Securities Mosaic® Blogwatch
February 23, 2017
The Resolution of Distressed Financial Conglomerates
by Howell Jackson and Stephanie Massman

One of the most elegant legal innovations to emerge from the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is the FDIC’s Single Point of Entry (SPOE) initiative, whereby regulatory authorities will be in a position to resolve the failure of large financial conglomerates (corporate groups with regulated financial entities as subsidiaries) by seizing a top-tier holding company, down-streaming holding company resources to distressed subsidiaries, wiping out holding company shareholders while simultaneously imposing additional losses on holding company creditors, and allowing the government to resolve the entire group without disrupting business operations of operating subsidiaries (even those operating overseas) or risking systemic consequences for the broader U.S. economy.

Although there is much to admire in the creativity underlying SPOE, the approach’s design also raises a host of novel and challenging questions of implementation. In our recent article, we explore a number of these questions and elaborate upon the following points. First, in contrast to traditional approaches to resolving financial conglomerates, SPOE is premised on the continued support of all material operating subsidiaries, thereby potentially extending the scope of government support and thus posing the possibility of mission creep and expanded moral hazard. Second, SPOE contemplates the automatic down-streaming of resources to operating subsidiaries in distress, but effecting that support is likely to be more difficult than commonly understood. If too much support is positioned in advance, there may be inadequate reserves at the top level to support a single subsidiary that gets into an unexpectedly large amount of trouble. Alternatively, if too many reserves are retained at the holding company level, commitments of subsidiary support may not be credible (especially to foreign authorities) and it may become difficult legally and practically to deploy those resources in times of distress.

SPOE is most easy to envision operating in conjunction with the FDIC’s expanded authority under its Orderly Liquidation Authority (OLA) established under Title II of the Dodd-Frank Act. However, the act’s preferred regime for resolving failed financial conglomerates is the U.S. Bankruptcy Code (where Lehman was resolved) and not OLA. Our article sketches out what is emerging as a complex choice architecture for the resolution of financial conglomerates, built around this statutory preference for the Bankruptcy Code. Which resolution method is ultimately utilized for an individual firm will depend upon the size and complexity of the firm in question as well as the practical ability of the Bankruptcy Code to handle such a firm.

Several complexities could arise were a bankruptcy court today called upon to implement an SPOE resolution plan. While many legal experts are working on legislative proposals to amend the Bankruptcy Code to facilitate SPOE resolutions, we examine a number of legal levers that federal authorities could deploy under current law to increase the likelihood that the SPOE strategy could be effected through traditional bankruptcy procedures. First, the Federal Reserve Board could use its expanded prudential regulatory authority under the Dodd-Frank Act to restrict or prohibit a financial conglomerate from entering into financial contracts with certain cross-default provisions that could trigger value-depleting runs on the conglomerate’s subsidiaries upon the holding company’s bankruptcy filing. Second, with appropriate pre-failure planning, section 365(o) of the Bankruptcy Code could be used to prioritize holding company commitments to all material operating subsidiaries, including non-IDI affiliates. Such priority status would shield the down-streaming of value to operating subsidiaries from challenges brought by holding company creditors, thereby alleviating some of the difficulty of the pre-positioning dilemma. Third, broad-based credit facilities under section 13(3) of the Federal Reserve Act or targeted lending under the Federal Deposit Insurance Act’s systemic risk exception may be available to provide necessary government-sponsored debtor-in-possession financing where no private or other public alternative (like that provided under OLA) is available.

The task of implementing these strategies would be challenging and would require considerable advanced planning. But there are substantial benefits to be had from taking steps now to increase the likelihood that the bankruptcy option represents a viable and credible alternative for effecting SPOE transactions without resort to OLA and Title II of the Dodd-Frank Act.

This post comes to us from Professor Howell Jackson at Harvard Law School and Stephanie Massman at the law firm of Davis Polk & Wardwell. It is based on their recent article, "The Resolution of Distressed Financial Conglomerates," available here.


February 23, 2017
Skadden Discusses the Current State of the U.S. Capital Markets
by Michelle Gasaway and Benjamin K. Marsh

The U.S. capital markets experienced continued volatility throughout much of 2016, as the bond and equity markets were affected by a series of significant events: the November U.S. presidential election; the June Brexit vote; fluctuating oil prices over the course of the year; the Federal Reserve’s December increase in interest rates, only the second since 2006; and a variety of geopolitical events throughout the year, most notably with respect to China and Russia.

How the U.S. capital markets perform in 2017 will largely depend on how and whether the Trump administration implements its proposals, and how those policies complement or contradict one another in their impact. Until there is some clarity on these issues, the markets may again experience volatility related to the new administration.

High-Yield Debt Market. The U.S. high-yield market in 2016 ended the year approximately 15 percent lower by dollar volume and 23 percent lower in number of issuances than 2015, the third consecutive year of decline.1 U.S. high-yield bond issuances totaled $245 billion (486 issuances) in 2016 compared to $288 billion (634 issuances) in 2015. Acquisitions and refinancing activity continued to drive volume last year; however, M&A issuances (including leveraged buyouts) decreased to approximately 19 percent of total volume in 2016, compared to approximately 33 percent in 2015. In addition, energy sector issuers remained active in the market, with exchange offers and other restructurings and — particularly with stronger oil prices in the fourth quarter — traditional refinancings. (See "Oil and Gas Industry Seeks Steady Ground Following Year of Restructurings, Restrictive Lending.") December 2016 was the busiest December for high-yield issuances since 2013, with refinancings accounting for 69 percent of dollar volume.

