Mergers and acquisition (M&A) practices vary – indeed, practitioner lore is that every deal is unique.  But M&A deals have much in common.  M&A contracts, techniques, and outcomes vary systematically.  While practitioners exploit such patterns, few have been reported, analyzed, or considered in academic research, and not all practitioners fully reflect these patterns in their practices.  In a recent working paper, available here, I show that ownership dispersion is a first-order determinant of M&A practices.  Firms with dispersed ownership are more salient, and tend to be larger, but dispersion varies significantly even at large US businesses, and affects M&A deal size, duration, techniques, contract terms, and outcomes.

Privately held firms are an important part of the US economy, as is private target M&A. Most US business corporations had 100 or fewer owners, and those firms generated 20+% of corporate receipts in 2006.  Of businesses with more than $250 million in assets, only 18% were C corporations with 500+ shareholders.  Even at public companies, dispersion varies significantly.  A few have millions of record owners, and 500+ have 15,000+ shareholders. But 500+ “public” companies have fewer than 50 record shareholders, and over a third have fewer than 300 record holders.  These companies are the reverse of firms that have “gone dark” – they could deregister with the SEC, but instead voluntarily choose to “remain lit” and file regular reports.

M&A practices thus can and do diverge based on variation in ownership. Dispersion creates transaction costs and heterogeneous beliefs and preferences that have straightforward effects on M&A deal size, techniques, and some contract terms.  But dispersion also has less intuitive, indirect, and important effects as mediated through laws that among other things compensate for agency costs and collective action problems.  Each key body of law for M&A – contract law, corporate law, securities law, and antitrust law – is shaped in practice by ownership of target firms.

These effects are tested with comprehensive M&A data from 2007 and 2008, and a new detailed hand-coded matched sample of 120 recent public and private target M&A contracts. Among other things, simple comparisons and regression analyses show:

• Size, frequency and volume.  Public target bids are ten times larger than private target bids, but much less common.  The overall result – aggregate deal volume – is roughly the same order for the two kinds of targets.
• Cross-border and diversifying bids.  Public target bids much more commonly are diversifying (i.e., bidder and target in different industries) and cross borders, even among similarly sized bids.
• Bid duration and completion. Private target bids typically involve simultaneous signing/closings, which are rare (but do sometimes occur) in public target bids.  Public target bids with deferred closings take twice as long to close, even above Hart-Scott-Rodino thresholds and controlling for bid size. Partly as a result, announced public target bids are withdrawn 10+ times more often.
• Deal structure.  Public target bids are almost always either one-step mergers or multi-step bids that include a tender offer.  Private target bids are most commonly negotiated stock purchases, but also commonly are one-step mergers or asset purchases.
• Bid consideration.  While both types of bids use a variety of types of consideration overall, bidders for private targets much more commonly offer mixed consideration and debt consideration (i.e., seller financing).
• Risk-and profit-sharing contracts.  Private target bid contracts much more commonly use earn-outs, indemnification, price adjustments, escrows, and holdbacks, all of which are rare (but are sometimes used) in public target bids.
• Fiduciary outs and deal protection.  Public target bid contracts much more frequently address the target board’s fiduciary duties, including through fiduciary outs, and much more frequently include deal protection clauses – but private target bids do sometimes include these provisions.  When included, termination fees are actually higher in private target bids (as a percentage of the bid size, and controlling for bid size).
• Dispute resolution and remedies.  Private target contracts more frequently choose arbitration, both for price adjustment clauses and for the contract as a whole, whereas public target contracts more frequently choose Delaware courts and more frequently provide for specific performance.

Appreciation of how pervasive and powerful the effects of ownership are on M&A should improve contracting and has implications for investment bankers, boards, courts, and researchers in choosing comparable transactions for valuation, benchmarking, doctrinal analogies, drafting models, teaching M&A in business and law schools, and econometric modeling of M&A.

The working paper is available here.

The SEC yesterday formally released an anticipated new initiative designed to encourage individual and company cooperation with SEC investigations and enforcement actions. [1] The initiative, laid out in a new section of the enforcement manual for the Division of Enforcement entitled “Fostering Cooperation,” (the “Initiative”) establishes incentives for early, substantial, robust cooperation with the stated goal of ensuring “that potential cooperation arrangements maximize the Commission’s law enforcement interests.” [2] The Initiative provides guidance for evaluating an individual’s cooperation and authorizes new cooperation tools, including cooperation agreements, deferred prosecution agreements and non-prosecution agreements. While the new Initiative provides more options for the Enforcement Division and individuals, only time will tell if it proves to be the “game-changer” that Enforcement Director Robert Khuzami anticipates.

I. Features of the New Initiative

A. Standards for Evaluating an Individual’s Cooperation

The revised Enforcement Manual includes a policy statement detailing an advisory framework of standards with which to evaluate an individual’s cooperation. There are four general considerations: (1) assistance provided by the individual; (2) importance of the underlying matter; (3) interest in holding the individual accountable; and (4) profile of the individual. The standards track the typical Department of Justice considerations for evaluating cooperation.

1. Assistance Provided by the Individual

In evaluating the assistance provided by the individual, the Commission will consider, among other things, the value and nature of the individual’s cooperation. The value of the cooperation includes the extent to which the individual’s cooperation substantially assisted the investigation and the timeliness of the cooperation, including whether the individual was the first to cooperate and whether the individual cooperated before he or she had any knowledge of an investigation or related action. The value of the cooperation will also be assessed based on its quality — whether it was truthful, complete, and reliable — and the time and resources conserved as a result of the cooperation. The Initiative further details that assessing the nature of the cooperation should include an evaluation of whether the individual cooperated voluntarily, the types of assistance provided by the individual, whether the individual revealed information not otherwise obtainable, whether the individual encouraged or authorized others to assist the Division, and other unique circumstances.

2. Importance of the Underlying Matter

In evaluating the seriousness and importance of the underlying matter, the Commission will consider the “character of the investigation” and the dangers presented by the underlying violations to investors and others. The character of the investigation includes whether the subject matter is a Commission priority, the type of securities violations, the age and duration of misconduct, the number of violations, and the isolated or repetitive nature of the violations. The danger presented by the underlying violations will be assessed based on, among other things, the amount of harm or potential harm caused by the violations, the type of harm, and the number of individuals or entities harmed.

3. Interest in Holding the Individual Accountable

The Commission will also assess the societal interest in ensuring that the cooperating individual is held accountable for his or her misconduct. The Initiative sets out that this will be evaluated by considering the severity of the individual’s misconduct, the culpability of the individual, the degree to which the individual tolerated illegal activity, the individual’s efforts to remedy the harm caused, and the sanctions imposed on the individual by other authorities. Additional considerations relevant to holding the individual accountable include the nature of the violations, the individual’s education, training, experience, and position of responsibility at the time the violations occurred, whether the individual acted with intent or knowledge of the wrongdoing, whether the individual took steps to prevent the violations, including bringing the misconduct to the attention of the Commission, other law enforcement entities, members of management, the board of directors, or a company’s auditors, whether the individual has agreed to pay or has paid disgorgement, and whether the individual assisted in the recovery of the fruits and instrumentalities of the violations.

4. Profile of the Individual

Finally, the Initiative provides criteria to evaluate the individual in terms of assessing the appropriateness of cooperation credit. The cooperating individual’s personal and professional profile should be assessed based on, among other things, the individual’s history of lawfulness, the individual’s acceptance of responsibility, and whether the individual will have an opportunity to commit future violations of the federal securities laws based on his or her occupation (e.g., persons in the securities industry, executives of public companies, accountants, attorneys, etc.) and any existing or proposed safeguards.

B. New Cooperation Tools

The new Initiative provides the Division of Enforcement with a nonexclusive list of tools to facilitate cooperation in investigations and enforcement actions.

1. Cooperation Agreements

The Initiative provides for cooperation agreements in which the Division agrees to recommend to the Commission that the individual or company receives credit for giving substantial assistance. The Division may also make specific enforcement recommendations to the Commission where appropriate. In return, the individual or company agrees, among other things, to cooperate fully and truthfully, and waive applicable statutes of limitations.

Before entering into a cooperation agreement, the Division staff is instructed to consider whether there are other timely and effective means of obtaining the desired cooperation, and whether the individual or company has entered or is likely to enter into a plea agreement with criminal prosecutors that will require the individual or company to cooperate in the Commission’s investigation and enforcement actions.

The Director of the Division and senior officers designated by the Director have the authority to enter into cooperation agreements on behalf of the Division. If the Division agrees to make a specific enforcement recommendation to the Commission, the cooperating individual or company must provide substantial assistance, as assessed by the Division, and must agree to resolve the matter without admitting or denying the alleged violations.

If the agreement is violated, the Division of Enforcement may recommend to the Commission that it institute an enforcement action against the individual or company without any limitation. In addition, cooperation agreements entered into with the Division are not binding on the Commission. Only the Commission has the authority to approve enforcement dispositions and accept settlement offers.

2. Deferred Prosecution Agreements

The Initiative provides for deferred prosecution agreements in which the Commission agrees to forego an enforcement action against the individual or company, and the individual or company agrees, among other things, to cooperate fully and truthfully, waive applicable statutes of limitations, comply with prohibitions and undertakings, pay any agreed disgorgement or penalty amounts, and admit or agree not to contest the relevant facts underlying the alleged offenses. Deferred prosecution agreements are for a set amount of time that cannot exceed five years. If the cooperating individual or company satisfies the terms of the agreement during the specified time, the Commission agrees not to pursue any further enforcement action concerning the subject of the agreement.

