Securities Mosaic® Blogwatch
January 30, 2015
Two-fer Week At The SEC: Two No-Action Letters; Two New CDIs; and Two New Volcker Rule FAQs
by Karen Lyons

Over the past seven days the SEC proved the old adage wrong. Good things don't come in threes, they come in twos. SEC staff published two no-action letters, two new Compliance and Disclosure Interpretations ("CDIs"), and two new frequently asked questions and answers ("FAQs") regarding the implementation of the Volcker rule.

No-Action Letters. The first no-action letter was issued by the Division of Corporation Finance and addresses abbreviated, five-day tender offers for non-convertible debt securities. The no-action position is notable not only for the relief it provides, but also for how it was obtained. Attorneys from 18 different law firms collaborated to submit and obtain the relief.

The no-action relief supersedes all previously issued relief relating to abbreviated offering periods in non-convertible debt tender offers. The no-action letter confirms that the Division of Corporation Finance will not recommend any enforcement action if an offeror conducts a tender offer for non-convertible debt securities and holds the tender offer open for at least five business days from and including the date the tender offer is first published by means of "immediate widespread dissemination" and continues to hold open the tender offer for at least three business days from and including the date of the announcement of any material change in the offer other than a change in the consideration offered. Unlike the previously issued no-action position, the relief requires "immediate widespread dissemination" of offer materials; employs a business day instead of a calendar day construct; allows for offers to be made with Qualified Debt Securities; and eliminates the distinction between investment grade and non-investment grade debt securities. View the no-action letter here.

The second no-action letter was issued by the Division of Trading and Markets, which advised it will not recommend enforcement action under Rule 10b-10 of the Securities Exchange Act of 1934 against broker-dealers effecting repurchase transactions on behalf of their institutional customers that rely on MarketAxess' electronic platform to satisfy confirmation delivery obligations to their institutional investors if all of the disclosures required by Rule 10b-10 are provided electronically. View the no-action letter here.

Compliance and Disclosure Interpretations. The Division of Corporation Finance added Question 279.01 and Question 118.01 to its CDIs. Question 279.01 concerns Securities Act Rule 905, which provides that any "restricted securities" under Rule 144 that are equity securities of a domestic issuer will continue to be deemed to be restricted securities notwithstanding that they were acquired in a resale transaction pursuant to Rule 901 or 904. The CDI clarifies that Rule 905 only applies to equity securities that, at the time of issuance, were those of a domestic issuer. Therefore, a holder of restricted securities, which were originally acquired from a foreign private issuer in a transaction described in Rule 144(a)(3) (other than Rule 144(a)(3)(v)), may resell those securities offshore pursuant to Rule 904 and without regard to Rule 905, even if the issuer no longer qualifies as a foreign private issuer at the time of resale. View Question 279.01 here.

Question 118.01, concerns Rule 304(e) of Regulation S-T, which requires information filed with the SEC to be in a searchable form. The CDI notes that with regard to required disclosures, a filer may present required information using graphics that are not text-searchable and still comply with Rule 304(e) if the filer also presents the same information as searchable text or in a searchable table within the filing. Any additional information that the filer chooses to include in the filing and that is not required to be disclosed may be presented graphically without a separate text-searchable presentation. View Question 118.01 here.

Volcker Rule Guidance. The Division of Trading and Markets added two new FAQs regarding the implementation of the Dodd-Frank Act's Volcker rule. The first addresses when banking entities subject to metrics reporting must begin doing so within 10 days of the end of each calendar month. Beginning with metrics for the month of August 2015, banking entities must submit metrics within 10 days of the end of the month. As a result, metrics for the month of August 2015 must be reported by September 10, 2015.

The second discusses the Treasury Department's Separate Trading of Registered Interest and Principal of Securities ("STRIPS") program. Under the program, eligible Treasury securities are authorized to be separated into principal and interest components and transferred separately. Because these separate principal and interest components are backed by the full faith and credit of the United States, the interest-only and principal-only components also are exempt from the Volcker rule. View the Volcker Rule FAQs here.


January 30, 2015
The "Successful" Shake Shack IPO
by Christine Hurt

I've never been to a Shake Shack. I believe this fast casual restaurant operates in other parts of the U.S. and abroad, but its website has been down all morning. Why? Because Shake Shack is having a whiz bang IPO. After just a few hours on the board (it debuted last night), SHAK is up 132%.

Readers familiar with my scholarship and rants know that, unlike the rest of the world, I don't see that as a successful IPO. Instead of selling its shares at $21, Shake Shack (the entity) could have issued shares for almost $50. The difference there was left on the table, just as if you sold your house for $200,000 yesterday and the buyer sold it with no modifications today for $500,000. I wouldn't think of that house sale as successful, even if it was quick and I thought it was worth only $200,000. I would be steaming mad.

But the founder of Shake Shack isn't steaming mad because he still owns 21% of the company, and his shares are worth over $50 now. As he sells into the market (presuming he does it before the price drops), he will get more cash. But Shake Shack (the entity) doesn't. It now must grow, expand, wrestle with the challenges of being a public company -- all with the capital it raised at $21/share.

Not to beat a dead horse, but even the author of the Forbes article linked above seems to be unclear about what a successful IPO is. The author recognizes that Potbelly's share price is now just 2% higher than its IPO price, but "IPO buyers had their chance to exit with profits after the stock popped 120% on its first day of trading." That is not really a ringing endorsement for the efficiency and substance of capital markets.

