In an important decision for proxy and takeover contests, the Delaware Supreme Court last week addressed significant questions of corporate “vote-buying” and stock ownership. Crown Emak Partners v. Kurz, No. 64, 2010 (April 21, 2010). (See this post.)

In the course of a corporate control contest, the incumbent directors amended the company’s by-laws to reduce the size of the board, thereby mooting the insurgents’ attempt to elect new directors. During the same period, the insurgents purchased from a former corporate employee the right to vote just enough shares to secure a bare majority, as well as the future economic interest in those shares. Because the former employee was contractually prohibited from selling his shares until 2011, however, the parties left “bare legal title” in his hands. After the inspector of elections invalidated pro-insurgent votes cast by holders of shares held in street name (for want of an appropriate “universal proxy”), the insurgents sued, challenging the validity of the by-law and the invalidation of their votes. The incumbents, in turn, alleged that the share purchase amounted to impermissible vote-buying. The Court of Chancery ruled for the insurgents, holding that street name holders – the banks and brokers who appear on the “Cede breakdown” – are “stockholders of record” for purposes of deciding who has the right to vote or act by written consent under Delaware law. Chancery also ruled that the share transaction was not impermissible vote-buying and that the by-law amendment was impermissible under Delaware law.

…continue reading: Delaware Addresses Vote Buying and Synthetic Ownership

Balancing risk and reward has never been more challenging than it is today. Companies face risks that are more complex, interconnected and potentially devastating than ever before. Over the past two years, a perfect storm of economic conditions has triggered an extraordinary downward spiral from which we are only recently beginning to emerge: the subprime meltdown, liquidity crises, extreme market volatility, controversial government bailouts, consolidations of major banking institutions and widespread economic turmoil both in the U.S. and around the world. Against the background of the global financial crisis and the still uncertain global economy, companies are re-assessing their strategies for responding to the challenges and pressures of the new environment. Risk—and in particular the risk oversight function of the board of directors—has taken center stage in this re-assessment, and expectations for board engagement with risk are at all-time highs. Risk from the financial services sector has contributed to large-scale bankruptcies, bank failures, government intervention and rapid consolidation. And the repercussions have spread to the broader economy, as companies in nearly every industry have suffered from the effects of a global constriction of the credit markets, sharply reduced consumer demand and volatile commodity prices, currencies and stock prices.

…continue reading: Risk Management and the Board of Directors

As we have pointed out for some time, non-traditional structured and derivative arrangements that create economic exposure to publicly traded securities have allowed activist and short-term investors to exert vast but hidden influence. With respect to equity securities, investors have used such instruments to secretly accumulate large equity positions with a view to exercising control over corporate decisionmaking, with little or no disclosure of the existence or nature of these positions or their plans. With respect to debt securities, such devices have often been used – frequently in conjunction with short selling – to manipulate the market in bear raids, placing companies dependent on access to the capital markets in peril. While these phenomena directly implicate the policies underlying traditional disclosure requirements and anti-manipulation rules, they have thus far largely escaped adequate regulation.

In testimony yesterday before the Senate, advancing Treasury Secretary Geithner’s regulatory reform agenda announced on May 13, SEC Chairman Schapiro has now addressed these concerns foursquare, calling for long-needed fundamental reform in the regulation of derivatives by the SEC. Chairman Schapiro put the matter clearly in saying:

The current regulatory framework has permitted certain opaque securities-related OTC derivatives markets to develop outside of investor protection provisions of the securities laws. These provisions include requiring the disclosure of significant ownership provisions and … prophylactic measures against fraud, manipulation, or insider trading…. … Trading in securities-related OTC derivatives can directly affect trading in the securities markets. From an economic viewpoint, the interchangeability of securities and securities-related OTC derivatives means that they are driven by the same economic forces and are linked by common participants, trading strategies, and hedging activities. … [M]anipulative activities in the markets for securities-related OTC derivatives can affect US issuers in the underlying equity market, thereby damaging the public perception of those companies and raising their cost of capital. To protect the integrity of the markets, trading in all securities-related OTC derivatives should be fully subject to the US regulatory regime designed to facilitate capital formation.

Chairman Schapiro called upon Congress to enact legislation to bring securities-related OTC derivatives clearly under the umbrella of the federal securities laws, including so that the SEC might require regulated central counterparties (CCPs) for derivatives markets, to address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of counterparties. In her testimony, Chairman Schapiro also recognized that “[a]ny new regulatory framework… should take into consideration the purposes that appropriately regulated derivatives can serve, including affording market participants the ability to hedge positions and effectively manage risk.”