Investment-Grade Debt Market. The U.S. investment-grade debt market in 2016 once again had record dollar volume — approximately $1.35 trillion (1,881 issuances) — exceeding the previous record of $1.32 trillion (2,177 issuances) set in 2015 and marking the sixth consecutive year of dollar volume increase. The total dollar volume was driven in part by several large acquisition financings, including: $46 billion by Anheuser-Busch InBev NV to finance its acquisition of SABMiller Plc (the second-largest bond offering ever behind Verizon’s $49 billion offering in 2013), $20 billion by Dell Inc. to finance its acquisition of EMC Corp., and $15 billion by Abbott Laboratories to fund its acquisition of St. Jude Medical. In addition to M&A issuances, the investment-grade volume in 2016 was driven by issuers refinancing debt in anticipation of interest rate increases as well as potential volatility and uncertainty associated with the implementation of President Donald Trump’s campaign proposals. Banks and financial issuers represented the largest total number of issuances by sector in 2016 (almost 50 percent) and approximately 42 percent by dollar volume, as banks issued new bonds both to replace maturing debt and to prepare to meet total loss-absorbing capacity rules adopted by the Federal Reserve in December 2016. The rules, which go into effect January 1, 2019, require banks identified as global systemically important banks to maintain a minimum level of long-term debt that could be used to recapitalize critical operations upon failure. They also set a new minimum level of total loss-absorbing capacity, which can be met with both regulatory capital and long-term debt. Strong investment-grade issuance volume — dominated by banks and financial issuers — continued into early 2017, with a record $44 billion of dollar volume in the first two days of the year. Year-to-date 2017 investment-grade issuance is nearly $150 billion, a record high for January.

Equity and IPO Markets. The U.S. equity markets reached record levels, starting in December 2016 and continuing into 2017. Toward the end of January 2017, both the Standard & Poor’s 500 index and the Nasdaq composite set new all-time highs, and the Dow Jones industrial average topped the 20,000 milestone. The records were driven by strong fourth-quarter earnings and executive orders from President Trump that provided some clarity on infrastructure policies, including accelerating the completion of the Keystone XL and Dakota Access pipelines and easing the regulatory burden for domestic manufacturers.

Despite the recent positive tone in the markets, volatility in the first half of 2016 depressed the initial public offering (IPO) market throughout most of the year, with only 105 IPOs raising approximately $20 billion, compared to 174 IPOs raising over $34 billion in 2015, representing the lowest dollar and issuance volumes since 2003 and 2009, respectively. The five largest IPOs in 2016 accounted for over one-quarter of the dollar volume, and the leading sectors by dollar volume were financial services and health care. Financial services and health care companies also had the greatest number of issuances, followed by technology issuers. Several companies that filed for IPOs in 2016 or were considered candidates for IPOs in 2017 (including Dollar Shave Club and Centennial Resource Development Inc.) instead consummated a sale process, which can provide a quicker path to liquidity, particularly for private equity firms looking to exit older investments. Special purpose acquisition companies (SPACs) continued to access the IPO market in 2016, with 13 SPAC IPOs raising $3.5 billion (down from 20 SPAC IPOs raising $3.9 billion in 2015, but still well above dollar levels in 2008-14).

Follow-on volumes in 2016 also were down materially from prior years, particularly with respect to marketed transactions. Despite the decline in overall follow-on activity, however, 2016 was a record year for block trades (which represented 57 percent of total follow-on proceeds raised), as issuers sought execution certainty and a transfer of risk to underwriters.

Looking Ahead

Implementation of President Trump’s campaign proposals has the potential to significantly impact the U.S. capital markets throughout 2017, as do a wide variety of exogenous political and global macroeconomic events. As in recent years, repeat issuers and companies with strong fundamentals, especially those in sectors that stand to benefit from President Trump’s stated policies, are likely to continue to have the best access to capital if volatility returns. More highly leveraged or distressed companies may need to seek alternative financing solutions and creative structures, as evidenced in recent years in the energy sector. In a positive sign for the IPO market, a healthy backlog continues to build, and investors have begun to rotate their portfolios back into equities, reversing a multiyear trend. So far, 2017 is off to a strong start, with a number of companies having launched or priced their IPOs in the first month of the year. However, some private companies may continue to delay IPO plans in favor of private capital raises, particularly with the increased number of shareholders allowed before a company is required to become a Securities and Exchange Commission reporting company.

M&A and Refinancing. A more favorable M&A environment under President Trump could positively impact both the debt and equity capital markets. Many of President Trump’s cabinet appointments have made careers in leveraged buyouts, which could further impact the M&A environment. The expectation is that a robust M&A market (see "Mergers and Acquisitions: 2016 Update") will drive significant acquisition financing. Similarly, at the beginning of 2017, issuers likely will continue to take advantage of the still relatively low interest rate environment to effect opportunistic financings or refinance existing near-term debt before interest rates rise.

Fiscal Stimulus. President Trump’s policy statements, including the promise of a large infrastructure investment, are expected to stimulate the economy if they come to fruition. Fiscal stimulus, together with corporate tax cuts, could improve corporate profits and result in higher stock prices and a stronger equity market. However, more protectionist trade policies could have the opposite effect. In addition, policies that are favorable for the equity market often have the opposite impact on the bond market. Growth-oriented fiscal policies could increase the threat of inflation and result in a faster pace of Federal Reserve interest rate increases, which would negatively impact the bond market. (See "Significant Changes Likely for US Trade Policy and Enforcement.")

