During the last decade, activist shareholders and corporate governance groups have been fairly successful in pressuring companies to voluntarily surrender a number of anti-takeover defenses, most notably the use of staggered boards and shareholder rights plans (also referred to as “poison pills”). In fact, according to FactSet SharkRepellent, between December 2002 and December 2009 the percentage of S&P 1500 companies with a staggered board decreased from 62.3% to 44.8%, and the percentage having a rights plan dropped from 61.6% to 23%. The success of activists and governance groups, at least as measured by these numbers, is partly attributable to the view held by certain groups that anti-takeover mechanisms are a reflection of poor corporate governance practices and, thus, antithetical to shareholder value. Also, given the healthy equity markets and high M&A transaction multiples, at least until recently companies may have been more willing to shed defense mechanisms as an easy give to appease activists and corporate governance groups. With respect to the termination of rights plans, companies also probably considered that, unless otherwise provided in the company’s organizational documents, the voluntary decision to terminate a rights plan did not restrict the board’s future ability to adopt a rights plan if it were to become the subject of an unsolicited tender offer.
Archive for February, 2010
In our paper Corporate Fraud and Business Conditions: Evidence from IPOs, which is forthcoming in the Journal of Finance, we use a sample of firms that went public between 1995 and 2005 to test a set of theories modeling how a firm’s incentive to commit fraud when raising external capital varies with investor beliefs. Instead of a strictly increasing relationship between investor beliefs and fraud propensity as highlighted in Hertzberg (2005), we find evidence more consistent with the predictions of Povel, Singh, and Winton (2007): a firm is more likely to commit fraud when investors are more optimistic about the firm’s industry’s prospects, but in the presence of extreme investor optimism, the probability of fraud becomes lower as the firm is able to obtain funding without misrepresenting information to outside investors.
In our paper, Why Do Firms Leave U.S. Equity Markets?, which is forthcoming in the Journal of Finance, we analyze a sample of firms that voluntarily deregister from the SEC and leave the U.S. equity markets over the period from 2002 through 2008. Because it was extremely difficult to deregister before March 21, 2007 when the SEC adopted its new Exchange Act Rule 12h-6, foreign firms that wished to deregister most likely did not do so because they were unable to meet the necessary requirements. When Rule 12h-6 came into effect, deregistration became substantially easier and the change in the rules was followed by a large spike in the number of deregistrations. We investigate why foreign firms deregister, how the Rule change affected firms’ deregistration decisions, and what the economic consequences are of the decisions to deregister.
Two theories offer predictions on which firms are likely to deregister and on the consequences of deregistration for minority shareholders. The first theory follows directly from the bonding theory of cross-listing that predicts corporate insiders value a listing when their firm has valuable growth opportunities that they can finance on better terms by committing to the laws and rules that govern U.S. markets. The listing comes at a cost to insiders since it limits their ability to extract private benefits from their controlling position. If a firm is no longer expected to require outside financing because its growth opportunities have been taken advantage of, or because they have disappeared, a listing is no longer valuable for insiders; the costs of a U.S. listing outweigh the benefits. Consequently, firms that deregister should be those with poor growth opportunities, with little need for external capital, and those which perform poorly. We find support for these predictions.
The Delaware Chancery Court recently issued a resounding affirmation of the business judgment rule in the case In re the Dow Chemical Company Derivative Litigation.  Directors can take comfort in this timely reminder that, despite challenging economic circumstances and an environment of heightened scrutiny of boards and individual directors, the protections of the business judgment rule remain robust in Delaware.
The Dow Chemical Case
Dow was a shareholder derivative suit filed nearly a year ago amid turmoil over Dow’s planned acquisition of another chemical company, Rohm & Haas, for aggregate consideration of approximately $18.8 billion. The Dow stockholders alleged that the directors and officers of Dow had breached their fiduciary duties in at least three different respects: first, in approving the Rohm & Haas transaction without a financing contingency; second, in misrepresenting the connection between the Rohm & Haas transaction and another pending transaction, a joint venture with a Kuwaiti company for which a memorandum of understanding had been entered into six months previously; and third, in failing to detect and prevent various corporate misdeeds during the course of both transactions, including bribery, misrepresentation, insider trading and wasteful compensation.
In an important new decision, Judge Shira A. Scheindlin of the United States District Court for the Southern District of New York has expanded upon her well-known Zubulake V opinion (229 F.R.D. 422 (S.D.N.Y. 2004)), setting forth crucial guidance for all parties to litigation as to their obligations to preserve and collect all potentially relevant records – whether paper or electronic – once litigation is reasonably anticipated, and providing an important example of the extremely serious consequences of failing to do so.
