Recently, in the Mergers and Acquisitions course at Harvard Law School, three preeminent M&A practitioners discussed the Merger Agreement as a Contract with Vice Chancellor Leo Strine, Jr., who teaches the class. The panelists were Rick Climan, a partner in the Mergers and Acquisitions group at Dewey & LeBoeuf LLP; Faiza Saeed, a partner in the Corporate Department of Cravath, Swaine & Moore LLP; and Kim Rucker, Senior Vice President and General Counsel of Avon Products, Inc.

The panel went through the main parts of an acquisition agreement, including:

• Representations and warranties;
• Disclosure schedules (”The power is in the disclosure schedules”, remarked Kim);
• Pre-closing covenants that apply between signing and closing, including the strength of covenants and the difference between covenants and closing conditions;
• Closing conditions, the standards to which they must be met, and the risk of a deal failing to close.  Faiza gave the example of the breakdown of the General Electric-Honeywell transaction, which led to a discussion of regulatory risks and their effect on the transaction, and the consequent standards of covenants to obtain necessary consents, such as “hell-or-high-water” provisions.

…continue reading: The Merger Agreement as a Contract

(Editor’s Note: This post is a statement by the Aspen Institute Business & Society Program’s Corporate Values Strategy Group, of which John Olson is a signatory, along with 27 other business, investment, academic, & labor leaders.  The complete list of signatories is available here.)

Introduction
We believe a healthy society requires healthy and responsible companies that effectively pursue long-term goals. Yet in recent years, boards, managers, shareholders with varying agendas, and regulators, all, to one degree or another, have allowed short-term considerations to overwhelm the desirable long-term growth and sustainable profit objectives of the corporation. We believe that short-term objectives have eroded faith in corporations continuing to be the foundation of the American free enterprise system, which has been, in turn, the foundation of our economy. Restoring that faith critically requires restoring a longterm focus for boards, managers, and most particularly, shareholders—if not voluntarily, then by appropriate regulation.

A coalition has been working for several years on what business and investors can voluntarily do to address market short-termism, including the reform of executive compensation to focus on long-range value creation (See Appendix). A new administration in Washington and unprecedented public attention to business and financial markets, offer a unique opportunity for public policy recommendations in pursuit of long-term wealth creation to gain visibility, and to obtain real traction.

Others will study and recommend actions to be taken by boards, managers and regulation to restore long-term focus. The recommendations in this document, directed at influencing the behavior of shareholders, present an important step towards an integrated approach to ensuring long-term wealth creation.

Shareholder Short-Termism
The word “shareholders” evokes images of mom-and-pop investors saving for their retirement or their children’s college tuition. Individual investors do participate directly in the market, but they are mostly passive and unorganized and their role has diminished in recent years. The largest and most influential shareholders today are institutions — including pension funds, mutual funds, private investment (or “hedge”) funds, endowments and sovereign wealth funds — many of which serve as agents for the providers of capital, their ultimate investors. For example, one-third of U.S. corporate equity today is held by mutual funds and hedge funds.

The diversity of investment vehicles contributes to healthy competition and liquidity and is a strength of our capital markets. Properly incentivized institutions of different kinds can contribute to long-term wealth creation. However, the influence of money managers, mutual funds and hedge funds (and those intermediaries who provide them capital) who focus on short-term stock price performance, and/or favor high-leverage and high-risk corporate strategies designed to produce high short-term returns, present at least three problems:

• First, high rates of portfolio turnover harm ultimate investors’ returns, since the costs associated with frequent trading can significantly erode gains.
• Second, fund managers with a primary focus on short-term trading gains have little reason to care about long-term corporate performance or externalities, and so are unlikely to exercise a positive role in promoting corporate policies, including appropriate proxy voting and corporate governance policies, that are beneficial and sustainable in the long-term. Risk-taking is an essential underpinning of our capitalist system, but the consequences to the corporation, and the economy, of high-risk strategies designed exclusively to produce high returns in the short-run is evident in recent market failures.
• Third, the focus of some short-term investors on quarterly earnings and other shortterm metrics can harm the interests of shareholders seeking long-term growth and sustainable earnings, if managers and boards pursue strategies simply to satisfy those short-term investors. This, in turn, may put a corporation’s future at risk.