Corporate Tax Reform. Corporate tax reform, if enacted, is expected to have a significant positive impact on the equity markets but could negatively affect the bond markets. (See "Business Tax Reform All but Certain in US, Europe.") An inability to deduct interest on bonds or a reduced corporate income tax that makes deductibility less valuable could make bonds, particularly high-yield bonds, less attractive. However, an ability to expense capital investments could benefit the bond market if companies issue debt to finance these investments. Similarly, if repatriation of corporate cash held abroad is facilitated with a lower tax rate, companies that benefit — including investment-grade technology and pharmaceutical companies — may need to raise less cash in the bond markets for share buybacks, dividend recaps, M&A and other purposes. Yet share buybacks and M&A activity, combined with higher capital spending and additional hiring that likely will occur with repatriation, are bullish indicators for the equity markets.

Financial Deregulation. The possible repeal of the Volcker Rule and the loosening of other Dodd-Frank Act regulatory standards could strengthen the bond market, particularly the high-yield market, by allowing banks to once again provide trading liquidity for high-yield bonds and underwrite bonds for more highly leveraged issuers. (See "The Trump Impact: Key Issues in Financial Services Reform for 2017.") Deregulation also could positively impact the equity markets, particularly financial stocks, and encourage additional issuances.

Equity Backlog. Following consecutive years of below-average issuance levels (by volume), a significant pent-up backlog exists across industry verticals. Conditions look ripe for issuance activity to pick up in 2017, fueled in large part by a recent recovery in corporate earnings, improved performance of the 2016 IPO class as compared to 2015 and an investor base that is underweight in its equity investment allocations by historical standards. The IPO of Snapchat’s parent, Snap Inc., is expected as early as March with a valuation in excess of $20 billion according to some sources. While the overall IPO market may be less focused on these so-called unicorns, the technology sector is poised for at least a modest recovery, and successful IPOs in the early part of 2017 could lead to greater offering activity during the year. In addition, the financial, energy and industrial sectors are expected to see significant upticks in equity issuances given prevailing pro-growth, anti-regulation and protectionist themes, combined with a recovery in oil prices and rising interest rates. These trends clearly favor domestic issuers, whereas foreign issuers or those with significant overseas exposure likely will be viewed more skeptically by investors, given geopolitical uncertainty, a strong dollar and fears around global trade. Overall optimism surrounding the equity markets is balanced between IPO and follow-on activity. One of the big unknowns, however, is the way in which the sponsor backlog will play out, with private equity shops largely pursuing dual-track processes. But with a target-saturated environment in many verticals and a sense that the bull run is in or nearing its final phase, the bias may be toward near-term IPO exits.

Strength Across Sectors in Equity Markets
Based on views of equity capital markets and syndicate bankers across Wall Street, the prevailing expectation is that most sectors should be active in the equity markets in 2017.

  • Technology. There is a consistent sense on Wall Street that technology companies will help lead the charge in the recovery of the IPO market. Smaller-scale, high-growth companies with high revenue visibility, such as software companies, are likely to form the initial wave, though significant pent-up supply of internet and e-commerce companies exists, which could generate larger deals. Snapchat’s plans to launch an IPO as early as the first quarter of 2017 may be the catalyst the tech market needs.
  • Health Care. While uncertainty around the fate of the Affordable Care Act may be disruptive to certain subsectors such as hospitals and services, a healthy rebound in life sciences issuance is expected. There are a significant number of biotechnology and pharmaceutical companies in the near- and medium-term pipeline, and already there have been a number of launches and public filings, including five IPOs and eight follow-ons launched as of January 27, 2017, on the back of a historically well-attended health care conference for investors and pharmaceutical executives.
  • Industrials. Industrials have rallied significantly on the prospects of increased infrastructure spending and protectionist trade policies. A number of capital markets professionals expect this to lead to significant equity issuance as well as debt refinancing activity. Pitch activity has been robust in recent months, and a few near-term public filings and launches are expected. Much of the supply remains sponsor-backed, with a number of longer-held positions ripe for exit. Companies in the building products and materials space could be particularly active, as could issuers tied to the steel market.
  • Energy. The trend toward consolidation, particularly in the exploration and production (E&P) space, is projected to continue, as players maintain their focus around the Permian Basin in Texas and New Mexico. That likely will drive a significant need for acquisition financing. However, many targets believe that oil price stability and a positive outlook for the industry will finally thaw the IPO market, and they have begun to engage in discussions with banks. A clearing of the E&P backlog would pave the way for issuances in the midstream space, where many master limited partnerships (MLPs) have been delaying capital spending as they wait for the equity markets to reopen.
  • Financial Institutions. The promise of decreased regulation, rising interest rates and a steepening yield curve have improved the outlook for the sector, resulting in expectations that significant post-election follow-on activity will continue and the market will see a reinvigorated IPO pipeline (including many IPOs that have been on hold for long periods). Banks are likely to be among the most active issuers, both in the IPO and follow-on markets, though there are a handful of insurers and reinsurers in the pipeline. In the specialty finance and business development company (BDC) space, many issuers are starting to trade back at or above book value. If that trend holds, there is likely to be a decent number of new issuances.
  • Consumer. The near-term IPO pipeline of sponsor-backed companies is relatively moderate, as much of the supply in this sector has been brought public in the last couple of years. However, there remain concentrated positions in a number of these companies, and sponsors may look to monetize those holdings aggressively if the market remains open. In addition, a number of nonsponsor-owned, high-growth retail names are starting to engage in IPO discussions. Investors currently seem to favor hard goods retailers, particularly those with a strong e-commerce platform, and the food and beverage sector is expected to remain strong.
  • Real Estate. Real estate investment trusts (REITs) struggled in 2016, underperforming the S&P 500 and suffering from elevated trading volatility as investors have rotated out of the space. The recent interest rate hike and the promise of more have not helped. However, certain areas such as hotels and residential- and consumer-driven sectors have the potential to outperform the broader sector, leading to potential equity issuances. Overall, the IPO pipeline is moderate, with a couple of large potential debuts expected and a number of midsized hotel and multifamily operators that may choose to test the market.