Deferred prosecution agreements must be approved by the Commission, and unless the Commission directs otherwise, these agreements will be made available to the public upon request. If the agreement is violated during the period of deferred prosecution, the Division may recommend to the Commission an enforcement action against the individual or company without limitation. Notably, the agreement will require the cooperator to agree that, if the Commission authorizes an enforcement action, any factual admissions made by the cooperator may be used against him. The Initiative indicates that this provision is generally appropriate for persons in the securities industry, fiduciaries, executives of public companies and licensed professionals, such as accountants and attorneys.

3. Non-Prosecution Agreements

The Initiative provides for non-prosecution agreements in which the Commission agrees not to pursue an enforcement action against the individual or company. In return, the individual or company agrees, among other things, to cooperate fully and truthfully, comply with express undertakings, and pay any agreed disgorgement or penalty amounts. The Initiative makes clear that these agreements should generally be used in limited circumstances and not early in investigations or for individuals with prior violations of the securities laws.

Before entering into a non-prosecution agreement, the Division staff should consider whether there are other timely and effective means of obtaining the desired cooperation, and whether the individual or company has entered or is likely to enter into a plea agreement with criminal prosecutors that will require the individual or company to cooperate in the Commission’s investigation and enforcement actions.

Non-prosecution agreements must be approved by the Commission. If the agreement is violated, the Division may recommend to the Commission an enforcement action against the individual or company without limitation. Additionally, if the Commission authorizes an enforcement action, any statements, information, and materials provided pursuant to the agreement may be used against the cooperator.

4. Expedited Immunity Requests

The Initiative also provides for expedited immunity requests to the Department of Justice in order to provide a cooperator with protection against criminal prosecution. In the past, this has been accomplished in limited circumstances by the Commission requesting a letter of immunity from the Department of Justice. The revised enforcement manual delegates to the Director the authority to make immunity requests to the Department of Justice. By eliminating a level of review, this delegation of authority streamlines the immunity request process.

In addition, unless the court and/or the Commission directs otherwise, immunity letters and orders will be treated as public documents. It is unclear whether this means that the immunity letters or orders will be affirmatively made public, or whether they will be available to the public upon request.

5. Proffer Agreements and Oral Assurances

The Division has used proffer agreements for many years as a means for both the staff and potential cooperators to assess the value and benefits of cooperation. The new Initiative codifies guidelines on the use of proffer agreements which generally provide that statements made by a person may not be used against that individual in subsequent proceedings except as a source of investigative leads or for impeachment or rebuttal if the person testifies inconsistently in a subsequent proceeding. The Commission may share the information provided by the proffering individual with the appropriate authorities in a prosecution for perjury, making a false statement and obstruction of justice.

In a related tool, the Initiative also authorizes the use of “oral assurances” to inform an individual or company that the Division does not currently anticipate recommending an enforcement action against the individual or company. These assurances can be given by Assistant Directors with the approval of a supervisor at or above the level of Associate Director. Oral assurances are based upon the evidence currently known to the Division staff, and the Division’s enforcement recommendations may change if new evidence comes to light. In addition, the oral assurances are not binding on the Commission, which has final authority to accept or reject enforcement recommendations.

II. Observations and Analysis

With the Enforcement Division’s new policy in its nascent stage, we offer below our initial observations and analysis of the Initiative and its implications. For a more detailed discussion of the challenges the SEC faces in motivating individual cooperators, see our article “Courting Cooperators: The SEC’s Effort to Motivate Individual Cooperation.”

To cooperate or not? That remains the question. The decision whether to cooperate or not to cooperate in any case involves a highly fact-specific balancing of the risk-adjusted costs and benefits of each alternative. The Enforcement Division’s Initiative on cooperation provides new options for the staff and defense counsel to explore as potential alternatives to the historically limited options of an enforcement action or nothing. However, the alternatives still come with costs, including admissions to (or agreements not to contest) facts, risks of collateral exposure, such as civil litigation, loss of current and future employment opportunities, and adverse publicity, just to name a few. Further complications may arise as the Commission considers whether cooperation would merit the forgiveness of disgorgement in the face of investor losses. The real question is whether the SEC will be able, in specific cases over time, to provide sufficient rewards for cooperating to overcome the costs. Only time will tell.

The issue of waiver. In a separate section, the Enforcement Manual notes the Commission’s policy that assertions of the attorney-client privilege and work-product protection will be respected by the staff, and voluntary disclosure of information need not include a waiver of privilege to be considered an effective form of cooperation. These provisions must now be assessed in the context of the cooperation guidelines recently announced and the expectations of the staff under such agreements. The same concerns that prompted the Commission’s announcement of policy as to privilege remain, and both respondents and the staff will have to proceed particularly carefully in this area.

In evaluating cooperation, timeliness counts. While the Initiative announces many factors to guide the evaluation of cooperation, Mr. Khuzami has emphasized timeliness above all else. In his remarks announcing the new cooperation guidelines, Mr. Khuzami reiterated the importance of early cooperation: “And for those thinking about cooperating, you should seriously consider contacting the SEC quickly, because the benefits of cooperation will be reserved for those whose assistance is both timely and necessary. Latecomers rarely will qualify for cooperation credit, so there is every reason to step forward — before someone else does — while you are in a position to benefit from your knowledge of wrongdoing.” [3] This means that the decisions about cooperation needs to be addressed early and often in order to maximize credit.

The criminal authorities. The staff’s emphasis on early cooperation does not address the continuing issue of coordination between the Commission’s investigations and potential interest on the part of the criminal authorities. Each often runs on a very different timeline and respondents may find themselves between the competing interests of two separate enforcement interests, making early reporting to the staff extremely difficult without the benefit of the grant of immunity by the criminal authorities — a process, even if expedited, that may itself delay or preclude early reporting.

For individuals in the securities industry, expect greater consequences to cooperating. One theme running through the Initiative is that the there will be less leniency afforded certain categories of individuals based on their role in the securities industry, including individuals associated with broker-dealers and investment advisers, officers and directors of public companies, and licensed professionals, such as accountants and lawyers. For example, the Commission is more likely to demand from such individuals an admission to (or agreement not to contest) adverse facts and perhaps other conditions as part of a deferred or non-prosecution agreement.

Transparency has its costs (and benefits for some). One of the obstacles the SEC has faced in encouraging cooperation has been the lack of transparency in SEC settlements that makes it difficult for the public to see the benefits of cooperation. In order to address this issue, the Initiative contains a section advising the staff to provide sufficient information to the public about the nature of the Commission’s cooperation program and its significant benefits, consistent with the existing duties of confidentiality. The Initiative also states that many of the cooperation tools will result in publicly available documents. This means that potential cooperators need to consider that cooperation may result in publicity and the consequences that will follow. But others, including experienced defense counsel, will get the benefit of reviewing resolutions which become public.

It’s not just about individuals. Although the Initiative is directed primarily at individuals, the Initiative also reiterates the Commission’s policy on cooperation by corporations contained in the so-called “Seaboard” report. In addition, each of the new cooperation tools may apply to companies as well as individuals. Thus, the additional options, such as deferred prosecution agreements and non-prosecution agreements, are now potential options by which corporations may seek to resolve investigations short of enforcement actions.

In the near term, the staff will likely grapple with the contours of the Initiative, just as defense counsel and putative defendants will. Only the application of the Initiative to matters over time will answer the question of whether the Initiative provides sufficient incentives to change the game for cooperators.

Endnotes

[1] “SEC Announces Initiative to Encourage Individuals and Companies to Cooperate and Assist in Investigations,” (Jan. 13, 2010), http://www.sec.gov/news/press/2010/2010-6.htm.
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[2] Enforcement Manual, section 6, http://www.sec.gov/divisions/enforce/enforcementmanual.pdf.
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[3] Robert Khuzami, Director of Division of Enforcement, U.S. SEC, “Remarks at Press Conference,” (Jan. 13, 2010), http://sec.gov/news/speech/2010/spch011310rsk.htm.
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In our paper Capital Allocation and Delegation of Decision-Making Authority within Firms, which was recently published on SSRN, we examine the allocation of capital and the delegation of decision-making authority within firms. Theoretical research examines how decision-making authority is delegated within groups. While the theoretical implications are far-ranging, there is a scarcity of empirical evidence about the delegation of authority within corporations (as noted by Prendergast (2002) and others). This paper provides some of the first empirical evidence that focuses on the delegation of decision-making authority with respect to major corporate policies. In particular, we study whether the chief executive makes decisions on her own versus delegating to lower-level executives and divisional managers.

We survey more than 1,000 CEOs and CFOs around the world to determine who within the firm makes five different corporate decisions: capital allocation, capital structure, investment, mergers and acquisitions, and payout. Most of our analysis focuses on the 950 CEO and 525 CFO survey respondents who work in U.S.-based companies, though we also examine smaller samples of Asian and European executives. Knowing the job title of the corporate decision-maker is important, given recent evidence that executive-specific fixed effects appear to drive some corporate policies.

Our empirical evidence partially supports the theoretical predictions about which corporate policies CEOs should make in relative isolation with little delegation to lower level employees, and under which conditions. Theory predicts that CEOs should delegate more when their workload is high, and less when the CEO‟s knowledge is particularly valuable. The empirical evidence is consistent with these predictions. We also report that CEOs dominate merger and acquisition decisions (more so than CEO dominance of other policies), again consistent with theoretical implications. We document that CEOs delegate less when their pay is incentive-based, when they have MBA degrees, and when they have a background in finance or accounting. In terms of capital allocation across a given firm’s divisions, we find that CEOs rely on a NPV ranking of the various projects, which is consistent with textbook recommendations. We also find evidence that other factors importantly affect capital allocation, including the divisional manager’s reputation, the timing of when cash flows are produced by a project (which may matter due to financial constraints), and senior management’s “gut feel.” Interestingly, in the eyes of CFOs, internal corporate politics are believed to affect capital allocation, more so than in the eyes of CEOs. Finally, corporate socialism (that is, even distribution of capital across divisions) and corporate politics are more important in Europe and Asia than they are in the United States.