…continue reading: Overcoming Short-termism: A Call for A More Responsible Approach to Investment and Business Management

For those that regularly read my blog, you know I was happy to see the SEC propose a requirement that would force companies to disclose the voting totals from their shareholder meetings more timely. It has always amazed me that some companies stonewall on the vote results – it’s a poor PR move as it riles shareholders (see this example) and they have to disclose it eventually. But I imagine they do this in the hope that shareholders – and the financial press – will lose interest in the story.

The SEC proposes that disclosure be made within four business days after the end of a shareholder meeting (on a Form 8-K or a periodic report). For a contested director election, the 8-K would be due within 4 business days after the preliminary voting results are determined. The proposal begs the question as to when “preliminary voting results are ‘determined’” (i.e. trigger date). Maybe I’m missing it, but there doesn’t seem to be any exception for other types of contested matters? Anyways, if it’s a contested director election, there could be two Form 8-Ks – one within four business days after the meeting’s end based on a preliminary vote and another one within four business days of the final vote being certified.

Importance of Tabulation Process

On page 44 of the SEC’s proposing release, the SEC provides its discussion of this proposal – and a cost analysis is on page 96. Understandably, there is not a detailed discussion of the tabulation process and what’s involved. But as I wrote about in the Fall ‘08 issue of InvestorRelationships.com (it’s free; just need to input contact info) – in my interview with Carl Hagberg – the time is now for companies to rethink how they process their votes as well as who they hire to do it.

For starters, you probably want to hire only those inspectors that have a well-defined process about how they inspect – and you probably should hire only those inspectors whom you feel comfortable would pass muster under the pressures of litigation (eg. an entity that is independent – perhaps one is not your transfer agent). With the loss of broker nonvotes, we can expect closer elections and more litigation over voting results. You need to protect yourself and not rely on procedures that historically have been pretty loose.

…continue reading: Musings: SEC’s Proposal to Report Voting Results

(Editor’s note: This post is by Scott Fenn, Senior Managing Director, Proxy Governance Inc.)

The Investor Responsibility Research Center Institute and PROXY Governance Inc. recently released an in-depth analysis of the proxy voting policies and recent voting records of seven of the largest exchange-traded fund (ETF) sponsors, which account for some 94% of the ETF market. Entitled “Proxy Voting by Exchange-Traded Funds: An Analysis of ETF Voting Policies, Practices and Patterns,” the study was commissioned by the non-profit IRRC Institute and conducted by PROXY Governance.

The findings indicate a considerable variation in the voting patterns and philosophies of these funds. The key research findings are as follows:

• There appear to be significant differences in the level of detail of proxy voting guidelines utilized by ETF sponsors. The ETF sponsors in the study that relied on guidelines provided by proxy advisory firms appear to have the most detailed and comprehensive, and prescriptive, guidelines. At the other end of the spectrum, Rydex has very summary guidelines that stipulate voting with management on virtually all issues.

• There is significant variation in the voting philosophies and patterns of the largest ETF sponsors, with some funds much more likely to vote against management on both shareholder and management-sponsored proposals than other funds

• The votes by the specific funds at selected 2008 annual meetings are generally consistent with the written voting policies of those funds. Case-by-case voting policies by many funds on most issues explain much of this consistency. In a few cases, however, specific votes were cast that appear to be potentially contrary to the fund’s written voting guidelines.

• Funds that rely heavily on a proxy advisory firm for voting guidelines or to make their vote decisions tend to vote against management proposals, and in favor of shareholder proposals, more frequently than those that rely on their own guidelines.

The study covers the following seven ETF sponsors – Barclays Global Investors (iShares), State Street Global Advisors (SPDRs), Vanguard Group (Vanguard ETFs), Invesco Ltd. (PowerShares), ProFunds (ProShares), Rydex Investments (RydexShares) and WisdomTree Trust (WisdomTree ETFs). (NB: Barclay’s Plc recently announced that it would sell its Barclay’s Global Investors asset management division, the single largest ETF manager, to BlackRock, Inc.)