January 30, 2015
The Ethical Slide, Train Tickets, and Helping the Next Generation of Corporate Leaders to Choose Differently
by Josephine Sandler Nelson

It has been a pleasure to guest-blog for the last two weeks here at the Glom. (Previous posts available here: one, two, three, four, five, six, seven, eight, and nine.) This final post will introduce the book that Lynn Stout and I propose writing to give better direction to business people in search of ethical outcomes and to support the teaching of ethics in business schools.

Sometimes bad ethical behavior is simply the result of making obviously poor decisions. Consider the very human case of Jonathan Burrows, the former managing director at Blackrock Assets group. Burrows's two mansions outside London were worth over $6 million U.S., but he ducked paying a little over $22 U.S. in train fare each way to the City for five years. Perhaps Burrows had decided that being fined would be less expensive than the inconvenience of complying with the train fare rules. Unluckily, the size of his $67,200 U.S total repayment caught the eye of Britain's Financial Conduct Authority, which banned Burrows from the country's financial industry for life. That's how we know about his story.

But how do small bad ethical choices snowball into large-scale frauds? How do we go from dishonesty about a $22 train ticket to a $22 trillion loss in the financial crisis? We know that, once they cross their thresholds for misconduct, individuals find it easier and easier to justify misconduct that adds up and can become more serious. And we know that there is a problem with the incentive structure within organizations that allows larger crises to happen. How do we reach the next generation of corporate leaders to help them make different decisions?

Business schools still largely fail to teach about ethics and legal duties. In fact, research finds "a negative relationship between the resources schools possess and the presence of a required ethics course." Moreover, psychological studies demonstrate that the teaching of economics without a strong ethical component contributes to a "culture of greed." Too often business-school cases, especially about entrepreneurs, venerate the individual who bends or breaks the rules for competitive advantage as long as the profit and loss numbers work out. And we fail to talk enough about the positive aspects of being ethical in the workplace. The situation is so bad that Luigi Zingales of the University of Chicago asks point-blank if business schools incubate criminals.

New business-school accreditation guidelines adopted in April 2013 will put specific pressure on schools to describe how they address business ethics. Because business schools are accredited in staggered five-year cycles, every business school that is a member of the international accreditation agency will have to adopt ethics in its curriculum sometime over the next few years.

We hope that the work outlined in my blogposts, discussed at greater length in my articles, and laid out in our proposed book will be at the forefront of this trend to discuss business ethics and the law. We welcome the engagement of those reading this blog to be a part of the development of this curriculum for our next generation of business leaders.

January 30, 2015
This Week In Securities Litigation (Week ending January 30, 2015)
by Tom Gorman

The SEC settled another action this week based on admissions of fact and that the Federal securities laws were filed, this time involving Oppenheimer. The action was based on the fact that the firm permitted an off-shore and non-U.S. broker to use its account to engaged securities transactions with its customers. It also permitted the sale of unregistered penny stocks by a customer. Oppenheimer settled at the same time with FinCEN for failing to file a SAR.

The Commission also brought an action against a community bank focused on claims that it failed to properly account for the diminution in value of certain securities held in its portfolio, an investment fund fraud action and a case centered on a prime bank fraud.


Remarks: Commissioner J. Christopher Giancarlo addressed the Commodity Markets Council, Miami Florida. His remarks were titled End-Users Were Not the Cause of the Financial Crisis: Stop Treating Them Like They Were (Jan. 26, 2015). His remarks focused on the burdens imposed on end-users by Dodd-Frank (here).

SEC Enforcement - Filed and Settled Actions

Statistics: During this period the SEC filed 1 civil injunctive action and 5 administrative proceedings, excluding 12j and tag-along-actions.

Unregistered broker: In the Matter of International Capital Group, LLC, Adm. File No. 3-16366 (Jan. 29, 2015) is a proceeding which names as Respondents the firm, a stock based lender, Brian Nord, its managing partner, Larry Russell Jr., a co-founder of the firm, and Todd Bergeron, a managing partner. Over a two year period beginning in 2008 the firm sold over 9 billion shares of microcap stock yielding about $62 million. The stock had been obtained as collateral for loans and frequently was sold shortly after the agreement was completed. On multiple occasions the firm sold shares that were not registered. The Order alleged violations of Securities Act Sections 5(a) and (c) and Exchange Act Section 15(a). Each Respondent settled, consenting to the entry of a cease and desist order based on the Sections cited in the Order. The firm was also censured. The firm and Messrs. Nord and Russell will jointly and severally pay disgorgement of $1,466,595 along with prejudgment interest. The firm will also pay a civil penalty of $1.5 million while Messrs. Nord and Russell will pay, respectively, penalties of $150,000 and $125, 000. Mr. Bergeron will pay a civil penalty of $150,000. In addition, the firm consented to the entry of a penny stock bar. Messrs. Nord and Russell will be barred from the securities business and from participating in any penny stock offering with a right to apply for re-entry after 5 years. Mr. Bergeron is subject to the same bar but with a right to apply for re-entry after 3 years.

Investment fund fraud: SEC v. Holzhueter, Case No. 15-cv-00045 (W.D. Wis. Filed Jan 29, 2015) is an action which names as defendants Insurance Service Center, an insurance brokerage firm, and its owner, Loren Holzhueter. The complaint alleges that the defendants raised over $10.4 million from about 120 investors since 2008 who were told their funds would be put in separate investment accounts and used to expand the business. In fact the funds were used to operate the firm and channeled off to other purposes. The complaint alleges violations Securities Act Section 17(a) and Exchange Act Section 10(b). The Court entered a temporary freeze order. The case is pending. See Lit. Rel. No. 23182 (Jan. 29, 2018).

