(Editor’s Note: This post is by Selina Sagayam of Gibson, Dunn & Crutcher LLP.)

The European Union has become the first jurisdiction to propose a comprehensive framework for direct regulation and supervision of the entire investment funds industry – the proposed Directive on Alternative Investment Fund Managers.

The EU already has an established regime for regulating investment funds known as UCITS (Undertakings for Collective Investment in Transferable Securities)[1]. UCITS invest in a prescribed range of transferable securities and/or other liquid financial assets and are composed of a collective pool of investments from retail investors.

The draft proposal which was published on 29 April aims to regulate investment funds within Europe which are not already covered by the UCITS regime, referred to in the proposal as alternative investment funds (AIFs). Rather than imposing requirements on the AIFs themselves, the proposals target AIF managers (AIFMs). It was considered that a broad regime focusing on those who manage investment funds rather than a defined set of entities prevalent in the investment fund world (e.g. hedge funds) would be more effective and less easy to circumvent, with enhanced scrutiny on leveraged hedge funds.

Currently, this sector is regulated in the EU through a combination of fragmented national legislation as well as some general provisions of EU law, in addition to voluntary industry standards in certain cases (e.g. the Walker Guidelines in the UK). With investor protection as its fundamental aim, the European Commission’s rationale for the proposals is the introduction of harmonised regulatory standards and enhanced transparency.

Early drafts of the directive had been leaked to the public weeks before and received a barrage of criticism particularly from different interest groups across various member states and not surprisingly, the hedge fund industry. The final draft proposals however have come under even greater attack with the UK Financial Services Secretary and key UK and European industry bodies (in particular the British Private Equity & Venture Capital Association and the European Private Equity & Venture Capital Association) voicing their strong opposition to proposals they consider are “deeply undesirable” and “immensely damaging” to industry.

Some of the main points under the proposed legislation are set out below.

Who Is Regulated?

All EU domiciled AIFMs that meet either of the two threshold tests below will be regulated:

• Leveraged AIFMs – Total assets under management equal to or above €100m (approx. US$1334m, £90m) where assets under management are acquired through use of leverage.

• Non-leveraged AIFMs – Total assets under management equal to or above €500m (approx. US$670m, £448m) where: (i) none of the assets under management were acquired through use of leverage; and (ii) investments are locked into the fund for 5 years or more from the date of its constitution.

…continue reading: Proposed New European Regulation of Investment Funds

In our paper Disclosure and the Cost of Capital: Evidence from Firms’ Responses to the Enron Shock, which was recently updated after I presented it at the Law, Economics and Organizations seminar here at Harvard Law School, my co-author Catherine Schrand and I exploit the Enron debacle as an exogenous shock for other U.S. firms and relate cost of capital shocks to subsequent disclosure responses in an attempt to understand the critical link between disclosure and cost of capital. This approach is different from existing research, which has examined the relation cross-sectionally , relating disclosure levels to the cost of capital. Even though this research has found that firms with more extensive voluntary disclosure exhibit less information asymmetry and have a lower cost of capital, a causal interpretation of such findings has proved problematic due to endogeneity concerns for which valid instruments are very difficult to find. Our approach tackles the endogeneity concern in a different way, exploiting the Enron collapse acts as a natural experiment. In addition, there are a number of features of the Enron collapse that make this a powerful setting to address the broad question of the relation between disclosure and cost of capital. First, the shock led to investor concerns about a systematic lack of transparency in financial reporting. Hence, it seems reasonable to expect firms to consider disclosure responses. Second, the shock occurred during a relatively short window. Finally, it occurred during the fourth quarter of 2001. Thus, firms had the opportunity to respond in their annual financial reporting.

Our sample comprises 1,868 U.S. firms with December fiscal-year ends and the required financial data from 1999 to 2001. Using this sample, we document that the cost of capital shocks are associated with an increase in the firms’ disclosures in their subsequent annual 10-K filings. Firms extend the number of pages in their 10-K filings, notably the sections containing the management discussion & analysis, related-party transactions, financial statements and footnotes. This link between cost of capital shocks and 10-K disclosure responses is robust to a broad set of alternative specifications. The increase in disclosure is particularly pronounced for firms that experience positive beta shocks and are likely to be more sensitive to their cost of capital because they have larger external financing needs and more growth opportunities. We also find that Arthur Anderson clients increase their 10-K pages and the section on related-party transactions more than firms that have other auditors, consistent with the idea that the disclosures are a response to the transparency concerns created by the Enron scandal.

