets, restore stability and prevent creditor runs.

But the best way to infuse additional capital where needed is not by giving gifts to the firms’ shareholders and bondholders. Rather, the provision of such additional capital should be done directly, aboveboard. While the draft legislation permits only the purchase of pre-existing assets, the final legislation should permit the Treasury to purchase new securities issued by financial firms needing additional capital. With the Treasury required to purchase securities at fair market value, taxpayers will not lose money also on these purchases.

Furthermore, this direct approach would do a better job in providing capital where it is most useful. Why? Because simply buying existing distressed assets won’t necessarily channel the capital where it needs to go. Allowing the infusion of capital directly for consideration in new securities can do so.

Finally, how do we ensure that the government does not pay excessive prices for troubled assets or new securities issued by financial firms? The proposed legislation allows the Treasury to conduct purchases through in-house operations, outside delegation, or any other method it chooses. It would be best, however, to direct the Treasury to operate through agents with strong market incentives.

Suppose the economy has illiquid mortgage assets with a face value of $1 trillion, and the Treasury believes that buyers with $100 billion would be enough to bring the necessary liquidity to this market. The Treasury could divide the $100 billion into, say, 20 funds of $5 billion, and place each fund under a manager who does not have conflicting interests.

Each manager could be promised a fee, say 5%, of the profit his fund generates — that is, the difference between the fund’s final value and the $5 billion initial investment. Competition among the fund managers, armed with the needed liquid funds and motivated by their 5% fee, would produce prices set at fair market values.

Revising the Treasury plan in the ways just described would do a far better job of protecting taxpayers’ interests, and restoring financial stability, than what the Treasury initially proposed.

(Editor’s Note: For a detailed memorandum from our Guest Contributor Ted Mirvis at Wachtell, Lipton, Rosen & Katz analyzing the final rules on cross-border business combinations, as published by the SEC on September 19, 2008, see here.)

At a recent public meeting, the Securities and Exchange Commission adopted a number of amendments to the rules that apply to cross-border tender offers, business combinations and rights offerings. The SEC also approved the issuance of interpretive guidance on several topics related to cross-border transactions. These amendments and guidance largely follow the SEC’s May 2008 proposals, and, in many instances, codify existing no-action, interpretive and exemptive positions previously articulated by the staff of the SEC. The SEC intends for the new rules to facilitate and encourage the inclusion of U.S. security holders in cross-border transactions.

A memorandum discussing the amendments to the rules is available here.

(Editor’s Note: This op-ed by Professor Howell Jackson will be published in the print edition of the Christian Scientist Monitor tomorrow.)

While many agree that dramatic governmental action is needed to restore confidence in financial markets, there is less consensus on the precise form that action should take. Secretary Paulson has sketched out one approach and Democratic leadership in Congress has responded with useful refinements. But there are better ways to structure the intervention and defray its costs.

On the structural side, consider how the government should spend its $700 billion. The basic strategy of both the Paulson and congressional plans is to buy back large quantities of toxic mortgage backed securities in some sort of auction process. These purchases would remove troubled assets from the balance sheets of selling institutions, and (hopefully) clarify the prices of similar securities held by other investors. But, exactly how this clarification of prices is to come about is unclear. Will the government’s purchases be considered accurate measures of market value or merely fire sales by frantic firms facing bankruptcy? The ownership of underlying mortgage pools will still be highly fragmented. The mere shifting of ownership of large quantities of securities may do little for price discovery, and could serve simply to transfer government resources to selling institutions.

A more effective strategy would be for the government to purchase all of the loans in mortgage pools underlying specific securitization transactions, starting first with the lowest quality subprime and Alt-A mortgage pools, which is where the underlying problems lie. With congressional authorization, the Treasury could force the purchase of these assets through eminent domain and make an immediate payment of an estimate of the loans’ current fair value, which would then be reviewed for adequacy by an appropriately constituted judicial forum at some point in the future. If the initial payment did not provide just compensation, additional compensation plus interest could be paid. Attacking the problem from the loan end of the securitization process, as opposed to the investor end, has numerous advantages.