Income inflation: SEC v. Lyndon, Civil Action No. CV 13 00485 (D. Haw.) is a previously filed action which named as defendants Troy Lyndon and Ronald Zaucha. The complaint alleged that Mr. Lyndon, the founder of religious themed video game manufacturer, Left Behind Games, Inc., and his friend Ronald Zaucha, falsely inflated the revenue of the firm. The Court granted summary judgment in favor of the Commission. Mr. Zaucha was permanently enjoined from violating the antifraud and registration provisions of the securities laws, barred from participating in any penny stock offering and ordered to pay $2.6 million in disgorgement, interest and penalties. See Lit. Rel. No. 23181 (Jan. 29, 2015).

Financial fraud: In the Matter of Laurie Bebo, Adm. Proc. File No. 3-16293 (Jan. 29, 2015) is a previously filed action naming as Respondents Laurie Bebo, formerly the president of Assisted Living Concepts, Inc., and Jon Buono, the firm's senior vice president and treasurer. The action centered on a financial fraud at the firm detailed (here). Ms. Bebo previously sued the SEC, claiming the action should have been filed in Federal district court (here). Mr. Buono settled with the Commission, consenting to the entry of a cease and desist order based on Exchange Act Sections 10(B), 13(A), 13(B)(2)(A) and 13(b)(2)(B). He also agreed to be barred from acting as an officer or director and will pay a penalty of $100,000.

Financial fraud: In the Matter of First National Community Bancorp Inc., Adm. Proc. File No. 3-16363 (Jan. 28, 2015). First National held a portfolio of investment securities valued at $273.6 million at year end 2009. If the securities decline in value below amortized cost, the Bank was required to assess if the decline it is other than temporary. If value of cash flows expected to be collected from the security is below amortized cost the amount must be recognized in the statement of operations. To measure the amount to be recognized GAAP requires that an estimate of expected future cash flows be made. Frequently financial institutions retain consultants to create a model. The assumptions in the model are critical. The model selected relied on unreasonable assumptions, according to the Order, regarding future cash flows and the timing of liquidation of the collateral related to issuers that had deferred or defaulted. Mr. Lance never inquired about the assumptions used in the model and was thus unable to assess whether they were reasonable in view of the circumstances. As a result of failing to establish and maintain the appropriate accounting policies and procedures to ensure that the bank properly calculated the other-than temporary impairment, the bank reported materially misstated amounts in its year-end financial statements and for the first two quarters of the next year. Ultimately the firm was required to restate its financial statements. The Order alleged violations of Securities Act Section 17(a)(2) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The bank resolved the matter, consenting to the entry of a cease and desist order based on the Sections cited. It also agreed to pay a penalty of $175,000. Mr. Lance consented to the entry of a cease and desist order based on the books and records provisions cited in the Order. He also entered into an undertaking to pay a penalty of $20,000.

Unregistered broker: In the Matter of Oppenheimer & Co., Inc., Adm. Proc. File No. 3-16361 (Jan. 27, 2015). The proceeding has two key parts. The first focuses on the period July 2008 through May 2009. During that period the firm executed the sale of millions of shares of penny stocks for Gibraltar Global Securities, Inc., a broker-dealer registered in the Bahamas but not the United States. Despite the fact that the Gibraltar account was in the name of the firm, the Order states that Oppenheimer knew the broker was actually executing transactions and providing brokerage services for its customers. By falsely representing to Oppenheimer that they transaction in the account were belong to them Gibraltar sheltered its clients from withholding taxes but since Oppenheimer knew or should have know the claim was not true it became liable for them. Oppenheimer failed record this liability making its books and records inaccurate. The firm also failed to file SARS. As a result of the rapid deposit and withdraw of, respectively, large amounts of penny stocks and cash, the firm was aware of suspicious activity. That triggered an obligation to file a SAR. Oppenheimer failed to make the requisite filings. As a result of these activities Oppenheimer violated Exchange Act Sections 15(a) and 17(a) and the related rules.

The second part of the action focuses on the period October 2009 through December of the next year. During that period a client of the firm deposited large amounts of penny stocks in its account for six companies. In total over 2.5 billion shares were deposited in the account. The transactions yielded $12 million in proceeds and just under $600,000 in commissions. There were no registration statements and the firm ignored a series of red flags related to the issue. As part of the resolution of the case the firm agreed to implement a series of undertakings including the retention of an independent compliance consultant who will prepare a report with recommendations which will be adopted. The firm also consented to the entry of a censure and a cease and desist order based on the Sections cited in the Order. Oppenheimer will pay disgorgement of $4,168,400, prejudgment interest and a civil penalty in the amount of $5,078,129 which, together with the disgorgement and prejudgment interest, totals $10 million, the same amount paid to resolve proceedings with FinCen.