We do not find a significant relation between the beta shocks and changes in the length of firms’ annual earnings announcements. However, an analysis of firms’ interim disclosures after the shock suggests that firms increase the number of 8-K filings in response to the crisis. We show that the 8-K disclosures mitigate the effects of the shock but such interim disclosures do not eliminate the relation between the cost of capital shocks and disclosure in the 10-K, consistent with the idea that firms’ 10-K filings and interim disclosures are complementary activities to reduce the transparency problems during this time period. The latter finding is important because it suggests that the annual 10-K filing contains relevant information that can alleviate investor concerns, despite its lack of timeliness. Finally, we show that firms’ disclosure responses subsequently reduce firms’ costs of capital and hence mitigate the impact of the transparency crisis.

The full paper is available for download here.

This post comes from my colleagues Joe Tringali and Michael Naughton.

The Federal Trade Commission (FTC) has begun making inquiries into the fact that certain individuals hold seats on the boards of both Apple and Google, according to an article in today’s New York Times.[1] Section 8 of the Clayton Act ( Section 8 ) prohibits an individual from serving as a director or board elected or appointed officer of two or more competing companies, absent certain exceptions detailed below. Section 8 has not been seen as an enforcement priority of the antitrust agencies in recent years, but this FTC inquiry may reflect a shift in priorities brought on by the new administration. In light of this FTC inquiry, we review Section 8 and its exemptions below.

Section 8 is a prophylactic statute prohibiting, in certain circumstances, a person from serving as a director or officer of two or more corporations (an interlock) where the interlocked corporations are competitors. Its intent is to help ensure that a director or officer of one corporation cannot affect the competitive behavior of a competing corporation by serving that corporation in a high-level position in which he or she would be privy to confidential competitive information or could affect competitive decisions.

IN ORDER FOR SECTION 8 TO APPLY, THE FOLLOWING CONDITIONS MUST BE MET [2]

1) There is an interlock between two or more corporations. Section 8 does not apply to interlocks between noncorporate entities or between a corporation and a noncorporate entity. In addition, Section 8 does not apply to interlocks involving banks and other depository institutions and their holding companies;[3]

2) For interlocks involving officers, the officer in question must be elected or appointed by the board of directors.

3) Both corporations must be engaged, in whole or in part, in interstate commerce.

4) The two corporations must be considered competitors by virtue of their products and the location of their operations. Section 8 requires a horizontal, competitive relationship between the two companies such that the elimination of competition by agreement between them would constitute a violation of any of the antitrust laws. If the companies have a vertical or supplier relationship, Section 8 does not apply. Factors to consider in determining whether the corporations compete include whether their products are interchangeable, whether the industry and customers recognize the products as competing, whether production techniques are similar, and whether the products have distinctive customers. The statute applies only to actual competition; potential competition is not enough.

5) Each of the corporations concerned must have an aggregate net worth of more than $26,161,000 (threshold adjusted annually). Net worth is measured as the total of capital, surplus, and undivided profits. In calculating the aggregate net worth, only the interlocking corporate entities themselves are considered; the net worth of parents, subsidiaries, and other affiliates are not included.

6) Finally, the interlock need not involve the same individual serving as the director or officer of two competing companies in order for a Section 8 violation to occur. In Reading Int’l Inc. v. Oaktree Mgmt. LLC, 317 F. Supp. 2d 301, 326 (S.D.N.Y. 2003), the court recognized plaintiffs’ theory that “when a parent company designates different persons to sit on the boards of competing subsidiaries, these persons are treated as ‘deputies’ for § 8 interlock purposes” (internal quotations and citation omitted). Accordingly, under Oaktree there can be a Section 8 violation where the parent corporation designates different persons to sit on the boards of competing companies if the relevant individuals’ service on the board is not in their individual capacity but rather “as the deputies of” the parent corporation “such that it can legitimately be said that it is” the parent company as an entity and not the individual that serves as a director. Id.

…continue reading: Federal Trade Commission Inquires Into Interlocking Boards

(Editor’s Note: This post is based on a client memo from Theodore N. Mirvis, Steven A. Rosenblum, Adam O. Emmerich, David C. Karp, Andrew R. Brownstein, Eric S. Robinson and Trevor S. Norwitz of Wachtell, Lipton, Rosen & Katz.)