To begin with, purchasing whole pools of loans would force liquidation of the mortgage backed securities used to finance those loans. Investors would get an immediate distribution of the government’s cash plus some sort of residual interest for whatever additional proceeds might come out of the after-the-fact judicial valuation proceedings. Critically, whole issuances of the most complex mortgage backed securities would disappear, and the market would receive strong pricing signals for comparable instruments.

A key advantage of this approach is that it moves whole loans (and not fractional securities) under government control. Once it holds these loans, the government can itself take charge of workouts and refinancings. This is the approach that the Home Owners Loan Corporation took in the Great Depression, and the FDIC is already operating such work-out programs for loans held by failed banks under its control. If the Treasury Department would start buying up whole pools of subprime loans and Alt-A transactions, it could dramatically expand the FDIC’s program, offering relief for borrowers who were mislead or abused and then dealing more harshly with those who knowingly entered into speculative transactions. In other words, a strategy of whole pool loan purchases provides the government with a vehicle for giving relief to home owners and not just financial institutions.

A further benefit of authorizing the government to purchase whole pools of loans is that it could change the incentives now facing loan-pool trustees. One of the reasons it has been so difficult for the market to adjust to falling housing prices and increasing foreclosures is that mortgage backed securities trustees have been reluctant to renegotiate individual loans, out of fear of litigation and uncertainty as to appropriate terms. Facing the threat of forced sales to the U.S. government and with clear guidance on how much the government is likely to pay for their loans, mortgage backed securities trustees will be highly motivated to renegotiate loan terms on their own, further clarifying market values and enhancing price discovery.

We also need to think harder about financing the cost of government intervention. Under the Paulson proposal, the American taxpayer would pick up the bill for whatever the government loses on its $700 billion of asset purchases. Exactly how big that bill will be is unclear, but the taxpayer is going to be on the hook for the full amount.

Congressional Democrats attempt to soften the blow by requiring the government to receive an equity interest from selling firms. While laudable, this approach does complicate the transactions – as the structure of equity interests will need to be negotiated on a case-by-case basis and the price signals to the market from these hybrid purchases will be less clear than it would be with purely cash transactions. More importantly, the extraction of equity stakes from selling firms does not spread the costs of the program to the many other financial institutions who benefit from the program by having the value of their portfolios clarified or increased through government purchases.

A cleaner approach would follow the model that Congress set up in 1991 for the FDIC when it spends extra funds to shore up systemically important commercial banks: impose an after-the-fact assessment on the entire industry to defray the costs. Congress could do exactly the same thing with the Paulson proposal. Once the government’s losses are clear, the Treasury should assess some share of the costs (let’s say one half) on all of the financial institutions eligible to participate in the program, based on some objective formula such as the value of assets held at the time the program was proposed. Assessments could be spread over a number of years, so as not to infringe upon current cash flow. But this would be a more equitable approach to cost sharing than what is currently being proposed on either side of the aisle. Also it would give the financial-services industry a strong incentive to help the government keep costs down and avoid similar interventions in the future.

The challenges facing the Treasury and Congress are formidable. And time is clearly of the essence. But even in the face of such pressures, it’s important to take the time to consider alternative approaches that may offer a more efficient and more equitable way out of the nation’s difficulties. A parallel program to purchase whole loan pools could easily be grafted onto the Paulson plan as could a mechanism for after-the-fact industry assessments.

This post is by my partners Randall Guynn and Arthur Long.

Yesterday, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a policy statement (the “Equity Policy Statement”) that relaxed and clarified its long-standing control rules relating to minority investments in banks and bank holding companies (“Banking Organizations”). These changes and clarifications relate to four principal areas:

• expanded director rights;
• increased voting and total equity ceilings;
• permissible business relationships; and
• veto rights.

The Federal Reserve also stated that it would use the liberalized rules to analyze noncontrolling investments by U.S. and non-U.S. bank holding companies in nonbanking firms.

Expanded Director Rights and Increased Equity Ceilings

Old Rule
Historically, the Federal Reserve has not allowed a minority investor that acquired 10% or more of a Banking Organization’s voting shares to have a director on the Banking Organization’s board without being deemed to have a controlling influence over the Banking Organization. In contrast, it has generally allowed a minority investor to acquire up to 9.9% of a Banking Organization’s voting shares, 14.9% of its total equity (including such voting shares) and to appoint one director.

