With the advent of mandatory “say on pay” votes this year for all public companies as required by the Dodd-Frank Act, institutional shareholders must consider not only whether to support a company’s executive compensation arrangements, but also, more broadly, how to ensure that their decision-making process will take into account the particular circumstances of the company, the impact that a negative vote could have on the company, the institutional shareholder’s fiduciary and other duties to its own investors, and the extent to which voting decisions should be dictated or influenced by recommendations of proxy advisory firms. In this regard, institutional shareholders may find it useful to bear in mind the following questions:
Archive for May, 2011
In the paper, The Power to Issue Stock, recently made publicly available on SSRN, I study the new but increasingly common practice of target management granting top-up options to bidders. The paper analyzes the mechanics and recent case law involving top-up options, as well as the more general implications of managers’ substantial power to issue stock.
A top-up option is given by a target to a bidder to reduce judicial scrutiny of the planned acquisition. Once the bidder succeeds in getting at least 51% of the shares, the bidder exercises the top-up option and is issued enough shares to bring its holdings up to 90%. At that point, the bidder can proceed with a short-form merger, freezing out dissenting shareholders. The bidder must offer all of the shareholders the same price at the tender offer, as required by federal regulations, and usually undertakes, as part of the top-up option agreement, to pay the same price also to the dissenters at the back-end squeeze-out to prevent judicial scrutiny for a potentially structurally coercive offer. The price that will convince holders of 51% of the shares to tender, however, may well be substantially lower than the price needed to cause the holders of 90% of the shares to sell. Dissenters’ only recourse is appraisal, which many believe is a weak form of protection.
In Broken Promises: Private Equity Bidding Behavior and the Value of Reputation, a paper recently made public on the SSRN, we examine the relation between reputation and financial contracting.
Beginning in August 2007, a number of private equity (PE) firms attempted to strategically default on pending acquisitions of publicly-traded targets. These attempts succeeded in a number of notable instances. We document that bidder-initiated terminations accounted for over $168 billion of transaction values announced in 2007 alone, representing an economically sizeable 39% of total announced private equity bids in 2007.
The large number of defaults represented a collapse of the prior relationship between the PE industry and targets. Prior to this wave of contract terminations, a promise between a private equity partner and target management set in motion a tacit relationship based primarily on trust and reputation but not contract. An unwritten rule held that private equity firms do not back out of their arrangements to acquire takeover targets despite the ability to do so under their formal contractual agreements. In other words, the private equity relationship with a target was one in which reputation played an important role. The trade-off between reputation and buyout losses reached a tipping point in 2007-2008 as many financial sponsors faced potential losses in the $billions on their bids for target firms of declining value. The extreme circumstances faced in the recent financial crisis thus provide a natural experiment to examine PE bidding behavior in relation to the value of reputation and contract design.
It would be natural to start this 2011 Foreword with a précis of the many dramatic regulatory developments newly affecting directors of publicly traded corporations beginning in 2011. Those changes, are, in fact, important to review and are summarized below. But with so much attention understandably focused on external requirements and pressures, it might be better to start first with a less highlighted and yet more central topic — namely, you, the director.
At the end of the day, the recent reforms deservedly catch headlines because they shift or channel some of the regulatory tides buffeting governance activity. But at the beginning of each day, the ability of the board to address those issues while running a successful business depends on you and your fellow directors. This suggests that we begin with recent developments concerning how you inform yourself as a director, how you deal with hidden burdens of the directorship, and how, as this Handbook describes in detail, you undertake the collectivity of tasks and human interactions, practices and rituals that together comprise what I call the anthropology of the boardroom.
In our paper, Is the Board Neutrality Rule Trivial? Amnesia About Corporate Law in European Takeover Regulation, which was recently made publicly available on SSRN, we suggest that there are two axes upon which we can assess the significance or triviality of the adoption of a board neutrality rule in European Union Member States. The first axis is the extent to which a Member States’ adoption of an unqualified board neutrality rule makes a consequential difference to the ability of boards to fashion and deploy defenses without requesting shareholder approval to do so: without a board neutrality rule does corporate law provide the tools to boards to construct defenses, and does it allow them to be used without restraint? If one emerges with a positive response from the analysis of these questions, the second axis comes into play, namely, the potency of such available defenses. There are two elements that structure defense potency: the first depends upon the nature of the defense itself – an asset sale, for example, is significantly less potent than a poison pill; the second element is the background corporate governance rules such as rules on director removal and the calling of shareholder meetings that enable or restrain the defenses’ deployment for non-corporate/non-shareholder value purposes.
In my paper, The Plight of the Individual Investor in Securities Class Actions, forthcoming in the Northwestern University Law Review, I offer a reassessment of both federal and Delaware law favoring the selection of institutional investors as lead plaintiffs in securities or transactional class actions. While it is clear that institutional investor lead plaintiffs have brought numerous benefits to class members, their influence has also marginalized the interests of individual investors. I identify four persistent sources of conflict between institutional and individual investors. These include derivatives trading, corporate governance reform, conflicts between selling and holding plaintiffs, and, in the transactional context, conflicts created when institutional investors own a stake in both target and bidder companies. I argue that in many instances, these conflicts render institutional lead plaintiffs atypical and inadequate class representatives, in contravention of the requirements of Fed. R. Civ. P. 23 and its state equivalents. To allay these concerns, I suggest that the optimal solution is for courts to appoint representative individuals as co-lead plaintiffs with the presumptive institutional lead plaintiffs.