Access to company proxy materials for board candidates nominated by shareholders is now an imminent reality. Since the SEC first proposed a shareholder proxy access regime in 2003, the wisdom of such a fundamental departure from traditional practice has been hotly debated. We have long been of the view that shareholder proxy access is a serious mistake, likely to impair the ability of public companies to attract and retain quality directors and lead to a further politicization and balkanization of the boardroom, with attendant negative consequences for American capitalism and competitiveness. (See our comment letters to the SEC in response to the SEC’s 2003 and 2007 proxy access rulemaking proposals.)

Political developments have turned the tide strongly in the other direction. SEC Chairman Schapiro has said that the SEC will consider a shareholder access rule later this month, and Senator Schumer has said that shareholder access will be an element of his so-called “Shareholder Bill of Rights Act of 2009.” In an effort to forestall these attempts to further federalize corporate law, Delaware last month enacted legislation which expressly enables the adoption by Delaware companies of bylaws permitting shareholder access to company proxy materials. Crucially, such bylaws can be adopted not only by a company’s board of directors, but also by shareholder action on shareholder initiative.

Due to the negative impact of shareholder proxy access, we expect that many companies will understandably resist the adoption of shareholder access bylaws of any sort. Others will favor a wait-and-see attitude, particularly since federal legislation or regulation may change the ground rules further. Some companies, however, may wish to consider the preemptive adoption of a reasonable and carefully tailored bylaw, in part to deter, or discourage adoption of, more extreme versions of shareholder access that may be proposed by short-term activist or special-interest shareholders. We have prepared a model shareholder access bylaw (attached) for consideration.

Our model permits shareholders holding at least 5% of a company’s common stock for at least a year to nominate a limited number of independent director candidates using the company’s proxy statement and card. Our model bylaw also contains features designed to prevent the use of shareholder access as a “Trojan Horse” for takeover activity. For shareholders seeking to effect a takeover via director election, the SEC’s existing proxy contest process, containing essential disclosure and procedural safeguards, remains the appropriate mechanism.

The potential variations on the model access bylaw are many, and a board’s decision whether to adopt a shareholder access bylaw at all and, if so, what features it should have, must be carefully considered in the context of each company’s particular situation. For that reason, we believe that if shareholder access is to be a part of our public company landscape, the private-ordering approach through company specific bylaws contemplated by the Delaware legislation is preferable to a federally mandated one-size-fits-all proxy access rule. We expect that significant, long-term shareholders that do not desire the companies in which they invest to be subject to director election free-for-alls – and the risks likely to result – should find that the attached model shareholder access bylaw offers a reasonable framework.

(Editor’s Note: This post comes from Enrichetta Ravina of Columbia Business School and Paola Sapienza of the Kellogg School of Management.)

In our paper What Do Independent Directors Know? Evidence from Their Trading which was recently accepted for publication in the Review of Financial Studies, we take a first look at the question of whether independent directors have enough information to monitor the company’s executives by analyzing their trading behavior in the company stock. The independence of directors is a key focus of recent regulatory changes. A criticism of this focus is that if executives want to act against the interest of the shareholders, they can simply leave directors in the dark. We indirectly measure the level of inside information independent directors collect while serving on the board by comparing the market-adjusted returns associated with their trades to those associated with the executive officers’ trades.

Using a comprehensive sample of reported executives’ and directors’ transactions in U.S. companies from 1986 to 2003, we find that executive officers earn higher abnormal returns than the market, when they make open market purchases, and that the independent directors do as well. We find that the difference between the returns earned by executives and independent directors is relatively small at most of the horizons analyzed. The results are robust to the inclusion of firm fixed effects in the regression, which allows us to compare officers and independent directors of the same firm, and to control for time-invariant, firm-specific characteristics that might affect returns, as well as individuals’ incentives and constraints. The results are also robust to using a variety of alternative specifications (e.g., controlling for the size of the transaction and stock holdings in the firm, the firm’s size, and book-to-market, and past return volatility). In addition, we find that the excess return earned by executives in the best governed firms (using the Gompers, Ishii, and Metrick Governance Index) are low and indistinguishable from zero, where as the excess return in the worst governed firms is 21%. The independent directors earn less than the executives at all governance levels. However, the gap in excess return between executives and directors is larger in the firms with the weakest governance, while it disappears for firms with the best governance.