We believe that our study provides unique information about how decisions are made within firms, as well as how capital is allocated. We hope that researchers will use our results to develop new theories or potentially modify existing views.

The full paper is available for download here.

Risk oversight is a high priority for today’s boards of directors. The risk oversight playbook is likely to evolve as boards refine their processes into 2010 and beyond. There are signs that legislators and regulators have risk oversight in their line of sight. For example, in the United States, the SEC proposed new proxy disclosures to spotlight directors’ qualifications and the role of the board in the risk management process. Some U.S. law- makers are sponsoring a bill to mandate a separate risk committee of the board. Whatever happens, it is clear the bar is being raised as boards take a fresh look at the qualifications of their members, how they operate, the extent to which they avail themselves of the appropriate company officers and other expertise to understand the enterprise’s risks, and whether their committee structure and the information to which their committees have access are conducive to effective risk oversight.

Key Considerations

“Risk oversight” describes the board’s role in the risk management process. Effective risk oversight deter- mines that the company has in place a robust process for identifying, prioritizing, sourcing, managing and monitoring its critical risks, and that this process is improved continuously as the business environment changes. By contrast, “risk management” is what management does to execute the risk management process in accordance with established performance goals and risk tolerances. Through the risk oversight process, the board (1) obtains an understanding of the risks inherent in the corporate strategy and the risk appetite of management in executing that strategy, (2) accesses useful information from internal and external sources about the critical assumptions underlying the strategy, (3) is alert for possible organizational dysfunctional behavior that can lead to excessive risk taking, and (4) provides input to executive management regarding critical risk issues on a timely basis.

If we accept this delineation as a working premise, then the role of risk oversight becomes clearer – it is the process by which the board and management develop a mutual understanding regarding the risks the company faces over time as it executes its business model and pursues new opportunities. If poisonous snakes are encountered along the way as the strategy is executed, the board and management will know they are there and, if the company is bitten, how much it might hurt. Therefore, risk oversight seeks a balance between enhancing and protecting enterprise value.

Questions for Boards

Following are some suggested questions that boards may consider, as appropriate to the entity’s operations, as they seek to clarify their risk oversight responsibilities:

• Is there a robust process in place for identifying, prioritizing, sourcing, managing and monitoring the enterprise’s critical risks in a changing operating environment?
• Do we understand the risks inherent in the corporate strategy? Is there a sufficient understanding of the significant assumptions underlying the strategy and is a process in place to monitor for changes in the environment that could alter those assumptions?
• Are we and executive management on the same page with respect to the risks the entity is willing to accept and the risks the entity should avoid (i.e., the entity’s risk appetite)? Is there sufficient dialogue enabling appropriate and timely board input to executive management on the risks undertaken?
• Are policies in place for managing significant financial and commodity risks on an enterprise-wide basis? Has management quantified the loss exposures involving these risks and prepared response plans to address multiple future scenarios?
• If new and complex risks emerge, are the appropriate expertise, processes and information brought to bear to ensure there is an understanding of the emerging risks and their implications to the enterprise’s strategy and business model?
• Is the board receiving the information it needs to foster effective risk oversight, or is it drowning in data providing little knowledge or insight? Is there sufficient agenda time for discussing the enterprise’s risks? In what areas does the organization need to improve its capabilities for managing risk?
• Does the organization have a process for thinking about the “unthinkable,” i.e., the plausible scenarios that could occur over the time horizon covered by the corporate strategy and business plan? Has management considered how the entity would respond should any of these scenarios occur? Has considering these scenarios created awareness of the forces affecting the organization in the present that can make it captive to events in the future?
• Are the enterprise’s “tone at the top” and culture conducive to effective risk management? For example, does the compensation structure reward short-term risk taking without taking into account the potential longer-term effects on the company? If there is a chief risk officer, does that individual have the right skills and is he or she positioned to be successful? Does he or she provide the board with timely information about the company’s risks? Is it clear that executive management will pay attention to the warning signs posted by the risk management function at the crucial moment?

For many public companies, the new year marks the commencement of compensation season. Setting pay and targets for the new year, determining achievement of performance objectives for the past year and preparing the annual proxy statement contribute to a busy first quarter for compensation committees and management teams working with them. In 2010, companies will undertake these activities in a fluid environment, with executive compensation continuing to receive significant attention from shareholder activists, government and the media. As companies prepare for the upcoming compensation season, they should consider the following items.

New SEC Disclosure Requirements. Companies should take steps to ensure compliance with the new SEC rules which, among other things, address corporate governance matters, risk in compensation programs, independence of compensation consultants and the valuation of equity awards in the compensation tables (see this Forum post or this Wachtell, Lipton, Rosen & Katz client memorandum for a description of the new rules). Companies should get an early start on organizing appropriate working groups, crafting necessary disclosures and preparing their directors so that they can meet their obligations with respect to upcoming filings.

Assessing Risk in Compensation Programs. Companies should review their incentive compensation plans and programs with a view to whether the compensation structures encourage excessive risk taking, and should consider appropriate modifications to programs identified as excessively risky. Under the new SEC disclosure rules, to the extent that risks arising from a company’s compensation programs for employees (not just executives) are reasonably likely to have a material adverse effect on the company, the company must discuss its compensation programs as they relate to risk management and risk-taking incentives. Importantly, the SEC release specifically notes that a company does not have to make an affirmative statement that it has determined that the risks arising from compensation programs are not reasonably likely to have a material adverse effect, if it has so concluded. Conducting a thorough analysis to determine whether company compensation programs carry the degree of risk necessitating disclosure will require lead time and a coordinated effort among company executives and directors.

SEC Hot Button Disclosure Issues. The SEC continues to express concern about the quality of disclosure regarding executive compensation, with particular focus on (1) the lack of adequate discussion in the CD&A of how and why a company arrives at specific executive compensation decisions and policies, (2) noncompliance with regard to the disclosure of performance targets and (3) inadequate detail regarding peer groups and benchmarking. Importantly, the SEC has indicated a policy shift with regard to noncompliance with its executive compensation disclosure rules. During 2007, 2008 and 2009, to the extent the SEC identified deficiencies, SEC comment letters applied to prospective SEC filings; companies did not have to amend existing filings. Going forward, the SEC has indicated that it will require companies that do not comply with the executive compensation disclosure rules to amend materially noncompliant filings.

Potential Adoption of Mandatory Say-On-Pay. The push to require public companies to submit executive compensation to an advisory “say-on-pay” shareholder vote intensified in 2009; however, it does not currently appear that broad-based mandatory “say on pay” will take effect for the 2010 proxy season. Nevertheless, directors should be aware that decisions made in 2010 may be subject to a “say-on-pay” vote during the 2011 proxy season.

Compensation Design. Compensation committees should regularly review compensation programs and consider whether existing arrangements most effectively promote a company’s long-term success. In recent months, in response to the TARP regulations and the determinations of the Special Pay Master, financial institutions have instituted changes to their compensation programs, which include limiting cash compensation and paying a greater amount in the form of stock with longer vesting, performance and/or holding periods to correspond to the time horizon of risk. Some observers have suggested that these changes may eventually extend beyond the financial services industry, particularly in light of the increased focus on the relationship between compensation and risk. As always, directors should take a flexible approach to executive compensation matters, tailoring pay programs to the individual needs, strategies and risk of a particular business.

RiskMetrics. Management and compensation committees should stay abreast of RiskMetrics’ positions on good and bad pay practices, as vote recommendations by RiskMetrics may influence the outcome of shareholder votes on director elections, “say-on-pay” referendums and equity compensation plan proposals. Beginning in 2010, if a company has a “say-on-pay” vote, RiskMetrics generally will use that vote as the primary avenue to address problematic pay practices. However, even for companies that include a “say-on-pay” proposal on their ballots, RiskMetrics may recommend a negative vote for compensation committee members and/or other directors if RiskMetrics considers pay practices “egregious,” or in instances in which directors have failed to respond to concerns raised in prior “say-on-pay” evaluations. While directors should understand the potential consequences of their decisions under applicable RiskMetrics policies, they should not lose sight of the underlying goal of executive compensation – namely, to attract and retain qualified individuals who will contribute to the long-term success of the company.

Section 162(m). Revenue Ruling 2008-13 provides that a right to payment of performance-based compensation upon termination without cause, resignation for good reason or retirement without regard to whether the performance condition is satisfied generally will cause the entire arrangement to fail to qualify for the performance-based compensation exception to § 162(m) of the Internal Revenue Code. Companies should be mindful of the Revenue Ruling when establishing new compensation arrangements or commencing new performance periods, and should review the terms of existing compensation arrangements to ensure that they do not run afoul of Revenue Ruling 2008-13.

Section 409A. Section 409A of the Internal Revenue Code imposes penalties on participants in deferred compensation arrangements that do not comply with the strict requirements of the rules. Last week, the IRS issued Notice 2010-06, which establishes a general framework for correcting certain documentary compliance failures under § 409A, limiting or eliminating altogether any negative tax consequences. Importantly, the relief provides advantages if companies make permitted corrections on or before December 31, 2010. Companies that identify documentary compliance deficiencies should take advantage of the opportunity to take corrective action.

