This week we bring you the second interview our “The Altman Interview” series where we speak with top experts and thought-leaders having an impact on corporate governance. Our interview with attorney Holly J. Gregory covers 10 questions on hot button issues for 2010.

Ms. Gregory is a well-known and highly respected figure in the world of corporate governance. As a partner at Weil, Gotshal & Manges, Ms. Gregory counsels corporate directors, executives and investors on the full range of governance issues and best practices. She played a key role in drafting the OECD Principles of Corporate Governance and advised the Internal Market Directorate of the European Commission on corporate governance regulation. Ms. Gregory has also served as an advisor to the World Bank and the joint OECD/World Bank Global Corporate Governance Forum on governance policy for developing and emerging markets.

In addition to her legal practice, Ms. Gregory has helped organize governance-related programs for the SEC, OECD, World Bank, Yale’s Millstein Center for Corporate Governance and Performance, Transparency International and Columbia University School of Law’s Institutional Investor Project.

Question 1

FH Byrd: Of all the proposed governance changes on the horizon which one, in your opinion, if adopted, will have the most impact on corporations?

Holly Gregory: This is difficult to predict given the number and range of governance reform proposals under discussion and the fact that if implemented the reforms will interact with recent rule changes concerning broker voting in the election of directors and new SEC rule interpretations that broaden shareholder power to bring advisory proposals on matters of CEO succession and risk oversight. But if I must identify one reform that threatens to work fundamental change, it is the grant to certain shareholders of direct access to the proxy for the nomination of competing candidates for director. Proxy access removes the gating mechanism of cost from a shareholder’s decision to put forward candidates to compete for board seats with the slate proposed by the board. Certain large shareholders or groups of shareholders who have held their stock for a year will be able to include their own candidates for up to 25% of the board in the company’s proxy at company expense. Greatly reducing the cost of mounting a campaign to elect a director outside of the board’s own proposed slate is designed to result in more contests for board seats. According to proponents, this is necessary to make directors more accountable to shareholders. What we will have to see play out is whether more frequent contests for board seats results in positive gains from heightened accountability. Some believe that boards are already under an unhealthy degree of shareholder pressure for immediate and ever rising share price gains. (See “Overcoming Short-termism”). Increasing the threat of election contests is not likely to reduce those pressures and improve board focus on the long-term performance that is essential to sustainable economic growth. This is especially so given the increasing number of elections that are held on an annual basis (and Senator Schumer has introduced a bill in Congress that would mandate annual elections for all directors by prohibiting staggered boards). Commentary to the SEC on the proxy access rule proposal has raised legitimate concerns about the impact of proxy access on the quality of board composition, the tenor of board deliberations and the board’s ability to reach consensus after full and constructive debate. The potential for more frequent director contests may discourage busy executives at the tops of their fields from serving on boards, and greater director turnover may undermine the quality of board decisions. New directors need time to develop the company-specific knowledge required for effective decision making. Time is also needed to develop the trust among directors that allows robust discussion, constructive debate and healthy disagreement to be followed by resolution and consensus. Greater director turnover may make it more challenging for boards to develop the appropriate culture of objectivity and constructive criticism that are the hallmarks of effective oversight of management. I hope that it will turn out that these concerns are overstated or unfounded.

Question 2

FH Byrd: Of the various stakeholders involved in U.S. corporate governance, who do you think will most likely benefit from proxy access, if adopted?

Holly Gregory: If the concerns that I’ve described are realized, proxy access will not be the panacea that the regulators intend, and shareholders as a whole will not be better off. In that scenario the primary beneficiaries will be shareholders who use proxy access to forward a specific objective or strategy that is not broadly shared by the entire shareholding body. Shareholders can no longer be thought of as powerless individuals with a common interest in corporate long-term performance that overrides other interests. The percentage of shares in the hands of institutional investors has grown considerably over the last 25 years, and these institutions and their interests are as diverse as the institutions are powerful. Public, private and union pension funds, mutual funds, private investment funds (including hedge funds), insurance companies, banks, endowments, and sovereign wealth funds are subject to varying levels of regulation, have distinct investment horizons and strategies, and exhibit varying levels of interest in the governance of portfolio companies. (What many institutions tend to have in common is their status as investment intermediaries who invest for the benefit of others and as a result face potential conflicts in managing fund assets.) Increasing diversity among shareholders brings with it heightened potential for divergent interests; this suggests a need for greater shareholder power to be accompanied with requirements for great transparency about the motives and interests of the shareholders who seek to exert the power.

Question 3

FH Byrd: With the likelihood of some form of Say on Pay, how do you think corporations should be preparing?

Holly Gregory: Corporations should be reassessing how they engage with their shareholders. It is important for boards and managers to understand who their shareholders are and what issues are important to them. In a say on pay and proxy access world, the ability to communicate clearly and effectively with shareholders about strategies and objectives — and specifically about how compensation plans are designed to create incentives for achieving strategic objectives — will differentiate companies and be associated with greater levels of “investor peace” and board and management stability. This is the time for boards and management teams to be gearing up and thinking about shareholder relations in new, more creative and more engaged ways. Improved engagement with shareholders is the best hope companies have of avoiding or mitigating the concerns addressed in my answers to the preceding questions.

Question 4

FH Byrd: With the loss of the broker vote, do you feel there will be more “vote no campaigns” in 2010?

Holly Gregory: Whether or not we see a rise in the number of “vote no campaigns” in 2010, it is a fair prediction that such campaigns will be more successful in a world in which brokers are not allowed to vote uninstructed shares in the election of directors.

Question 5

FH Byrd: Do you think HealthSouth’s decision to allow reimbursement of proxy contest expenses for dissidents (earning 40% or more of the vote) will lead other boards/companies to take similar action?

Holly Gregory: This kind of “private ordering” has significant value because it reflects board judgment about how to accommodate legitimate shareholder concerns in a company specific manner. Encouraging companies and shareholders to reach their own solutions is far preferable to the imposition of strict mandates. Recent approaches to say on pay by Microsoft (which will now give shareholders an advisory vote on executive compensation every three years) and Prudential ( say on pay every two years) further reflect the private ordering approach, and provide examples of how these concepts can be distinctly tailored. If companies believed that adopting reimbursement provisions would satisfy the SEC as a replacement for mandated proxy access, I predict many companies would seriously consider adopting it.

Question 6

FH Byrd: Excise tax gross-ups received a lot of attention in 2009, primarily due to RiskMetrics taking a harder stance on them. Do you think there are any other pay practices that corporations should be leery of?

Holly Gregory: Compensation committees and boards need to develop greater understanding of and sensitivity to the concerns about executive compensation that have resulted in such intense popular and political backlash. Many of these issues are not new, but at times boards and managements have exhibited tone-deafness or an unwillingness to set forth in plain and rational terms the legitimate justifications for certain pay practices. It is no longer enough to simply cite competition and retention concerns to justify large packages and grants.

Question 7

FH Byrd: Senator Schumer’s legislation proposes mandatory risk committees for U.S. corporations. Should boards be getting in front of this by establishing risk committees or reviewing their present risk mitigation and oversight structure?

Holly Gregory: The idea that independent risk committees of the board should be mandated for every public company is one reform idea that simply defies logic. Risk committees may provide efficient oversight structures for some boards but there is no reason to think that they are a universal solution. Only about 7% of public companies currently have risk committees — and the industry in which they are most prevalent is financial services. There is no evidence that I’m aware of to show that financial services companies are better than other companies with respect to risk management or the oversight of risk management. Indeed, the anecdotal evidence appears to draw into question the ability of the financial services industry to manage certain risks. So it is difficult to understand why the committee structure relied on in that industry should be mandated for all other public companies. Undoubtedly boards need to spend considerable energy and attention on understanding risk and the processes management has in place to identify and manage risk, since this is fundamental to the board’s ability to provide strategic guidance. The National Association of Corporate Directors’ recent Blue Ribbon Commission Report on Risk Governance: Balancing Risk and Reward, reflects a private sector effort to raise the level of understanding among directors about their responsibilities for risk oversight. In all of this, however, I think it is especially important that we recognize the growing gap between expectations about what boards can do and the reality of their limitations. Boards are neither positioned nor expected by the law to identify company-specific risks that executives have missed, let alone system-wide risks that regulators and central banks have missed.

Question 8

FH Byrd: In this environment of changing shareholder influence and pending reforms, do you have any concerns that companies considering adopting a majority voting standard may be voluntarily impeding the ability to have their directors elected?

Holly Gregory: The majority of S&P 500 companies have already adopted some form of majority voting, whether through actual charter or bylaw amendments or policies that require directors to tender their resignations if they fail to receive more “for” votes than “withhold” votes. There is a certain amount of nervousness about how all the reforms will play out in a majority vote system, and it appears that the momentum for companies to adopt majority voting has slowed. I think many companies are now adopting a “wait and see” posture given the high level of uncertainty in the current regulatory and legislative reform environment.

Question 9

FH Byrd: There has been a recent uptick in the amount of criticism leveled at proxy advisory firms, in particular RiskMetrics. Do you feel this criticism is well-founded?

Holly Gregory: There are legitimate concerns about the power of certain of the proxy advisory firms and about their capacity to provide the kind of nuanced company-specific analysis that will only become more important to our economic system as shareholders gain power. As shareholders gain influence on the actual composition of boards, the recommendations that proxy advisors make about voting in director elections gain importance. In particular, the propensity of certain proxy advisors to recommend against directors for any single item on a long list of one-size-fits-all governance no-no’s, rather than on a broader view of the director’s skills and qualifications and contributions, needs to be adjusted in the new world of heightened shareholder influence. Director elections will be too important to use as vehicles to protest what in the scheme of things are often relatively minor decisions the board makes about how it can best govern.

Question 10

FH Byrd: You recently chaired an ABA Task Force on the distinct shareholder and board roles. Will the reforms on the table change the roles of shareholders and boards in any meaningful way?

Holly Gregory: I think that the reform proposals if enacted in whole certainly will increase shareholder power, and will change the balance of shareholder and board power. Whether the roles change in meaningful ways will depend on how shareholders use their new power in the real world and how their use of their power interacts with other forces (such as the power of proxy advisors and their propensity to recommend protest votes against directors). At the extreme, we may see directors coerced to abandon their own judgment in certain circumstances to buy peace with a small but powerful and vocal set of shareholders. That would be unfortunate. As our Task Force Report emphasized, there is value to our economic system in allocating to boards the power and discretion to manage and direct the affairs of the corporation, while enabling shareholders to participate as passive investors with the benefit of limited liability for the actions of the corporation and the ability to freely enter and exit from their investments.

Francis H. Byrd is Managing Director and Corporate Governance Advisory Practice Co-Leader at The Altman Group

Securities analysts play a key role in securities markets, and publicly held companies as a matter of market practice regularly brief them to help them understand company results and business trends. There have been some unfortunate instances, however, in which analysts have received nonpublic information on which their clients have acted before the information was disclosed to the general public. In the wake of these cases, as well as Enron and the unanticipated and significant decline in the financial position of other public companies, the role of the securities analyst was scrutinized by Congress, the Securities and Exchange Commission (the “SEC”), state regulators and various self-regulatory organizations. The result was a heightened campaign against selective disclosure, facilitated by the SEC’s adoption of Regulation FD (Fair Disclosure) in 2000.