To study whether independent directors are also informed in bad times, we analyze their trading performance when they make open market sales. To increase the power of our tests, we focus on the return from sales in two situations when trading is more likely to be driven by information rather than diversification motives: bad news (i.e., events in which the firm is experiencing a substantial market-adjusted drop in stock price) and earnings restatements. In both cases, we find that independent directors and executives outperform the market. These results are consistent with the hypothesis that independent directors are informed ahead of the market in critical situations.

Overall, these results suggest that independent directors are informed about the firm. The full paper is available for download here.

(Editor’s Note: This post by Professor Roe appeared today on Forbes.com.)

Capital markets players have been grumbling that Chrysler’s creditors are being badly treated and that their contract is being ignored. Warren Buffett said last week that there’ll be “a whole lot of consequences” if the government’s Chrysler plan keeps on its current trajectory. If priorities are tossed aside, “that’s going to disrupt lending practices in the future,” he said. “If we want to encourage lending in this country,” Buffett added, “we don’t want to say to somebody who lends and gets a secured position that the secured position doesn’t mean anything.”

This is not a good economic time to disrupt lending to troubled companies. That’s just the kind of lending that the Treasury is trying to unglue with TARP and the plans to sign-up private investors to buy the toxic mortgage assets off bank balance sheets.

But is this gelling capital market opinion on the Chrysler plan right or wrong? Maybe there really isn’t any more value in the government’s last offer than belongs to the Chrysler creditors. If there isn’t, Buffett and lenders are getting themselves unnecessarily worked up.

The trouble is that with the bankruptcy set-up approved this week, no one can tell. There’s no real market check on the Treasury plan, just a pseudo-market test that won’t fool any market player. This pseudo-test, approved by the court last week, led Chrysler’s dissenting creditors to give up.

In the test approved, outsiders can bid the deal away from Fiat and the U.S.,But bidders can bid on only one deal — the same UAW deal that the government negotiated before the bankruptcy. The court agreed to Chrysler’s and the Treasury’s proposal that no one be allowed to bid on the assets alone. But that’s what Buffett and the capital markets grumblers are complaining about: the government, and now the bankruptcy judge, is ignoring creditors’ contracts priority access to a first cut at Chrysler’s assets. The deal on the table gives them no access to those assets.

But there was a way to check the bona fides here to convince Buffett and financial players that the deal was fair: the court could have market-tested the plan. If the court and the Treasury had given Buffett and others the chance to outbid the Treasury for those assets and Buffett didn’t bid more than the Treasury, grumbling would have ended. If Buffett or someone else credible came in with a better bid, the Treasury and Chrysler would then have had to top it.

The best way to think about the bankruptcy plan is that the government is buying Chrysler from the creditors, giving it to the UAW, and hiring FIAT to manage it. Financial markets players are grousing that the UAW and the retirees are doing much better than the secured creditors. The UAW is owed $10 billion and they’ll get a big fraction of that back while the secured creditors take a big hit to their $6.9 billion in loans. But if the Chrysler winners are doing better with the government’s money and not the creditors’ money, that’s not for the creditors to complain about in the deal itself (as opposed to complaining as citizens and taxpayers.)

Bankruptcy law entitles the secured creditors to the liquidation value of the company. With that in mind, the government and the court ought to have set up a true market test: find out how much an outsider would pay for the company’s facilities, shorn of its operations, employees and dealers.

…continue reading: Stress Testing the Government’s Chrysler Plan

(Editor’s Note: This post is from Martin Lipton and Theodore N. Mirvis of Wachtell, Lipton, Rosen & Katz and Jay W. Lorsch of Harvard Business School. An op-ed piece based on this post appeared in today’s Wall Street Journal. The text of the proposed Act is available here, and a section-by-section analysis of it is available here.)

A few weeks ago, Senator Schumer announced his intention to introduce the Shareholder Bill of Rights Act of 2009. The central stated goal of the Act — “to prioritize the long-term health of firms and their shareholders” and create “more long-term stability and profitability within the corporations that are so vital to the health, well-being, and prosperity of the American people and our economy”— is commendable. That goal represents a significant break from the agendas of many self-proclaimed governance experts who, in actuality, have sometimes hijacked the banner of “good governance” to amp up stockholder power in a campaign to press Corporate America away from attention to and investment in the long term.