Broad-based reform of the OTC derivatives market to prevent the abuses and dangers exposed by the recent financial crisis – without destroying the ability of financial institutions, corporations and investors to make appropriate use of derivatives to assist in the process of capital formation and risk management – is a complicated project that will require a great deal of judgment and compromise. Disclosure under the Securities Exchange Act of 1934 of equity derivatives so that ownership and transactions in the derivatives would be treated equally with ownership and transactions in the underlying security is but one part of this larger task. It is, however, an important part, and one that we do not believe requires legislation but only rule-making and interpretation by the SEC. For so long as the current loopholes in the 13D reporting regime are not closed, parties seeking to disguise their activities or manipulate the market will try to take advantage of those loopholes. So too with manipulative trading in credit default swaps and short selling. We encourage the SEC to close the gaps in the current disclosure regime and to actively take enforcement action against abusive transactions, even while the SEC, other regulatory bodies, the Congress and the Administration together pursue the larger project of comprehensive reform of the regulation of derivatives that is now under consideration.

A tidal wave of anger over the economic climate – what Delaware Chief Justice Myron Steele has called a “populist frenzy” – has created a fertile political environment for recent efforts by three of five SEC Commissioners and Senator Schumer to federalize corporate law under the cloak of shareholder empowerment. Unfortunately for long-term shareholders, and the companies in which they have invested, there is no evidence linking the one-size-fits-all broad proxy access currently under consideration at the SEC and on Capitol Hill to better corporate governance or long-term performance. To the contrary, these proposals, if adopted, will likely exacerbate, rather than mitigate, the emphasis on short-term results that played a significant role in the economic crisis.

First, the SEC’s proposal sets a minimum ownership threshold for shareholder eligibility to the corporate proxy entirely too low, at 1% of the shares of a company with a market capitalization greater than $700 million (with higher thresholds of 3% and 5% for smaller companies). Lowering the bar to 1% (and permitting even smaller shareholders to aggregate their stakes for purposes of achieving the 1% threshold), in contrast to the 5% threshold in our model access bylaw, gives activist and special interest holders a very low cost avenue to seek to influence board composition and corporate strategy. This low threshold will enable shareholder activists to create disruption at many companies each year, and reduce the willingness of qualified directors to serve.

Second, if there are more shareholder nominations than slots available, the SEC’s proposal would give priority to shareholders who submitted their nominations the earliest, regardless of the size of the nominating shareholders’ stakes. This contrasts with the approach of our model access bylaw which prioritizes nominations based upon the relative holdings of the nominating shareholders. Under the SEC’s proposal, a long-term institutional investor holding well in excess of 5% of the company’s equity for many years may have to suffer the negative effects of routine director election contests initiated by holders of 1% for only one year, and also lose the opportunity to avail itself of proxy access merely because the smaller holders beat a faster path to the corporate secretary’s office. As a result, the SEC’s proposal does not merely facilitate access for the occasional proxy access election contest, but rather creates incentives for routine election contests, as shareholders race to make access nominations in order to gain control over the process.

The SEC’s proposal advances a mandatory proxy access regime that will not only weaken corporate boards, but also weaken the relative strength of long-term investors as compared to those investors that pursue short-term strategies often based on hollow financial engineering. The Delaware private-ordering approach to proxy access is more consistent with shareholder democracy in that it allows all the shareholders of each Delaware company to consider, debate and if appropriate adopt through shareholder action – rather than government fiat – shareholder access bylaws that suit the particular circumstances of each individual company and its shareholders. Accordingly, and as we have said before, we agree with the position taken by two of the SEC Commissioners, that a mandatory federal “one size fits all” rule is a serious policy error and the SEC should instead amend Rule 14a-8 to allow the issue to develop at the state law level.

Forthrightly addressing the continued proliferation of swaps, options and other equity derivatives, the UK’s Financial Services Authority (“FSA”) has now adopted final rules requiring the disclosure under the UK’s Disclosure and Transparency Rules of swaps, options and other derivative contracts, including those providing for cash settlement. See Policy Statement 09/3. The new rules require disclosure of aggregate equity positions (including derivatives) beginning at the 3% level (with an exemption for the writers of equity derivatives acting as intermediaries).

The FSA noted two important changes from its prior thinking in adopting the final rules.

First, while the FSA’s prior intention was to make the new rules effective in September 2009, it determined, “in light of the changes in market conditions since last summer and the need for increased transparency driven by these changes,” to accelerate the effectiveness of the new rules to June 1, 2009.

Second, the FSA decided that disclosures should be made on a delta-adjusted (rather than nominal) basis, which the FSA believes is a more accurate reflection of the actual extent of economic interest held at any one time. As a transition matter, the FSA will allow reporting on either a nominal or a delta-adjusted basis for a period of seven months following effectiveness of the new rules, provided that firms choosing to report on a nominal basis during the transition period will be required to provide sufficient information – including the strike or exercise price of each financial instrument reported and the total number of voting rights relating to shares referenced by each financial instrument reported – to allow market participants to calculate the underlying adjusted economic interest.