Offering fraud: In the Matter of Spectrum Concepts, LLC, Adm. Proc. File No. 3-16356 (Jan. 23, 2015) is a prime bank fraud action which names as Respondents Spectrum, a vehicle used in the transactions; Donald Worswick, the president and owner of Spectrum; Michael Grosso, previously a nutritionist and fitness trainer; and Michael Brown who claimed to be an attorney but in fact was not. The scheme was orchestrated by Mr. Worswick and Spectrum with assistance from Messrs. Grosso and Brown. Over several months in 2012 the Respondents sold about $465,000 of investments in a "Private Joint Venture Credit Enhancement Agreement" to at least five elderly investors. Investors were told their funds would be invested in a variety of items including private funding projects used to set up a credit facility and a trade slot that would be blocked for the benefit of a trade platform. A number of investors were promised the full return of their capital in addition to returns on their investment. Those returns supposedly ranged from 900% in 20 days to as much as over 4,600% annually. The investments were fictitious, according to the Order. While some investors were able to obtain a refund after changing their mind, others had their funds misappropriated. The Order alleges violations of Securities Act Sections 5(a) and (c) and 17(a) and Exchange Act Section 10(b). The proceeding will be set for hearing.

Prime bank fraud: In the Matter of David B. Havanich, Jr., Adm. Proc. File No. 3-16354 (Jan 23, 2014) is an offering fraud action. The scheme was allegedly conducted by Respondents: David Hananich, the co-founder and president of Diversified Energy Group, Inc. and the president and director of St. Vincent de Paul Children's Foundation, Inc., a non-operating non-profit corporation; Carmine DeLLaSala, a co-founder and director of Diversified; and Matthew Welch, an officer of Diversified. They were assisted by Hampton Scurlock, RTAG Inc., a registered investment adviser owned by Mr. Welch, Jose Carrio, Dennis Karaski, Carrio, Karasik & Associates LLP and Michael Salovay. About $17.4 million was raised from 440 investors over a six year period beginning in 2006. Investors were told that Diversified invested in fractional interests in oil and gas production properties and commodities trading. A portion of investor funds were also used to purchase interests in oil and gas wells, cattle, a device to increase gas mileage and real estate. Misrepresentations were made to investors. Those included misstatements regarding Diversified's financial performance, its use of industry experts and technologies and the affiliation of certain officers with St. Vincent's charity which did not operate. The interests sold were not registered. The agents retained beginning in 2009 to sell Diversified bonds were not registered. Those agents were paid 5% to 10% of the investor proceeds. Despite receiving an email and other correspondence from Diversified's outside counsel detailing the limits on the firm’s use of unregistered agents, sales by agents continued. Collectively those agents earned about $985,000. The Order alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a). The matter will be set for hearing.

January 30, 2015
House Bill: Repeal of Pay Ratio
by Broc Romanek

Last week, the "Burdensome Data Collection Relief Act" (HR 414) was introduced to repeal Dodd Frank's Section 953(b), the pay ratio disclosure requirement. The bill is real simple - a single paragraph. This same bill was introduced in 2013 and went nowhere. Not sure what will happen this time around.

Transcript: "The Latest Developments: Your Upcoming Proxy Disclosures"

We have posted the transcript for our recent webcast: "The Latest Developments: Your Upcoming Proxy Disclosures."

SEC Grants Second Bad Actor Waiver With Conditions

Here's news from this blog by Steve Quinlivan:

SEC Commissioner Kara Stein recently described what many saw as a possible model for harsher bad actor waivers after settling a matter with the SEC. According to Ms. Stein "The waiver was for a limited time, and only if certain conditions were met, creating essentially a probationary period for the firm with a right to reapply after a second showing of good cause. And the conditions are important. For example, the recent case included a review by an independent compliance consultant, and a document signed by the principal executive or principal legal officer when the consultant's recommendations have been implemented." Ms. Stein added "This approach represents a breakthrough in the Commission's method of handling waivers, and I hope to see more of this and other thoughtful approaches in the future." She also remarked "Each waiver request should receive an individualized, detailed, and careful analysis based on all of the relevant facts and the particular waiver policy."

Many wondered if her remarks actually foreshadowed a change in policy by the SEC in granting waivers. The question may now be answered. The SEC charged Oppenheimer & Co. with violating federal securities laws while improperly selling penny stocks in unregistered offerings on behalf of customers. Oppenheimer agreed to admit wrongdoing and pay $10 million to settle the SEC's charges.

The SEC granted Oppenheimer a waiver as a bad actor under Rule 506(d). The SEC's order says "Oppenheimer will comply with the conditions stated in its December 10, 2014 waiver request letter, including that it will retain a law firm to review its policies and procedures relating to Rule 506 offerings, and that it will adopt improvements or changes, both as private placement agent in its investment banking business and as issuer and as compensated solicitor in its wealth management business. Oppenheimer's waiver is also conditioned upon its completing firm wide training for all registered persons on compliance with Rule 506 of Regulation D."

– Broc Romanek

January 30, 2015
Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 5)
by J Robert Brown Jr.

We are discussing Pontiac General Employees Retirement v. Healthways.  

What makes this case so remarkable?  One possibility is the decision.  By denying the motion to dismiss, the court has announced that boards putting in place dead hand poison puts will confront litigation risk.  The court also emphasized that poison puts, even without a deadhand feature, raise possible fiduciary duty concerns.

Most importantly, however, the decision not to allow dismissal of the aiding and abetting claim raises the specter of liability for the bank or other lender in the transaction. Banks aware of this possibility will now have to determine whether the value of the provision outweighs the litigation risk that will arise from any subsequent challenge by shareholders. One suspects that most banks will decide that this vestige of the 1980s has little real value and that the marginal value does not outweigh the litigation risk.  The provisions are likely to disappear not at the insistence of the board but at the insistence of the lender.