Short-termism is a disease that infects American business and distorts management and boardroom judgment. But it does not originate in the boardroom. In is bred in the trading rooms of the hedge funds and professional institutional investment managers who control more than 75% of the shares of most major companies. Short-termist pressure bred by stockholder power demanded unsustainable ever-increasing (quarterly) earnings growth, possible only via the shortcut of over-leverage and reduced investment, and the dangerous route of excessive risk. Stability and financial strength to weather economic cycles were sacrificed for immediate satisfaction. That short-termist pressure, in the view of many observers, contributed significantly to the financial and economic crises we face today.

Thus, the legislation’s purpose— to restore the long-term stability of the firm as the ultimate goal of corporate governance— is a salutary and important guidepost.

But the suggested provisions of the Act threaten to encourage the opposite of its stated goal. The Act proposes to enhance stockholder power and thereby would fuel the very stockholder-generated short-termist pressure that, in the view of many observers, contributed significantly to the financial and economic crises we face today. The Act would implement, by federal mandate, a series of yet further empowerments of stockholders: it would require annual stockholder advisory votes on executive compensation, facilitate a federal requirement that stockholders be granted access to every corporation’s proxy to nominate their own candidates to boards of directors, end staggered boards at all companies, require that all directors receive a majority of votes cast to be elected, and order that all public companies split the CEO and board chair positions.

…continue reading: The Proposed “Shareholder Bill of Rights Act of 2009”

This post is by my partners B. Robbins Kiessling, Sarkis Jebejian and Erik R. Tavzel.

As the financial crisis has deepened over the past year, first the Bush Administration and now the Obama Administration have announced ambitious plans for comprehensive reform of the financial regulatory system. Not to be left behind, at the same time current and former members of Congress and Government officials, international groups such the G-20 and even the mainstream press are weighing in on the need for reform and the shape it should take. Although the immensely complex process of actual reform has barely begun, the key players have said enough to allow a good guess as to their goals for the post-regulatory reform financial world. There will be an intense focus on regulating and reigning in “systemically important” financial institutions. Institutions will face tighter regulation of risky activities and stricter capital and funding requirements. The regulatory net will be cast much wider, capturing institutions and activities previously not subject to substantial regulatory oversight (most notably, purveyors of derivatives and credit default swaps such as AIG’s Financial Products division as well as certain private investment funds). What will these changes mean for today’s financial institutions? How will reform change the shape of the industry in the coming years?

Turning to the history books may, in fact, provide useful insights. One popular point of view is that the post-reform financial industry should look more like it did in the 50 years from the mid-1930’s to the mid-1980’s before the consolidation and deregulation of the past two decades. Whereas in the mid-1980’s the only financial institutions that even theoretically could pose systemic risk were a handful of highly-regulated money center banks whose business was largely limited to taking deposits and making loans to large corporations and foreign governments, over the past 12 months we have learned that a much broader array of institutions with extensive unregulated or lightly regulated businesses can be “too big to fail.” However, while looking back at history is informative and certain of the deregulatory changes of the last two decades may in hindsight seem like mistakes, simply turning back the clock is impossible and undesirable. The reform effort will face many difficult questions in figuring out how to restructure the system based on today’s financial market and macroeconomic realities. This bulletin looks ahead to some expected features of regulatory reform and associated questions and challenges.

Size of Institutions
Treasury Secretary Timothy Geithner and others have stated that one of the goals of regulatory reform should be to avoid institutions that are “too big to fail.” The trend in the financial services industry in the past few decades, however, has been precisely the opposite. Since the early 1980’s, we have witnessed massive consolidation, fueled by the lifting of the prohibition on interstate banking, the repeal of the Glass-Steagall Act, the S&L and regional bank crises, globalization and technological advances. Today, the combined assets of the four largest U.S. commercial banks – JPMorgan Chase, Citigroup, Bank of America and Wells Fargo – represent 64% of the total assets of all U.S. commercial banks. Many firms that were once prominent, well-known names have been absorbed by other institutions, even before the financial crisis led to further consolidation. On the banking side, for example, today’s JPMorgan Chase includes among its predecessors Chemical Bank, Manufacturers Hanover, Chase Manhattan, J.P. Morgan & Co., First Chicago, Texas Commerce and Bank One (itself the product of numerous mergers). The current Bank of America’s predecessors include NationsBank, NCNB, First National Bank of Boston, Security Pacific, Continental Illinois, LaSalle Bank, Fleet, Norstar, Maryland National Bank and the old Bank of America. On the investment banking side, Citigroup acquired Salomon Brothers and Smith Barney. Credit Suisse acquired First Boston and DLJ. Morgan Stanley merged with Dean Witter.