The FSA’s decisive action to require disclosure of accumulations of significant stakes in publicly traded companies through derivative instruments – and its corresponding approach toward disclosure of short positions (see Discussion Paper 09/1) – only further highlights the inadequacy of the current U.S. disclosure and regulatory regime. While there has been piecemeal reform and adjustment in the U.S. – through judicial decisions such as that in CSX, through private and contractual ordering in by-laws, rights plans and other contracts, and through a variety of other mechanisms – the need for comprehensive reform and market transparency has not been met. There continues to be an overwhelming global consensus towards full and fair disclosure of equity derivatives and other synthetic and non-standard ownership and control techniques. We remain strongly of the view that U.S. regulation should be comprehensively reformed to address derivative arrangements in a clear and uniform manner, generally treating all such arrangements that are coupled with direct or indirect ownership of actual shares by counterparties as in all respects equivalent to actual ownership, and requiring appropriate disclosure of all such arrangements involving more than 5% economic equivalent ownership, whether long or short, and whether accompanied by underlying ownership positions or otherwise.

With the explosion in natural resource prices and trade surpluses, the corresponding
increase in the size and investing profile of sovereign wealth funds (SWFs), and the unprecedented stress on the global financial system, SWFs have faced substantial and increasing political and popular suspicion and pressure from the international community to address concerns that their investment decisions may be motivated by political, rather than economic, considerations. (See our December 2007 and June 2008 memos.) In a much-anticipated response, on October 11, a group of 26 nations with SWFs (the “International Working Group”) unveiled a set of 24 non-binding best practices, known as the “Santiago Principles,” designed to safeguard the operational independence of SWFs from political influences, promote greater transparency and accountability, and enhance internal investment and management frameworks, thereby encouraging continued political and popular acceptance of SWF investment in the developed world.

Intended to demonstrate that SWFs are soundly established and that investment decisions will be made on an economic and financial basis, the Santiago Principles address three broad areas of concern regarding SWFs: (i) their legal structure and relationship with the state, policy and investment objectives, and degree of coordination with their sovereign’s macroeconomic policies; (ii) their institutional structure and governance mechanisms; and (iii) their investment and risk management framework. While much will turn on how SWFs actually implement these aspirational guidelines (and it is worth noting that all of the principles are well caveated and subject to home country laws, regulations, requirements and obligations), the Santiago Principles may help reduce political influence in SWF investing and encourage the flow of sovereign wealth across borders.

Notably, the Santiago Principles provide for public disclosure of an SWF’s legal relationship with state bodies, general investment policies and goals, details of funding, withdrawal and spending arrangements, and audited financial information compliant with international or national auditing standards. In addition, the guidelines call for public disclosure of relevant financial information to demonstrate the SWF’s economic and financial orientation. Preferred governance frameworks would establish clear divisions of responsibilities to facilitate the operational independence of the SWF, and governing bodies would be appointed in accordance with defined procedures and with adequate authority to function in an independent manner. Disclosure regarding the SWF’s approach to exercising ownership and voting rights is provided for as is an explicit prohibition on seeking or taking advantage of privileged information or inappropriate influence by the broader government in competing with private entities. The Santiago Principles also make explicit that SWFs will comply with applicable recipient country regulatory and disclosure requirements. Of course, the capacity of the Santiago Principles to allay concerns about the transparency of SWF operations and objectives and their investment motivations will ultimately depend on the level and robustness of each SWF’s compliance with the letter and spirit of these voluntary guidelines.

…continue reading: Sovereign Wealth Funds Adopt Voluntary Best Practices

Ted Mirvis, Bill Savitt, David Shapiro and I have written a memo entitled “De-Coupling of Ownership, Economic and Voting Power in Public Companies – The UK’s Financial Services Authority (FSA) Moves Decisively to Close the Gap.” The memo considers the decision of the Financial Services Authority – the UK’s financial and securities markets regulatory authority – to require disclosure of cash-settled and other derivative contracts, on an aggregated basis with ownership of actual common stock, at the 3% level. The FSA’s new policy is aimed squarely at the now-popular technique of making undisclosed accumulations of significant stakes in publicly traded companies through derivative instruments (including cash-settled derivative instruments) and in other non-traditional ways.

The memo also discusses the urgent need for reform of section 13(d) of the Exchange Act to expand required disclosure to include within the definition of “beneficial ownership” all derivative instruments which provide the opportunity to profit or share in any profit derived from any increase in the value of public equity securities, as well as to require disclosure of large short positions. We note that unless and until lawmakers and securities regulators in the U.S. adopt disclosure requirements in accord with what is now the overwhelming global consensus towards full and fair disclosure of equity derivatives and other synthetic and non-standard ownership and control techniques – which must and should be done promptly – U.S. corporations are well advised to adopt such self-help measures as may be available, including appropriate provisions in by-laws, rights plans and other arrangements with change-in-control protections.

The FSA’s statements on this topic are available here and here. Our memo is available here.