The full report is available here and here.

(Editor’s Note: This post is based on a client memo by Randall Guynn, Arthur Long, Annette Nazareth, Margaret Tahyar, Robert Colby, Courtenay Myers and Reena Agrawal Sahni of Davis Polk & Wardwell LLP.)

The Obama Administration is currently on the legislative leg of the regulatory reform marathon that began earlier this year with the release of its Rules of the Road and continued with its White Paper on Financial Regulatory Reform. The Obama Administration released last week its legislative text to implement many elements of the White Paper. Overall, the Administration’s proposed legislation hews closely to the White Paper, though it provides important details in a number of areas where the White Paper was more general. The proposal would expand the Federal Reserve’s powers to include those of a systemic risk regulator, and create a new interagency Financial Services Oversight Council to assist the Federal Reserve in its new mission.

No sooner had the proposed legislation been released, however, than critics began to pull apart the proposals in commentary and through counterproposals. FDIC Chairman Sheila Bair criticized aspects of the proposal to appoint the Federal Reserve as systemic risk regulator, and SEC Chairman Mary Schapiro argued that a council of federal regulators, on which the SEC would have a seat, should have enhanced authority. The House Republicans proposed their own regulatory reform legislation, which contained a number of alternative proposals, including to limit the Federal Reserve’s authority to overseeing monetary policy, to transfer all of the Federal Reserve’s current regulatory authority to a new financial institutions regulator, and to fundamentally reform Fannie Mae and Freddie Mac. House Financial Services Committee Chairman Barney Frank argued that the federal thrift charter should not be abolished, even if the OTS were merged into the OCC in the form of a new national bank supervisor.

This memorandum, The Regulatory Reform Marathon, available here, builds on the analysis in our memorandum on the White Paper, A New Foundation for Financial Regulation?, by discussing the Obama Administration’s proposed legislation and the Republican counterproposal. Specifically, the memorandum discusses the Administration’s proposals for managing systemic risk, including the revised proposal for resolution authority and the proposal to designate certain large, systemically important financial companies as Tier 1 FHCs, subject to enhanced supervision and regulation by the Federal Reserve. The memorandum also discusses the Administration’s proposal to merge the OTS and the OCC, to eliminate the thrift charter, and to expand interstate branching; to expand bank and bank holding company regulation to include holding companies of insured depository institutions that have not otherwise been regulated as bank holding companies; and to enhance standards applicable to, and restrictions on, banks and bank holding companies. The memorandum also contextualizes other proposed regulatory enhancements, including the Administration’s proposal to give the Federal Reserve additional authority over payment, clearing and settlement systems and activities; the proposed reform of the asset-backed securitization markets; and the proposal to create an Office of National Insurance within the Treasury Department.

One way to sum up the “big picture” of corporate governance in the U.S. today is as follows:

We are in the midst of a true revolution in our private enterprise economic system, much of which is being driven in the name of “corporate governance” by multiple parties with an ever-expanding agenda.

This may sound like one of those deliberately extreme statements sometimes designed to stimulate debate—but I offer it simply as a description of where things are. In fact:

• The roster of participants in the U.S. corporate governance arena today is extraordinarily large and diverse, the collective agenda of these participants is very broad, and the level of dedication of these various participants to achieving their agendas is quite high.

• The common purpose or effect of their efforts is to redesign in significant ways the publicly traded business corporation, a central instrument of U.S. capitalism.

• This redesign involves sources of capital, the role of risk-taking, the fundamental purpose of business corporations and the role of directors.

The bottom line reality is that today’s corporate governance reform movement is reshaping materially our private enterprise economic system. Moreover, inadequate attention is being paid to assessing the scope and magnitude of the changes — and the risks they present to our economy. This inattention needs to be corrected promptly, before the law of unintended consequences produces considerable harm to our economic system in the name of “corporate governance.”

