It is generally accepted that the full board has overall responsibility for risk oversight, mirroring the board’s responsibility for overseeing strategy. In deciding how to organize itself to oversee risk and risk management, the question arises as to whether the board should establish a separate risk committee. This article explores that question and provides examples to clarify the role and responsibility of a separate risk committee in situations where the board decides to establish one.

Through the risk oversight process, the board of directors obtains an understanding of the critical risks inherent in the corporate strategy, accesses useful information from internal and external sources about the critical assumptions underlying that strategy, remains alert to organizational dysfunctional behavior that can lead to excessive risk taking, and provides input to executive management regarding critical risk issues on a timely basis. How the board views risk oversight as a process should dictate how it chooses to organize itself for purposes of executing that process. The risk oversight process enables the board and management to develop a mutual understanding regarding the risks the company faces over time as it executes its business model for creating enterprise value. In organizing itself for risk oversight, what are some of the factors for boards to consider and when should boards establish a separate risk committee?

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The U.S. House of Representatives passed by a vote of 417-2 its version of the STOCK Act, which, as you may know from our previous post, was introduced in response to the U.S. Senate’s passing its own version of the STOCK Act. Now that the House version has passed, we expect that the House and Senate versions will go to conference. A copy of the House version of the STOCK Act can be found here.

Please note that among the more notable differences between the bills are that the Senate version amends both the Lobbying Disclosure Act of 1995 (by adding a new category of activities, “Political Intelligence Contacts”) and the illegal gratuities statute, but the House version does not. The differences between the two bills will have to be resolved and then approved by both the House and Senate in order for a final bill to be sent to the White House.

In our paper, Cross Border Shareholder Class Actions Before and After Morrison, we conduct an empirical inquiry into the effect of the Supreme Court’s 2010 decision in Morrison v. National Australia Bank on the competitiveness of US markets as a venue for listings by foreign issuers and trading in cross-listed stocks. Passed in the wake of Morrison, the Dodd-Frank Act requires that the SEC inform Congress about the merits of creating a new extraterritorial private right of action. We provide input into the debate by using data on 329 shareholder class actions filed against foreign companies and discussing the effects of such a right on the competitiveness of U.S. capital markets.

We conclude that foreign companies’ expected litigation costs should fall after Morrison, because investors who purchased their shares on overseas exchanges will be excluded from classes. By reducing expected litigation costs, Morrison eases a deterrent to US listing by foreign issuers and thereby makes the US a more competitive venue for cross-listings, as well as for the volume in the cross-listed stocks. We submitted our paper to the SEC as part of its public comment process, and have posted it on SSRN.

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A September 2011 Delaware Court of Chancery decision refused to dismiss claims alleging that a board of directors breached its fiduciary duty of loyalty in authorizing a sale of a corporation to a third party. The stockholder plaintiff alleged that the sale was motivated by the corporation’s former chairman and chief executive officer, who owned 37% of the corporation’s common stock and needed liquidity. The decision is significant for refusing to dismiss allegations of disloyal conduct against outside directors who were disinterested in the transaction and otherwise unaffiliated with the former CEO.

Background

New Jersey Carpenters Pension Fund v. infoGROUP, Inc. involved the 2010 sale of infoGROUP, Inc., to a private equity fund. The stockholder-plaintiff alleged that the sale was motivated by the corporation’s former chairman and chief executive officer, who owned 37% of the company and “desperately needed liquidity” to fund a new venture and to satisfy $12 million in settlement obligations stemming from a Securities and Exchange Commission action and a derivative suit brought against him. The plaintiff claimed that the board of directors breached its fiduciary duties by capitulating to the former CEO’s pressure and approving a transaction that was not in the best interests of all shareholders.

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In my paper, Managerial Investment and Changes in GAAP: An Internal Consequence of External Reporting, which was recently made publicly available on SSRN, I investigate whether changes in Generally Accepted Accounting Principles (GAAP) affect corporate investment decisions. I hypothesize that the relation between changes in GAAP and investment manifests for at least two non-mutually exclusive reasons. First, I hypothesize that changes in GAAP can affect investment because the numbers reported in financial statements have a direct bearing on contractual outcomes. For example, debt contracts often contain covenants based on numbers reported in financial statements (Leftwich [1983]). Consequently, if a change in GAAP has an unfavorable (favorable) impact on current and future financial statements, and debt covenants are not adjusted to incorporate the changes, the change in GAAP will likely tighten (loosen) covenant slack. As a result, managers may alter their actions to avoid covenant violation. Specifically, since most investments have an uncertain future outcome and some positive probability that the outcome is a loss, they increase the probability of violating covenants in the future by adversely impacting future financial ratios. Consequently, managers might respond to changes in GAAP that adversely affect financial statements by cutting investment in risky assets with the goal of preserving net worth and preventing deterioration of financial ratios.

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Last Thursday, February 2, 2012, the Senate passed S. 2038 (the STOCK Act) which, among other things:

• confirms that the insider trading ban under Section 10(b) of the Securities Exchange Act of 1934 (’34 Act) applies to congressional members and staff, and executive and judicial branch officials;
• amends the Lobbying Disclosure Act of 1995 (LDA) to cover political intelligence contacts; and
• broadens the illegal gratuities statute.