New Rule
The Equity Policy Statement reiterates that a “control” determination still depends on all the facts and circumstances.

While the Equity Policy Statement is unclear and contradictory in certain respects, we believe that it provides that a minority investor may now generally acquire up to 15% of the voting shares of a Banking Organization, one-third (33%) of its total equity and appoint one director to the Banking Organization’s board without raising a “control” issue. In addition, such an investor may generally have two board seats as long as (i) its board representation is proportionate to its total equity interest and does not exceed 25% of the voting members of the board and (ii) another, larger shareholder is a bank holding company that controls the Banking Organization.

Board Committees
The Federal Reserve also clarified the extent to which the board representatives of a minority investor may serve on board committees. No minority investor’s board representative should be the chairman of the board or of a board committee. However, its representatives may serve on any board committees as long as they do not constitute more than 25% of such committees and do not have the authority or practical ability to make or block policymaking decisions.

Convertible Securities
The Equity Policy Statement reaffirms the traditional rule that nonvoting shares convertible into voting shares at the holder’s option or mandatorily convertible after a passage of time should be considered voting shares at all times. However, it also provides that nonvoting shares may become voting in a transfer in a widespread public offering, in a transfer in which no transferee would receive 2% of more of any class of voting shares, or in a transfer to a transferee that will control more than 50% of the voting securities of the Banking Organization without counting the transferred shares. This mechanic has traditionally aided minority investors in making larger dollar investments via nonvoting shares while still maintaining exit and liquidity rights.

Limited Business Relationships

The Federal Reserve has previously allowed minority investors to have “quantitatively limited and qualitatively nonmaterial” business relationships with the Banking Organization in which they have invested. The Equity Policy Statement reiterates that business relationships should remain limited and will continue to be reviewed on a case-by-case basis, taking into particular account the following factors: (i) the size of the proposed business relationships and (ii) whether they would be on market terms, non-exclusive and terminable without penalty by the Banking Organization.

No Meaningful Veto Rights

The Federal Reserve reiterated that minority investors will not be permitted to have any meaningful veto rights to protect the value of their investments, without being deemed to control the Banking Organization. It merely reaffirmed that minority investors may have veto rights, subject to safety and soundness concerns, over very limited matters such as issuing senior securities or borrowing on a senior basis, modifying the terms of the minority investor’s security, or liquidating the Banking Organization. They may also have limited financial information rights and limited consultation rights.

For a copy of the Equity Policy Statement, see here.

My firm extends an invitation to readers of the Harvard Law School Corporate Governance Blog to join us for a 60-minute informative Webcast on Developments in Takeovers Defenses tomorrow, September 23 at noon ET. You may do so from the comfort of your office by simply logging in a few minutes prior to the start of the program.

Not all takeover defenses are created equal and recent trends show that yesterday’s state of the art may not be very effective in the current environment which is dominated by hedge fund destabilization and other activist investor campaigns. This complimentary Webcast will first focus on the risks posed by investors who don’t seek 100% ownership of a company, but rather embrace short term “event” driven strategies. We will then turn to potential innovative strategies companies can adopt to defuse these risks.

The program is as follows:

Review of Market
• Hostile deal making
• Hedge Fund destabilization

Advance Notice Bylaws
• Implications of Cnet and Office Depot cases
• Disclosure of derivatives and empty voting
• Disclosure of activist investor “Wolf Packs”
• Other disclosures to increase transparency
• Updating requirements for increased transparency

Poison Pills
• Pros and cons of adoption vs. putting Pill on the “shelf”
• Treatment of synthetic equity and other derivatives
• Can and should Pills deal with “Wolf Packs”
• Is conventional Pill design too draconian for today’s markets

I will be presenting, together with my partners Mark Gerstein, Laurie Smilan, and Bradley Faris.

The program materials are available here. To register online, click here. Additional details and a link to log-on to the Web conference site will be sent to registrants prior to the event. For more information and questions about this event, please contact
Wendy Moore at +1.714.755.8109.

(Editor’s Note: For an analysis on this Blog of the SEC’s emergency order temporarily banning short selling, issued contemporaneously with the SEC order discussed in this post, see here.)