Despite the concern over systemic risk, this trend toward consolidation has been accelerated by the financial crisis, as weaker firms have been absorbed (either voluntarily or involuntarily) by better-capitalized rivals. For example, Bank of America acquired Merrill Lynch, JPMorgan acquired Bear Stearns and Washington Mutual, and Wells Fargo acquired Wachovia.

Against this background, the objective of limiting the size of institutions raises important questions and faces significant challenges. As a threshold mater, what will be the framework for achieving this goal? Will there be new rules simply limiting size based on certain clearly identifiable metrics (such as assets or deposits)? Will there be objective criteria at all or a “you know it when you see it” approach? How will financial institutions and their regulators deal with the fact that systemic importance is at least in part a function of the identity and importance of your counterparties? Will institutions be subject to an after-the-fact determination that could have a significant impact on their activities? And what will be the consequences of being systemically important? Will it be more stringent capital requirements, as suggested by Secretary Geithner, or limitations on certain risky activities, as suggested by Paul Volcker and others, or will divestitures be required? And, if divestitures are required, how will the downsizing of firms that are currently “too big to fail” be accomplished? Will some of the crisis-related combinations encouraged by the government in the past year have to be undone? Putting aside systemic importance, are we entering an era where scale will be discouraged? How can institutions simultaneously be big enough to compete globally but not be too big to fail? The answers to these questions not only will impact the new rules, but will influence every aspect of the business and strategy of large financial institutions—including decisions on lines of business, M&A activity, capital structure, risk management and personnel.

…continue reading: (Re)regulation of Financial Services—Back to the Future?

(Editor’s Note: This post is based on a paper authored for the 29th Annual Ray Garrett Jr. Corporate and Securities Law Institute by Mark Gerstein, Bradley Faris, and Christopher Drewry of Latham & Watkins LLP.)

Shareholder rights plans were developed more than 25 years ago to fend off opportunistic hostile offers and other abusive takeover transactions. Rights plans deter unauthorized stock accumulations by imposing substantial dilution upon any shareholder who acquires shares in excess of a specified ownership threshold (typically ten to twenty percent) without prior board approval. Although the freewheeling takeover environment of the 1980s is now a distant memory, corporations today face continued threats of abusive takeover transactions, as well as threats from activist and other “event-driven” investors. The credit crunch and the resulting recession, accompanied by substantial deterioration in U.S. equity markets, has exacerbated these vulnerabilities.

Perhaps predictably in light of recent events, there was a resurgence in the adoption and use of rights plans in 2008 and the first quarter of 2009. Using data derived primarily from FactSet’s Sharkrepellent.net, this paper documents and analyzes these trends, including:

• rights plan adoptions, generally, and adoptions by small cap companies, in particular;
• NOL rights plans (plans with less than 5% triggers designed to protect a company’s net operating loss carry-forwards (“NOLs”) and certain other tax attributes);
• expirations versus extensions of existing rights plans;
• rights plans that include synthetic equity provisions;
• the duration of rights plans;
• trigger thresholds; and
• rights plans with corporate governance-related features.

We posit that the increase in adoption of rights plans in 2008 and the first quarter of 2009 is attributable to the deterioration in equity values, increased hostile activity, the proliferation of activist abuse of synthetic equity positions including total return swaps, coordinated “wolf-pack” tactics, the reduced utility of HSR as an early warning system for issuers and the decline in shareholder proposals to redeem rights plans. Considered together, these factors have lead many corporations to reconsider the widely accepted strategy of keeping a rights plan on the shelf to be deployed quickly in response to a specific threat. The premise for the on-the-shelf strategy—that a board will have sufficient time and opportunity to pull a rights plan “off the shelf” if necessary—has recently eroded due to the advent of synthetic equity abuses and wolf-pack strategies that may not trigger a filing under the Williams Act until an investor wants to make its campaign public. Additionally, the precipitous declines in market capitalization suffered by many corporations have enhanced a sense of vulnerability to hostile bids and resulted in the loss of efficacy of HSR as an early-warning mechanism. Boards of directors are concluding that the adoption of rights plans is necessary and prudent under the circumstances and that they will be less exposed to investor backlash for doing so. Indeed, many boards of directors are confident that they can effectively manage investor relations following the adoption of a rights plan given current market conditions.