But perhaps the most interesting aspect of this case is the apparent irrelevance of the Delaware courts to issuers and their boards in adopting these provisions.  Amalyin addressed poison puts.  The court in that case gave Amylin a pass on the use of the provision but served warning that the provisions were suspect. Nonetheless, the "warning" did not stop Healthways.  Moreover, a search of the EDGAR data base in the post-Amalyin period reveals that poison puts remain not uncommon. 

The behavior has a number of possible explanations.  One possibility is that issuers simply did not believe the "warning" issued by the Delaware court in Amalyin. In other words, when the next poison put was litigated, the company would get another stern lecture but given the same pass that went to Amalyin.  The reaction of the Delaware courts, therefore, was irrelevant in deciding whether to adopt these provisions.  Given the management friendly nature of the Delaware courts, this is not an unreasonable expectation.   

Delaware courts probably have their greatest influence when they provide management with increased authority and discretion.  Where, however, the courts are seeking to impose limits, their authority appears to be decidedly less robust and, at least in some cases, irrelevant.  

The primary materials in Pontiac General Employees Retirement v. Healthways can be found at the DU Corporate Governanceweb site. 

January 29, 2015
The M&A Landscape: Financial Institutions Rediscovering Themselves
by Edward D. Herlihy

Editor's Note: Edward Herlihy is a partner and co-chairman of the Executive Committee at Wachtell, Lipton, Rosen & Katz. The following post is based on a Wachtell Lipton memorandum by Mr. Herlihy, Lawrence S. Makow, Jeannemarie O’Brien, Nicholas G. Demmo, and David E. Shapiro.

The year 2014 was marked by accelerating mergers and acquisitions activity in the financial institutions space and by several distinct trends. Institutions continued to adapt to the changed regulatory environment, as several important rule proposals and releases brought the ultimate contours of that environment into clearer focus. Profitability pressures continued for traditional businesses. And, as investors continue to seek yield in a low-rate world, shareholder activism notably proliferated. Continued improvement in the economy brought new opportunities into sight and ramped up private equity activity in the financial services sector. Cutting across all of these trends, technological changes, and associated business challenges, continued to reshape firms' strategic playbooks.

Early indications suggest the M&A activity trend continuing into 2015. In the opening days of the new year, City National agreed to merge with Royal Bank of Canada. The largest bank holding company merger since the financial crisis, at $5.4 billion, the City National deal signals the continuing recovery of the U.S. market from post-crisis distressed deal terms, transaction motivations and negotiating positions. City National is widely considered to be among the strongest franchises in the U.S. It maintained its position of strength and financial performance throughout the financial crisis - as evidenced by the 2.6x multiple of deal price to tangible book value to be paid to City National shareholders. The merger is also a significant vote of confidence by RBC in the outlook for the U.S. banking market and in particular for the type of clientele served by City National. RBC will be reentering retail and commercial banking in the U.S. with 75 branches and $32 billion in assets, and a franchise that is highly complementary to its existing strong U.S. asset management presence.

Deals the size of City National/RBC may not become routine anytime soon. What the deal does suggest, along with other recent announcements like BB&T/Susquehanna and CIT/OneWest, is that improved economic confidence, ongoing expense management challenges and improving stability and visibility of the U.S. regulatory climate will facilitate, episodically, major mergers where the institutional size, strategic fit and perceived opportunity are just right. More opportunities of this type will surely arise in 2015 and thoughtful, committed dealmakers will stand ready to act on them. The deal activity continues to build a clear picture of financial firms increasingly turning from a more defensive post-crisis posture to going back on offense and taking the initiative to grow and strengthen their businesses. A noteworthy feature of the current M&A landscape is the presence of repeat buyers who demonstrate considerable mastery of the new environment and its challenges.

On the sell side, in addition to familiar reasons driving sellers to consider a deal - tight net interest margins, pressure on returns, higher compliance costs, restless investors, better visibility into the currencies of potential buyers - it is noteworthy that during the last year selling institutions were frequently characterized by relatively concentrated equity ownership. Investors are recognizing that in a world where banks and other financial firms face challenges affecting many of the traditional measures of financial health - return on capital, net interest margin, fee income, dividend and repurchase activity, efficiency ratios - M&A continues to be available as an attractive and viable lever for improving returns, and are encouraging managements to be open to strategic alternatives.

Regulatory factors continue to impact, but not impede, committed dealmaking.

Several deals announced in 2014 demonstrated that the strategic rationale for a good transaction can more than compensate for the potential regulatory cost of increased size:

  • CIT Group's transformational proposal to acquire OneWest Bank promises to help a stalwart of the commercial finance industry remake its business model and add substantial stability to its funding strategy. The deal, which would raise CIT's assets from about $45 billion to over $65 billion, demonstrates that, despite the additional regulation that today comes with exceeding $50 billion in assets, managers perceive net benefits from combinations of the right heft and quality. At $3.4 billion, the deal was also significant for being, until the RBC/City National announcement, the largest bank acquisition announced since M&T's proposed acquisition of Hudson City Bancorp in 2012.
  • Sterling Bancorp of New York - which just last year underwent a transformative merger-of-equals with Provident - announced its acquisition of Hudson Valley Holding Corp. to create a company with over $10 billion in assets. Here again, management expects cost savings to offset increased regulatory costs from crossing the $10 billion threshold, and cites anticipated benefits of adding more cost-effective funding and bolstering asset-generation capability.