Although the number of Regulation FD cases has diminished in recent years, this is perhaps because compliance has become deeply ingrained in market participants. Nonetheless, given the potential for SEC enforcement action, as well as insider trading litigation, ongoing vigilance in this domain is certainly warranted. A memorandum prepared by Cleary, Gottlieb, Steen & Hamilton LLP (available here) sets out guidelines for communications between management and securities analysts in light of applicable case law and the SEC’s Regulation FD. A summary of the guidelines is included below.

The U.S. rules governing disclosure to analysts by issuers originally emerged from case law construing a basic antifraud rule, Rule 10b-5 under the Securities Exchange Act of 1934 (the “Exchange Act”). As a result, the rules are not straightforward, are at times ambiguous and, in any event, have not been applied, with one known exception, to communications between issuers and analysts. This situation led the SEC to adopt a new disclosure regime, Regulation FD, to prevent material nonpublic information from being given selectively to market professionals (broker-dealers, investment advisers and managers, and investment companies), who could use such information to their own or their clients’ advantage. Regulation FD applies to communications on behalf of the issuer with market professionals and with securityholders who may foreseeably trade on the basis of the disclosed information. Although Regulation FD does not apply to foreign issuers, they too should avoid selective disclosure of material nonpublic information both as a matter of best practice and to avoid potential liability. Ill-considered disclosure can lead to liability both for the company and for its management personally under Rule 10b-5, raise potential issues regarding correcting or updating information and have adverse market consequences.

The U.S. Supreme Court has established that there must be a breach of a fiduciary duty or other relationship of trust and confidence, or a misappropriation of information received in violation of such a relationship, before tipping or trading on the basis of material nonpublic information results in a violation of Rule 10b-5. This has led to three general principles with respect to the disclosure of corporate information to securities analysts and the public. First, Rule 10b-5 by itself does not normally require management to disclose material nonpublic information regarding the company to the investment community. Subject to certain exceptions discussed below, the timing of such disclosure is ordinarily left to the business judgment of management. Second, if a company does disclose corporate information (whether voluntarily or otherwise), Rule 10b-5 requires that those disclosures neither contain misleading statements of material information nor omit material facts necessary to make the statements made not misleading. Third, when divulging material nonpublic information, company officials may not disclose it selectively—e.g., exclusively to securities analysts—but rather must make the information available to the general public, if those officials could be found to have gained a personal benefit from the selective disclosure. Selective disclosure can lead to liability for the company and for company officials themselves for insider trading by persons receiving the disclosure. Although Rule 10b-5 might not require dissemination of material information, the New York Stock Exchange (the “NYSE”) and the NASDAQ Stock Market (“Nasdaq”) require listed companies to disclose material information promptly to the public through any Regulation FD-compliant method of disclosure, except under certain limited circumstances.

In addition, listed companies may be required to notify the NYSE or Nasdaq of the release of any such information prior to its release to the public. NYSE and Nasdaq rules, however, do not have the force of law and cannot be the basis for an implied private right of action. The Second Circuit held in State Teachers Retirement Board v. Fluor Corp. that no private right of action exists for a violation of the NYSE Listed Company Manual’s disclosure rules. The court reasoned that, given the extensive regulation in this area by Congress and the SEC, “a federal claim for violation of the [NYSE’s Listed] Company Manual rules regarding disclosure of corporate news cannot be inferred.”

In addition to annual reports on Form 10-K and quarterly reports on Form 10-Q, a domestic issuer subject to Exchange Act reporting must file current reports on Form 8-K with the SEC to disclose certain specified events. In many cases, disclosure is required within four business days of an event’s occurrence. For a foreign private issuer, Form 6-K requires submission to the SEC of all significant information that (i) must be made public under local law in the issuer’s country of incorporation or domicile, (ii) is filed with any foreign stock exchange on which the issuer’s securities are listed and made public by such exchange or (iii) is distributed to the issuer’s securityholders. Finally, when preparing disclosure responsive to the SEC’s Exchange Act reporting requirements, companies should be mindful of Rule 12b-20, which requires inclusion of any information beyond what is expressly required “as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading.” The SEC has brought enforcement actions for violating Rule 12b-20 even in the context of Form 6-K filings, where there are no express disclosure requirements.

Management should be very careful in its communications with securities analysts. Under certain circumstances, the disclosure of material information selectively to analysts can violate Rule 10b-5 and thereby generate both SEC sanctions and liability for damages to investors. Pursuant to the tests courts have fashioned to determine “materiality,” company officials should be wary of disclosing to analysts, but not to the public generally, any information (such as earnings information) that might affect the company’s share price or that a reasonable investor would deem important in deciding whether to buy or sell company securities.

Furthermore, companies should take precautionary measures in advance to avoid selective disclosure. Prophylactic procedures include the scripting of presentations to analysts, the pre-meeting review of the proposed presentation by counsel and officials familiar with the issues to be discussed and a debriefing of the officials after the presentation to verify that no material nonpublic information has been disclosed, as well as a limitation on the number of company officials responsible for giving such presentations. Management should also consider maintaining a “no comment” position if it wants any particular issue to remain confidential. Finally, less formal communications with analysts should also be conducted in accordance with procedures designed to minimize inadvertent disclosure of material information and to provide the company with evidence to defend potential allegations of intentional selective disclosure. When a domestic company discloses material nonpublic information to analysts or other market professionals, or to its securityholders when it is reasonably foreseeable they will trade, the disclosure regime established by Regulation FD requires that the company must make the disclosure broadly to the investing public too. Although Regulation FD does not apply to foreign issuers, foreign issuers should continue to take into account best practices and avoid selective disclosure of material nonpublic information out of concern for potential liability under Rule 10b-5.

Regulation FD requires that if material nonpublic information is inadvertently disclosed to analysts or others to whom selective disclosure is restricted by the regulation, the company must promptly (and, in any event, generally within 24 hours) make public disclosure of that information. Public disclosure for purposes of Regulation FD can be made by filing or furnishing a Form 8-K or by disseminating the information through a method or combination of methods that is “reasonably designed to provide broad, non-exclusionary distribution of the information to the public,” such as a press release. The NYSE and Nasdaq also require listed companies to disclose material information promptly to the public through any Regulation FD-compliant method of disclosure. In addition, listed companies must notify the NYSE or Nasdaq of any such information prior to its release to the public in certain circumstances. Management should also avoid participating to a significant extent in the preparation of analysts’ reports to minimize potential 10b-5 liability. Specifically, company officials should not “entangle” themselves with the creation of such reports to the extent that the information they contain can be attributed to the company. Accordingly, any participation by the company should be limited to reviewing the report for factual accuracy (which is all a U.S.-based analyst is permitted by applicable SRO rules to request), with care being taken in any event not to comment on any forecasts or other judgmental statements made by the analyst. Similarly, a policy of not commenting on analysts’ projections can prevent the company from being required to correct or verify market rumors on the grounds that such rumors cannot be attributed to the company.

While Rule 10b-5 liability can arise from selective disclosure of accurate information, it is important to note that liability can also attach if such disclosure, made selectively to analysts or generally to the public, contains a materially misleading statement or omits a material fact necessary to make the statement made not misleading. Even if a company’s statement is accurate when made, if intervening events render the disclosure materially misleading, management may have a duty to update the prior comment. Finally, management should institute a process for identifying all non-GAAP financial measures contained in any public disclosure by the company, accompanying that disclosure with the most directly comparable GAAP financial measure and quantitative reconciliation of the two measures. To minimize the impact of these rules on public presentations of non-GAAP financial measures disclosed orally, telephonically, by webcast or broadcast, or by similar means, the company should also consider maintaining a reconciliation of these non-GAAP financial measures, for at least a 12-month period, on its website under the section dedicated to investor relations and set forth the location of the website in the public presentation in which the non-GAAP financial measure is used. In particular, for information disclosed in conjunction with the company’s earnings conference call, management should furnish the earnings press release to the SEC under Item 2.02 of Form 8-K before the conference call, include a statement identifying where the call will be archived on the company’s website and distribute the announcement through a widely
circulated news or wire service.

Guidelines for Communications with Analysts

• 1. Designate one company executive to communicate with analysts.
• 2. Make each presentation to analysts on the basis of a prepared text that has been reviewed by senior executives and by counsel.
• 3. Do not disclose material nonpublic information to analysts unless you disclose the information to the public at the same time; this can be done by permitting the public, on reasonable advance notice, to participate in any call with analysts during which material nonpublic information may be discussed.
• 4. Refrain from responding to analysts’ inquiries in a nonpublic forum unless you are certain that the response does not include material nonpublic information.
• 5. If you are asked about a matter that is not ripe for disclosure, simply say “no comment.”
• 6. If requested by an analyst to review a research report, do not comment except to correct errors of fact. Do not comment in any way on an analyst’s forecasts or judgments, including by saying you are “comfortable” with them, that they are “in the ballpark” or other words to similar effect. Do not distribute analysts’ reports or hyperlink to them on the company’s website.
• 7. Avoid favoring one analyst over another.
• 8. Review public statements to identify any non-GAAP financial measures. If disclosure contains non-GAAP financial measures, include a presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP and a quantitative reconciliation of the two measures. To avoid reconciliation of non-GAAP financial measures in public presentations given orally, telephonically, by webcast or broadcast, or by similar means, provide the most directly comparably GAAP financial measure and the required reconciliation on the company’s website and include the location of the website in the presentation. If materials distributed (electronically or in hard copy) during a public presentation contain non-GAAP financial measures, provide the most directly comparable GAAP measures and provide the required reconciliations in close proximity to the non-GAAP financial measures.
• 9. Do not make specific forward-looking statements, unless (a) you set out the assumptions on which the forecast is based, (b) you indicate the factors that could prevent the forecast from being realized, (c) you make the statements to the public at the same time and (d) you are always prepared to evaluate the need to update the statement when circumstances change. The steps contemplated by (a) and (b) can be effected by referring to a filed document that contains the relevant information.

Edward F. Greene is a partner at Cleary Gottlieb Steen & Hamilton LLP where he specializes in corporate law matters.

Policy Drivers in the Current Environment — As public companies, Boards and Compensation Committees begin to make year-end 2009 compensation decisions, draft proxies for their 2010 shareholder meetings and design 2010 executive compensation plans, they face many challenges caused by the uncertain economic environment, limited visibility for future business prospects, public anger over executive compensation and increased activity by proxy advisors, institutional shareholders and corporate activists, as well as looming legislative and regulatory changes aimed at executive compensation and related corporate governance.

TARP Participants and Banks — The more than 300 TARP participants are dealing with stringent new compensation limits imposed by Kenneth Feinberg, the Special Master for TARP Executive Compensation. All banks regulated by the Federal Reserve (the Fed) will be required to review their incentive compensation arrangements and governance processes relative to risk under the Fed’s unprecedented pay guidelines and review policies.

Other Companies — For companies outside of TARP and the financial sector, thankfully there is now a lull in the storm over executive compensation which gives them an opportunity to survey the scene and take deliberate steps to review compensation programs and improve governance processes heading into 2010 and also plan for the likely “say on pay” vote in 2011.