Compensation Clawbacks. Clawback policies provide companies with the ability to recoup incentive-based compensation in certain circumstances, such as a financial restatement, commission of an act detrimental to the company or a reversal in company performance. Over the past several years, the number of companies that have adopted compensation clawback policies has increased dramatically. Clawback policies may enhance shareholder confidence in executive accountability and may help to align company risks and rewards. A company that chooses to institute a clawback policy will need to consider a number of key design issues, as no single approach is appropriate for every company. The SEC disclosure rules require a company to disclose in its CD&A any clawback policies applicable to named executive officers.

Additional Challenges. 2009 witnessed a series of legislative proposals that would impact executive compensation matters, including with respect to “say-on-pay,” independence of compensation committees and their advisors, and the relationship between compensation and risk. More is on the way.

Let me preface my testimony by stressing the urgent need for broad regulatory reform in light of the financial crisis on matters ranging from the structure of our regulatory system, to the reduction of systemic risk in the derivatives market, to improving resolution procedures for insolvent financial companies, to increasing consumer protection, and to revamping the GSEs. The Committee on Capital Markets Regulation dealt with these issues in its May 2009 Report titled The Global Financial Crisis: A Plan for Regulatory Reform. These issues were also fully laid out in the Treasury Department’s June 2009 proposal on financial regulatory reform, and have been vigorously debated in public meetings, the press, and Congressional hearings for months. These efforts have so far culminated in the Wall Street Reform and Consumer Protection Act (H.R. 4173) as well as in Senator Dodd’s thoughtful Discussion Draft. And I applaud the ongoing efforts of this Committee to reach bipartisan consensus on these issues. In my judgment, we should not hold up these important reforms while we debate activity and size limitations.

The Volcker Rules would limit the ability of banks to own, invest in, or sponsor a hedge fund or private equity fund, or to engage in “proprietary trading.” The size limitation would limit the market share of all financial institution liabilities beyond the current 10% market share cap applied to bank deposits.

At the outset, it is important to focus on the stated objective of these new proposals—to reduce bank risk so as to minimize the necessity of public rescue of banks that are “Too Big to Fail.” There is no question that we need to address the “Too Big to Fail” issue. We need to understand whether the conventional wisdom—that we cannot let large financial institutions fail, in the sense of imposing a full measure of losses on the private sector, whether they be equity or unsecured debt holders or counterparties—is actually true. The concern rests on an assumption that we cannot permit certain large and interconnected financial institutions to fail because such failure would trigger a chain reaction of other financial institution failures, with disruption to the entire economy.

In the notable $85 billion federal bailout of AIG, however, some question whether the asserted prospect of severe counterparty losses actually existed. Goldman Sachs, one of AIG’s major counterparties, has stated that it had adequate cash collateral to survive an AIG default. We need to be careful that “Too Big to Fail” does not become a self-fulfilling prophecy.

Clearly, the absolute size of an institution is not the predicate for systemic risk; it is rather the size of its debt, its derivatives positions, and the scope and complexity of many other financial relationships running between the firm, other institutions, and the wider financial system. As Senator Schumer’s example at Tuesday’s hearing illustrates, 50 small but highly correlated hedge funds might combine to create systemic risk. In short, the proper focus is on a bank’s interconnectedness with other financial institutions, and we have only a primitive understanding of the nature and extent of these connections. To the extent interconnectedness is a problem, the most fundamental way to attack it is to reduce the interconnections so that we can allow institutions to fail safely. This will also require that Federal regulators be given enhanced resolution authority, as set forth in H.R. 4173 and Senator Dodd’s Discussion Draft. And as Secretary Geithner recently acknowledged, “the Bankruptcy Code is not an effective tool for resolving the failure of a global financial services firm in times of severe economic stress.”

To address our “Too Big to Fail Problem,” we need to modernize financial regulation to address the problems of today, not of the past.

Let me now turn in more depth to the Volcker Rules.

I. Proposed Restrictions on the Scope of Bank Operations

A. Proprietary Trading and “Too Big to Fail”

The Volcker Rules would prohibit banks and bank holding companies from engaging in proprietary trading “unrelated to serving customers for [their] own profit,” as well as from investing in or sponsoring hedge fund and private equity fund operations. Given that Mr. Volcker is the Chairman of the Trustees as well as the Chairman of the Steering Committee of the Group of 30 (G-30), it is worth noting that the Volcker Rules are significantly more aggressive than the G-30’s recent proposal to merely limit proprietary trading by “strict capital and liquidity requirements.”

The objective embodied in the Volcker Rules is to restrict banks that are “Too Big to Fail” from participating in non-traditional risky investment activity, thus minimizing the chance they might fail and have to be rescued to avoid endangering uninsured depositors or the FDIC insurance fund. This might have been the concern in the past but it misses the mark today. The reason for the rescues during the crisis, such as AIG, or the TARP injections to forestall failures, was not to protect depositors of banks or the FDIC insurance fund. The reason was rather to avoid a chain reaction of failures set off by interconnectedness. Furthermore, this need for rescue does not depend on what activity gives rise to the potential bank failure. We will have to rescue banks whose failure will endanger other banks even if these failing banks are engaging in traditional activities. Mr. Volcker seems to imply that it is acceptable to rescue banks engaging in traditional activities. I disagree. Quite frankly, I do not think a taxpayer would feel better about rescuing a bank that made risky loans than he would rescuing a bank that engaged in less traditional risky activity.

As a solution to the problem of “Too Big to Fail,” the Volcker Rules are over-inclusive because not all banks, and not even all large banks, pose chain-reaction risks to the financial system. The Rules are also potentially under-inclusive, because many interconnected financial institutions which do pose systemic risks are not deposit-taking banks. Goldman Sachs—which is the only U.S. bank with significant revenue exposure to proprietary trading—could avoid falling under the Volcker Rules by divesting itself of its small deposit-taking operations, which account for only 5.19% of its liabilities. Similarly, Morgan Stanley would lose only 8.70% of its liability base by giving up bank holding company status. None of the most prominent failures of the financial crisis—Fannie Mae, Freddie Mac, AIG, Bear Stearns, or Lehman Brothers—were deposit-taking banks.

Furthermore, major U.S. banks that do have high levels of deposits relative to total liabilities derive only a marginal fraction of their revenues from walled off proprietary trading activities, if “proprietary trading” is understood as trading activity carried out on internal trading desks purely for a bank’s own account. Wells Fargo and Bank of America, two of the largest deposit-funded banks, report deposits accounting for approximately 72% and 49% of their total liabilities, respectively, but are both estimated to earn less than 1% of revenues from proprietary trading. These data show that U.S. banks with significant deposit bases assume little to no balance sheet risk from proprietary trading. Riskier institutions that do have exposure, if forced to choose between proprietary trading and deposits, may opt to “de-bank.” But because banks are highly regulated entities, regulators are in a good position to respond to bank failures. By encouraging banks to take themselves off the regulatory radar, the Volcker Rules could actually increase systemic risk. The regulatory and supervisory system is much better able to deal with controlling the risky activity of regulated banks than of unregulated investment banks, insurance companies, hedge funds, or commercial companies with large financial operations. The migration of risky bank activities to other large firms that may be “Too Big to Fail” would compound, rather than reduce, the systemic risk problem. The Administration’s earlier proposals envision some level of regulation of systemically important institutions other than banks, but such regulation will be much less comprehensive than it is for banks.

The original proposal was somewhat ambiguous as to the level of the banking organization at which the Rules would apply. Unless the Rules limit the activities of bank holding companies and all holding company subsidiaries, banks could evade the restrictions by shifting hedge fund or private equity investments and proprietary trading activities to non-bank subsidiaries. This would, perhaps, protect bank depositors, but it would not solve the need to rescue bank holding companies to avoid the chain-reaction-of-failures problem. Because proprietary trading, hedge fund, and private equity investments could pose the same threat to other financial institutions because of connectedness, regardless of whether they occur in a bank or its holding company, the Volcker Rules only make sense if they apply to bank holding companies and all of their subsidiaries (including banks and non-banks).

B. What is Proprietary Trading?

Mr. Volcker is confident that he as well as bankers know proprietary trading when they see it. Yet it is notable that neither Mr. Volcker nor the Treasury Department has presented a workable definition of this term. The suggestion that it can be measured by a pattern of large gains and losses is unclear. Hedges or positions taken for customers can exhibit the same pattern.

Defining “proprietary trading” presents tremendous difficulties. Too narrow a definition, limited to discrete internal hedge fund and private equity activity undertaken by banks for their own accounts, is unlikely to lead to material reduction of risk, since these activities account for only a small fraction of most banks’ operations. Defining proprietary trading too broadly, meanwhile, might seriously impair the basic function of modern banks as market-makers in government and non-government securities, and as securitizers of consumer debt. Neither of these options is very attractive.

1. Proprietary Trading as “Internal Hedge Funds” is Insignificant to Banks

Strictly construed, proprietary trading “unrelated to serving customers” encompasses any trading activity carried out on internal trading desks for a bank’s own account, but not on behalf of clients. Writing in the New York Times on Sunday, Mr. Volcker echoed this definition, identifying proprietary trading as “the search [for] speculative profit rather than in response to customer need.” Generally speaking, there are at least two reasons why this narrow definition of the activity is unlikely to reduce systemic risk. First, in absolute terms, the scale of such internal, non-customer, proprietary trading is too negligible to drastically impact banks that engage in it. As outlined above, most U.S. banks, with the exception of Goldman Sachs, report minimal proprietary trading activity so defined.