The Sterling and CIT deals will no doubt be closely watched by institutions considering mergers or other sizable acquisitions that would push them above the $10 billion or $50 billion threshold.

Regulatory size thresholds also helped drive divestiture activity. In an innovative and unusual transaction, Hawaiian Electric Industries, the parent of American Savings Bank, a major bank Hawaiian bank, plans to spin off the bank as a prerequisite to being acquired by NextEra Energy. Among the strategic benefits cited by the bank's management is that its deemed asset size for regulatory purposes will be reduced below $10 billion, freeing it from the restrictions on interchange fees under the Durbin Amendment.

Compliance demands and associated costs continue to drive sub-scale firms to combine and create efficiencies. For all financial firms, investments in systems and compliance programs are growing dramatically to respond to the interrelated moving targets of regulator demands, cyber threats and competitive advancements. The constant assault on financial firms' systems by hackers requires sophisticated personnel and costly technology that some firms will conclude they simply can't afford on their own. The savings created by mergers will help allow them to securely serve their customers and continue to prosper. Besides instigating a search for cost-saving mergers, these requirements have fostered rapid growth and development among technology and processing firms that service or partner with regulated financial institutions. This, in turn, has contributed to nearly unprecedented levels of investment and mergers in portions of the financial technology sector.

Another facet of the relationship between regulation and deals continued into 2014: the increased sensitivity of deal success to the regulatory standing of the parties and of the buyer in particular. The current regulatory environment is highly demanding of buyers. As regulators increasingly seize on merger applications as opportunities to develop the filigree of regulatory expectations and assessment of systemic risk, acquirers need to have a pristine compliance record in order to pull deals off. Buyers will need to proactively demonstrate the capacity to manage the combined institution, and the need will be particularly acute if the seller also has a history of regulatory issues.

Neither the fact of, nor the timetable for, regulatory approval can any longer be taken for granted, and 2014 provided some fresh examples. Simmons First, recently a serial acquirer, announced in December that it would invoke time extension options in agreements for two pending deals, with Community First Bancshares and Liberty Bancshares, in order to continue for several more months to seek regulatory approval. BSA/AML and fair lending compliance seem particularly likely to become trouble areas. Last summer, BancorpSouth, citing issues in each area, announced that it would push back closing deadlines for two separate acquisitions and subsequently withdrew (with intent to re-file) its Federal Reserve applications for each deal. While Cullen/Frost Bankers in May received prompt approval for its acquisition of WNB Bancshares, the Federal Reserve reportedly required it to halt further expansion activities while it remediated certain fair-lending compliance issues. Meanwhile, community groups are keeping up the pressure on regulators to scrutinize applicants' records under the CRA. The new reality demonstrated by these experiences and the need to accommodate it is driving dealmakers to think anew about terms and conditions of merger agreements.

Regulatory compliance and risk management now divide the "haves" and "have nots" of financial M&A. Regulators have clearly upped the ante on compliance and strategic expansion. Along with the analytical, financial and dealmaking acumen that traditionally characterized successful acquirers, in the post-Dodd-Frank world, compliance is now being wielded as a primary competitive weapon. To carry out a successful expansion strategy, financial institutions more than ever need to discern what the regulators want and give it to them - and convince would-be sellers of their ability to do that.

Knowledge of deal technology remains of critical importance.

Successful participants in newly expanded M&A activity will be those who master not only deal strategy but also deal technology - the nuts and bolts of merger and acquisition agreements - in the service of accomplishing the deal successfully. The terms of M&A agreements have a tremendous degree of flexibility, and crafting the right set of terms and conditions - including making careful judgments about what to leave out as well as what to put in - will, as always, be critical in insuring that the parties are able to reach agreement and deliver on the expectations of the parties that the deal, once announced, will successfully be completed.

Acquisition agreement provisions will reflect the realization of crucial negotiating points such as the allocation of company-specific and market risk between the parties during the period the agreement is in effect; governance arrangements for the combined company; the freedom of the target company to consider other offers that may arise; the efforts the parties must make to obtain regulatory and other third party approvals and resolve any regulatory objections to the transaction; the extent of efforts to obtain any necessary shareholder approvals; the speed with which the parties must act to progress the transaction; the rights of the parties to exit the transaction before it is completed; and the extent of any recourse the parties may have if the agreement is breached or terminated.

In addition, a variety of approaches is available in contacts to implement the parties' basic financial agreement. The parties will need to negotiate, for example, whether a stock deal is based on fixed-dollar consideration (in which case target shareholders know the dollar value of the stock they will receive on closing, but give up potential upside appreciation in the pre-closing period and expose the seller's shareholders to potentially higher dilution), a fixed exchange ratio (in which case the seller knows precisely how many shares it will issue to close the deal and the buyer shareholders get the benefit of any pre-closing appreciation in the buyer's stock but also shoulder some risk of downward moves) or a "collar" (a compromise between these other two outcomes). In many strategic deals, the parties consider that the underlying logic of the deal is best reflected through the use of a fixed exchange ratio which, notwithstanding stock prices that always fluctuate, provides a fixed and definite allocation of the fundamental economics of the combined company between buyer and seller shareholders.

In many situations, though, it will be desirable to introduce cash, as well as stock, into the mix. Often, the use of both forms of consideration will allow the buyer to optimize the impact of the transaction on its financial statements and may be easier and more certain to execute in the current environment than doing an all-stock deal followed by a share repurchase program, or an all-cash deal accompanied by a share issuance. The use of mixed consideration also introduces additional degrees of freedom into the financial terms of the merger agreement. Should shareholders be required to each take some stock and some cash, when individual shareholders may have varying preferences for one or the other? Or should they be allowed to elect their form of preferred consideration, subject to pro-ration to meet a specified overall distribution of consideration acceptable to the buyer?