To prepare for these changes, all companies must first understand the current status of legislative and regulatory developments, the prospects for more changes and the 2009 activities of proxy advisors and institutional shareholders. Companies then need to address these developments and challenges in making their year-end decisions.

The following are important questions and summary answers on these matters, as previously covered in a recent Latham & Watkins webcast, Kicking Off the 2009 Executive Compensation Season: A Real-time Discussion of Critical Issues and Looming Legislative and Regulatory Changes. To view the webcast, download it as a podcast and download additional materials, please click here or go to www.lw.com and visit the Webcast and Podcast archive under the Resources menu.

Special thanks to Roger Brossy and Blair Jones of Semler Brossy for participating in our Webcast and contributing to this Client Alert.

Here are the questions we are hearing since the webcast; our answers follow. We hope that they are helpful to you.

The Questions

1. What are the major corporate governance reforms that will affect executive compensation practices in the current environment and beyond?

2. What are the major legislative and regulatory drivers aimed directly at executive compensation that will affect executive compensation practices?

3. What is the status and nature of the SEC’s additional proxy disclosure requirements?

4. What do the SEC’s proposed rules require regarding risk disclosure and what should companies be doing now to address these issues?

5. What is “say on pay” and what is its US history?

6. What is the likelihood of the enactment of a requirement that all public companies allow their shareholders to have a “say on pay”?

7. What has been the outcome of shareholder votes on executive compensation?

8. To what extent did proxy advisory services, such as RiskMetrics Group (ISS), institutional shareholders and shareholder activists impact executive compensation policies in the 2009 proxy season?

9. Given the growing influence of proxy advisors, institutional investors and shareholder activists, and the unprecedented level of legislative and regulatory developments aimed at executive compensation, what should companies be doing now to prepare for increased scrutiny of and added pressure on executive compensation plans and policies?

10. How should companies and Compensation Committees use pay surveys and other market data this year?

Our Answers

1. What are the major corporate governance reforms that will affect executive compensation practices in the current environment and beyond?

Reforms already in effect — On July 1, 2009, the SEC approved an amendment to NYSE Rule 452 which effectively eliminates broker discretionary voting in uncontested director elections. Specifically, the rule prohibits brokers holding shares in “street name” for their clients from voting in uncontested director elections on behalf of their clients without receiving specific voting instructions from those clients. Since it is estimated that brokers typically control approximately 20 percent of the votes at public companies and historically support management in their votes, the new voting restrictions will likely have a significant impact on the outcome of director elections.

Reforms on the horizon — Congress is considering mandating majority voting in uncontested director elections while the SEC has also proposed allowing shareholder director nominees to be included in companies’ annual proxy statements.

• Both the proposed Shareholder Bill of Rights Act of 2009 (Senator Charles Schumer, D-NY) and the Shareholder Empowerment Act of 2009 (Representative Gary Peters, D-MI) provide for directors at all listed US public companies to be elected by: — A majority vote in uncontested Board elections — A plurality vote in contested Board elections
• In May 2009, the SEC proposed a “proxy access” rule that would allow large shareholders to nominate director candidates directly in a company’s proxy statement, eliminating the additional fees and documentation otherwise required for such shareholders to nominate director candidates by separate mailings. The SEC has said that the proposal requires further study and will not be in effect for the 2010 proxy season, but it is likely that some form of proxy access will be required in 2011.

Taken together, these reforms mean that more directors are more likely to lose election votes and Compensation Committee members may be particularly at risk. Already in 2009, nearly 10 percent of directors up for election had 20 percent of the shares voted against them or withheld, which is almost double the number from 2008. Approximately 60 percent of these directors were Compensation Committee members, and given the heightened scrutiny of executive compensation plans, such elections may prove more difficult than in past years.

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2. What are the major legislative and regulatory drivers aimed directly at executive compensation that will affect executive compensation practices?

The primary legislative and regulatory initiatives directly impacting executive compensation practices include (a) additional proxy disclosure required by the proposed SEC rule changes, (b) likely enactment of a mandatory “say on pay” vote for all public companies and (c) additional requirements for Compensation Committee independence.

Currently, “say on pay” and Compensation Committee independence are key provisions of legislation proposed by Representative Barney Frank, D-MA, as part of the Corporate and Financial Institution Compensation Fairness Act of 2009 (CFICFA). A number of proposed bills currently under consideration in the House of Representatives and the Senate contain “say on pay” provisions as well as Compensation Committee independence requirements. CFICFA, approved by the House on July 31, 2009, is the leading bill.

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3. What is the status and nature of the SEC’s additional proxy disclosure requirements?

On July 10, 2009, the SEC published proposed rules that, if adopted, will significantly change public companies’ required disclosures in their proxy statement and certain other filings. The SEC comment period on the proposed rules ended on September 15, 2009, and the proposed rules are expected to be finalized by early November and in effect for the 2010 proxy season. Companies should be studying the proposed rules now and preparing to act on the final rules as soon as they are adopted.

The proposed rules, among other things, would increase compensation practice disclosure to:

• require disclosure of the relationship between compensation policies and risk, for any employees involved in material risk taking activities (not limited to executive officers);
• change the manner in which stock and option awards are currently reported to require reporting of compensation for the entire award at the date of grant;
• require additional disclosure regarding director qualifications and Board leadership structure; and
• require information relating to compensation consultants’ fees and services if consulting firm does work for company beyond advising the Board or Compensation Committee.

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4. What do the SEC’s proposed rules require regarding risk disclosure and what should companies be doing now to address these issues?

The SEC’s proposed rules require companies to disclose their compensation polices for all employees where risks generated by those policies “may” be “material.” Specifically:

• Companies will be required to discuss compensation arrangements that could create incentives for any employees to take on excessive amounts of risk.
• In a major break from the current rules, the rules pertaining to risk disclosure would specifically extend the requirement beyond executive officers.
• Disclosure of risks arising from compensation practices would be required if such risks “may have” a “material” impact on the company.

The proposed risk rules are highly controversial, appear to be aimed at financial firms, arguably fight the last war and are likely to be modified substantially in response to many comments received by the SEC.

Compensation Committees should begin to discuss enterprise risk issues with management, identify material risk areas and assess whether the compensation plans applying to employees involved in these areas may encourage the employees to take undue risks in order to maximize their compensation.

In analyzing these issues, Compensation Committees and management should review the general design philosophy of the compensation programs, the mix of compensation elements, the structure of performance goals, the use of holdbacks or escrows, clawbacks and equity holding period requirements, how adjustments are made or policies are changed based on changes in risk profiles and how compensation policies are monitored with respect to risk.

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5. What is “say on pay” and what is its US history?

Although “say on pay” comes in many forms, it generally refers to a shareholder advisory vote on executive compensation policies, practices and/or pay for the “named executive officers” whose compensation is reported in a company’s proxy. Although such votes are non-binding and only advisory, “say on pay” provides shareholders with an opportunity to express satisfaction or dissatisfaction with companies’ executive compensation policies, practices and/or payments. How a company responds to a shareholder vote is likely to influence the outcome of their director elections, especially with respect to Compensation Committee members, and shareholder votes with respect to equity compensation plans.

“Say on pay” has been advocated by shareholder activists since 2006 via individual company proxy proposals requesting that companies permit “say on pay” votes by shareholders. This issue has gained substantial momentum over the years:

• In 2006, seven proposals were submitted by shareholders for shareholder vote.
• In 2007, 53 proposals were submitted by shareholders for shareholder vote.
• In 2008, 66 proposals were submitted by shareholders for shareholder vote.
• In each of these years, these proposals received approximately 40 percent favorable votes, on average.

As of October 1, 2009, results have been tracked for 71 companies for which “say on pay” proposals were submitted to shareholder vote in 2009. The “say on pay” proposals at these 71 companies received approximately 46 percent favorable votes, on average.

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6. What is the likelihood of the enactment of a requirement that all public companies allow their shareholders to have a “say on pay”?

Very likely.

Momentum for required “say on pay” votes has been building since 2007, when the House passed the Shareholder Vote on Executive Compensation Act (Representative Barney Frank), which would have required companies to allow “say on pay” votes on compensation disclosed in their proxy statements. A companion bill, introduced in the Senate by then- Senator Barack Obama, died in the Senate.

In 2009, numerous bills pending in House and Senate committees include mandatory “say on pay” provisions, such as the Investor Protection Act of 2009 (Treasury Department), the Shareholder Empowerment Act of 2009, the Shareholder Bill of Rights Act of 2009 as well as CFICFA, also proposed by Representative Barney Frank.

CFICFA is considered to be the front runner of the various bills under consideration, having been passed by the House on July 31, 2009. The key provisions of CFICFA as enacted by the House include:

• an annual non-binding vote on named executive officer compensation, based on the disclosure of such compensation in the proxy statement;
• a non-binding vote in proxies approving corporate transactions (not annually) on “golden parachutes” (very broadly defined) payable to named executive officers in connection with the transaction, no matter the amount of compensation; and
• requirements for Compensation Committee members to meet strict standards for independence.

As passed by the House, CFICFA would apply to annual meetings of public companies held six months after the date the final rules are issued, and the SEC would be required to issue final rules within six months of enactment. Thus, such rules would apply no later than 12 months from enactment.

CFICFA is currently awaiting action by the Senate, where the Senate Banking Committee may consolidate the “say on pay” and other provisions of CFICFA into a larger bill overhauling the regulation of the financial services industry. Such a move would likely delay the enactment of a mandatory “say on pay” requirement for all public companies until 2011 or 2012.

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7. What has been the outcome of shareholder votes on executive compensation?

In 2009, the American Recovery and Reinvestment Act of 2009 requires the more than 300 financial institutions participating in TARP to include a “say on pay” vote in proxy statements filed after February 17, 2009. To date in 2009, approximately 24 non-TARP companies, including Intel Corporation, Verizon Communications Inc., Motorola, Inc. and Blockbuster, Inc., have also conducted “say on pay” votes.

Results have been tracked for 127 companies whose shareholders voted on “say on pay” proposals. As of September 28, 2009, “say on pay” proposals at these 127 companies have received approximately 89 percent favorable shareholder votes. Most of these advisory votes have been held at TARP companies. These votes seem anomalously favorable and could be influenced by a number of factors, including the impact of broker voting of non-directed shares, the scaling back of financial sector compensation in 2008 and 2009 in reaction to the financial crisis and the relatively little time TARP shareholders were given to evaluate company plans. The 2010 results could differ.

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8. To what extent did proxy advisory services, such as RiskMetrics Group (ISS), institutional shareholders and shareholder activists impact executive compensation policies in the 2009 proxy season?

Proxy advisory services, institutional shareholders and shareholder activists are more active than ever and have had greater influence on compensation policies, especially with respect to equity plans and director elections. As of September 28, 2009, 93 Board members at 50 companies received fewer than half the votes cast at annual meetings. This is more than twice as many as any other year since 2003, the year such information was first tracked.

For 2009, proxy advisors, such as RiskMetrics Group, recommended that shareholders vote against a record number of equity plans and directors on the basis of “poor pay practices,” such as golden parachute payment tax gross ups, tax reimbursements on perquisites, “single trigger” severance payments, overly generous perquisites (such as personal use of corporate aircraft or car allowances), “egregious” pension/ SERP payouts and payments upon an executive’s termination in connection with performance failure. In many cases, companies were forced to amend their pay practices, generally prospectively, in order to obtain the support of the proxy advisors, often requiring the amendment of outstanding proxies.