Pension Committee of the University of Montreal Pension Plan v. Bank of America Securities, Case No. 05 Civ. 9016 (SAS), involves an action under both the federal securities and New York State laws by a group of investors seeking to recover more than a half billion dollars in losses alleged to have resulted from the liquidation of two hedge funds in which they were investors. In her opinion, Judge Scheindlin closely reviews the discovery efforts of 13 plaintiffs and finds their failure to institute timely, written litigation hold notices, and their careless and indifferent collection efforts, resulted in the loss or destruction of evidence. Finding their conduct to be negligent or grossly negligent, Judge Scheindlin imposed sanctions, including a rebuttable adverse inference instruction, monetary fines, and, for two plaintiffs, limited additional discovery involving the search of their backup tapes.
In our paper, Corporate Governance and Internal Capital Markets, which was recently published on SSRN, my co-author, Zacharias Sautner, and I take advantage of a unique opportunity for a natural experiment provided by a recent tax change in Germany to explore the link between corporate governance and internal capital markets. In 2002, the prevailing 52% corporate tax on capital gains from investments in other corporations was repealed, thus eliminating a significant barrier to changes in ownership structures. The tax repeal affected most large shareholders in German corporations since, in addition to companies, banks, and other financial institutions that are commonly organized in corporate form, most wealthy individual and family shareholders in Germany hold their shares through intermediate corporations (La Porta, López de Silanes, and Shleifer (1999); Franks and Meyer (2001); Faccio and Lang (2002)). Indeed, the tax change gave rise to a significant reshuffling of corporate ownership structures. This exogenous shock allows us to overcome or at least mitigate concerns about the endogeneity of ownership in estimating its effect on internal capital markets.
In our paper, Who Blows the Whistle on Corporate Fraud?, which is forthcoming in the Journal of Finance, we study all reported fraud cases in large U.S. companies between 1996 and 2004 to identify the most effective mechanisms for detecting corporate fraud.
The large and numerous corporate frauds that emerged in the United States at the onset of the new millennium provoked an immediate legislative response in the Sarbanes Oxley Act (SOX). This law was predicated upon the idea that the existing institutions designed to uncover fraud had failed, and their incentives as well as their monitoring should be increased. The political imperative to act quickly prevented any empirical analysis to substantiate the law’s premises. Which actors bring corporate fraud to light? What motivates them? Did reforms target the right actors and change the situation? Can detection be improved in a more cost effective way?
It has become commonplace to hear the corporate proxy voting system described as “broken” or “dysfunctional,” yet its most fundamental defect is mostly ignored: the absence of retail investor participation. If the voters from an entire region of the country – say the Southwest – did not show up at the polls for presidential elections, most would agree that there was a problem. At the very time when shareholders are calling for greater access to the corporate proxy, it is more important than ever that proxy voting represent the views of all shareholder constituencies in rough proportion to their numbers.
Overall, the voting rate among individual investors hovers at the 20% level. Companies that mail their investors a notice that the materials are available on the internet – in lieu of mailing the all materials in paper – have seen even lower voting levels in the 5% range.
An earnout—under which a portion of a purchase price is deferred and dependent on future events—is a regularly discussed and somewhat less often implemented tool to bridge the final purchase price gap in negotiations for the sale of a business. Particularly where the disparity results from a seller and buyer holding differing expectations of future performance or the outlook for a new product or initiative, an earnout offers an appealing alternative to the typical “split the difference” compromise by tying the payment of the “disputed” portion of the purchase price to the actual outcome in the future. Dealmakers are surely aware that negotiating an earnout is never as easy as it seems; What metric should be used? How long is the earnout period? What happens if the buyer sells the business? What costs are allocated to the business? Who controls the business during the earnout period? Should there be a cap on the earnout, especially if paid in buyer shares? are but a few examples of the hard issues that need to be settled at the outset, with increased importance in cases where the earnout represents a meaningful portion of the overall consideration. In fact, many parties end up abandoning a proposed earnout before implementation when the weight of these issues—and the resulting tense negotiations—threatens to overwhelm the overall sale process. While much has been written about the intricacies of drafting and negotiating earnouts, a few recent cases highlight the sobering practical reality that the disputes often don’t end upon implementation and that earnouts frequently are mere recipes for future disagreements regardless of the time and care expended on their creation.
In our paper Local Dividend Clienteles, which is forthcoming in the Journal of Finance, we examine the role of investor demand in shaping corporate payout policy. Miller and Modigliani (1961) raise the question of whether firms set policies and investors sort accordingly, or companies respond to the preferences of their current shareholders. In this paper, we provide evidence consistent with the latter.
Specifically, we test for the effect of dividend demand on payout policy. The tendency of older investors to hold dividend-paying stocks in combination with individual investors’ inclination to hold local stocks results in stronger dividend demand for companies located in areas with many seniors. Demographics thus provide an empirical proxy for dividend demand, which we exploit in this paper to examine the broader question of whether the preferences of current owners influence corporate actions.
As predicted, we find a significant positive effect of Local Seniors, the fraction of seniors in the county in which a firm is located, on the firm’s propensity to pay dividends, its propensity to initiate dividends, and on its dividend yield. The effect of Local Seniors on the corporate decision to start paying dividends is particularly strong and of the same economic magnitude as other key determinants such as company size and age.