Second, proprietary trading through internal hedge funds and other non-customer-related trading desks was not the source of the damaging losses that fatally impaired many of the banks at the center of the financial crisis. According to one Wall Street analyst’s estimate, of the approximately $1.67 trillion of cumulative credit losses reported by U.S. banks, losses taken on trading activities and derivatives accounted for less than $33 billion, or 2%, of this total. And as Bernstein Research notes in a recently published analysis, a construction of the Volcker Rules confined exclusively to internal hedge fund activity would not, for example, have reached the significant mortgage positions and unsecuritized loans held by Lehman Brothers that plummeted in value as liquidity drained from the market during the crisis. These positions, while proprietary, were not trading positions assumed by an internal trading desk for Lehman’s own account. Instead, they were accumulated as part of Lehman’s mortgage-underwriting and securitization businesses.

2. Loan and Securitization Losses Were the at the Heart of the Financial Crisis

The losses at the center of the financial crisis mainly resulted from the credit, lending, and securitization functions of U.S. banks. To date, the vast majority of overall credit losses— approximately 80%—have been linked to lending and securitization operations.17 Goldman Sachs estimates that approximately $577 billion, or 34%, of cumulative losses were incurred by banks on direct real-estate-related lending, including mortgages, commercial real-estate loans, and construction lending. An additional $338 billion of losses on non-real-estate loans accounted for 20% of cumulative losses. A further $519 billion, or 31%, represented losses on indirect real-estate-backed securitizations, including RMBS, CMBS, and CDOs. The loss experiences of smaller regional banks, where poor-quality mortgage and construction loans drove the largest failures, confirm the centrality of credit and lending to bank losses. For example, option ARMs represented 65% of total loans at Downey Savings, 59% at BankUnited, 29% at Indymac, and 22% at Washington Mutual. Construction loans accounted for 88% of Corus Bank’s loan book. At regional U.S. banks, just as at the national and global levels, under-priced credit risk embedded in loans and securitized debt, and not speculative internal hedge funds, generated the lion’s share of the losses that led to financial collapse.

To be clear, portfolios of securitized debt instruments held on- and off-balance sheet by banks were responsible for roughly one-third of total credit losses. Broadening the definition of “proprietary trading” to restrict banks from holding securitized debt instruments might address one of the central risks banks were exposed to in the financial crisis. But do we really want to prevent banks from investing in securitized debt altogether? The question is complicated by the fact that owning securitized assets typically serves several purposes for banks, including making markets in securitized assets and assuring clients that the banks that structured their deals will have “skin in the game,” particularly by holding junior tranches of securitized debt. Indeed, recently adopted legislation in the European Union requires banks to retain a 5% interest in securitizations. While it was also true that banks held securitized debt for speculative reasons, it would be difficult to separate such positions from those needed to engage in the securitization business. A blanket rule preventing banks from holding securitized debt might interfere with the revival of our already moribund securitized debt markets, since it would deprive banks of an important way of signaling the quality of issuances. Because restoring these markets is crucial to fueling new lending and economic growth—Mr. Volcker himself, in his opinion piece, cited the “large challenge in rebuilding an efficient, competitive private mortgage market, an area in which commercial bank participation is needed”—regulators must bear this risk in mind when implementing reforms.

3. Market-Making in Securities is a Core Function of Banks

In its most expansive formulation, proprietary trading could include any activity that places principal at risk, including the longstanding role that banks have played in modern capital markets as market-makers in U.S. government, agency, and non-government securities. A rule which restricts the scope of this function by classifying market-making as a form of proprietary trading would reduce liquidity and increase borrowing costs throughout a wide range of securities markets, including the market for GSE and U.S. Treasury securities. This activity cannot easily be performed by other institutions—it requires the large balance sheets of banks.

According to Federal Reserve data cumulating securities ownership across all bank securities portfolios (including held-to-maturity, available for sale, and trading), over 60% of the securities held by banks are agency MBS and Treasuries. Forced reductions in this inventory under the Volcker Rules would drain liquidity from important government funding markets and entail higher borrowing costs for the U.S. government and its sponsored entities, negatively impacting economic recovery. Mr. Volcker likewise recognizes what he has called the “essential intermediating function” banks serve in meeting the “need for reliable sources of credit for businesses, individuals, and governments.” And Glass-Steagall itself recognized the linkage between liquidity in government debt markets and proprietary trading by banks in government securities, providing for an exception authorizing banks to deal in, underwrite, and purchase for their own account securities issued by the U.S. government. So the area which comprises the largest portion of bank trading, U.S. government securities, would have to be preserved.

4. Proprietary Trading Is a Source of Diversification for Banks

Portfolio diversification reduces risk. All else being equal, more concentrated portfolios are more volatile than portfolios containing an array of uncorrelated earnings streams, even when parts of the uncorrelated income are volatile. As the breakdowns discussed earlier illustrate, a substantial portion of bank losses sustained in the 2007-2008 financial crisis emanated from highly concentrated exposures to direct real-estate loans. And past financial crises, like the sovereign debt and thrift crises of the 1980s and the Asian crises of the 1990s, also involved lending operations. Proprietary trading (excluding securitization, as discussed earlier), which barely contributed to losses in these earlier periods, is a source of diversification that may help to mitigate, not aggravate, the risk profile of U.S. banks in the future. During the financial crisis, firms with significant proprietary trading operations like Goldman Sachs, or those that ran complex, interconnected books of business, including Goldman, Morgan Stanley, and JP Morgan, survived. Indeed, this diversification helped protect them in the crisis. By contrast, firms that concentrated their exposures in real-estate, like Lehman, or isolated these exposures in large, undercapitalized, off-balance sheet silos either did not survive, or needed government capital injections to keep them afloat.

C. Limitations on Private Equity and Hedge Fund Investing by Banks

The Volcker Rules, in addition to limiting proprietary trading activity, would also restrict banks from owning, investing in, or sponsoring private equity funds (including venture capital funds whose activity is crucial to small business) and hedge funds.

Worldwide, banks and investment banks account for $115 billion, or 12%, of the $1.1 trillion of investment by limited partners including co-investments in private equity funds involved in corporate finance and buyouts. Indeed, banks are a larger source of capital as private equity limited partners than endowments or sovereign wealth funds. Historically, banks have also represented an important source of direct proprietary involvement in private equity as general partners, raising an estimated $80 billion in committed capital from investors over the past five years. Mandating the exit of banks from involvement in these activities could force the withdrawal of a substantial fraction of the private equity industry’s available investment capital. This would deal a disruptive blow to the recovery of the private equity industry on the heels of serious setbacks in terms of both fundraising and transaction activity which the industry sustained from 2007 to 2008. U.S. and global private equity fundraising activity remains at or below 2004 levels, with less than $10 billion raised by U.S. funds in Q4 2009 as compared to an excess of $100 billion raised in the same period in 2007. Nonetheless, private equity is still an important financing source for the U.S. economy, providing needed investment to undercapitalized or recapitalizing U.S. industries, including the financial sector. In Q4 2009, as investment activity began to recover, private equity funds invested $8 billion in U.S. buyouts (executing $48 billion in M&A transaction volume). At a moment when private equity activity is starting to rebound, rules that would force a withdrawal or reconfiguration of significant capital in the industry could chill investment in U.S. industry.

These prospective costs to the economy might be acceptable if they were offset by a commensurate reduction in bank balance sheet risk. But while bank investment is an important source of capital to private equity, it is not a meaningful proportion of bank assets. As of September 30, 2009, investment in private equity accounted for less than 3% of the aggregate reported trading and/or “other” assets of the six largest U.S. banks. As a percentage of total bank assets, private equity investments accounted for less than 1% of the total consolidated balance sheet of Bank of America, JP Morgan, Wells Fargo, and Citigroup, and less than 2% of the total balance sheet assets of Goldman Sachs and Morgan Stanley. While relatively little bank capital is at risk in the private equity business, private equity nevertheless represents an important source of advisory, syndication, and underwriting revenues for banks which sponsor private equity funds. Mandating the spin-off or closure of these funds would not improve the composition of bank balance sheets or the profile of bank riskiness, but would terminate a lucrative source of earnings at a time when banks are focused on recapitalizing.

Although we have not been able to gather much data regarding bank exposure to the hedge fund industry, the information we do have suggests that eliminating these activities will not significantly reduce bank risk profiles either. Analysis by Preqin shows that banks directly invest only $10 billion (or 0.9%) of the total capital invested by U.S. investors in hedge funds. In addition, banks have fund-of-funds units that are responsible for channeling $180 billion (or 16%) of all U.S. capital flowing to hedge funds. It is unclear what percentage of this $180 billion represents banks’ own capital. But even on the implausible assumption that all of $180 billion comes from banks, it likely represents a negligible portion of bank risk. It is far more likely that a significant portion of the $180 billion is money that banks are managing on behalf of clients. Managing client funds (apart from the use of seed money) generally does not place bank capital at risk, and therefore does not implicate the underlying rationale of the Volcker Rules.

In his written testimony, Deputy Secretary Wolin seemed to refer to Bear Stearns when he wrote that “[m]ajor firms saw their hedge funds and proprietary trading operations suffer large losses in the financial crisis. Some of these firms ‘bailed out’ their troubled hedge funds, depleting the firm’s capital at precisely the moment it was most needed.” Although Bear Stearns later pledged $3.2 billion to bailout Bear Stearns High-Grade Structured Credit Fund and Bear Stearns High-Grade Structured Enhanced Leverage Fund, Bear’s original principal exposure was only $40 million. Clearly, Bear’s real exposure, on a reputational basis, exceeded its investment. The same was true for many banks’ SIVs and conduits. This problem is best addressed by FASB’s new consolidation accounting rules, FAS 166 and 167, which effectively require banks to hold capital against these exposures. There is no need to ban these sponsorships entirely.