Institutional investors also played a bigger role in influencing executive compensation practices in 2009 than ever before. For example, it has been reported that Fidelity Investments voted against 55 percent of all executive compensation plans presented for vote, against 23 percent of directors seeking election (citing reasons such as the adoption of “golden parachute” pay plans, poor attendance at Board meetings and failure to follow through on promises to change compensation practices as key drivers of their vote) and against at least one management recommendation at half of the shareholder meetings at which the firm voted.

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9. Given the growing influence of proxy advisors, institutional investors and shareholder activists, and the unprecedented level of legislative and regulatory developments aimed at executive compensation, what should companies be doing now to prepare for increased scrutiny of and added pressure on executive compensation plans and policies?

Although many of the legislative and regulatory changes are still in the “proposed” stage, companies should start preparing now for the increased scrutiny of and added pressure on their compensation practices and policies and Boards. Boards, Compensation Committees and/or company leadership should:

• Consider strategies to create a dialogue with important shareholders, such as through investor surveys or the use of technology to deliver information and exchange ideas.
• Spend time understanding the composition of the company’s shareholders, what issues are topof- mind for shareholders and how executive compensation programs can be modified and effectively communicated to shareholders in response.
• Consider doing away with “hot button” components of executive compensation packages, such as tax gross-ups and excessive executive perquisites.
• Allow for enough time to draft carefully persuasive proxy disclosure which both describes executive compensation practices as well as justifies the policies driving such practices.
• Continue monitoring legislative and regulatory developments to prepare for any material changes to proposed rules and regulations and to maximize preparation time once applicable rules go into effect.
• Consider triennial vote if considering adopting “say on pay” vote. A triennial vote was recently adopted by Microsoft for its 2009 meeting, which has much to recommend it.

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10. How should companies and Compensation Committees use pay surveys and other market data this year?

Always limited by their “rear view mirror” perspective, surveys and past market data must be considered with extra care in a year such as this one. Two important aspects need special attention:

• For example, most current surveys reflect that the 2008 year was still strong for some sectors of the economy but weaker for others. 2009 will mostly be a weaker year so bonuses will generally be less than what surveys show to be competitive based on 2008 pay. Further, where surveys show target bonus levels for 2008 or even 2009, those structures may be suspended or modified for 2010. In other words, the business objectives being set for 2010 may be sufficiently below the acceptable range of “full performance” such that companies may suspend or reduce their target payout structures for 2010. Companies should take care to understand the performance context of the reporting companies to a survey or data set. This is obviously easier if it is a sector-focused survey than a general industry report. By example, the life sciences sector has had a strong year in 2009 relative to other sectors, such as semi-conductors. Perspective on market, quite possibly developed anecdotally (if not systematically), is important.
• 2008 data might include grants made by one reporting company in February of 2008 at relatively high share prices and from another reporting company in December when prices were markedly lower. Intuitively we know those December grants are more valuable than the February ones but the survey data will report otherwise. Again, developing perspective on the reporting companies is important. Companies that grant all or mostly full-value shares generally tried to stay “true” to target grant date dollar values. Nonetheless, share usage constraints may have caused them to reduce dollar values with the result that they still may have granted more shares than the prior year as a result of the steep drop in share price. Companies using options also tended to grant more of them but their grant date fair values probably dropped even further. Testing in many sectors shows that grant date fair values dropped in 2009 by 15-30 percent. Concurrently, the numbers of shares or options granted generally still went up. Further, while equity grants made in prior years are out-of-the-money or well below their grant values, many equity grants made in early 2009 have significant paper gains stemming from the broad recovery in equity markets over the course of the year.

Survey data should remain an important reference point to pay decision-making, but as always, it should remain just that and not be the predominant driver of pay actions. More than ever, research and investigation to build a context to understand the data is critical.

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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.

To illustrate many of the concepts, the panel used as examples the Agreement and Plan of Merger between Brocade Communications Systems, Inc. and Foundry Networks, Inc. (which Rick was involved in negotiating) and the Agreement and Plan of Merger between Ticketmaster Entertainment, Inc. and Live Nation, Inc.

The panel also discussed the role of reverse break-up fees, and their quantum, and the differences between public and private company transactions.  The panel then considered In re IBP, Inc. Shareholders Litig., and the decision of Vice Chancellor Strine in that case.  The discussion then moved to the meaning of ‘material adverse effect’ clauses.  Rick pointed out the preponderance of the “material adverse effect” standard, as evidence of which he referred to the 2009 Strategic Buyer/Public Target M&A Deal Points Study published by the Mergers & Acquisitions Committee of the American Bar Association’s Business Law Section (of which committee Rick is the former Chairman), which was discussed on the Forum here.  Each of the panelists also gave their advice to the class on negotiating mergers and acquisitions transactions, including Kim’s “Rucker’s Top 5″ tips for young associates.

The video of the panel is available here. (Quicktime .mov format)

Regulation and litigation do not occur in isolation. In almost every case of a harm which leads to litigation some regulatory agency had initially monitored the activity that lead to the harm. Thus pharmaceutical litigation does not occur in isolation of the FDA and auto accident litigation does not occur in isolation of the enforcement of traffic laws. While this point may seem obvious it has important implications of the design of regulatory systems as well as limitations placed on the ability of potential plaintiffs to seek redress using the civil justice system. In a series of papers Steve Shavell (“A Model of the Optimal Use of Liability and Safety Regulation.” RAND Journal of Economics, 1984 and. “Liability for Harm Versus Regulation of Safety.” Journal of Legal Studies, 1984) examines the tradeoff between regulation and litigation. The basic intuition is that litigation maybe a substitute or a complement to regulation. In the case of substitutes we would expect that an increase in regulation reduces the need for litigation at least at the margin.

In a new paper, The Relation between Regulation and Class Actions: Evidence from the Insurance Industry, which we recently presented at the Law and Economics seminar at Harvard Law School, we investigate the relationship between litigation and regulation, using a unique data source covering the experience of insurance companies with class action litigation. The dataset contains information on class actions against firms in the insurance industry from 1992 to 2002. We examine four different facets of the regulation litigation tradeoff. The first is to examine whether regulator’s interest in a particular cause of action reduces the likelihood that class actions covering this cause of action will be filed in the regulator’s home state. We examine several measures of regulatory stringency in the state to determine whether there is a substitution effect between regulatory action and litigation. We also examine whether class actions are less frequent when regulators issued an administrative decision on a particular issue previously or if there are no existing state laws on the particular issue. We examine the impact of electing judges on patterns of filing. The hypothesis is that elected judges are more sympathetic to plaintiffs and hence class actions are more likely to be filed in states that elect their judges. Lastly, we examine the impact of pervious litigation both in the state and the specific line of litigation.

We find little evidence of a tradeoff between litigation and regulation. We do find that success of previous litigation is important in determining filing location. Perhaps more surprisingly we find cases are more likely to be filed in states that elect their judges in partisan elections. In previous research one of the authors has found that in states that elect their judges in partisan elections tort awards against out of state defendants are significantly higher (see Helland, Eric and Alexander Tabarrok. (2002) “The Effect of Electoral Institutions on Tort Awards,” American Law and Economics Review. 4(2):341-370). The implications are the previous findings for public policy are perhaps ambiguous. Although the legal system is an inefficient method of transferring income given the high transaction costs there are likely other reasons why states might wish to elect judges. In the case of insurance class actions the finding is more troubling. If states that elect judges are relying on litigation to deter harm the Shavell model would suggest reducing regulation to offset the increase.

Clearly there are a number of dimensions to the tradeoff to litigation and regulation. This paper represents only a first step in understanding the relationship. As the country prepares to overhaul the financial regulatory system more research into relationship is clearly warranted.

The full paper is available for download here.

Bob Pozen’s book, Too Big to Save: How to Fix the US Financial System is one of the most important books on financial reform written to date. The book not only provides an overview of how the US economy entered into a deep recession, but also a comprehensive plan for reform and a return to growth. Filled with original insight, the book clearly explains the failure of our modern capitalist society that has morphed into one-way capitalism that penalizes taxpayers who do not participate in upside gains but are exposed to losses from bailed out financial institutions. The book offers pragmatic advice for policymakers and important guidelines for all readers to understand the nature, causes, and appropriate reforms associated with the current US financial crisis. There has not been a more timely and important book written this decade.

Furthermore, Bob Pozen approaches each potential idea of reform with a well-reasoned perspective on the legal, economic, political and cultural implications of such reform. Pozen has a unique ability to describe complex phenomona such as the housing boom and bust and explosive growth in the use and complexity of financial derivatives with ease. His grasp of the complex issues is second to none, and his ability to convey these complex ideas in easily understandable, succinct prose is remarkable. Pozen’s suggestions for reform – including reducing moral hazard problems, strengthening boards, and improving the regulatory system – present feasible, necessary steps that policymakers must heed to improve financial markets and the real economy.

The book is presented in four parts: The US housing slump and the global financial crisis, the impact on public markets, evaluating the bailout act of 2008, and the future of the American financial system. Most books on crises tend to be more descriptive then prescriptive and stop with an evaluation of the events that unfolded throughout the crisis. Bob Pozen is particularly adept at proposing solutions to market failures and government policy mistakes. His analysis of the housing slump and impact on global markets is as sharp and well-informed as notable economists such and is the most refreshing look at the causes of asset bubbles and ensuing busts since Robert Shiller’s “Irrational Exuberance”. His analysis of the bailout act of 2008 and the future of the American financial system do not merely identify the flaws in our financial system but also clearly layout a blueprint for reform and recovery. The book is not an esoteric, ivory tower rumination of the events that have unfolded since 2008 but a pragmatic manual on reform that is refreshingly readable.

In summary, Too Big to Save is comprehensive, rigorous, and descriptive as well as prescriptive. The US economy is too important a global player to be ignored, and Pozen’s analysis in “Too Big Too Save” is too important to not be read. This book is truly a gem and a strongly recommended read. Pozen has the in-depth, sound thought processes of a prominent academic from his experience as a senior lecturor at the Harvard Business School as well as his experience on the front line of reform and change through his experiences as Chairman of MFS Investments, Chairman of the SEC advisory committee on improving financial reporting, and member of President Bush’s Commission to Strengthen Social Security. Read this book.

The legislative season for financial regulatory reform is now in full swing. In the last two weeks, the leadership of the House Financial Services Committee and Treasury have jointly proposed a revised version of the Obama Administration proposals of last summer. Thereafter, the House Financial Services Committee began to amend the proposal, titled the Financial Stability Improvement Act of 2009, and the Chairman of the Committee, Representative Barney Frank (D-MA), has made clear that further changes will be made next week. This week, Senator Christopher Dodd (D-CT), Chairman of the Senate Banking Committee, released his own competing discussion draft of regulatory reform, entitled the Restoring American Financial Stability Act of 2009.