1 Sources for the data in this article are: Dealogic, Debtwire,, S&P Capital IQ LCD, Bloomberg and Thomson Reuters.

This post comes to us from Skadden, Arps, Slate, Meagher & Flom LLP. It is based on the firm’s client update, "Volatility and Uncertainty Continue in the US Capital Markets," dated January 30, 2017, and available here.

February 23, 2017
A Broader Perspective on Corporate Governance in Litigation
by Cameron Hooper, Hans Weemaes, Ilene Friedland, Ronald Gilson, Cornerstone
Editor's Note: Ronald J. Gilson is Marc & Eva Stern Professor of Law and Business at Columbia Law School, Meyers Professor of Law and Business (Emeritus) at Stanford Law School, and a senior fellow at the Stanford Institute for Economic Policy Research. Hans Weemaes is a principal at Cornerstone Research. This post is based on a Cornerstone Research publication by Professor Gilson, Mr. Weemaes, Ilene Friedland, and Cameron Hooper.

Corporate governance issues often figure prominently in litigation, but the issues raised typically have a narrow focus. Disputes most often build on the formal legal skeleton of corporate governance created by the state’s corporation’s statutes, the particular corporation’s organizational documents, and the judicially imposed fiduciary duty of directors and officers. However, this structure represents an overly formal and significantly incomplete understanding of what makes up a publicly held corporation’s corporate governance structure. In this article, we outline the much broader corporate governance structure that underlies the operation of a modern public corporation, and show how that structure has important implications for a wider range of litigation than is commonly understood. What is Corporate Governance?

The basic shape of a corporation’s governance structure is provided by the formal legal skeleton. Indeed, this formal structure addresses a set of high-profile matters, including the allocation of decision-making rights (and, hence, the influence over corporate control) among the board of directors, senior management, and shareholders. However, this structure accounts for only a relatively small part of how the corporation actually carries out its business and how it adapts to its business environment. The rest of the governance structure—what we might call the “dark matter” of corporate governance—lies in the realm of reporting relationships, organizational charts, internal controls, risk management, and information gathering. These are non-legally-dictated policies, practices, and procedures that do not appear in the corporate statute or the corporation’s charter or bylaws. Put differently, corporate governance is the corporation’s operating system.

Specifically, corporate governance encompasses how the corporation:

  • Obtains the information it uses in making, implementing, and monitoring the results of its business decisions, including decisions concerning how best to conduct the company’s business and decisions relating to its efforts to comply with applicable regulation;
  • Causes that information to move up the corporate hierarchy from where it originates to those in management who have the expertise and experience to evaluate that information; and
  • Makes, communicates, and monitors the implementation of the decisions arrived at based on that information.

Since each company has a different governance structure, the totality of the corporate governance structure must be understood before analyzing an individual or specific governance issue.

Corporate Governance in Litigation

When viewed more broadly as a corporation’s operating system, corporate governance has implications not only for litigation that typically arises in connection with contests over corporate control and with claims of fiduciary duty breach, but also for operational matters, including those related to materiality and scienter issues.

As Figure 1 illustrates, this broader view of corporate governance figures prominently when the litigation calls into question the character of a corporate decision, for example, a decision concerning disclosure under the securities laws or the “state of mind” of a corporation charged with violating the Foreign Corrupt Practices Act (FCPA). A corporate governance perspective may also be relevant in analyzing product liability issues or mutual fund excessive fee claims. Thus, a corporate governance analysis can be useful in addressing allegations related to bribery, fraud, and reckless conduct in whatever legal context those issues are raised.

For instance, a common pattern in securities fraud class actions is for plaintiffs to identify a “smoking gun”—for example, an e-mail written by a lower-level employee such as a sales manager containing apocalyptic statements about what the employee thinks is happening to the company’s business. Plaintiffs typically claim that had the information contained in the e-mail been disclosed at that time, the company’s stock price would have fallen before the plaintiffs purchased the stock.

Figure 1: Corporate Governance Litigation Pyramid

A common approach to assessing the consequences of the alleged undisclosed or improperly disclosed information is to employ a statistical analysis to determine whether a particular disclosure is associated with a significant change in the total mix of information—often measured by conducting an event study. In contrast, a governance approach to assessing the consequences of the “smoking gun” claims is to examine the company’s corporate governance system.