As the above analysis suggests, bank involvement with private equity and hedge funds can benefit bank customers in significant ways. Banks that sponsor or invest in private equity funds and hedge funds are better positioned to serve their global clients, who increasingly look to banks for “one-stop shopping” in financial products and services. Given the dramatic rise in assets under management in the private equity and hedge fund industry, it is fair to infer that clients are particularly interested in these offerings. In addition, to the extent that banks are permitted to continue managing funds or fund-of-funds, allowing them to invest their own money alongside customers’ is an important way to align interests.

Taking a more skeptical view of the implications for customers of bank involvement in proprietary trading as well as private equity funds and hedge funds, Mr. Volcker recently argued that these activities “present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called Chinese walls between different divisions of an institution.” Mr. Volcker elaborated on this point in his testimony before the Committee:

I want to note the strong conflicts of interest inherent in the participation of commercial banking organizations in proprietary or private investment activity. That is especially evident for banks conducting substantial investment management activities, in which they are acting explicitly or implicitly in a fiduciary capacity. When the bank itself is a “customer”, i.e., it is trading for its own account, it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to the interests of an unrelated commercial customer of a bank. “Inside” hedge funds and equity funds with outside partners may generate generous fees for the bank without the test of market pricing, and those same “inside” funds may be favored over outside competition in placing funds for clients. More generally, proprietary trading activity should not be able to profit from knowledge of customer trades.

If there is a sound justification for the Volcker Rules, it is that they would limit systemic risk, not that they would prevent conflicts of interest. Moreover, the issue of conflicts of interest was considered and rejected during the repeal of Glass-Steagall. If Mr. Volcker’s contention were correct, it would be equally applicable to a much wider range of bank activities than proprietary trading and investment in hedge funds and private equity. It would extend to bank involvement in the underwriting of securities, for example, where the argument has long been made that a banker underwriting a faltering securities offering would encourage clients to invest in the securities. Given that there is no proposal to limit bank underwriting, or other securities services that raise potential conflicts, it is unclear why conflict of interest concerns justify restricting bank investments.

II. Proposed Restrictions on the Size of Banks and other Financial Institutions

A. Proposed Limitations on the Size of Banks

The actual operation of the size limitations is even less clear than the meaning of the Volcker Rules on bank activity. The Administration has referred to “limits on the excessive growth of the market share of liabilities at the largest firms, to supplement existing caps on the market share of deposits.” This appears to mean that the size limit would apply to banks’ market share of non-deposit liabilities.

Deputy Secretary Wolin’s recent testimony that the “size limit should not require existing firms to divest operations,” but will instead “serve as a constraint on future excessive consolidation among our major financial firms,” would appear to be addressed to market concentration and antitrust concerns since they carry the striking implication that no firm is currently “Too Big to Fail.” If market concentration is the concern, we need to understand why existing antitrust law is not up to the task of dealing with this problem, while if systemic risk is the issue, it is puzzling why the size caps should apply only to firms that grow by acquisition. Presumably we should be concerned about the size (or the interconnectedness) of firms, whether the result of acquisition, organic growth, or otherwise.

To the extent systemic risk is the issue, the central questions are: (a) whether larger banks are more or less likely to fail than smaller banks; (b) whether the failure of large banks generates higher levels of systemic risk; and (c) whether the Administration’s proposal to cap each banks’ market share of liabilities is a plausible remedy for the problem.

If larger banks are riskier than smaller ones, the differences are likely to be relatively minor. Studies have found that large banks hold more diversified portfolios and are engaged in a wider range of business, and that such diversification serves as a source of strength. Scholars have also found that size promotes stability since it is easier for large banks to obtain funding in the capital markets. On the other hand, larger banks tend to use size advantages to make riskier loans, conduct more off-balance sheet activities, and maintain more aggressive leverage ratios. As banks grow larger, they may take on additional risk by becoming reliant on non-interest income and non-deposit funding. On net, this combination of considerations may roughly balance out.

Turning to the second question, the surprising fact is that we do not know whether larger institutions pose greater systemic risk and, if so, whether that increase is significant. As discussed above, this question requires more data and discussion. The issue is whether larger banks are more interconnected in such a way that their failure would set off a chain reaction of failures. This should not be accepted on faith.

To the extent that systemic risk does increase with “size,” it is unclear that broad-brush restrictions on non-deposit liabilities are the solution. First, the focus on liabilities ignores the fact that a bank’s riskiness is determined in large part by the assets it holds. Some of the most prominent victims of the financial crisis failed because of the interactions between different parts of their balance sheets (e.g., funding risky assets with overnight loans). Second, a bank could comply with the general liability restrictions while maintaining risky assets. The Volcker Rules would not limit the ability of banks to make risky loans. Thus, the somewhat smaller bank, faced with Volcker Rules and size caps, may shift its activity to overall higher levels of risk in search of return. As Raghuram Rajan, Professor of Finance at the University of Chicago and author of a prescient paper anticipating the financial crisis, recently wrote:

Crude asset size limits, for example, would probably ensure a lot of financial activity is hidden from the regulator, only to come back to light (and to the balance sheets) at the worst of times. There are many legal ways to mask size. Banks can offer guarantees to assets placed in off-balance sheet vehicles, much like the conduits of the recent crisis. If, instead, capital is the measure, then we will be pushing banks to economize on it as much as possible, hardly a recipe for safety.

Finally, we should consider if overall size limitations are preferable to an approach targeted at individual institutions. It appears that, at most, only six banking institutions would be impacted. Assuming, for example, that a 10% of domestic wholesale funding market share ceiling is imposed on U.S. banks—analogous to the deposit market share limits already in place—Bank of America, Citigroup, Goldman Sachs, JP Morgan Chase, and Morgan Stanley are the only institutions that appear to approach this ceiling level. If a higher ceiling than 10% wholesale funding market share is imposed, it is possible that only the very largest domestic users of wholesale funding—Bank of America and JP Morgan Chase, the only two institutions with wholesale funding market shares significantly greater than 10%—would be impacted. We note that beyond these six institutions, the U.S. bank wholesale funding market is highly fragmented; no other institution has more than a 3% market share. Given that the size limitations might affect only a handful of banks, a better policy would be to address issues at those banks individually through better and more intense supervision.

We must also take into account that size limitations on our biggest banks will negatively affect their global competitiveness. Size limitations could cause U.S. banks to lose the business of their largest and most important customers, who will prefer to work with banks that have the capacity to address their global needs. Larger banks and their customers also benefit from the economies of size and scope that exist when banks are large enough to offer a wider range of products, such as lending and derivatives. One study by an economist at the New York Federal Reserve found that bank productivity grew more than 0.4% per year during the bank merger wave of the early 1990’s, while Charles Calomiris of Columbia Business School suggests that the increasing size of banks has lowered underwriting costs associated with accessing public equity markets by as much as 20%. As it is, as of the end of 2008, the United States only had two of the ten largest banks in the world, Bank of America (6th) and JP Morgan Chase (9th). The world’s five biggest banks are BNP Paribas (France), Royal Bank of Scotland (U.K.), Barclays (U.K.), Deutsche Bank (Germany), and HSBC (U.K.).

In this connection, it is worth recalling that a major motivation for the decision to repeal Glass-Steagall was the need to increase the competitiveness of U.S. financial institutions. At the time, Senator Proxmire noted that Glass Steagall’s “restrictions inhibit a U.S.-based firm from offering the entire range of financial services to both domestic and foreign customers in the United States.” Therefore, many U.S. and foreign financial institutions were choosing to locate offshore, where they could provide such products to foreign clients. Furthermore, although U.S. banks had expertise as underwriters through offshore activity, they could not achieve the economies of scale attainable through underwriting domestically. Any limitation on U.S. bank activities that did not extend to foreign banks would be damaging to their future profitability.

B. Proposed Limitations on the Size of Other Financial Institutions

To the extent that the proposed rules regarding non-deposit liability market share addresses financial institutions other than bank holding companies, it is important to consider the potential impact on four additional groups. First, there are a number of U.S. wholesale-funded lending businesses—most notably credit card lenders and non-bank commercial lenders—that are not typically grouped with banks in regulatory discussions. Many of the largest of these lending businesses are subsidiaries of bank holding companies. Of those that are not bank holding company subsidiaries, although some are large within the context of their narrowly defined business segments (credit carding lending, etc.), even the largest have modestly sized wholesale funding bases compared to the largest bank holding companies. In credit cards, for example, American Express and Capital One Financial (the largest pure-play card lenders by wholesale liabilities) have only 3% and 1% wholesale funding market shares, respectively. Similarly, GMAC and CIT, the largest wholesale-funded commercial lending businesses have only 4.5% and 2.2% non-deposit liability market shares, respectively. Though the precise details on the proposed wholesale funding limits are not yet available, it is hard to imagine that the market share ceiling would be set low enough to impact even the largest of these lenders.

Second, a number of U.S. insurance companies also have sizable balance sheets, with ostensibly sizable non-deposit liability bases. Although these large liability bases may seem to place insurers within the purview of the proposed liability size restrictions, the size caps are unlikely to apply to these institutions for two reasons: (1) insurers in general simply do not rely heavily on wholesale funding as part of their business models—the majority of the large funding bases of these institutions consists of expected future benefits or actuarial estimates of unpaid claims (classic insurance “float” funding that appears to fall outside the definition of the funding targets) and (2) as the last crisis has shown, the riskiest insurance institutions, like AIG, suffered primarily from underwriting risk—much of which was opaquely held in off-balance sheet vehicles—not from funding risk per se.