This memorandum analyzes the resolution provisions in the House Interim Version (by which we mean the House Financial Services Committee’s version as of November 6, 2009). We also identify any significant differences between the House Interim Version and the Senate Banking Committee’s discussion draft. This memorandum focuses on the key issues raised by the resolution of financial companies that could, in the future, be deemed to be systemically important. While the proposed resolution authority is only one of several regulatory restructuring proposals under consideration both in the United States and abroad, we view it as the most technically challenging. It is also key to many other reforms since it will be at the core of the political compromise around the knotty problems of “too big to fail,” moral hazard, and the global interconnectedness of highly leveraged institutions.

The revised resolution proposals in the House and Senate versions, like their predecessors proposed by the Administration, could have profound implications for our economy. Yet none of these proposals has been subject to sufficient discussion and debate because it requires such a high degree of technical expertise to understand their full implications. Few people have a working knowledge of the bank resolution provisions in the Federal Deposit Insurance Act on which they are modeled, and no one has any experience applying this model to non-depository institution financial companies. Those who are experts with the bank resolution model typically do not have any real experience with the bankruptcy process that the proposed new resolution authority would replace. What is needed is for a full range of bankruptcy and bank resolution experts to sit in a room and craft a resolution authority that reflects the strength and avoids the weaknesses of both the bank resolution and bankruptcy models, as applied to large, interconnected, non-depository institution financial companies.

The goals of resolution authority require a clear and detailed statutory framework. Shareholders and creditors should suffer losses if their financial institutions fail. But a federal agency should have the power to preserve systemic stability and prevent contagion by acting quickly to sell selected assets and liabilities to a third party at fair value or, if that is not possible, to set up a temporary bridge company and transfer them to the bridge company to be held and unwound in an orderly fashion.

All claimants left behind should have a right to a minimum recovery based on what they would have received in a liquidation proceeding under the Bankruptcy Code, had the federal agency not exercised its core resolution powers. The claims process for left-behind claimants should provide an equivalent level of legal certainty, due process protections and judicial review as in a normal bankruptcy proceeding. It should be based on the rules governing creditors’ rights contained in the Bankruptcy Code.

Otherwise, the proposed resolution authority will have the unintended consequence of producing inefficient credit markets, with higher credit costs and lower credit availability to Wall Street, Main Street and consumers. The reason is that there appears to be a substantially greater risk of reduced recovery for secured and unsecured creditors and counterparties if the rules governing creditors’ rights in the proposed resolution authority are modeled on the rules contained in the bank resolution statute instead of those contained in the Bankruptcy Code.

We first summarize the key features of the proposed resolution authority and then identify some of the key policy issues that need to be resolved in order for the proposed resolution authority to have the potential to do good without producing immediate harm. We conclude with a brief discussion of international coordination.

Introduction

Both the House and Senate financial regulatory reform proposals include a proposal for resolving large, interconnected financial companies. They are both modeled on the resolution authority for insured depository institutions in the Federal Deposit Insurance Act. “Resolution authority” refers to a type of insolvency law and procedure that includes both the “core resolution powers” set forth in the sidebar and an ancillary claims process for left-behind assets and liabilities. The core resolution powers are exercised by a federal administrative agency, but the ancillary claims process may be administered either by the federal agency or a bankruptcy court.

The proposed new resolution authority could potentially apply to any US financial company and its covered subsidiaries (that is, all US subsidiaries other than insured depository institutions, insurance companies or broker-dealers that are members of the Securities Investor Protection Corporation), if certain financial distress and systemic risk determinations are made. Indeed, the relevant definition of the term “financial company” in the House Interim Version is so broad that the new resolution power could potentially apply to almost any company, including commercial companies. In both the House and the Senate versions, resolution authority would displace the Bankruptcy Code, which otherwise governs the liquidation or reorganization of such financial (or commercial) companies.

The revised resolution authority is virtually identical to the Administration’s original proposal for systemically important financial companies released on March 25, 2009 and its first revised proposal for large, interconnected financial companies released on July 23, 2009. We described those prior versions in the Davis Polk memoranda, Treasury’s Proposed Resolution Authority for Systemically Significant Financial Companies, March 30, 2009 and The Regulatory Reform Marathon, July 28, 2009. This memorandum assumes a basic familiarity with those prior proposals.

Key Features

How does it work?

The proposed resolution authority would authorize the Treasury Secretary to appoint the FDIC as receiver of any financial company that has been designated as an “identified financial holding company” (House version) or as a “specified financial company” (Senate version) and all of its covered subsidiaries, if the required financial distress and systemic risk determinations are made. In the version of the proposed legislation originally released by the House Financial Services Committee, the FDIC could also have been appointed as a qualified receiver of an identified financial holding company; however, this option was deleted by a later amendment. A qualified receiver is similar to a “conservator” under the Federal Deposit Insurance Act, except that a qualified receivership would have had a limited initial term of two years, with up to three one-year extensions, for a maximum life of five years. The distinction between a receiver and a conservator (or qualified receiver) is that a receiver is a liquidator whereas a conservator (or qualified receiver) simply takes control of the going concern to preserve its value.

The FDIC would have the power to act immediately to exercise its core resolution powers. These would include selling any or all of the assets or liabilities of a covered financial company to a third party at fair value, without the need to respect any third-party consent rights. If the FDIC could not find a buyer at an acceptable price, it would have the power to incorporate a temporary bridge financial company under federal law and transfer the selected assets and liabilities to this bridge company to hold until they could be disposed of in an orderly fashion. The assets and liabilities left behind would then be liquidated.

Creditors and counterparties whose claims were assumed by a third party or bridge financial company would ordinarily recover at par, but the FDIC would presumably have the discretion to recoup any benefits received by such transferred claimants in excess of their guaranteed minimum recovery, discussed below. Indeed, the Senate version appears to give the FDIC this very power. Creditors and counterparties left behind would suffer losses to the extent that the assets of the company were less than its liabilities, subject to their guaranteed minimum recovery. Equity holders would be wiped out completely, unless the assets of the company turned out to be more than its liabilities.

Authority to cherry pick

In exercising its core resolution power to sell or otherwise transfer assets and liabilities, the FDIC would have the flexibility to cherry-pick among creditors and counterparties within the same class, as long as the left-behind creditors and counterparties receive their guaranteed minimum recovery. More generally, the FDIC would have the power to treat similarly situated creditors differently, as long as all creditors receive their guaranteed minimum recovery.

Minimum recovery

The provisions of both the House and Senate versions of the resolution authority, like their predecessors proposed by the Administration, that give the FDIC its cherry-picking authority also include the guaranteed minimum recovery provisions. [1] These provisions state that all creditors, including those whose claims are left behind for liquidation, are entitled to receive what they would have received in a liquidation proceeding under the Bankruptcy Code, as if the transfer of selected assets and liabilities or other differential treatment had not occurred.

Financial assistance powers

The FDIC would have the power to provide financial assistance to any covered financial company to facilitate its resolution, provided that certain conditions set forth in the sidebar are satisfied. It is not clear whether the requirement in the House Interim Version that unsecured creditors bear losses would be satisfied if only some of the unsecured creditors suffer losses, or whether the provision that all unsecured creditors, including those whose claims are assumed by a third party or bridge financial company, must suffer losses. Nor is it clear whether these creditors must suffer the same amount of losses that they would have suffered in a liquidation proceeding under the Bankruptcy Code, or some different amount. The Senate version attempts to address these issues by rewording the requirement to say that the assistance does “not prevent unsecured creditors from bearing losses.”

The permitted assistance would include making loans, purchasing debt obligations, purchasing assets, assuming or guaranteeing obligations, acquiring any equity interest or security, taking a lien on any or all assets, including taking a first priority lien on all unencumbered assets, or selling or transferring any or all such acquired assets, liabilities, obligations, equity interests or securities.

Why financial assistance?

The reason the proposed resolution process—unlike a liquidation under the Bankruptcy Code—requires at least some financial assistance to work is that giving the FDIC the core resolution power to transfer selected assets and liabilities to a third party or bridge financial company would typically result in some creditors and counterparties receiving more than they would have received in a liquidation. This, in turn, means that there will not be sufficient assets left behind for left-behind creditors and counterparties to receive what they would have received in a liquidation proceeding under the Bankruptcy Code. The financial assistance powers are required so that enough assets are available to left-behind claimants to ensure that they receive the same amount they would have received in a liquidation proceeding under the Bankruptcy Code as if the FDIC had not exercised its authority to transfer selected assets and liabilities to protect the system.

Recovery fund

The FDIC would have the right to recoup the cost of ensuring that left-behind claimants receive their guaranteed minimum recovery or otherwise providing any financial assistance by imposing ex-post assessments on any financial company with assets of $10 billion or more. House Financial Services Committee Chairman Barney Frank has stated that he intends to change this recoupment power to an ex-ante funding mechanism.

The definition of the term “financial company,” set forth in the sidebar, suggests that a broad range of US financial companies with assets of $10 billion or more, including hedge funds, credit and finance companies and any new Section 6 financial holding companies, would be subject to assessment.

Emergency open assistance

The FDIC’s power to provide open assistance that existed in the Administration’s prior versions of the resolution authority has been stripped out of the resolution authority subtitle in the House Interim Version. But a new, more constrained version of this power has been added elsewhere in the House Interim Version. [2] The Senate version gets rid of this power altogether. Open assistance refers to assistance provided to a company before it has been put into receivership, qualified receivership or conservatorship.

The FDIC’s emergency open assistance authority in the House Interim Version is limited to extending credit or guaranteeing obligations of solvent insured depository institutions or other solvent companies, including identified financial holding companies, that are predominantly engaged in activities that are financial in nature, if necessary to prevent financial instability during times of severe economic distress as determined by the Treasury Secretary (in consultation with the President), upon written recommendation by at least two-thirds of the members of the Federal Reserve Board then serving and two-thirds of the members of the FDIC board then serving. The House Interim Version clarifies that the emergency power does not include the provision of equity in any form.

The House Interim Version defines the term “solvent” as meaning “assets are more than the obligations to creditors.” It does not specify whether the assets and obligations are to be valued using historic cost or mark-to-market values for purposes of determining the solvency of any potential recipient of such assistance.

Covered financial companies

The House Interim Version limits the new resolution authority to “identified financial holding companies” and their covered subsidiaries. But that limitation is more apparent than real for several reasons. First, the term “identified financial holding company” is not defined in the subtitle that contains the resolution authority, but only in the general definitions of the overall bill. Nor is it built on the term “financial company” as defined in the resolution provisions. Instead, it is built on the definition of that term in the general definitions of the bill, which is much broader than its cousin in the resolution provision, and is summarized in the sidebar. Indeed, the definition is broad enough to sweep in a wide range of companies including some that are not ordinarily considered to be predominantly financial in nature, from vehicle manufacturers and retail chains with financing arms, to conglomerates with vast financial operations, credit and finance companies, hedge funds, insurance companies, asset managers, traditional bank holding companies and similar holding companies currently not treated as bank holding companies.

Second, although a financial company cannot ordinarily be considered to be an identified financial holding company under the House Interim Version unless the proposed new Financial Services Oversight Council (the “Council”) designates it as such after a notice and hearing, the Council has the emergency power to designate any financial company as an identified financial holding company at any time without prior notice or hearing, including on the eve of bankruptcy, with the necessary financial distress and systemic risk determinations being made simultaneously.