As discussed above, a corporate governance system can be conceived as an information flow and a decision-making process by which information moves from the operating level up through the managerial hierarchy to where decisions are made. Understanding the system of information flows (including reporting mechanisms) and decision-making structures (such as committees) allows isolated pieces of information to be considered in their proper context. For instance, an analysis of the company’s corporate governance system (including a review of memos, minutes, and other e-mails) might reveal that the information in the “smoking gun” e-mail did in fact work its way up the corporate hierarchy to the level where assessments concerning the corporation’s operating strategies and projections are made. This analysis, along with an open mechanism for allowing lower-level employees to air concerns or grievances, can provide evidence that such concerns were reported and assessed.

These assessments provide the basis for the corporation’s disclosure decisions. A corporation’s governance structure locates the decision about what is material—to the corporation’s business decisions and its disclosure obligations—at the senior management level where the information (and the buck) stops. The decision maker satisfies both her obligations and those of the corporation under corporate and securities law by making this decision in good faith and not recklessly.

In this sense, the information portrayed as a smoking gun can be addressed by the fact that the decision makers had the information at issue and addressed it. A case can therefore be defended by analyzing the operational system of a corporation and placing the “smoking gun” information in its proper context. This type of analysis involves an investigation into:

  • Where the information originated;
  • How and where the information was disseminated;
  • Who recognized and reviewed the information;
  • Whether the flow of information was consistent with company policies;
  • In what form the information arrived at the relevant decision makers within the governance structure; and
  • Whether the decision was made according to the standard of care that would normally apply to the individual(s) in that position.

These represent just some of the considerations that are relevant when addressing the “smoking gun” claims.

Another claim that plaintiffs frequently make in securities fraud class actions is that company managers caused the company to issue false financial statements. Again, the alleged actions of the defendants can be addressed by analyzing the company’s corporate governance system. Management is obligated to have a system in place that provides reasonable assurance that reliable information—information that management can confidently rely on to make business decisions and to comply with financial reporting requirements—is generated at the appropriate place in the governance structure. The alleged actions of the defendant cannot be considered in isolation; they should be assessed with an appreciation of the company’s operating environment. Whether a standard of care has been met will depend on the decision and information structure of the company. Information related to the alleged omission or misleading statement can be traced throughout the company’s operational system and placed in the proper context of the company’s structure, policies, practices, and procedures.

Corporate governance issues are often intertwined with other allegations and thus might initially be overlooked. For example, in litigation related to allegations of accounting misconduct, issues surrounding company processes (such as certification and disclosure processes) may provide important contexts. Similarly, in consumer product failure cases issues of product evaluation processes and testing procedures, as well as the information and decision-making structure through which product decisions are made, may be relevant to responding to the claims and defenses in the litigation.

Corporate Governance Experts Provide Context

The goal of a corporate governance expert is to address the alleged conduct in the proper context of the company’s operating environment and in terms that jurors can relate to the collective experience. Most jurors have had little experience with how a company operates. For them the issue is how the “company” acted. For example, did the company act in a “reckless” manner? Without guidance, they may be unaware that the company can act only through its employees and executives, who in turn act through the company’s governance process. That process determines how the company obtains the information needed to run its business and comply with applicable regulatory requirements, how this information gets to the right decision makers, and how the ensuing decisions are implemented and monitored.

One role of a corporate governance expert thus may be to evaluate how information is collected and disseminated through a specific company’s reporting and information systems. The expert may also evaluate how these systems supported the decisions and judgments at issue in the litigation in the proper context of the information that was available at the time. For example, the expert may opine on the reasonableness of the company’s process in support of management’s certification of its financial statements. The expert might proceed by analyzing how information about the design, implementation, and results of the certification process was collected and disseminated throughout the company’s reporting and information systems and how these systems supported the certification.

Similarly, in an FCPA case, a corporate governance expert may be called upon to examine a company’s policies, procedures, and structures in order to ensure compliance with FCPA laws and regulations. In this context, the expert can assess whether the process caused relevant decisions to be made at a level where information, expertise, and access to professional advice coincided. The expert may also evaluate the activities of directors, officers, managers, and their advisors to determine whether they acted in a manner consistent with the company’s FCPA compliance structure.

This type of analysis is frequently relevant to a broad range of issues and thus the work of a corporate governance expert can often provide a foundation for the work of other experts. For example, in a Rule 10b-5 case, identification of the appropriate class period requires determination of when the alleged stock inflation was first impounded into price. A corporate governance expert’s analysis of the company’s information and decision structures can help determine when the relevant information should have been disclosed to the public. The same inquiry can help the damages expert determine the period over which there are economic damages.


Corporate governance issues in litigation appear most clearly in cases raising issues of corporate control. These issues often require parsing the sometimes conflicting role of directors and shareholders in control contests that have been a familiar pattern for years and show no indication of slowing down. However, corporate control is only the visible tip of the corporate governance iceberg. Assessments of the corporation’s governance system can provide the context within which state of mind assessments, such as good faith and recklessness, are made. Issues such as these pervade a wide range of claims against corporations. A corporate governance expert can provide useful guidance in explaining how a corporation actually acts, assessing the quality of a corporation’s information and decision-making processes, and providing important context for the opinions of other experts.

February 23, 2017
Related Investing: Corporate Ownership and Capital Mobilization During Early Industrialization
by Zorina Khan
Editor's Note: B. Zorina Khan is Professor of Economics at Bowdoin College and a Research Associate with the National Bureau of Economic Research. This post is based on her recent paper.