The past year also brought a number of important developments related to the next generation of rights plans:

• Following the well-publicized case involving CSX Corporation, and in light of the changing nature of equity ownership in the U.S., corporations have modified their rights plans to include derivatives, swaps and other synthetic equity positions within the definition of “beneficial ownership.” However, these new definitions of beneficial ownership are untested and may be imperfect. For example, certain provisions included in next generation rights plans intended to capture ownership of synthetic equity positions (which we categorize as: (i) the Full Ownership Approach; (ii) the Double-Trigger Approach; and (iii) the Atmel Approach) may be overly broad or may undermine the deterrent effect of dilution of the triggering shareholder’s ownership position that underpins rights plans.
• To address coordinated wolf-pack campaigns by activist and other event-driven investors, who may seek to execute their strategies without disclosure of their coordinated activities, at least one corporation has modified its rights plan to treat parties acting in concert or acting with “conscious parallelism” as having formed a group for purposes of determining beneficial ownership under the rights plan. This could be a particularly important issue for public companies because the wolf pack tactic (as opposed to ownership of synthetic equity described above) has been used virtually exclusively by the activist investor community in campaigns against corporations, often culminating in successful proxy contests or other change-of-control events as documented in the CSX case. The market’s knowledge of the formation of a wolf pack (either through word of mouth or public announcement of a destabilization campaign by the lead wolf pack member) often leads to additional activist funds entering the fray against the target corporation, resulting in a rapid (and often outcome determinative) change in composition of the target’s shareholder base seemingly overnight. Many investors take the position that these coordinated activities are not conducted pursuant to any formal agreement, arrangement or understanding and thus are not required to be disclosed under applicable federal securities laws, which denies companies of the key benefits of the Williams Act (affording timely notice to the target company and other investors) and rights plans (avoiding the accumulation of outcome determinative equity positions).
• NOL rights plans gained prominence due to the recession, which is generating significant net operating losses at many companies. NOLs may be used to reduce future income tax payments and have become valuable assets to many corporations. If a corporation experiences an “ownership change” as defined by Section 382 of the tax code, then its ability to use a pre-change NOL in a post-change period could be substantially limited or delayed. While NOL rights plans afford some protection for a corporation’s NOL asset, the protection is not complete. NOL rights plans cannot prevent an ownership change for tax purposes or prevent a potential acquirer from purchasing more than the triggering threshold. They merely serve as a deterrent. An amendment to the corporation’s charter to include ownership limitations is arguably more effective, though perhaps more difficult to implement. Moreover, while the potential merits of NOL rights plans have been recognized by corporations as well as the proxy advisory firm, RiskMetrics Group, they remain untested by the courts, especially in terms of examination of the board of directors’ motivations for adopting NOL rights plans. For example, a Delaware court will apply a heightened standard to boards’ decision to adopt if the NOL rights plans are viewed as defensive measures, which we believe is a likely scenario. We may have a better understanding of this issue in the very near future as the NOL rights plan implemented by Selectica, Inc. and triggered by Versata Enterprises, Inc. is the subject of current litigation in Delaware. Selectica’s situation demonstrates that an NOL rights plan is a limited defense against impairment of the NOL asset. It can deter, but not prevent, share trades that may result in an ownership change.
• Selectica’s NOL rights plan was triggered in December 2008 by Versata Enterprises which became the first shareholder to have swallowed a modern rights plan by intentionally buying shares in excess of a rights plan’s trigger amount. This situation has provided important lessons for the design and implementation of certain common provisions found in virtually all rights plans. In particular, we argue the exchange feature (exchanging the rights on a one-for-one basis for common stock) offers significant advantages over a traditional flip-in rights plan because it provides certain and automatic dilution, no cash is required to exercise the right and it may have less impact on the NOL asset itself. The Selectica situation has also demonstrated the importance of adding “back-office” mechanics for the exchange feature. In particular, corporations should include a process to verify that rights being exchanged include rights held in “street name” through the Depository Trust Corporation. We also believe that it is preferable that an NOL rights plan be non-redeemable after the ownership threshold has been crossed so that no post-trigger waivers can be granted. As with traditional rights plans, this incentivizes a potential share purchaser to engage in a pre-purchase discussion to request a waiver from a board of directors. The board of directors can then consider the waiver in advance without undue pressure and grant it if the proposed share purchase does not threaten the value of the NOL asset. The board of directors should also institute a formal pre-clearance process which would demonstrate that the board of directors has adopted the NOL rights plan for the purpose of protecting the corporation’s NOL asset, not for entrenchment or other improper motives, and frames the board of director’s consideration of waiver requests in this context.