The breadth of the term “financial company” in the general definitions of the House Interim Version suggest that the term “identified financial holding company” could include the US branches or agencies of a foreign bank or even certain types of commercial companies. We do not believe that such branches, agencies or commercial companies were intended to be included for purposes of the resolution authority. It was probably a technical error that crept in because of the apparent speed with which the bill was drafted and will likely be corrected in subsequent drafts.

The Senate version limits the resolution authority to “specified financial companies,” which are defined by reference to the narrower definition of “financial company” in the resolution section.

Systemic risk determinations

The proposed resolution authority would only apply to an identified financial holding company and its covered subsidiaries under the House Interim Version if the Treasury Secretary, upon written recommendation from the Federal Reserve and the FDIC, or in certain circumstances, the SEC, in consultation with the President, makes the financial distress and systemic risk determinations set forth in the sidebar. Under the Senate version, the proposed resolution authority would only apply to a specified financial company and its covered subsidiaries if the Treasury Secretary, upon written recommendation from the new Financial Institutions Regulatory Administration and the FDIC, or in certain circumstances, the SEC, in consultation with the President, makes the financial distress and systemic risk determinations set forth in the sidebar.

Ancillary claims process

The FDIC would have the exclusive authority to conduct an ancillary claims process for resolving the claims of left-behind creditors and counterparties. This process would be modeled on the process contained in the Federal Deposit Insurance Act. The FDIC’s actions would be subject to no judicial review until the process was completed, at which point de novo review of a person’s claim could be sought from a federal court. The rules defining creditors’ rights would be the rules contained in the Federal Deposit Insurance Act, with only a few minor modifications. Even though each left-behind creditor and counterparty would be entitled to receive the same recovery that would have been received in a liquidation under the Bankruptcy Code, the rules defining creditors’ rights contained in the Bankruptcy Code would not otherwise be binding on the FDIC.

Mandatory / permissive rulemaking

The House Interim Version would require the FDIC to promulgate rules governing the claims process. Otherwise, the FDIC’s rulemaking authority would be permissive only. This is in contrast to the prior versions of the Administration’s proposals, which only included permissive rulemaking authority. In contrast, the FDIC’s rulemaking authority under the Senate version is permissive only.

Qualified financial contracts

Under the House Interim Version, counterparties on qualified financial contracts (QFCs) would be stayed from exercising their close-out rights for one business day to give the FDIC time to determine whether to transfer such QFCs to a third party or bridge financial company. Under the Senate version that stay period would be extended to three business days.

Living wills

As a supplement to resolution authority, the House and Senate versions would require the Federal Reserve (House version) or the new Financial Institutions Regulatory Administration (Senate version) to require identified financial holding companies (House version) or specified financial companies (Senate version) to prepare and report periodically on plans for their rapid resolution in the event of severe financial distress. These rapid resolution plans, however, would not be legally binding on the FDIC or a bankruptcy court that is authorized or required to resolve such identified financial holding companies or their subsidiaries or affiliates.

Mandatory bankruptcy

As part of the new prompt corrective action provisions for identified financial holding companies (House version) or specified financial companies (Senate version), and as a further supplement to the resolution authority, the Federal Reserve (House version) or the Financial Institutions Regulatory Administration (Senate version) would be required to cause a bankruptcy proceeding to be commenced against an identified financial holding company (House version) or specified financial company (Senate version) within 90 days after it becomes critically undercapitalized, unless the FDIC is appointed as the company’s receiver under the resolution authority.

Section 13(3)

The House and Senate versions would both amend Section 13(3) of the Federal Reserve Act. Section 13(3) allows the Federal Reserve, in “unusual and exigent circumstances,” by affirmative vote of not less than five members to provide emergency financing to any individual, partnership and corporation. The House Interim Version would add a requirement to obtain the written consent of the Treasury Secretary, and to allow emergency financing only as part of a broadly available credit or other facility. The Federal Reserve would not be allowed to provide financing for only a single and specific individual, partnership or corporation. The Senate version would limit the Federal Reserve’s Section 13(3) emergency lending powers so that assistance is available only with respect to financial utilities or payment, clearing or settlement activities that are systemically important, or any program or facility with broad-based participation, not to any individual, partnership or corporation.

Open bank assistance limit

Both the House and Senate versions would also change the “systemic risk exception” for open bank assistance in the Federal Deposit Insurance Act. The Federal Deposit Insurance Act allows the FDIC to provide open bank financial assistance, notwithstanding the “least cost resolution” requirement in the statute, if, upon written recommendation of at least two-thirds of the Federal Reserve Board and the FDIC board, the Treasury Secretary makes a systemic risk determination. This has been the basis for the FDIC’s temporary liquidity guarantee and other assistance programs to insured depository institutions and their holding companies and affiliates in the recent financial crisis.

As amended in the House and Senate versions, the systemic risk exception would be limited so that it could be used only for an insured depository institution, except where severe financial conditions exist which threaten the stability of a significant number of insured depository institutions. The Senate version would also replace the Federal Reserve Board with the Financial Institutions Regulatory Administration board.

Key Policy Issues

Why not Bankruptcy Code?

In the absence of the required financial distress and systemic risk determinations, the Bankruptcy Code would govern the liquidation or reorganization of a financial company other than an insured depository institution or insurance company. Even broker-dealers that are members of the Securities Investor Protection Corporation are resolved under the Bankruptcy Code, with the Securities Investor Protection Act supplementing its provisions with respect to customer property. The Bankruptcy Code prevents moral hazard—that is, the incentive to take excessive risks if investors are entitled to the upside from their investments but are protected from the downside—by ensuring that shareholders, creditors and counterparties of covered financial companies suffer appropriate losses if such companies are insolvent. The bankruptcy process is generally considered to be transparent and consistent with due process. It has rules governing creditors’ rights that are widely understood and considered to be neutral among similarly situated classes of creditors.

“Too big to fail” / moral hazard debate

Treasury and other proponents of the proposed resolution authority argue that some form of resolution authority is necessary to eliminate taxpayer-funded bailouts of financial companies that are perceived to be “too big to fail,” and the moral hazard that such bailouts produce, in a way that does not destabilize the financial system. The only alternatives to such resolution authority are to allow these companies to fail in a disorderly fashion the way Lehman Brothers was or to rescue them in an ad hoc fashion the way AIG was.

These proponents argue that the resolution of large, interconnected financial companies through the normal bankruptcy process occurs far too slowly. This is because of the extraordinary speed with which both credit disappears during a financial crisis and the value of certain assets dissipates upon the commencement of bankruptcy proceedings. The follow-on effects of this loss of value are distributed throughout the financial system, potentially causing other financial companies to fall like dominos, thereby increasing systemic risk and the cost of government intervention to stabilize the financial system.

Critics argue that the proposed resolution authority will not end “too big to fail” or reduce moral hazard, but rather institutionalize them. They point to the financial assistance provided to Freddie Mac and Fannie Mae in connection with their conservatorships as examples, and argue that the proposed resolution authority will create 20 new Fannies and Freddies. The institutionalization of such bailouts will increase moral hazard and give potentially covered companies a funding advantage over their competitors. Such critics would leave the Bankruptcy Code in place to insure that shareholders, creditors and counterparties of non-depository institution financial companies suffer appropriate losses if such companies fail.

Which model for ancillary claims process?

Some proponents of the general concept of resolution authority strongly support giving a federal agency “core resolution powers” modeled on the Federal Deposit Insurance Act. But they believe that the Federal Deposit Insurance Act is the wrong model for the claims process for left-behind assets and liabilities, as applied to non-depository institution financial companies. [3] They argue that an administrative claims process modeled on the Federal Deposit Insurance Act is too opaque and does not provide the same level of due process and judicial review as the Bankruptcy Code. They also argue that the rules defining creditors’ rights in the Federal Deposit Insurance Act should not be used for the resolution of non-depository financial companies. Using such rules is inconsistent with provisions in the resolution authority statute which guarantee all creditors that they will receive the same recovery as they would have received in a liquidation under the Bankruptcy Code.

In addition, the Federal Deposit Insurance Act rules were deliberately designed to reinforce the priority of deposit creditors—a class of creditors that does not exist for non-depository institutions—over unsecured non-deposit creditors—a class of creditors that account for only a tiny portion of the balance sheets of most depository institutions. The rule allowing the FDIC to set security interests aside if they were taken “in contemplation of insolvency” will also create a serious risk that otherwise perfected security interests may be set aside when applied to non-bank financial companies, thus causing secured credit (other than repos) to dry up during times of financial stress.

Instead, they argue that the resolution authority should be amended so that it provides a more transparent claims process, additional judicial review, neutral rules governing creditors’ rights and protection of secured creditors rights modeled on the Bankruptcy Code. Attached as Annex A to this memorandum is a chart comparing the key differences between the Bankruptcy Code and the proposed resolution authority.

Finally, they argue that unless the proposed resolution authority is amended to be a compromise between the Federal Deposit Insurance Act and bankruptcy models, it will have the unintended consequence of making our credit markets inefficient—increasing the cost and reducing the availability of credit to these financial companies, consumers, small businesses and others in the system; slowing jobs growth; increasing unemployment; and causing liquidity to dry up during times of financial stress.

Defenders of the bank insolvency model for both the core resolution powers and the ancillary claims process counter that the right of de novo judicial review after the administrative claims process has been completed provides adequate due process. They argue that there is no significant difference in outcomes between the FDIC’s application of the rules defining creditors’ rights in the Federal Deposit Insurance Act and a typical bankruptcy court’s application of the rules in the Bankruptcy Code. As a result, the unintended consequences are more feared than real.

Proponents of the bankruptcy model for the ancillary claims process have responses to each of these defenses. First, the administrative claims process under the Federal Deposit Insurance Act is in fact more opaque and provides far less due process and judicial review than a bankruptcy process. Second, there are in fact significant differences in outcomes between the two sets of rules. Moreover, if there really were no significant differences in outcomes, the FDIC should be required to apply the rules under the Bankruptcy Code to avoid creating any legal uncertainty about the matter and to avoid any inconsistencies between the applicable rules and the minimum recovery guarantees in both the House and Senate versions.

Other defenders of the bank insolvency model for both the core resolution powers and the ancillary claims process argue that if the rules governing creditors’ rights in the proposed resolution authority would impose greater losses on creditors or subject them to greater legal uncertainty of recovery than the Bankruptcy Code, they serve the important public policy purpose of further enhancing market discipline and reducing moral hazard.

Proponents of the bankruptcy model for the ancillary claims process counter that it is inconsistent with the minimum recovery provisions in the resolution authority to impose greater losses on creditors than they would have suffered in a liquidation under the Bankruptcy Code. Moreover, the public policy goals in favor of market discipline and reducing moral hazard must be balanced against the important public policy goals of due process and fundamental fairness. Otherwise, Congress could deny all recovery to creditors even if there were some assets available to satisfy all or part of their claims.

Who should pay?

Under both the House and Senate versions, the FDIC would have the power to recover its cost of providing any financial assistance by imposing ex-post assessments on US financial companies with $10 billion or more in assets.

A serious policy question arises as to whether it is appropriate to impose the cost of the new resolution authority on this pool of large companies. The direct beneficiaries of the financial assistance would not be these companies, except to the extent that they were among the creditors or counterparties whose claims are assumed by a third party or bridge financial company pursuant to the FDIC’s exercise of its core resolution powers. Instead, the direct beneficiaries would be the creditors and counterparties whose claims are assumed. To the extent the transfer of these claims helps to stabilize the financial system, the indirect beneficiaries would be everyone who benefits from financial stability.