In an emergency order that became effective yesterday, September 19, 2008, the SEC suspended the timing and volume restrictions of Rule 10b-18. Rule 10b-18 is the rule that says that repurchases by a company will not be viewed as manipulative if they are effected in accordance with the conditions of the rule. The SEC emergency order:

• suspends the timing conditions of Rule 10b-18(b)(2)(i) - (iii). These provisions typically restrict purchases that are the opening trade or that occur in the last 10 minutes (or for less actively traded companies, during the last 30 minutes) of the regular trading session. Under the emergency order, repurchases can be made at any time during the day.

• raises the volume condition of Rule 10b-18(b)(4). This provision typically limits the number of shares purchased on any single day to 25% of the average daily trading volume (subject to an exception for block trades). Average daily trading volume is calculated over the four calendar weeks preceding the week in which the purchase occurs. Under the emergency order, the volume of permissible repurchases is now 100% of the average daily trading volume.

• does not change the condition under Rule 10b-18(b)(1) that restricts a company to using a single brokerage firm on any given day to effect any solicited repurchases.

• does not change the pricing conditions of Rule 10b-18(b)(3), which generally restrict purchases at a price above the last bid or transaction price.

It is important to note that Rule 10b-18 and the SEC’s emergency order address only whether a company’s repurchases may be viewed as manipulative. Rule 10b-18 and the SEC’s emergency order do not alleviate potential insider trading concerns. Thus, companies should continue to assess whether they possess any material nonpublic information (that is, information that would be viewed by a reasonable investor as having significantly altered the “total mix” of information available) before they effect discretionary transactions in the open market. For companies that are near the end of a fiscal quarter or fiscal year, it may in certain cases be possible for the companies to conclude, based on the market price of their stock and on information currently available to them regarding the fiscal period results, that they are able to engage in open market repurchases without insider trading concerns. However, because of the difficulty in assessing the extent to which the market has anticipated a company’s financial results and the general difficulty in assessing materiality, other companies should consider whether to pre-announce results prior to effecting any discretionary repurchases, or to remain out of the market.

A copy of the SEC’s emergency order is available here. The order is effective as of September 19, 2008 and expires at the end of the day on Thursday, October 2, 2008, unless further extended by the SEC.

(Editor’s Note: This post comes to us from Lanny A. Schwartz and Gerard Citera of Davis Polk & Wardwell. A memorandum, issued after this post was published, describing amendments to the temporary banning order is available here.)

Yesterday the SEC issued an order temporarily banning all persons from short selling publicly traded securities of any issuers that are included in a list of financial companies attached to the order. The order, which is currently effective, expires at 11:59 p.m. (Eastern) on October 2, 2008.

There are several narrow exceptions to the blanket short selling ban, including:

• Registered market makers, block positioners, or other market makers obligated to quote in the over-the-counter market that are selling short as part of bona fide market making in a security;

• short sales that occur as a result of automatic exercise or assignment of an equity option held prior to the effectiveness of the order; and

• until 11:59 p.m. on September 19, 2008, short selling as part of bona fide market making and hedging activity related directly to bona fide market making in derivatives on the publicly traded securities of a covered issuer.

The SEC stated that it took this extreme action because of its belief that fair and orderly markets were threatened by the sudden and excessive fluctuations in prices of financial institution securities, which may have been fueled by short selling. In the SEC’s view, such conditions have contributed to a crisis of confidence without an underlying basis.

Unlike a similar action taken by the U.K. Financial Services Authority on September 18th, the prohibition is not limited to the active creation or increase of net short positions. Without this exception, it would appear that financial institutions (including those the SEC is trying to protect) and other market participants who hold convertible securities, options and other equity derivatives, cannot adjust their delta hedge positions in the underlying common stock that hedge their risk of owning the equity derivatives. Therefore, contrary to its intent, the SEC action may significantly limit the ability of the indentified financial institutions to access the convertible and equity derivative markets.

The SEC has been addressing a number of specific questions and concerns that have been noted. For example, we understand that the SEC staff has informally advised market participants that, despite the reference to “publicly traded security” in the order, the order is not intended to cover debt securities. Also, a number of issuers believe that they have been inadvertently omitted from the list of financial institutions whose stock is covered by the order, and Davis Polk has been in contact with the SEC staff concerning revising the list.