Participants in the Corporate Governance Universe Today

There is no question that the ranks of the participants in the corporate governance dialogue have been steadily expanding over the past decade, and as a result of the recent financial crisis and global recession, this has significantly accelerated in the past year or so. These participants now include: (1) the SEC; (2) the NYSE and Nasdaq; (3) shareholder governance activists; (4) hedge funds/other shareholders with shortterm or special economic interests; (5) public pension funds and other institutional investors; (6) corporate governance rating services; (7) proxy advisory firms; (8) academics in various disciplines; (9) labor unions; (10) the President/White House; (11) Congress; (12) the Treasury Department; (13) the Federal Reserve System; (14) the Federal Deposit Insurance Corporation; (15) the Department of Justice; (16) state Attorneys General; (17) the media; and (18) state corporate law (legislatures and courts).

Each of these parties or groups has become an active voice of corporate governance “reform.” The growth of this universe is a clear testament to the dramatically increased visibility and importance ascribed to “corporate governance” in today’s world.

…continue reading: U.S. Corporate Governance Today: A Reshaping of Capitalism

(Editor’s Note: This post is by Andrew J. Nussbaum, William Savitt, and Ryan A. McLeod of Wachtell, Lipton, Rosen & Katz.)

In a decision that could increase the litigation risk associated with short-form mergers under 8 Del. C. § 253, the Delaware Supreme Court has ruled that where there is a breach of the duty of disclosure in connection with a short-form merger, the appropriate remedy is an automatic “quasi appraisal” action in which the minority shareholders may adopt an “opt-out” class approach and need not escrow any of the merger consideration they have already received. Berger v. Pubco Corp., No. 509, 2008 (Del. July 9, 2009).

Under Delaware’s short-form merger statute, a parent corporation that owns at least
90% of its subsidiary’s outstanding stock may summarily cash out the minority holders by the unilateral adoption of a resolution setting forth the consideration to be given. In 2001, the Supreme Court ruled that controlling stockholders owed no duty to pay a fair price in a short-form merger, and a minority stockholder’s only recourse is to seek appraisal. Consequently, the only obligation of a company effecting a short-form merger is to provide minority shareholders with all information material to the decision of whether or not to seek appraisal. Glassman v. Unocal Exploration Corp., 777 A.2d 242, 248 (Del. 2001).

The Court of Chancery in Berger found several inadequacies in the parent’s disclosure notice, including that it had failed to provide any information about the method used to determine the consideration offered. Because the merger had already been effected and consideration had already been paid, the Court of Chancery ordered a “quasi appraisal,” which would replicate a statutory appraisal action by requiring minority shareholders to “opt-in” to the proceeding and place in escrow a portion of the consideration they had already received.

Reversing, the Supreme Court held that principles of “fairness” dictated that “majority stockholders that deprive their minority shareholders of material information should forfeit their statutory right to retain the merger proceeds payable to shareholder who, if fully informed, would have elected appraisal.” Consequently, the Court held that the proper remedy for disclosure violations in a short-form merger is a quasi appraisal action on behalf of an automatic class of all minority stockholders with no escrow requirement.

Because the Supreme Court’s remedy removes the ordinary downside risks of an appraisal action and facilitates class action-style proceedings, this decision may encourage increased litigation following short-form mergers. At the same time, however, Berger reemphasizes the limited fiduciary remedies available to minority stockholders in a short-form merger, and its holding applies only in circumstances where the merger was accompanied by material disclosure violations. The decision thus serves as a useful reminder to Boards and controlling shareholders pursuing shortform mergers that appropriately complete disclosure is critical to obtaining the statutory benefits to acquirors of the Delaware short-form merger and appraisal provisions.

This post is by my colleagues James T. Rothwell, Mark M. Mendez, and Katia Brener.