Within the realm of stock-cash election deals, deal technology can be used in different ways to optimize the result. In the recently announced City National/RBC transaction, for example, the parties used an "equalization" structure in which City National's shareholders may elect between receiving RBC stock and cash, but whichever they choose, the per-share value of the consideration they receive will have substantially the same value at the time of the closing - while preserving precisely the 50/50 overall split of City National shares that will be converted into RBC shares, on the one hand, and into cash, on the other. Although somewhat complex to draft, with various traps for the unwary, such techniques permit stock/cash election structures to be used while reducing the risk that pre-closing fluctuations in the buyer's share price will stampede seller shareholders into demanding one form of consideration overwhelmingly over the other.

Compensation and retention are critical deal issues.

Issues surrounding compensation - treatment of equity awards, severance protection, retention - continue to be of critical importance in financial services deals. With the changes in compensation arrangements stemming from the influence of proxy advisors and increased bank regulator focus - including the trends of eliminating "golden parachute" excise tax gross-ups and single-trigger vesting, and the increasing prevalence of equity awards that are performance-based and deferred - companies considering a deal need to consider in careful detail the consequences and tax implications of a change in control.

In businesses where personal relationships are a large part of the value being acquired, it has become customary for the parties to negotiate employment and retention arrangements in connection with the execution of a definitive agreement. These frequently take the form of individual employment or consulting arrangements for executives and key producers, and retention pools to be allocated among a broader group of critical employees.

A well-tailored program will incorporate both "upside" incentives (retention programs) and "downside" protections (severance benefits and vesting). Retention programs provide key employees who will be critical to the success of the combined company a tailored financial incentive to remain focused on the company's best interests and mitigate any unavoidable personal uncertainty relating to the deal. Severance and termination protections provide key individuals with greater security against the risk of an involuntary termination (including a constructive discharge) associated with combining of two companies.

The numerous considerations in implementing an effective retention program include identifying participants, the form of payment (cash, stock, or a combination), the size of the retention pool, the allocation of awards to individual participants and the timing of payments. Generally, within an overarching agreement as to the size of the pool, the form of payment and basic criteria for allocating the awards, senior management of the seller has substantial latitude to identify specific recipients and determine award amounts and terms. In sizing the retention pool and individual awards, it is often helpful to use a reference to an existing compensation metric, such as a percentage or multiple of base compensation or target bonus. Individual awards often also take into account factors such as the individual's role, the likelihood of being poached by a competitor, other severance or retention vehicles in place and the vesting/payment period for the retention. To effectively retain employees through closing, retention payments are usually conditioned on the transaction closing and provide for at least a portion of the award to be paid to still-employed employees on or shortly after that milestone. Retention awards can be structured as one-time payments or in installments over time. Retention programs must also be carefully designed with a knowledge of applicable tax consequences, including the impact of the "golden parachute" excise tax.

When carefully structured, deal-related compensation programs can play a critical goal in guaranteeing the successful completion and integration of the transaction.

Regulation continues to shape asset deals across all financial services sectors.

Regulation continues to influence the shape of deal activity among the largest, diversified financial institutions. Focus on systemic risk, reflected in 2014 in numerous ways including the proposal of capital surcharges for the largest systemic institutions and broad regulatory criticism of resolution plans, continued to send a strong signal to large institutions about growing further. But while the largest banks continued in asset portfolios by carrying out strategic bolt-on asset acquisitions or sales of noncore assets. Individually these deals may not all be blockbusters, but they are legion, and cumulatively they constitute a significant realignment of the industry. Buyers included Capital One, BB&T and PNC, and sellers included Bank of America (selected branches and other assets), Citibank (agreeing to sell its Texas branch franchise to BB&T) and J.P. Morgan Chase (selling its Health Savings Account business to Webster Financial Corporation, which sought to build additional strategic size in that business).

A perhaps less obvious regulatory impact is on the integration of asset deals. In the sale of a component business, the transfer to the new buyer is often smoothed by arranging for the seller to continue for some period after closing to provide many of the services it historically provided, until the buyer is ready to take over in a smooth fashion. Heightened sensitivity around the risks associated with breaches of network security, particularly unauthorized access to customers' personal data, and the need to extend institutions' risk management capabilities to services provided to them by outside vendors, have focused buyers and sellers anew on the provisions allocating these risks. Transition services arrangements have become caught up in recent regulatory prescriptions requiring the extension of internally-focused risk management and auditing to functions outsourced to third-party vendors, with sellers providing transition services being likened to such outside vendors. Sellers may view transition services as one-off accommodations ancillary to a sale and, if not otherwise in the business of providing outsourced functions, may need to adjust to the new compliance expectations.