At the same time as it issued this emergency order, the SEC also took two further actions, including the issuance of emergency orders to establish short sale and short position reporting requirements for institutional investment managers and a liberalization of certain requirements under Rule 10b-18 under the Securities Exchange Act of 1934 concerning securities repurchases by issuers.

The SEC press release on these actions is available here. The list of companies covered by the SEC’s short sale ban is in Appendix A to the order, which is available here.

My colleagues Randall Guynn and Joerg Riegel and I have recently written a memorandum entitled Treasury Encourages Development of Covered Bonds in the U.S. and Issues “Best Practices”, which discusses the Treasury Department’s issuance of Best Practices for U.S. Covered Bonds intended to set standards for the development of a covered bond market in the U.S. The memorandum describes the salient terms of the Best Practices and discusses other recent events in the development of regulatory support and a market infrastructure (such as electronic trading or acceptance of covered bonds as collateral) for covered bonds. The memorandum also analyzes the current U.S. legal structure supporting covered bonds and comments on the possible development of market practices.

The memorandum is available here.

(Editor’s Note: Earlier memoranda and posts on this Blog by the author may be accessed here and here. The SEC’s new rules on short-selling issued yesterday are available here. A subsequently issued statement by the SEC is available here.)

The SEC yesterday announced three actions addressing short selling. Its actions are too little too late.

First, the SEC adopted a rule requiring short sellers and their broker-dealers to deliver securities by the settlement date (three days after the transaction date) and imposing penalties for failure to do so. In addition, the SEC eliminated the option market-maker exception to the three day delivery requirement. Finally, the SEC adopted a new anti-fraud provision making it unlawful for sellers to deceive specified persons about their ability or intention to deliver securities by the settlement date. This last rule is not necessary and will not help eliminate abusive short selling practices.

The measures adopted by the SEC yesterday fall far short of the type of bold measures needed to constrain the abusive short selling and rumor mongering taking place. The securities markets continue to be in a crisis and there continues to be a significant disruption to their fair and orderly functioning.

As we have previously said, the SEC should immediately re-impose, under its emergency powers, the “Uptick Rule.” In addition, the SEC must now consider other very strong measures such as using its emergency powers to place limitations on short sales for a period of time to restore a fair and orderly market. Also, it is essential for the SEC to scrutinize short sellers and their related transactions, including options and credit default swaps to determine whether these strategies are contributing to the severe dislocations taking place in the marketplace.

Finally, the SEC should promptly make public the results of their examinations of the short selling activities and take immediate enforcement action against those who are engaging in this abusive manipulative conduct.

Time is of the essence and the SEC must act now.

The Harvard Law School Program on Corporate Governance is pleased to announce the availability of the video of its event on corporate litigation. The event, which was held earlier this month, is the first of the Program’s series entitled Introduction to Corporate Practice. The series’ aim is to expose students to leading practitioners and their perspective on corporate practice—What do they enjoy about their jobs? What issues do they deal with? And what does it take to succeed in their field? The videos are made public as a resource for law students and young lawyers everywhere who are considering corporate practice.

The three panelists at the corporate litigation event were:

• Theodore N. Mirvis, a partner in the litigation practice at Wachtell, Lipton, Rosen & Katz, as well as a member of the advisory board of the Program on Corporate Governance and a frequent contributor to the Blog.
• Allan J. Arffa, who is co-chair of the litigation department at Paul, Weiss, Rifkind, Wharton & Garrison LLP.
• Andrew S. Tulumello, who is a vice-chair of the class action and complex litigation practice group and a vice-chair of the crisis management group at Gibson, Dunn & Crutcher LLP.

Each member of the panel gave introductory remarks, and answered questions from the audience. Allan Arffa started the event by describing the work of a corporate litigator, contrasting it with other types of corporate legal work. Andrew Tulumello added that litigators often deal with “messes”, which they have to assess and navigate for their clients, and which often result in disputes that are very difficult to settle outside of the courtroom. Ted Mirvis spoke about the unique thrills of deal litigation, such as the quick turnaround time and the highly qualified specialized judges. He also emphasized the importance of having a good reputation with these judges. The panel offered their perspectives on career planning issues, including working for a large versus a small firm, the types of characteristics they felt were central to the success of associates, and the types of courses they believed to be the most useful for aspiring corporate litigation associates.