Unless the creditors and counterparties whose claims are assumed bear the cost of the financial assistance, they will be insulated from losses. This could undermine market discipline and create a degree of moral hazard that would not exist if all financial companies were resolved under the Bankruptcy Code. But if a tax is imposed on these creditors and counterparties equal to the difference between what they would have received in a bankruptcy liquidation and what they actually received because of the third-party assumption of liabilities, it might undo the stabilization benefits of giving the FDIC the power to transfer the claims.

There is also a vigorous debate that is just beginning over whether the tax to recover these costs should be imposed before or after the resolution authority is exercised. The principal argument advanced so far in favor of an ex-ante tax is that an ex-post tax would allow the companies that are resolved to escape bearing any of the cost of their own resolution. The principal argument advanced so far against an ex-ante tax and in favor of an ex-post tax is that it is impossible to know whether the resolution authority will ever be used or how much it will cost if used.

Resolving agency?

Under both the House and Senate versions, the FDIC would be appointed as the receiver for all covered financial companies. The FDIC would be required to consult with the state or federal regulators of a covered financial company in carrying out its functions as receiver. But nothing would require the FDIC to follow the direction of any other regulator.

Some observers have argued that that the FDIC does not have the experience necessary to resolve the type of large, complex and global financial institutions that would be the subject of the new resolution authority. Its supervisory experience is limited to community banks and other relatively small insured depository institutions. Under the Senate discussion draft, it would lose even this experience over time because its supervisory authority would be transferred to the new Financial Institutions Regulatory Administration. Although the FDIC has resolved at least one relatively large savings association (Washington Mutual), that savings association had relatively simple activities compared to the targets of the proposed resolution authority.

To ensure that adequate experience is brought to bear on the resolution process, some observers have argued that a Systemic Resolution Board should be created consisting of the Treasury Secretary, the Chairman of the Federal Reserve (or the Financial Institutions Regulatory Administration), the Chairperson of the FDIC and the primary federal regulator of the company being resolved. The FDIC would carry out the resolution powers under the new authority, subject to the direction of the Systemic Resolution Board. The Systemic Resolution Board would also be the rulemaking authority under the proposed resolution authority and be responsible for international coordination.

Covered companies?

The original impetus for the proposed resolution authority was the disorderly failure of Lehman Brothers and the rescue of AIG. The government argued that it needed the proposed resolution authority to be able to resolve the AIGs or Lehmans of the future.

But the proposed resolution authority excludes both insurance company subsidiaries and broker-dealers that are members of the Securities Investor Protection Corporation from its scope of coverage. As a result, this resolution authority would not give the government authority over the entire AIG or Lehman groups. It would give the FDIC power to resolve a future AIG holding company or AIG Financial Products—where most of the AIG losses were located this time—but it would not extend to AIG’s insurance company subsidiaries—which represent the vast majority of its operations, where the losses could be located next time. Similarly, the proposed resolution authority would allow the FDIC to resolve the Lehman holding company and certain of its subsidiaries, but not its flagship broker-dealer. Indeed, it would exclude virtually all US broker-dealers from its scope of coverage because almost all of them are members of the Securities Investor Protection Corporation.

Mandatory rulemaking?

A number of observers have commented that the FDIC does not have a culture of transparency in providing ex-ante legal certainty on how ambiguities in the Federal Deposit Insurance Act are to be resolved. Although it has permissive rulemaking authority under the Federal Deposit Insurance Act, it has rarely exercised that authority. It has also been very sparing in providing other forms of legal guidance, including policy statements, general counsel opinions and other interpretations. In addition, all of these sources of legal guidance can be withdrawn by the FDIC at any time with, or in some cases without, notice.

These observers argue that the proposed resolution authority should include mandatory rulemaking authority, with the requirement that the FDIC or Systemic Resolution Board use this authority for the purposes of increasing ex-ante legal certainty and harmonizing the rules governing creditors’ rights to those in the Bankruptcy Code.

Valuation of transfers?

None of the proposals for resolution authority have included any specific procedures for ensuring that the FDIC obtains the highest possible price for any assets and liabilities sold or transferred pursuant to its exercise of core resolution powers. Because the amount received for such assets and liabilities has a direct relationship to the size of the difference between what left-behind claimants can obtain from left-behind assets and what they would have received in a liquidation under the Bankruptcy Code if any transfer of assets and liabilities had not occurred, the government should probably consider adding some incentives and procedures to ensure that the FDIC does not sell any assets or liabilities at below the maximum value possible over some reasonable time period.

International Coordination

Under both the House and Senate versions, the FDIC would be required to consult with the state and federal regulators of each covered financial company in exercising its powers as receiver. The FDIC would also be required to consult with the primary regulators for non-US subsidiaries and coordinate regarding the resolution of those entities.

Many large US financial companies have international operations outside the United States through a network of branches, offices and subsidiaries. These branches, offices and subsidiaries are generally subject to different bankruptcy laws in different national jurisdictions. Currently, there is no set of international agreements or arrangements that provide any overarching coordination when a major cross-border financial firm fails. The failures of a few major cross-border financial firms during the financial crisis have been a real wake-up call to the international community.

The G-20 summit in Pittsburgh specifically endorsed two major international initiatives to develop cross-border bank resolution frameworks. [4] One initiative is the Cross-Border Bank Resolution Group of the Basel Committee on Banking Supervision. That group issued a consultative paper in September that proposes specific actions to improve efficiency and effectiveness of cross-border crisis management and bank resolutions. [5] Among other things, the Basel Committee recommended that national authorities and multinational groups should seek convergence on national resolution regimes and put in place bilateral or multilateral procedures to facilitate mutual recognition of crisis management and resolution proceedings. The other initiative is the IMF/World Bank Global Bank Insolvency Initiative, which issued an interim report in April 2009 and will issue a final report in the spring of 2010. [6] The final report is expected to include practical steps to achieve consistency among national laws for crisis intervention and bank resolution.

Endnotes

[1] Financial Stability Improvement Act of 2009, §§ 1609(b)(4) and 1609(h)(5); Restoring American Financial Stability Act of 2009, §§ 208(b)(4) and 208(h)(5).
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[2] Financial Stability Improvement Act of 2009 § 1109 (2009).
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[3] Testimony of T. Timothy Ryan Jr., President and CEO of the Securities Industry and Financial Markets Association, before the House Financial Services Committee (October 29, 2009), available at Restructuring and Liquidation of U.S. Financial Institutions, GLOBAL FINANCIAL CRISIS: NAVIGATING AND UNDERSTANDING THE LEGAL AND REGULATORY ASPECTS (September 25, 2009).
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[4] See Overview of Progress in Implementing the London Summit Recommendations for Strengthening Financial Stability, Report of the Financial Stability Board to G-20 Leaders, Financial Stability Board (September 25, 2009), available at http://www.financialstabilityboard.org/publications/r_090925a.pdf.
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[5] See Report and Recommendations of the Cross-border Bank Resolution Group, the Basel Committee (September 2009), available at http://www.bis.org/publ/bcbs162.pdf?noframes=1.
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[6] See An Overview of the Legal, Institutional, and Regulatory Framework for Bank Insolvency, International Monetary Fund and the World Bank Group (April 17, 2009), available at http://www.imf.org/external/np/pp/eng/2009/041709.pdf
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One of the fundamental tenets of market capitalism is the freedom of willing buyers and willing sellers to transact business. Ironically, this basic rule does not apply in the world of corporate mergers and acquisitions. Because of so-called “poison pills,” corporate mergers and acquisitions effectively require the support of the target company’s board of directors. Based on massive value losses from withdrawn tender offers a result of poison pills in the last few years, we suggest that it is time to revisit the broad judicial deference that has allowed directors to use poison pills to stand between bidders and stockholders indefinitely.

Poison pills emerged in the 1980s as a solution to corporate raiders use of “two-tiered” tender offers to coerce shareholders into tendering their shares for unfair prices. In Moran v. Household Int’l Inc., the Delaware Supreme Court upheld directors’ power to use this powerful defensive device, but with conditions. The Court seemingly tied its validation of the poison pill on two points: (1) a board’s decision to keep a pill in place is always subject to fiduciary duties (and therefore open to judicial review) and (2) if shareholders do not like how a board is using the pill, the shareholders preserve their ability to remove the directors from their jobs by running a proxy fight.

The validation of the poison pill in Moran coincided (and arguably caused) the decline of the coercive hostile takeover bids that marked the 1980s. Once poison pills were held to be lawful, however, boards used these devices to prevent shareholders from accepting all-cash for all-shares tender offers. In City Capital Associates v. Interco, the Delaware Court of Chancery upheld a board’s power to employ the pill to give itself time to develop an alternative transaction or provide previously undisclosed information to stockholders, presumably to persuade against accepting the tender offer. However, the Court held that once those purposes were achieved, the stockholders should have the right to decide for themselves, whether to accept a noon-coercive offer. The Court recognized that corporate directors – even those acting in subjective good faith – could seriously harm shareholder interests by using a pill to preclude a legitimate alternative to the board’s preferred course.

The balanced rule of Interco was short lived. Soon after Wachtell Lipton publicly advised clients to reincorporate outside of Delaware if Interco remained good law, the Delaware Supreme Court issued its landmark decision in Paramount Communications, Inc. v. Time, Inc. (“Time Warner”). The Time-Warner opinion suggested (but did not expressly rule) that directors can use a poison pill to reject indefinitely any bid, so long as the directors believe their long-term strategy will eventually generate greater wealth for stockholders. Thus, boards seemingly could “just say no” to a premium bid that a majority of a company’s shareholders prefer over staking their future on the current board’s managerial skill.

Why should a board of directors have this significant power? Does a pill create shareholder benefits that justify its use to override majority rule? The conventional wisdom often presented by corporate advisors is that besides protecting against coercive offers, poison pills cause bidders to pay higher prices to gain director support than the price shareholders would otherwise demand for their shares. In other words, in the absence of any pill, bidders can pay price “X,” which is the amount needed to get a majority of shareholders to sell their shares in a takeover bid. In theory, a pill allows boards to elicit a price higher than “X.” Whatever intuitive appeal this argument may have, we have not found empirical proof that poison pills actually create this positive effect. There is little reason to conclude that shareholders would accept materially lower premiums than boards are able to elicit, suggesting that any higher premium the poison pills elicit is marginal, at best. Also, poison pills may be no more effective in eliciting higher premiums than other less aggressive defenses. Conversely, by looking at the past three years alone, we find ample empirical evidence of poison pills contributing to massive destruction of shareholder and firm value. The chart below lists recent cases where a board rejected an unsolicited takeover bid and refused to redeem the company’s poison pill, and the bidder withdrew its bid rather than wait for whatever time it would take to replace the board through a proxy fight. The chart shows the percentage loss in stock price following withdrawal of the bid:

The above data illustrates that tens if not hundreds of billions of dollars of potential shareholder gains have been lost when bidders withdrew offers in the face of boards refusing to redeem their poison pills. Whether or not the target boards acted for improper entrenchment or out of a good faith belief in their own long term strategies is irrelevant to the shareholders who were denied the chance to tender shares and saw the stock price then plummet. Notably, these examples do not even address the billions of dollars of firm value that shareholders never knew they could have enjoyed from offers that were never made public because the target CEO deters a bid by making clear that the board will leave the pill in place and actively oppose any takeover efforts. This empirical evidence is particularly salient given that numerous scholars, such as Harvard Law School’s Lucian Bebchuk and Allen Ferrell, have shown that poison pills are among the anti-takeover provisions contributing most to managerial entrenchment and the reduction of firm valuation.