In Zacharias v. SEC, the U.S. Court of Appeals for the District of Columbia Circuit affirmed an SEC order finding that two officers and directors of a public company and an unaffiliated third party engaged in a “scheme” to sell securities in violation of the registration requirement of Section 5 of the Securities Act, despite the fact that the only shares sold to the public were freely tradable shares owned by the third party. The Court’s praise of the SEC decision as “a triumph of substance over form” [1] and the reasoning of the case (as well as the result) stand in contrast to the recent decisions of three U.S. District Courts that rejected the SEC’s claims of Section 5 violations in the hedging of “PIPEs” securities. [2]

The “Swap” Transactions

Christopher Zacharias and John Carley (the “Option Holders”) were officers and directors of Starnet Communications International, Inc. (“Starnet”) and held options to purchase Starnet shares. Starnet registered the exercise of the options on Form S-8, but the registration statement did not cover resales of underlying shares. Thus, the Court stated that “[s]ales to the public of shares acquired by exercise of their options would have been illegal unless a registration statement under § 5 had been in effect” but noted that the Option Holders “did not . . . have a registration statement filed.” [3]

Separately, Alfred Peeper controlled foreign entities (the “Peeper Entities”) that held several million Starnet shares that “they could lawfully resell to the public.” [4] The Peeper Entities also held warrants to purchase several million additional shares that had not yet been exercised.

The “scheme” consisted of two transactions:

Transaction 1: The Peeper Entities sold their shares of Starnet to the public, and also exercised their warrants and sold the resulting shares to the public. It appears that absent the other facts of the combined transactions, the sale of the shares initially owned by the Peeper Entities would have been legal, and the sale of the shares issued upon exercise of the warrants “would likely have been legal as well.” [5]

Transaction 2: Shortly after these sales by the Peeper Entities, the Option Holders exercised their options and sold the underlying shares to the Peeper Entities in a private placement. [6] The number of shares the Option Holders so sold to the Peeper Entities was apparently equal to the number of shares the Peeper Entities sold in Transaction 1 (hence the SEC’s characterization of the transactions as a “swap” of the shares sold by the Peeper Entities for the shares purchased by the Peeper Entities). It appears that this sale also would not have been problematic absent
Transaction 1 – the Court explained that a “simple sale to the Peeper Entities . . . would likely have been lawful had such a sale . . . not been part of any ‘chain of transactions . . . involving any public offering.’” [7]

The apparent purpose of the two transactions was to enable the Option Holders to sell their option shares at a price that reflected little or no “liquidity discount” to the prevailing market price for freely tradable shares, without having to file a registration statement. If the Option Holders had sold their shares to a buyer who did not have other shares to sell to the public, that buyer would have paid a discounted price because the shares would be “restricted” under the Securities Act and therefore illiquid. However, the Peeper Entities (a) currently owned shares, and (b) presumably intended to remain invested (but not increase their investment) in the company for the long term. Therefore, the Peeper Entities likely cared less about liquidity than a typical investor and thus were willing to pay a price that was closer to the prevailing market price. By buying shares from the Option Holders and selling an equal number of shares to the public (albeit in reverse order in this case), the Peeper Entities maintained their level of investment in Starnet.

…continue reading: D.C. Circuit Adopts Expansive Meaning of Underwriter

(EDITOR’S UPDATE: The recent decision of the Court of Appeals for the Second Circuit in SEC v. Dorozhko further illustrates the uncertain state of the limits of insider trading. Reversing an earlier District Court decision, the Court held that while a breach of a fiduciary duty is required where the fraud is premised on silence, no such breach is required where there has been an affirmative misrepresentation. A memo by Davis Polk & Wardwell LLP, available here, discusses the decision.)

This post is by my colleagues William M. Kelly, Joseph A. Hall, Michael Kaplan, William J. Fenrich, and Janice Brunner.

On Friday, a federal district court in the Northern District of Texas dismissed the SEC’s insider trading case against Dallas Mavericks owner Mark Cuban. While the celebrity of the defendant has undoubtedly contributed to the widespread publicity of the dismissal, the real news is that the SEC has, for the moment at least, lost a case on what might seem to have been slam-dunk facts:

What’s missing here? Mr. Cuban, abetted by a group of law professor amici, argued that Rule 10b-5 liability requires a fiduciary or fiduciary-like relationship with the provider of the information, and that a mere agreement cannot provide a basis for liability. The court rejected this view, but it also rejected the SEC’s long-held view, reflected in its adoption of Regulation FD and Rule 10b5-2, that third parties who accept material nonpublic information from a company on a confidential basis are precluded from trading on the information. The court held that Mr. Cuban’s oral agreement to maintain confidentiality, without an agreement not to trade, was not enough.