The above changes are described in greater detail below. Information about the House version of the STOCK Act is provided later in the post.

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In Gerber v. Enterprise Products Holdings, LLC, C.A. No. 5989-VCN (Del. Ch. Jan. 6, 2012), the Court of Chancery enforced the contractual modification of fiduciary duties in Enterprise GP Holdings, L.P.'s partnership agreement and, on a motion to dismiss, dismissed all claims against the defendants arising out of the sale of a subsidiary by Enterprise GP Holdings to an affiliate and the subsequent merger of Enterprise GP Holdings into the same affiliate.

In April 2009, Enterprise GP Holdings sold Texas Eastern Products Pipeline Company, LLC to Enterprise Products Partners, L.P., a publicly traded partnership managed by a subsidiary of Enterprise GP Holdings (the "Sale"). A committee of independent directors of EPE Holdings, LLC, the general partner of Enterprise GP Holdings, approved the Sale after receiving a fairness opinion from Morgan Stanley & Co. In September 2010, Enterprise Products Partners and Enterprise GP Holdings entered into a merger agreement that provided for Enterprise Products Partners to issue units in exchange for all of the outstanding units of Enterprise GP Holdings (the "Merger"). Again, a committee of independent directors of EPE Holdings approved the Merger after receiving a fairness opinion from Morgan Stanley.

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A recent acquisition approval order of the Board of Governors of the Federal Reserve System (the “FRB”) provides the first analysis of the “financial stability” factor in Section 604(d) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). This section amended Section 3(c) of the Bank Holding Company Act of 1956 (“BHC Act”) to require the FRB, when evaluating a proposed bank acquisition, merger, or consolidation, to consider “the extent to which [the] proposed acquisition, merger, or consolidation would result in greater or more concentrated risks to the stability of the United States banking or financial system”. Section 604(e) of the Dodd-Frank Act similarly amended Section 4(j)(2) of the BHC Act to require the FRB to consider financial stability concerns when reviewing notices by bank holding companies to engage in nonbanking activities.

On December 23, 2011, the FRB issued an order (the “Order”) explaining its reasons for approving the acquisition of RBC Bank (USA) (“RBC Bank”) by The PNC Financial Services Group, Inc. (“PNC”). (The FRB announced its approval of the transaction on December 19, 2011 but, unusually, the Order was not released until several days later.) The Order constitutes the first articulation by the FRB of how it will analyze proposed transactions under the new financial stability factor. The FRB stated in the Order, however, that it expects to issue a notice of proposed rulemaking implementing this change to Section 3(c) of the BHC Act as well as other provisions of the Dodd-Frank Act that require the FRB to consider the effect on financial stability of other proposals by financial institutions, and that this will afford the public an opportunity to provide comments on how the FRB should take financial stability into account when reviewing applications and notices.

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In our paper, The Real Effects of Financial Markets: The Impact of Prices on Takeovers, forthcoming in the Journal of Finance, we provide evidence on the real effect of financial markets. Using non-fundamental shocks to market prices — occurring due to non-discretionary trades by mutual funds that face liquidation pressure from investors’ outflows — as an instrumental variable, we show that market prices affect takeover activity. A non-fundamental decrease in the stock price creates a profit opportunity for acquirers, and increases the probability that the firm will be taken over. Using an instrument for price changes is essential for identifying this effect since market prices are endogenous and reflect the likelihood of an upcoming acquisition. This may explain the weak relationship between prices and takeover activity found by prior literature. By modeling the relationship between prices and takeovers as a simultaneous system that accounts for anticipation, and identifying using an instrument, we find a significantly stronger effect of prices on takeovers than previous research.

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Strategic M&A Continues to Drive Overall Deal Activity

The dollar value of announced M&A transactions involving U.S. targets rose by approximately 12 percent during 2011 compared with 2010, according to Dealogic data. However, the total number of announced transactions remained relatively flat, with activity levels at their highest in the first quarter of 2011 and slowing during the rest of the year amid increasing economic uncertainty and market volatility.

Strategic M&A was the primary driver of overall activity last year, with an increase in larger, billion-dollar-plus transactions compared to 2010. Strategic buyers — in particular, well-established investment grade companies that have substantial amounts of cash on their balance sheets, improving outlooks on future business performance and access to financing on favorable terms — looked to M&A as a way to generate growth faster than could be achieved organically in the current economic environment. Industry sectors that were particularly active in 2011 M&A transactions included pharmaceuticals/health care, energy/oil & gas, telecommunications/ technology, real estate, chemicals and financial services. Given the liquidity available to strategic buyers, we expect cash to continue to be the preferred form of consideration in acquisitions, although equity and mixed consideration will continue to be used in transformative combinations (including mergers of equals), transactions where the buyer faces leverage constraints and those in which the seller is unwilling to give up the opportunity to participate in the potential future upside of the combined company.

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