Given the above data, the arguments favoring the indefinite use of poison pills may make more sense in theory than in reality. Even assuming that pills allow boards to elicit marginally higher takeover premia in the normal course, it only takes a few boards who overplay their hand to wipe out any gains attributed to poison pills, and to turn the effect of pills into massive shareholder and societal losses. While we are not advocating the invalidation of poison pills in all instances, it may be appropriate for the Delaware courts to reexamine the broad discretion the law has given to directors to prevent transactions the shareholders may want to accept. Delaware courts may well return to the standard articulated in Interco, and require that in order to maintain a poison pill in the face of a significant premium offer, a board demonstrate a legitimate need for more time to adequately inform its shareholders about the company’s standalone prospects or to pursue a realistic and imminent alternative transaction.

Mr. Monks began his talk by emphasizing the importance of shareholders. He noted that in the absence of having an informed, motivated and powerful counter force to management, the corporation will always have the problem of autocrat who is answerable to no-one. The capital markets generate tremendous wealth. The key issue is who is entitled to this wealth.

Mr. Monks discussed his past experience with Sears Roebuck, where he submitted himself as a nominee for director, and Exxon Mobil, where he filed proposals to separate the chairman and CEO roles. Throughout this discussion, he noted that the current system is in need of serious reform, in part because of the asymmetry of resources available to the company compared with the activist shareholder. Mr. Monks also discussed his proposal for a mandatory rule that gives 5% of the shareholders the right to call a special meeting at which a majority of the shareholders present can remove any or all of directors with or without cause.

The student questions covered a broad range of topics, from whether increased litigation would lead to more activism or more reliance on ISS voting guidelines, to the desirability of government versus private sector employment.

Background materials about Mr. Monks and his talk are available here. A video of the talk is available here (Quicktime .mov format).

As we now know all too well, the credit crisis and the global recession stemmed, in important part, from stark failures of boards of directors and operating business leadership in important financial institutions: the witch’s brew of leverage, poor risk management, creation of toxic products, lack of liquidity – all made more poisonous by compensation systems which rewarded short-term revenues/profits without regard to risk.

Buffeted by the recession and the seizing up of the credit markets, GM and Chrysler veered into bankruptcy, burdened by decades of questionable decisions.

As a result of these dramatic collapses in both the financial and industrial sectors, trust in corporate leaders – indeed in the ability of corporations to govern themselves – has eroded dramatically (even though there are, of course, well run corporations in both areas of the economy). This crisis in confidence, due to problems real or perceived, has spawned numerous public sector initiatives, both here and abroad, to impose new limits on private sector governance and self-determination.

In the financial sector, the regulatory debate is robust. It has focused on imposing direct, substantive government rules limiting private sector discretion: e.g. counter-cyclical capital requirements, liquidity protections, revised accounting standards, credit rating agency reform, regulatory review of executive compensation, regulatory approval of certain complex products, better consumer protection, assessment of systemic risk, and special oversight for large complex financial institutions.

But for all publicly held corporations, financial and industrial, a dominant, recurring theme has been to “improve” the process of corporate governance by mandating an enhanced role for shareholders as a check on boards of directors and business leadership.

But a fundamental, recurring question needs to be asked and answered: are “shareholders” part of the solution or part of the problem in this governance crisis of confidence?

• One public policy initiative is to give shareholders more “voice,” primarily through advisory votes at annual meetings on the executive compensation regimes approved by the boards of directors (”say on pay”). This would mandate uniform federal “process” in an area of the law historically governed by the states and by shareholder efforts, company-by-company, to secure the right have such “say on pay” votes.
• A second regulatory change would increase the ability of small groups of shareholders to nominate alternative candidates in the annual shareholder election of directors (”ballot access”). Today, shareholders customarily vote for slates of directors nominated by the directors themselves – and it is expensive and cumbersome for shareholders to field additional candidates. (Of course, powerful economic interests can buy large blocks of stock and force directors onto boards or launch a hostile takeover for the whole company.)

These are “hot” shareholder issues. Both the Obama Administration and the Congress support “say on pay” shareholder votes for all publicly held corporations in the U.S. . And the SEC, which has debated the subject for years, now has a Democratic majority to approve some version of a “ballot access” rule.

The problem: the easy assumption about “shareholder” as “solution” ignores some obvious issues which have gained force in recent years.

• There is no such animal as “the” shareholder. Instead there is an extraordinary menagerie: large and small individual investors; public and private pension funds; a wide array of mutual funds; endowment funds for educational, health and other non-profit institutions; and an equally wide array of hedge funds. Almost all these institutional shareholders are trying, in one way or another, to beat their “benchmarks” whether those are the Dow Jones or the NASDAQ or relevant S&P or MSCI indexes or to make annual, absolute profits for themselves to justify the fees charged clients (including the two percent fee and 20 percent of profits often required by hedge funds).
• Institutional investors now own approximately 60 percent of U.S. equities (using other people’s money). Many observers say, while there are some long-term value holders, many of these investors are driven by the goal of short-term performance in their portfolios, engage in relatively short-term trading strategies and have little interest in corporate creation of long-term economic value by the corporations whose securities they own and trade. (Shares of stock are now held, on average, for far shorter periods than was the case 10 or 20 years ago.)
• Indeed, important questions have been raised about the role institutional investors played in causing the melt-down by pressuring financial service entities to take undue risk for short-term profits., Did the short-term investors crowd out long-term value investors in influencing corporations, and, if so, is this likely to be the future pattern?
• Questions have have also been raised about what kinds of salary and bonus plans do the institutional investors provide to their fund managers – the people who drive the stock market and may be an important source of the short-term pressure on companies? And, how are powerful institutional investors–from pension to mutual to hedge funds – governed and what are their fiduciary duties to individuals whose money they “manage”?
• Ultimately, how imperfect are shareholders and the stock market in valuing companies given the widely divergent time frames and objectives of institutional investors and the irrationalities (e.g. herd mentality) and inefficiencies of the market at any moment in time?

As Henry Kaufman, a prominent Wall Street economist for decades has written in a recent book (The Road to Financial Reformation), most “investment relationships today are very fickle. Portfolio performance is measured over very short time horizons…Day trades and portfolio shifts based on the price momentum of the stock – rather than anything having to do with the underlying fundamentals – are commonplace.”

Or, as Ira Millstein, a godfather of the corporate governance movement and long-time advocate of more shareholder voice, has recently written (in Directorship magazine): “…the model of shareholder activism…envisioned in the 1980s and 1990s [is] under severe strain. Institutional investors were once presumed to share a common goal when exerting pressure on boards to monitor management and effectively guide firm strategy. That assumed homogeneity is long gone…The diversity of shareowners has brought a whole new host of agendas, strategies and values to the table. Some of these owners have limited investment horizons and are only interested in realizing a short-term profit, and others have hedged or shorted their positions and consequently have a financial interest in the failure of the enterprise.”

Non-US regulatory bodies like the multinational Financial Stability Board or the UK’s Financial Services Authority in their lengthy post-mortems on the financial crisis have analyzed the harmful effects of investor short-termism. And when the Federal Reserve Board recently announced that it would supervise, and if necessary regulate, executive compensation at the nations banks, its proposed rule noted that a shareholder perspective was inadequate: “Thus a review of incentive compensation arrangements and related corporate governance practices [as through "say on pay" votes] to ensure that they are effective from the standpoint of shareholders is not sufficient to ensure they adequately protect the safety and soundness of the organization.”

In fact, there is now a growing movement to examine the institutional shareholders critically and systematically as a cause of the short-termism that drives bad corporate behavior (the Millstein Center for Corporate Governance and Performance at Yale’s School of Management and Aspen Institute Business and Society Program come to mind). The important issues noted above need systematic empirical and prescriptive exploration.

Seen through the lense of history, this is, in fact, just the latest chapter in an historic argument about the respective powers of shareholders, boards and management to control corporations (within the context of legal rules and regulations). Shareholders “own” the company and elect the directors, but often in the past there was no real electoral competition because the only candidates were those selected by the board itself, with heavy CEO influence, and management had a monopoly on important information. A famous book by Adolf Berle,Jr. and Gardiner Means in 1932 described this separation of “ownership” and “control” (The Modern Corporation and Private Property). Game on – for more than 75 years.

To be sure, those advocating a bigger role for shareholders are addressing real and important issues.

• Companies should consult shareholders, but not just on pay in a formal annual meeting vote. More importantly, corporate directors, CEO’s and senior business leaders need to give all stakeholders “voice”, not just shareholders: creditors, employees, customers, suppliers, communities. All are critical to the health of the corporation; all come in different shapes and sizes; all have important, but divergent interests. Company leadership must hear and balance all these concerns in reaching a decision about how to carry out the corporation’s fundamental mission. But how many listen well?
• Shareholders have also raised the profound issue of board and CEO “accountability.” The problem, as noted, is the self-perpetuating nature of corporate power, CEOs suggesting board members, board members nominating each other for routine shareholder election. If the company leadership is complacent or making bad decisions, how fix the problem. (GM?) The broad answers have their own issues. Regulation can be too heavy handed, have unintended consequences and stifle creativity and innovation (especially regulation about governance in contrast to laws protecting a social good like the environment). Turning corporations into political entities with blocs of shareholders fighting continuously about control and direction would sap precious time from providing great services. And the stock market may in the long run value companies correctly but in the short run be irrational and punish companies for taking actions for long term growth (investments, R&D) that depress profits in short term.

The ultimate question which underlies virtually all of the regulatory debates is: “voice” and “accountability” in the service of what mission? Many would argue that the dominant mission of the past two decades of creating shareholder value is too narrow and too prone to short-termism. Many market participants (and we need much more study to understand precisely) are not interested in what most would argue is the the basic task of corporations: to create sustainable economic value by providing great goods and services which customers want and which benefits all stakeholders using sound risk management and with high integrity (law, ethics, values).

Put a slightly different way, boards and CEOs must balance risk taking (innovation and creativity) with risk management (financial and operational discipline) and must fuse high performance with high integrity (to address legal, ethical, reputational, policy risk). Carrying out this mission by defining and attaining key operational goals in performance, risk and integrity dimensions – and compensating according to those goals– is the fundamental role of boards of directors and senior management. This what creates long-term shareholder value.

In light of the deleterious focus of many institutional shareholders on short-term results in their own, not the corporation’s interest, we need to understand in a much clearer way when shareholders can be part of the solution – and when they are a major part of the problem – in advancing that fundamental corporate mission. But the deeper problem is finding the right accountability mechanisms which allow the right measure of corporate self-determination at the board/CEO level but which also holds them to account.

Ben W. Heineman, Jr. is a Senior Fellow of the Harvard Law School Program on Corporate Governance.