Family businesses and concentrated ownership have been the norm across time and place. Business historians like Alfred Chandler have noted these patterns with disapproval, attributing the decline of European industrial dominance in part to subjective “family capitalism,” and the advance of the United States to its development of objective and impersonal “managerial capitalism.”

According to economic models, market efficiency implies depersonalized transactions where outcomes are based on prices and fundamentals rather than the identity of participants. Personal or familial connections can serve as conduits for inefficiency, with the potential for nepotism, corrupt governance, and exploitation of other stakeholders. Outsider investors face the risk that both internal and external control mechanisms may be too weak to protect them from “tunneling” or corruption in the firm. By contrast, others maintain that such personalized institutions as family firms or venture capital might provide a mechanism to reduce risk or asymmetries in information, and to increase trust, social capital and the enforceability of contracts. The intergenerational links that characterize family membership can similarly provide a cost-effective signal to outsiders that a firm values continuity and future exchange.

Empirical studies typically draw conclusions from data that are limited to the top shareholders, directors, and other visible members of the firm. Apart from these key insiders, the nature of corporate ownership currently remains very much a black box. My research draws on a rich and unique data source that encompasses all of the shareholders in antebellum Maine corporations, in banking, manufacturing, and transportation, over several decades during a period of rapid structural economic growth and transformation. The panel data (cross-sections tracked over time) include information on personal characteristics of each investor including gender, age, occupation, residence, household composition, real estate holdings and personal wealth. The corporate charters specified the founding members of the company, the initial capitalization, and shareholder liability; as well as governance measures regarding restrictions on officers of the corporation, voting rights, and disclosure requirements, among other factors.

Current ongoing research examines how such patterns are related to central issues in corporate governance. Charters at that time exhibited a great deal of heterogeneity, which allows us to systematically assess variation in voting rights, restrictions on directors, and limited liability rules. The invaluable individual-level information on real estate holdings, personal wealth, and total equity ownership can also be exploited to directly investigate such questions as portfolio composition over the lifecycle; and the “Bagehot hypothesis” about the relationship between wealth and limited liability laws.

The first paper from this project is Related Investing: Corporate Ownership and Capital Mobilization during Early Industrialization. “Related investing” refers to investors whose family relationships or networks influence their decisions to enter or exit the market, the balance of their portfolios, or other actions that they might not otherwise undertake.

As most other studies have found, my results confirm that elite insiders—officers of the firm including treasurers, directors, and its presidents—were typically part of a family network in the corporation. Family networks among these business elites were positively related to concentration and did not decline over time; instead, the importance of these personal ties increased as the economy developed. Rather than seeking to expropriate their smaller investors, related founders of corporations introduced institutional mechanisms to ensure transparency, disclosure and close monitoring of the financial and accounting status of the firm. Nevertheless, these patterns might initially seem to provide support for scholars who have concerns about “unacceptable grasping.”

However, lifting the lid on the “black box” reveals a pervasive pattern in all firms and all industries over the entire period: related investing was not just limited to corporate insiders. Instead, personal ties characterized the majority of all shareholders. Indeed, it is striking that family connections were especially prevalent among women, less-wealthy shareholders, and small investors. Such groups were more likely to include individuals who were not as experienced or knowledgeable about financial markets. At least one implication of this finding is that “outsider investors” were able to overcome a lack of experience and information by taking advantage of their own networks, which also likely offered countervailing power against elite insiders.

Systematic analysis of variation across such factors as industry, gender, wealth, ownership concentration, and persistence in shareholding, offers some insights into the underlying mechanisms that in part might explain these results. For instance, differences across the banking, manufacturing, and transportation sectors suggests that family networks may have served to attenuate perceived risks and transactions costs. The expansion of the railroads (high-risk start-ups at that time) in particular required and attracted extensive investments in securities markets, that predominantly consisted of small investors who were likely to have been uneducated about financial assets. Initially, women investors were primarily associated with bank shares, but their shareholding disproportionately shifted over time towards the risky transportation securities; and this shift was positively related to kinship networks. The analysis of the effects of related investing on the concentration of ownership in the corporations similarly suggests that this phenomenon was likely associated with a reduction in perceptions of risk. Outsider investors with family connections were significantly more likely to persist in holding shares over a longer term.

The overall patterns are consistent with a more productive interpretation of related investing and its function in developing societies. The link between family networks and ownership in these corporations suggests that this phenomenon was especially beneficial for capital mobilization in emerging ventures. Familial and other social connections arguably substituted for incomplete markets and helped to resolve problems that arose in the presence of such market imperfections as high risk and asymmetrical information. Personalized trades in the context of family networks may have facilitated a process of investor education and compensated for other disadvantages that small shareholders encountered. This interpretation is consistent with my research on enterprise in France, which showed that women were able to overcome legal inhibitions on their market transactions, by participating in family firms as managers and entrepreneurs.

In general, the organization of the firm tends to be approached as a dichotomy that contrasts personalized family firms and impersonal corporations. Alfred Sloan is said to have referred to the modern corporation as “an objective organization,” rather than an institution that becomes “lost in the subjectivity of personalities.” My research instead suggests that the personal elements within the ownership structure of firms and corporations are arrayed along a continuum, that endogenously adjusts to accommodate the nature of transactions costs within the organization and in the market.