What does this decision mean for potential providers and recipients of material nonpublic information?

For providers—for example, companies interested in sharing information with potential investors or acquirers—the case says that if you want the recipient not to trade, you had better be specific. The safest approach, of course, is to seek a written contractual standstill from recipients. But agreements of this sort are often difficult to get parties to agree to, especially where, as in this case, the recipient would be asked to sign the agreement “blind”, without knowing the nature of the information. As a practical matter, providers may have to content themselves with a “sole use” provision, along the lines of “recipient agrees to use the information solely for the purpose of considering an investment”. Had such a provision been in place, the result in this case might well have been different.

For recipients of material nonpublic information, our advice is not to rely on this decision. The case was decided at the trial court level, is not binding on other courts, and the SEC has been given the right to file an amended complaint. Whether or not the SEC chooses to replead the case or to appeal the decision, we are certain that it will not accept the case as the final word and will continue to seek enforcement action on facts like these. Thus, while the decision will provide comfort to parties who have to defend themselves for what they have done, we would not use it as a basis for deciding what you should do. The prudent judgment continues to be that if you have agreed to keep information confidential, you should not use it as a basis for trading.

Lastly, the case highlights the curious fact that, 75 years after the enactment of the Securities Exchange Act and the creation of the SEC, and after decades of judicial exegesis of the Delphic text of Section 10(b), we still don’t quite know when insider trading is illegal.

See S.E.C. v. Cuban, No. 3:08-CV-2050-D (N.D. Tex. July 17, 2009)

(Editor’s Note: This post is based on a client memo by Martin Lipton and Ted Mirvis of Wachtell, Lipton, Rosen & Katz.)

Since the apex of the economic crisis last year, American companies have been buried in an avalanche of corporate governance initiatives designed to increase the power of fund managers to dictate corporate policies to boards of directors. Unfortunately, few, if any, of the proposals focus on what must be the overriding objective of corporate governance—encouraging long-term economic growth: the type of growth that is achieved without risking the environment or the financial system; the type of growth that creates and maintains full employment; the type of growth that creates affordable housing, healthcare and education for all.

The evidence is irrefutable that the pressure for short-term performance and quick stock market profits were prime factors in causing the economic crisis. Indeed, President Obama has said that compensation practices tied to short-term performance were responsible for “a reckless culture and a quarter-by-quarter mentality that in turn wrought havoc in our financial system.”

It is critical that we recognize that short-termism encourages excessive risk and diversion from the long-term planning essential to sustainable economic growth and that we use this insight to critically evaluate the entire range of corporate governance initiatives that are now on the table. There is no reason to embrace a plethora of ill-conceived federal regulation and legislation that usurps the traditional role of state law and thereby overturn the fundamental legal doctrines that have formed the bedrock of history’s most successful economic system. The engine of true economic growth will always be the informed business judgment of directors and managers, and not the hunger of short-term oriented shareholders for quick profits.

Particularly at a time of depressed stock market valuations and the resulting danger of opportunistic attacks to bust up or takeover American companies, directors and managers must remain free to invest in the future and take the long-term view, so as to ensure prosperity for future generations. To the same extent that we need to avoid legislative and regulatory actions that would undermine the ability of companies to achieve long-term growth, the courts should continue to recognize the prerogative of directors to plan for and achieve long-term value for the company and its stockholders, protected against short-termist pressure from any source and especially from the unintended consequence of proposed “reforms” (such as shareholder proxy access) that are not appropriately defined and contained. In particular, the right of a well-informed board of directors to “Just Say No” to a takeover bid remains a critical deterrent to short-termism. Under the Business Judgment Rule, directors must remain unfettered in their ability to engage in long-term planning and investment.