Third, there are money market mutual funds that as of the week ended January 27, had assets totaling $3.218 trillion. The five largest money market fund families managed roughly 15% (Fidelity), 11% (JP Morgan), 8% (Federated), 7% (Blackrock) and 6% (Dreyfus) of this amount. Since even the largest money market fund family does not have a dominant share of the market, and there are numerous fund families with substantial levels of assets under management, the case for capping the size of money market mutual funds based purely on market concentration of liabilities appears weak.

Fourth, though GSEs are not bank holding companies, the largest GSEs use sufficient wholesale funding to make them worth discussing here. Freddie Mac and Fannie Mae each have roughly $800 billion in wholesale funding, an amount that dwarfs the domestic wholesale funding requirements of all bank holding companies, except that of Bank of America whose wholesale funding is slightly over $1 trillion. Given these very large non-deposit liability requirements—together these two GSEs use more wholesale funding than half of the entire U.S. bank holding company total—excluding them from any new size restrictions would seem highly inconsistent with the treatment of banks.

In concluding the discussion of liability size restrictions, it is important to keep in mind that regardless of the liability size of any bank or non-bank financial institution, the proposed rules fail to address the more fundamental issue that non-deposit liability market share is not a good proxy for an institution’s broader systemic risk. Even if a commercial lender or an insurer does not rely on systemically large amounts of wholesale funding, the interconnectedness of these and similar institutions could ultimately make them “Too Big to Fail.” Any set of new regulations designed to reduce systemic risk must focus not just on the size of institutions’ wholesale liabilities, but also on institutions’ connections with the broader financial system.

III. There Has Been a Lack of International Coordination in the Newest Proposals

Up to this point, the Obama Administration wisely and appropriately has been careful to coordinate its regulatory reform recommendations with international efforts. In the Treasury White Paper, the Administration stressed the importance of international coordination stating, “The United States is playing a strong leadership role in efforts to coordinate international financial policy through the G-20, the Financial Stability Board, and the Basel Committee on Banking Supervision. We will use our leadership position in the international community to promote initiatives compatible with … [U.S.] domestic regulatory reforms.” Regrettably, this has not been the case with the Volcker Rules or size limitations.

Based on the initial reaction from international financial and regulatory bodies, we are far from reaching consensus on this issue. Speaking at the Davos economic summit, Dominique Strauss-Kahn—head of the International Monetary Fund—highlighted the lack of international cooperation behind President Obama’s proposed banking reforms saying, “The question of coordinating the financial reform is key and I’m afraid we’re not going in that direction.” The Financial Stability Board says that the proposals are “amongst the range of options and approaches under consideration” and that a “mix of approaches will be necessary to address the [‘Too Big to Fail’] problem,” hardly an endorsement. And earlier this week, the Deputy Director-General of the European Commission’s internal market and services division, David Wright, said he was surprised the U.S. had taken a radical line on the structure of banking without first consulting European leaders—especially in light of U.S. discontent last year when the European Commission took the lead on securitization and credit rating agency reforms. Wright added that it might be difficult to find the right definition of “proprietary trading” to satisfy the Obama administration’s goals without inflicting unintended consequences on the industry, emphasizing that Europe traditionally prefers to reform processes rather than change bank structure.

National leaders have also emphasized the need for a coordinated approach. French President Nicolas Sarkozy stressed that all regulation concerning banks should be dealt with at an international level, coordinated by the G-20. Sarkozy called the current crisis a “crisis of globalization itself,” urging broad coordination of regulation and accounting rules. In Germany, the Finance Ministry merely referred to the President’s proposals as “helpful suggestions,” with Chancellor Angela Merkel stating that her government will offer its own proposal to prevent G-20 banks from getting too big or interconnected.

As Mr. Volcker asserted in his testimony before this Committee on Tuesday:

A strong international consensus on the proposed approach would be appropriate, particularly across those few nations hosting large multi-national banks and active financial markets. The needed consensus remains to be tested. However, judging from what we know and read about the attitude of a number of responsible officials and commentators, I believe there are substantial grounds to anticipate success as the approach is fully understood.

In his appearance before the Committee, Mr. Volcker added that London was the other financial center whose acceptance of the Volcker Rules would be critical. Yet Prime Minister Gordon Brown of the United Kingdom, while welcoming the suggestion, stated the U.K. should consider similar rules only if there is an international agreement. The U.K.’s Chancellor of the Exchequer, Alistair Darling, expressed concerns that separating banks does not solve the problem posed by interconnectivity. To the extent there is a solution, he noted that “everything we do has to be a global solution otherwise we will get arbitrage.” Such comments are anything but an endorsement.

IV. The Perlmutter-Miller and Kanjorski Amendments Suggest a Preferable Approach

If Congress were to conclude that bank activities and the size of financial companies were a problem, the Perlmutter-Miller and the Kanjorski Amendments to the House Bill are better solutions than the Volcker Rules and size limitations.

The Perlmutter-Miller Amendment would allow the Federal Reserve Board (Board) to prohibit a systemically important financial holding company that is subject to stricter prudential supervision from engaging in all proprietary trading activities when the Board finds that trading activities threaten the safety and soundness of such company or of the U.S. financial system. The Amendment defines “proprietary trading” broadly, as “trading of stocks, bonds, options, commodities, derivatives, or other financial instruments with the company’s own money and for the company’s own account.” However, the Board has the flexibility to ban certain forms of proprietary trading at a company without putting an end to all of company’s proprietary trading activities. Instead, the Board can exempt proprietary trading activities that are “ancillary to other operations of the company” and do not pose a threat to the company or U.S. financial stability, provided they are carried on for the purpose of making a market in securities issued by the company, hedging or managing risk or other purposes permitted by the Board. While it would be preferable to extend this exemption to market making in a broader range of securities, allowing the Board to address proprietary trading at individual institutions and to distinguish between different trading activities is a better approach than the Volcker Rules.

If the Perlmutter-Miller Amendment is a better way of addressing proprietary trading, the Kanjorski Amendment is a better solution to the broader problem of all activities and size. The Kanjorski Amendment would allow a new Financial Services Oversight Council to require “mitigatory actions” whenever an individual firm that has been subject to stricter prudential supervision is deemed to pose a “grave threat to the financial stability or economy of the United States.” The Amendment anticipates that such a threat could arise from a wide range of sources—including the amount and nature of a company’s financial assets and liabilities, offbalance sheet exposures, reliance on leverage, interconnectedness with other firms, the company’s importance as a source of credit for households and businesses and the scope of its activities. It considers a wide range of remedies: requiring the institutions to terminate one or more of its activities; restricting its ability to offer financial products; and requiring the firm to sell, divest or otherwise transfer business units, branches, assets or off balance sheet items. Firms that are subject to mitigatory actions have the right to a hearing and can seek judicial review if such actions are imposed on an arbitrary or capricious basis.

I am not endorsing these amendments but do believe they are preferable to the Volcker Rules and size limitations.

For the second year in a row, Skadden, Arps, Slate, Meagher & Flom LLP has published a collection of commentaries addressing what we see as critical legal issues and areas of focus by businesses and industry sectors likely to be in the forefront of the matters considered by the U.S. and global financial and business communities in the year ahead. Many of these are a direct or indirect product of the national and global financial and economic crises of the past two years. By far the most powerful force that will drive these issues and areas of focus in 2010 is the continuing activist response of governments around the world to the recent financial and economic crises.

Nowhere is this more clearly illustrated than by the dramatic intervention of the federal government in the U.S. with respect to fundamentals of its financial and economic systems. In this regard, two of the major thematic questions from 2009 that will continue to dominate and shape the business environment in 2010 and beyond are:

• How will the federal government use, further broaden or change its newly expanded powers and presence, including in its role as regulator of financial institutions and markets and as a significant investor in the banking, insurance and auto industries?
• How will the federal government’s intrusions into the private enterprise system – through expanded legislatively endowed powers, adoption of more expansive rules and interpretations by regulators and enhanced enforcement efforts – impact capital markets, competition, corporate governance and controversies between the government and private sector or within the private sector?

These thematic questions should not be viewed as presenting inevitable outcomes depending solely on what Washington decides to do. One of the real needs and challenges of 2010 for the private sector is to marshal its forces to have a meaningful and respected voice in these outcomes.

In this regard, among the commentaries contained in 2010 Insights are discussions of the challenges facing boards of directors and management of publicly traded business corporations. These companies play a central role in enabling the U.S. private enterprise economic system. The “reforms” under consideration at the federal level include such matters as proxy access and say on pay and they may finally arrive in 2010. These and other “reforms” represent the federalization of significant aspects of traditionally state-regulated corporate law and a continuing shift away from a board-centric model of corporate governance toward a shareholder-centric model.

At the same time, financial services firms face potential reform legislation that may result in whole new federal bureaucracies, the work of the Financial Crisis Inquiry Commission is just beginning and may result in proposals for additional reforms, the Obama administration has proposed a new tax on the nation’s largest financial institutions and there are continuing calls for heavy taxes to be levied on bonuses paid by banks.

The efforts at reforming Corporate America remain a work in progress. One urgent question for policy makers, business leaders and lawyers is whether all of these changes will ride a wave of populist emotion and become enacted or will they be subject to an open and critical assessment of the risks they pose to our private enterprise economic system. Although recent events may have pointed out some flaws in the system that should be addressed by reforms, our free enterprise system has created vast wealth and successfully endured numerous business and economic cycles. Without question, one ingredient necessary to bring about this open and critical dialogue regarding the proposed reforms involves restoring the credibility of the financial community and public company boards of directors and management so that Corporate America is a meaningful participant in the discussion.