B. Zorina Khan, “Invisible Women: Entrepreneurship, Innovation and Family Firms in Nineteenth-Century France,” Journal of Economic History, vol. 76 (1) 2016: 163-195.

B. Zorina Khan, “Related Investing: Corporate Ownership and Capital Mobilization during Early Industrialization,” NBER Working Paper No. 23052, January 2017.

Randall K. Morck (ed.), A History of Corporate Governance Around the World, Chicago: University of Chicago Press, 2005.

February 23, 2017
Who Bleeds When the Wolves Bite?
by Leo Strine
Editor's Note: Leo E. Strine, Jr. is Chief Justice of the Delaware Supreme Court, the Austin Wakeman Scott Lecturer on Law and a Senior Fellow of the Harvard Law School Program on Corporate Governance. This post is based on Chief Justice Strine’s recent essay, Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System, forthcoming in the Yale Law Journal. Related research from the Program on Corporate Governance includes Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law (discussed on the Forum here) and Securing Our Nation’s Economic Future (discussed on the Forum here), both by Chief Justice Strine, and The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here).

Leo E. Strine, Jr., Chief Justice of the Delaware Supreme Court, the Austin Wakeman Scott Lecturer on Law and a Senior Fellow of the Harvard Law School Program on Corporate Governance, recently issued an essay that is forthcoming in the Yale Law Journal, which is available here. The abstract of Chief Justice Strine’s essay summarizes it as follows:

This essay examines the effects of hedge fund activism and so-called wolf pack activity on the ordinary human beings—the human investors—who fund our capital markets but who, as indirect of owners of corporate equity, have only limited direct power to ensure that the capital they contribute is deployed to serve their welfare and in turn the broader social good.

Most human investors in fact depend much more on their labor than on their equity for their wealth and therefore care deeply about whether our corporate governance system creates incentives for corporations to create and sustain jobs for them. And because human investors are, for the most part, saving for college and retirement, they do not gain from stock price bubbles or unsustainable risk taking. They only gain if the companies in which their capital is invested create durable value through the sale of useful products and services.

But these human investors do not typically control the capital that is deployed on their behalf through investments in public companies. Instead, intermediaries such as actively traded mutual funds with much shorter-term perspectives and holding periods control the voting and buy and sell decisions. These are the intermediaries who referee the interplay between activist hedge funds and corporate managers, an interplay that involves a clash of various agents, each class of which has a shorter-term perspective than the human investors whose interests are ultimately in the balance.

Because of this, ordinary Americans are exposed to a corporate republic increasingly built on the law of unintended consequences, where they depend on a debate among short-term interests to provide the optimal long-term growth they need. This essay humanizes our corporate governance lens and emphasizes the living, breathing investors who ultimately fuel our capital markets, the ways in which they are allowed to participate in the system, and the effect these realities have on what corporate governance system would be best for them. After describing human investors’ attributes in detail—their dependence on wages and locked-in, long-term investment needs—this essay examines what people mean when they refer to “activist hedge funds” or “wolfpacks” and considers what risks these phenomena may pose to human investors. Finally, this essay proposes a series of reforms aimed not at clipping the wings of activist hedge funds, but at reorienting our corporate governance republic to truly serve the needs of those whose money it puts to work—human investors.

The full essay is available for download here.

February 23, 2017
The Filing of Canadian Securities Class Actions Increased in 2016
by Tom Gorman

The filing of securities class actions increased significantly last year in the U.S. In Canada the number of such actions filed also increased last year. Over the last two years in Canada however, the number of securities class actions filed has not matched that of earlier years. This is in "stark contrast" to the U.S., according to a new report by NERA Economic Consulting titled Trends in Canadian Securities Class Actions, 2016 Update (Feb. 22, 2017)(here).

Last year nine securities class actions were filed in Canada. That more than doubled the four brought in 2015. At the same time, it is less than the 13 brought in 2014, 11 in 2013, 10 in 2011 and 15 filed in 2010. This contrasts significantly with the U.S. where the number of these cases has increased significantly in recent years.

The risk of being named in a securities class action in Canada is also far less than in the U.S. Over the last six years 44 securities class actions were filed against TSX listed firms, according to NERA. That represents about 2.9% of the average number of firms listed on the exchange meaning that there is about a 0.5% chance of being named in such a suit. For firms listed on the TSX Venture Exchange, the risk is about 0.4%. In contrast, the risk of being named in such a suit for a firm listed on a major U.S. exchange, on average, is about 3.1% for the period from 2011 through 2016, the same time span used to compute the risk for the Canadian issuers.

Over the last 20 years a disproportionate number of the Canadian class action suits have been filed in Ontario. For the period 1997 through 2005 about 55% of those suits were filed in Ontario. For the period 2006 through 2016 that percentage increased to 62% of the suits filed.

Six of the nine Canadian cases filed in 2016 had a parallel action brought in the U.S. This is consistent with trends in earlier years in which the majority of the Canadian class actions had a parallel U.S. case. A key difference between the U.S. and Canada is the "responsible issuer" definition in the provincial securities laws. Under this provision an action was brought against Volkswagen AG in Canada last year although the firm’s shares are not listed there. The action parallels a U.S. filing where the firm’s shares are listed. Other, similar actions, have been filed. The "responsible issuer" cases cannot be brought in the U.S. Four Canadian firms were named in suits filed in the U.S. but not in Canada.