In our paper, Mandatory IFRS Adoption and Financial Statement Comparability, which was recently made publicly available on SSRN, we examine the effect of mandatory IFRS adoption on financial statement comparability. To isolate the effects of comparability, we use firms domiciled in the UK as our setting. Prior academic and practitioner research argues that UK domestic standards are similar to those under IFRS. Thus, any effects of changing to IFRS for UK firms are more likely driven by changes in comparability of financial statements (such as between UK firms and non-UK firms) versus changes in information quality. To proxy for changes in the information environment, we use two measures: abnormal returns to insider purchases of stock, and abnormal returns to analyst recommendation upgrades. Both insiders and analysts represent sophisticated users likely to possess private information regarding the firm. If IFRS reduces private information by enhancing the comparability of financial statements, we predict that abnormal returns to insider purchases and analyst recommendation upgrades will be reduced following mandatory IFRS adoption in the UK. Empirical results are consistent with these expectations. We find that abnormal returns to both insider purchases as well as analyst recommendation upgrades decrease following IFRS adoption. These findings occur in univariate and multivariate analyses, and across 1-month, 3-month, and 6-month return windows.
The most important development this proxy season has been the new requirement under Dodd-Frank that all public companies hold an advisory “say on pay” vote. The following are our observations on “say on pay” thus far this proxy season.
Results of General Vote. As of May 6, 2011, all but 15 of the 807 companies that have reported results with respect to their say on pay votes have received favorable votes, with over 2/3 of companies receiving more than 90 percent favorable votes.
Influence of Proxy Advisory Firms. The recommendations of Institutional Shareholder Services (ISS) have had a measurable impact on voting results. ISS has recommended against say on pay proposals at approximately 12 percent of companies holding such votes. Of companies receiving unfavorable vote recommendations from ISS, 11 out of 60 that reported results as of April 29, 2011 failed to receive majority support. Companies receiving negative ISS recommendations that have nonetheless passed have generally done so with considerably lower margins than those receiving favorable vote recommendations. No company receiving a positive recommendation from ISS has failed to receive a majority support.
The influence of Glass Lewis, the other major proxy advisory firm, appears thus far to have been minimal. Glass Lewis has recommended against a strikingly high percentage of companies, and perhaps for this reason, has influenced voting results by approximately three percent or less. In our experience, many companies have determined not to address directly criticisms raised by Glass Lewis.
In our paper, Employee Stock Ownership Plans: Employee Compensation and Firm Value, which was recently made publicly available on SSRN, we investigate whether adopting a broad-based employee stock ownership plan enhances productivity by improving team incentives and co-monitoring. That is, does employee capitalism work? If so, how are gains divided between shareholders and employees?
We find that small ESOPs increase productivity. Unlike Jones and Kato (1995) on Japanese ESOPs, our evidence of productivity gains is based on the effects on two main beneficiaries of such gains: employees and shareholders. Because our evidence indicates both stakeholders gain from adopting small ESOPs, we infer employee share ownership increases the size of the economic pie by improving worker productivity.
This causal interpretation is substantiated by our evidence on how the division of productivity gains is related to employee mobility within an establishment’s industry and location of work place. We find that when labor mobility increases, increasing workers’ bargaining power vis-à-vis shareholders’, employees’ share of gains increases and stockholders’ share decreases.
With the seeming full return of the public M&A market, we thought it was an opportune moment to reflect briefly on a number of recent trends in deal terms. The non-exhaustive list below is intended more as an observation rather than an analysis or judgment on the propriety of any of the terms. Some of the trends are fully developed, while others are nascent; either way, dealmakers should be aware of these market developments as they consider their upcoming deals:
- 1. Deal Certainty — As we argued 18 months ago, the unexpected developments in deal certainty provisions for strategic and financial buyers in the immediate aftermath of the credit crisis did not represent a new “market” or “deal paradigm” but rather reflected a more thoughtful and nuanced approach to issues of certainty of closing in light of market conditions. While we have continued to see a blurring of some of the techniques from the pre-crash poles of full specific performance (strategic acquirers) and full optionality for a small reverse termination fee (financial buyers), recent evidence has shown a continuing shift towards a return to the traditional bifurcated deal certainty models described above depending on the identity of the buyer. Again, we believe this reflects economic conditions, particularly in the credit markets, with strategic buyers increasingly willing to offer greater certainty because of renewed confidence in the staying power of the current favorable liquidity environment and sellers willing to accept the inherent optionality in the private equity buyer model, relying on the buoyancy of the debt markets and more sizable reverse termination fees to impose economic discipline on a wavering financial buyer.