As business lawyers, our first instinct often is to deal with the tasks immediately at hand for clients across a broad range of needs and disciplines – such as protecting a challenge to a client’s intellectual property, defending a mass tort or securities class action lawsuit, implementing a needed capital raise in the most efficient and effective manner, defending or pursuing an unsolicited takeover, just to name a few. However, for the reasons noted above, 2010 is likely to be a year of continuing unusual intersection between law and fundamental policy – including with respect to financial services regulation, the source and substance of corporate governance regulation, healthcare reform, capital markets regulation, consumer protection and intellectual property rights. Accordingly, it will be particularly important for both business lawyers and their clients to understand where these larger issues are arising, how they may be resolved, what consequences may flow from the resolution and how might the outcome be appropriately influenced to produce a better result. We hope that 2010 Insights will contribute to that effort.

In our paper Dividend and Corporate Taxation in an Agency Model of the Firm, which is forthcoming in the American Economic Journal: Economic Policy, we propose a simple model based on the agency theory of the firm (Jensen and Meckling 1976) that provides an alternative to the two leading theories of corporate taxation – the “old view” (Harberger 1962, 1966, Feldstein 1970, Poterba and Summers 1985) and the “new view” (Auerbach 1979, Bradford 1981, King 1977). Our model is motivated by empirical studies of the 2003 dividend tax reform in the U.S. (e.g. Chetty and Saez 2005), which found that: (1) the 2003 dividend tax cut caused large, immediate increases in dividend payouts, and (2) the increases were driven by firms with high levels of share ownership among top executives or the board of directors. These empirical findings are difficult to reconcile with the two leading theories of corporate taxation.

The critical new feature of our model is a divergence between the preferences of managers and shareholders. We model this divergence as arising from perks and pet projects, although the underlying source of the conflict between managers and shareholders does not matter for our analysis. Shareholders can provide incentives to managers to invest and pay out dividends through costly monitoring and pay-for-performance. Only the large shareholders of the firm choose to monitor the firm in equilibrium (Shleifer and Vishny 1986, 1997). In this model, a dividend tax cut leads to an immediate increase in dividend payments because it increases the manager’s preference for dividends relative to the pet project and increases the amount of monitoring by large shareholders. Firms where managers place more weight on profit maximization – either because the manager owns a large number of shares or because there are more large shareholders – are more likely to increase dividends in response to a tax cut.

After showing that the predictions of the agency model fit the recent evidence on dividend taxation, we characterize its implications for the efficiency costs of dividend and corporate taxation by deriving empirically implementable formulas for excess burden. We obtain two results that challenge intuitions from existing old and new view models. First, dividend taxes create an efficiency cost even if the marginal source of investment is retained earnings by distorting the tradeoff between pet project investment and dividend payouts. Second, if the contract between shareholders and the manager is inefficient – as is the case in a model with diffuse shareholders – dividend taxation creates a large (first-order) efficiency cost. In contrast, the corporate tax may generate only small (second-order) efficiency costs because it does not amplify the manager’s incentive to hoard cash for pet projects. This suggests that corporate taxes may be a more efficient way to generate revenue than dividend taxes. Indeed, our analysis suggest that a Pigouvian dividend subsidy would be desirable to correct the negative externality created by agency problems in firms.

Our analysis suggests that the main source of inefficiency from increasing the dividend tax rate is the misallocation of capital by managers because of reduced monitoring, and not the distortion to the overall level of investment emphasized in the “old view” model. From a policy perspective, if agency problems are prevalent, dividend taxation should be used relatively little if the government has other tools – e.g., progressive income taxation integrated with corporate taxation – that have similar distributional effects but do not create large (first-order) distortions.

The full paper is available for download here.

Seven major law firms — Cravath, Swaine & Moore LLP, Davis Polk & Wardwell LLP, Latham & Watkins, LLP, Simpson Thacher & Bartlett LLP, Skadden, Arps, Slate, Meagher & Flom LLP, Sullivan & Cromwell LLP and Wachtell, Lipton, Rosen & Katz — collaborated on a 17-page comment letter  in response to a request by the SEC last December for additional comments on its proposed proxy access rules.  These seven firms previously submitted a comment letter  last August on the proxy access proposal, which was described on the Forum here.  In light of the additional data and analyses cited in the SEC’s request for additional comment, as well as the recent comments by some of the Commissioners regarding the possibility of permitting shareholders to approve a more restrictive proxy access standard, the comment letter elaborated on the seven firm’s earlier recommendation that shareholders should have the opportunity to modify or opt-out entirely from the SEC’s proxy access regime if Rule 14a-11 were adopted.  As currently proposed, Rule 14a-11 only permits shareholders to adopt less restrictive provisions (a one-way opt-out) to facilitate proxy access.  The most recent seven firm letter recommended that shareholders should be permitted to adopt either more or less restrictive provisions (a two-way opt-out), including a complete exemption or an alternative regime, for the following reasons:

• A two-way opt-out (compared to the Proposal’s one-way opt-out) is fundamentally more consistent with the SEC’s goal of enfranchising shareholders.
• Given the diverse nature and needs of the over 12,000 companies that would be subject to a proxy access rule, uniform proxy access would not be effective or workable without the safety valve of a two-way opt-out.
• A two-way opt-out is widely endorsed by the SEC’s constituencies, with only narrow opposition.

The most recent seven firm letter also notes serious issues with the criticism of a two-way opt-out:

• Proxy access is not fundamentally a “disclosure” regime and concerns regarding its modification by shareholder cannot be properly analogized to weakening disclosure requirements or to permitting shareholders to opt-out of a disclosure regime.
• In contrast to the potential impact on proxy access that impediments to shareholder by-law amendments may pose under an opt-in regime, concerns regarding such impediments, to the extent applicable, under a two-way opt-out regime are misplaced because any such impediments will only make the achievement of a two-way opt-out more difficult and therefore lead to greater prevalence of the default rule.

The letter includes detailed discussion and recommendations regarding the best way to implement two-way opt-out as part of an SEC proxy access rule.

The complete comment letter can be downloaded here.

Last year’s headlines were filled with announcements of major new insider trading prosecutions. The DOJ and SEC have promised there will be more such cases to come in 2010, including through the use of more aggressive investigative techniques such as wiretaps and wired informants. The question is what can a firm practically do to stop insider trading, and if the risk of improper trading cannot be entirely eliminated, how to protect the firm and its constituencies?

Most responsible firms of sufficient size — hedge funds, investment advisors, broker-dealers and banks — have adopted and implemented written policies and procedures that are fairly standard. These written policies are helpful in educating people about the bright lines, but, as typical policies candidly recognize, they cannot cover every situation. In today’s world — which reflects an exponential expansion of the sources of information, as well as the means and speed of communication and the webs of relationships among trading professionals, consultants, advisors and corporate insiders — situations can arise where the lines are less than bright.

In this memorandum, we outline some measures that can make a genuine difference when implementing compliance policies and procedures. It is, of course, critically important for firms to continue reinforcing the message that clearly improper conduct will not be tolerated. But firms could also significantly enhance their compliance environment by devoting more time to developing detailed guidance for employees concerning the range of conduct that borders the often blurry and uncertain lines that arise in everyday business. It is important that firms maintain a current understanding of how traders are actually gathering information and pursuing trading strategies. This approach can help prevent a disconnect between a firm’s compliance procedures and the day-to-day business practices that can put the entire firm in peril.

We thus suggest the following:

• first of all, it is necessary to drill down sufficiently to gain an understanding of the actual information-gathering techniques and trading strategies that are being employed throughout the firm’s various trading and investing operations; the firm should have an up-to-date understanding of what its business practices are in this critical area and information should be gathered from investment professionals in a manner sufficient to spot the kinds of issues that arise in the course of their business;
• this effort will enable the firm to evaluate whether these techniques and strategies present legal and reputational risks and to conduct training that is not abstract and general, but instead tailored to the real-world challenges and issues faced by the various trading desks or investment operations within the firm; this kind of tailored training will allow employees to develop a better understanding of the sometimes unclear line between fair, thoughtful and well-informed investment and trading strategies, on the one hand, and the misuse of material non-public information on the other;
• such training should sensitize employees and supervisors sufficiently so that they know when to raise issues and seek additional advice and input before taking any action;
• these kinds of training sessions should be reinforced through mandatory attendance, record-keeping and annual certifications to document that training has been completed and that compliance has been agreed upon — in other words, the formal pieces of paper do matter but are most effective when part of an integrated approach where legal and compliance personnel understand how the business actually operates and where the investment professionals are taught how to spot issues;
• consideration should be given to shortening written compliance materials (or creating easily consulted summaries) and presenting them in a format that facilitates training;
• firms should revisit their insider trading policies and training with an eye to the communications and social media revolution of recent years, in recognition that many employees now carry on much more extensive communications with many more people and with far less reflection than was ever the case in the past — which multiplies the opportunities and risks for personnel to engage in potentially inappropriate communications;
• information technology and other compliance resources should be deployed wisely to conduct surveillance and monitoring that helps the firm to evaluate compliance; and
• finally, a firm’s senior management should clearly and periodically reinforce the “tone from the top” message that individual investment professionals should not take chances with the firm’s reputation, and, when there is any question, should escalate situations that present legal and reputational risk to appropriate levels within the firm so that decisions can be made on a fully informed and collective basis.

Detecting and punishing insider trading will continue to be a key enforcement priority for prosecutors and regulators. Existing compliance programs should be reviewed in light of today’s level of risk and the realities (sometimes not fully appreciated by all firms) of how their business is actually conducted. It is critical (1) to implement a compliance program that reflects how the firm actually does business, (2) to periodically reassess the program in light of potentially changing business practices and trading strategies, and (3) to maximize the ability of the firm to contain any problem that may nonetheless arise so that it does not threaten the firm’s future.