Canadian class actions were brought last year against firms engaged in a number of sectors. Those included consumer durables and services, health, technology and non-energy minerals. No suit was brought against a financial services firm last year. Three of the cases brought in 2016 involved the non-energy mineral sector. This is consistent with a trend observed last year, according to NERA – an increasing proportion of new cases involving firms in the minerals sector.

Finally, only two Canadian securities class actions settled last year. That is down significantly from the 7 in 2015, 6 in each of 2014 and 2013 and just above the 3 in 2012. Only one of the two settlements involved cross-border actions. Historically the domestic cases settle on average for about $6.2 million representing about 12.1% of the claimed compensatory damages. In contrast, the cross-border cases settle on average for about $21.9 million, according to NERA.

February 23, 2017
Whistleblowers: Language for Severance Agreements
by John Jenkins

As we’ve noted in several prior blogs, in recent months, the SEC’s Division of Enforcement has made a cottage industry out of going after companies with provisions in their standard severance agreements that it believes may discourage whistleblowing. In addition to these SEC actions, last year, Congress enacted legislation – the Defend Trade Secrets Act, or DTSA – protecting whistleblowers who disclose trade secrets.

This Perkins Coie memo provides some suggested language for inclusion in severance agreements to address the issues identified by the SEC & to conform to the DTSA’s requirements. Here’s an excerpt with the language:

Savings Clause for Confidentiality Provisions. The "savings clause" BlueLinx agreed to include in its severance agreements to resolve the SEC’s charges is broader in its application than Rule 21F-17 requires. We continue to recommend the shorter version:

"Nothing in this agreement is intended to or will be used in any way to limit employees’ rights to communicate with a government agency, as provided for, protected under or warranted by applicable law."

Waiver for Severance Agreements. Severance agreements should also include waiver language designed not to violate Rule 21F-17’s prohibition on interference with SEC whistleblower activity:

"Employee agrees to waive the right to receive future monetary recovery directly from Employer, including Employer payments that result from any complaints or charges that Employee files with any governmental agency or that are filed on Employee’s behalf."

Because this does not require an employee to waive the right to any future monetary recovery from the government in connection with any communication the employee may have with the SEC, there is no violation of Rule 21F-17.

DTSA Language. To comply with the DTSA, we suggest this language in governing the use of trade secrets:

"Employee may not be held criminally or civilly liable under any federal or state trade secret law for the disclosure of a trade secret that: (a) is made (i) in confidence to a federal, state, or local government official, either directly or indirectly, or to an attorney; and (ii) solely for the purpose of reporting or investigating a suspected violation of law; or (b) is made in a complaint or other document that is filed under seal in a lawsuit or other proceeding."

Non-GAAP: Corp Fin Focused on "Equal or Greater Prominence"

This Andrews Kurth memo reviews recent Corp Fin Staff comments & enforcement activity surrounding presentation of non-GAAP information – and notes the heavy focus on Item 10(e)’s "equal or greater prominence" requirement. Here’s an excerpt discussing recent comments:

Following the issuance of the May 2016 guidance, the Staff increased its focus on the prominence requirement by issuing comments related to issuers’ failure to comply with the requirement. These comments have included, among other things, a failure to:

– Describe or characterize the most comparable GAAP measure in equally prominent terms if a characterization was provided for the non-­GAAP measure (for example, "strong overall results" and "record EBIT");
– Present the most comparable GAAP measure first in a tabular presentation, including in the required quantitative reconciliation (meaning that the reconciliation should begin with the GAAP measure instead of the non-­GAAP measure);
– Present the GAAP measure first in the body of an earnings release or in its headline;
– Provide similar percentages or prior period amounts for the GAAP measure when provided for the non­-GAAP measure; and
– Include the required disclosure if the issuer relies on the "unreasonable efforts" exception to exclude a quantitative reconciliation for forward­ looking non­-GAAP measures, specifically identifying the information that was unavailable and its probable significance.

Many comments issued during the second half of 2016 were "futures" comments, but the memo says that after an apparent grace period the Staff may increasingly require amendment of prior filings.

Broc & John: The OTC White Paper & The Absence of Snow

We were in the midst of our strategic planning meetings in Siesta Key when Broc suddenly leapt from his chair, smashed his glass on the floor & shouted – "I can whup any man in this bar!" A group of large gentlemen in motorcycle jackets seemed eager to take Broc up on his challenge. At this point, I suggested that we head to the beach for another podcast – and that’s how this 4-minute podcast on DERA’s OTC White Paper & the Absence of Snow came to be. Anyway, that’s my story & I’m stickin’ to it.

This podcast is also posted as part of our "Big Legal Minds" podcast series. Remember that these podcasts are also available on iTunes or Google Play (use the "My Podcasts" app on your iPhone and search for "Big Legal Minds"; you can subscribe to the feed so that any new podcast automatically downloads…

John Jenkins

2/23/2017 posts

CLS Blue Sky Blog: The Resolution of Distressed Financial Conglomerates
CLS Blue Sky Blog: Skadden Discusses the Current State of the U.S. Capital Markets
The Harvard Law School Forum on Corporate Governance and Financial Regulation: A Broader Perspective on Corporate Governance in Litigation
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Related Investing: Corporate Ownership and Capital Mobilization During Early Industrialization
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Who Bleeds When the Wolves Bite?
SEC Actions Blog: The Filing of Canadian Securities Class Actions Increased in 2016 Blog: Whistleblowers: Language for Severance Agreements

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