A video of the panel discussion is available for download here.

My partner James C. Woolery and I have prepared a memorandum entitled “Beneficial Ownership - By-Law Disclosure Proposal,” in which we propose an innovative by-law amendment as a response to the threat posed to a company by the secret accumulation of its shares by activist investors. Secrecy is often achieved in this context through the use of total returns swaps and other derivatives, which may allow the accumulation of a large, and sometimes dominant, position in the target company. Despite legal claims that these derivative holdings are not the same as beneficial ownership - claims being tested in litigation arising from the recent CSX proxy fight - in reality activists demand that targets, and their board of directors, defer to the activists as though they were full owners of the stock represented by the derivatives.

In the memorandum we discuss a number of techniques corporations have used to protect against this threat, and we outline a proposal that involves amending advance notice by-laws governing shareholder proposals to include new continuous disclosure obligations. Compliance with this disclosure obligation is a prerequisite for giving effective notice of an intention to nominate directors or present business at a stockholders’ meeting. To our knowledge, a by-law incorporating the concepts we outline in our proposal has not yet been adopted by any corporation.

Our memorandum is available here.

(Editor’s Note: This post comes to us from Ronald Anderson and Augustine Duru of the Kogod School of Business at American University, and David Reeb of the Fox School of Business at Temple University.)

In our forthcoming Journal of Financial Economics paper entitled Founders, Heirs, and Corporate Opacity in the U.S., we investigate the impact of founder and heir shareholders on corporate opacity and whether, and how, they use their influence to affect firm performance.

We argue that founders’ and heirs’ unique and dominant control positions provide particularly strong incentives to diminish corporate transparency. We explore two hypotheses with regard to these controlling shareholders and transparency. Our first hypothesis centers on the notion that founders and heirs affect corporate transparency to entrench themselves and extract private benefits of control. However, a plausible alternative is that large shareholders have the incentive to collect information and the power to monitor managers. As a result, founders or heirs, acting as committed monitors with relatively undiversified stakes in the firm, may provide control and oversight that substitute for the disciplinary role of transparency. Further, if these controlling shareholders act as effective monitors, corporate opacity potentially provides competitive and cost advantages to the firm. Both the monitoring and entrenchment arguments suggest a positive relation between founder and/or heir shareholders and corporate opacity. However, the entrenchment hypothesis suggests corporate opacity allows these controlling shareholders to accrue private benefits of control. To differentiate between these non-mutually exclusive arguments, we examine whether the interaction of founder and/or heir ownership and corporate opacity affects outside shareholder wealth.

We test these arguments using the 2,000 largest U.S. firms from 2001 through 2003. Of our total sample, founder-controlled firms constitute 22.3% and heir-controlled firms comprise 25.3% with average equity stakes of approximately 18% and 22%, respectively. The analysis further indicates that founder controlled firms tend to be smaller, riskier, and more R&D intensive than manager or heir controlled firms. We develop an opacity index to gauge the relative opaqueness of our sample firms and find that both founder and heir ownership exhibit a significant and positive relation to opacity. We also find that founder and heir controlled firms exhibit a negative relation to performance in all but the most transparent firms. Surprisingly, additional tests reveal that concerns about divergences in ownership versus control management type, dual class shares, and board influence appear to be substantially less important than corporate opacity in explaining the performance impacts of founder and heir control. Finally, we decompose corporate opacity into disclosure and market scrutiny components, finding that the disclosure quality component appears to be of greater importance to investors. However, irrespective of whether these controlling shareholders create and/or stay in the firm because of corporate opacity, our analysis suggests that founders and heirs in large, publicly traded firms exploit opacity to extract private benefits at the expense of minority investors.

The full paper is available for download here.

(Editor’s Note: This comes to us from Gar Bason, Phillip Mills and Justine Lee of Davis Polk & Wardwell.)

In late July, Delaware Vice Chancellor Noble issued a decision in Ryan v. Lyondell denying the directors of Lyondell Chemical Company the protection of the company’s exculpatory charter provision for the alleged breach of their fiduci