…continue reading: Recent Poison Pill Developments and Trends

This post is by my colleagues Bruce Clark and Aisling O’Shea.

SUMMARY
The United States Court of Appeals for the Eighth Circuit has ruled that the size of a mutual fund investment adviser’s fee is only one factor to be considered in reviewing a claim under Section 36(b) of the Investment Company Act of 1940. Gallus v. Ameriprise Financial, Inc., No. 07-2945 (8th Cir. April 8, 2009). The decision purports to affirm the long-followed Second Circuit decision in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982), which, while respecting the deliberations of independent directors, requires courts to consider those deliberations in light of multiple factors in determining whether investment adviser fees are excessive. However, the decision notes that Gartenberg demonstrates one way in which a fund adviser can breach its fiduciary duty, but not the only way. According to the Eighth Circuit, the proper approach to Section 36(b) looks both to the adviser’s conduct during negotiations and the end result. To that end, the Eighth Circuit ruled that the district court erred in failing to compare the fees charged to an adviser’s institutional clients and mutual fund clients. As more fully discussed below, Gallus also departs from the Seventh Circuit’s opinion in Jones v. Harris Associates, 527 F.3d 627 (7th Cir. 2008).

The United States Supreme Court recently announced that it will hear an appeal in Jones v. Harris Associates, where the Seventh Circuit disagreed with the Second Circuit’s decision in Gartenberg, and held that as long as a mutual fund investment adviser does not breach the fiduciary duty owed to shareholders by failing to disclose all of the pertinent facts or otherwise hindering the fund’s directors from negotiating a favorable price, no judicial review of the reasonableness of the adviser’s fee is required to dismiss a claim under Section 36(b).

Separately, the Eighth Circuit also held that Section 36(b)’s statutory damages period does not end with the filing of a lawsuit because the plain language of the statute yields only a retrospective limitations period. Accordingly, plaintiffs may recover damages incurred after the filing date.

EVALUATING WHEN FEES VIOLATE THE INVESTMENT COMPANY ACT
Section 36(b) of the Investment Company Act
Section 36(b) of the Investment Company Act governs the compensation or payments made to investment advisers of registered investment companies and imposes a fiduciary duty on those advisers in connection with their receipt of fees from the funds they manage. 15 U.S.C. § 80a 35(b). Specifically, Section 36(b) provides that “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services” and provides that claims for excessive fees may be brought by the SEC or by shareholders.

The Second Circuit’s Decision in Gartenberg
In 1982, the Second Circuit considered whether fees paid to a money market fund manager were “so disproportionately large as to constitute a breach of fiduciary duty in violation of § 36(b).” Gartenberg, 694 F.2d at 925. After analyzing the legislative history, Gartenberg concluded that a court should scrutinize the fee itself using a variety of factors. As articulated in Gartenberg, the test is “whether the fee schedule represents a charge within the range of what would have been negotiated at arm’s-length in the light of all the surrounding circumstances.” Id. at 928. Put another way, “[t]o be guilty of a violation of § 36(b) . . . the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Id. In evaluating the reasonableness of adviser fees, Gartenberg found that the fees paid to other fund advisers were not dispositive because there was insufficient competition in the adviser marketplace. Id. at 929.

Gartenberg identified a number of factors that courts should consider in evaluating “whether a fee is so excessive as to constitute a ‘breach of fiduciary duty’” under Section 36(b), including, among others: (i) the cost to the adviser-manager of providing the service, (ii) the nature and quality of the service, (iii) “the extent to which the adviser-manager realizes economies of scale as the fund grows larger” and (iv) the volume of orders being processed by the adviser-manager. Id. at 930. In other words, in assessing the adviser’s fee, a court should rely on its own business judgment to determine whether the fee is inconsistent with the investment adviser’s fiduciary duty under Section 36(b) rather than recognizing that the inherent competition of the marketplace sets an appropriate fee.

…continue reading: Mutual Fund Advisory Fees