Strong divestiture activity in the asset management space, in particular dispositions by banks of asset management businesses, was driven by more stringent capital requirements and the Volcker Rule. A 2014 KPMG report noted that U.S. banks had closed or spun-off asset management operations totaling more than $5 trillion in AUM since the original announcement of the Volcker Rule. Among the most notable in 2014 was the spin-off of One Equity Partners by JPMorgan, including the sale of $4.5 billion in private equity assets to Lexington Partners and AlpInvest. But regulatory divestitures did not account for all asset management deals. Stronger equity markets, competition to reduce transaction costs and the maturing of the private equity acquisition cycle that peaked before the financial crisis combined to create a strong dynamic for strategic asset management transactions. These included the $6 billion sale by Madison Dearborn of Nuveen Investments to TIAA-CREF, Northwestern Mutual's sale of its Frank Russell Company unit to the London Stock Exchange, TPG and Pharos Capital's sale of American Beacon Advisors to Kelso & Co. and Estancia Capital, and the acquisitions of Munder Capital by Victory Capital in partnership with funds managed by Crestview Partners and Reverence Capital Partners, and of KKR Financial by KKR.

Repeat dealmakers find great opportunities and seize a strategic and financial advantage.

In this environment, where the regulatory price for admission to the buyer's club has clearly increased, acquirers capable of pulling off multiple repeat deals are particularly noteworthy. Repeat acquirers again represented a substantial share of M&A activity in 2014, and 2015 could see the same trend continue. Notable in 2014 were BB&T's two announced whole-bank deals, its $367 million announcement in September to acquire Bank of Kentucky Financial and, in one of the larger bank deals since the financial crisis, its $2.5 billion announcement in November to acquire Susquehanna Bancshares. These diverse deals will allow BB&T to achieve efficiencies, bolster existing important markets and extend its model into nearby geographies. In addition to two whole-bank deals, BB&T also agreed to acquire Citibank's remaining Texas branch franchise and about $2.3 billion in Texas deposits, significantly boosting BB&T's retail presence in the state.

The theme of repeat acquirers is also demonstrated by the merger of Banner and AmericanWest, two banks that emerged from the post-2008 distress of the Pacific Northwest to build successful franchises, in large part through rigorous yet ambitious M&A. Like Sterling Financial and West Coast Bancorp last year, the AmericanWest transaction was a success story for the private equity investors who took on the uncertainty of recapitalizing a distressed institution.

And, while some crisis-era investors are exiting, others are continuing to find new opportunities. Last year's announced acquisition of a majority of California's Mechanics Bank by private-equity firm Ford Financial Fund II, coming soon after its successful investment in Pacific Capital Bancorp and subsequent sale of that bank to Unionbancal, is notable for the purchase of control of a healthy, profitable bank by a private equity fund.

Other examples of whole-institution acquisitions by repeat players included the acquisition of First Southern Bancorp, Inc. by CenterState Banks, Inc. and the contested "Section 363" bankruptcy sale of 1st Mariner Bank to an investor consortium including Patriot Financial Partners. First Mariner Bancorp, like other bank holding companies that have made the decision to seek a sale of their subsidiary banks through a holding company bankruptcy, was under formal regulatory enforcement orders and was confronting the end of the five-year interest deferral period on trust preferred securities that had been issued years earlier at the holding company level. Like those others, it also confronted an urgent need to increase regulatory capital levels, a lack of capital-raising options and frustrated attempts to find other buyers. Also in 2014, Triumph Bancorp and several other private active acquirers successfully completed initial public offerings, providing these institutions with the equity currency to extend their acquisition strategies.

Elsewhere in the Americas, strong non-U.S. banks with a penchant for acquisitions also continued M&A efforts. A prominent example was Brazil's Banco Itau, which agreed to merge its Chilean and Colombian operations with CorpBanca, in the process obtaining a controlling stake in the resulting joint venture, which will have over $40 billion in assets. This merger followed closely on the heels of Itau's $5.2 billion take- private via tender offer of RedeCard, Brazil's dominant credit card processing and merchant acquiring business.

Shareholder activists agitate for change at financial institutions.

Increasing intensity and scope of financial regulation has in recent years brought into sharper focus the fact that the interests of shareholders and regulators sometimes diverge. While the goals of the two can often be harmonized, there are undeniably tensions at the margin. It will not be lost on investors that, in recent years, regulatory initiatives have taken aim at the variety of businesses financial institutions are permitted to conduct, the fees these firms can earn from consumers, the riskiness and liquidity of assets they are allowed to own (and thus the returns that can be expected on these assets), distributions that banks and insurance companies can make to shareholders, the capital cushion that financial firms must carry, the cost of deposit insurance, and the overhead costs firms are effectively required to incur in order to meet enhanced compliance expectations.

In part as a result of these realities, shareholder activism at financial firms has historically looked different than at other businesses. Due to the regulatory overlay, it may be difficult for activists to credibly follow some aspects of their customary playbook, including pushing for buybacks, increased dividends to shareholders (indeed, for larger banks, these will be effectively prescribed in advance by an approved capital plan) or fundamentally different business strategies. The credibility of aggressive proposals aimed primarily at increasing short-term valuation may collide with the reality of safety and soundness and, at the larger institutions, even systemic risk. Suggestions during 2014 by senior bank regulators to impose upon financial institution directors fiduciary duties to the broader financial system would, if enacted, potentially create additional impediments to activist agendas.

It would be a mistake, however, to believe that financial institutions are immune from shareholder activism. History clearly shows the opposite. The record of activist shareholders driving significant disruption at financial institutions is by no means sparse. Just this year two of the most newsworthy activist situations were at financial firms, and there has been an ever increasing activist push, both publicly and privately, into the financial services space. BNY Mellon headed off a potential fight with Trian Partners over grievances about cost management and margin compression by adding a Trian representative to its board in December. eBay first faced a potential proxy fight at its 2014 annual meeting; then, following a tentative truce and renewed pressure from shareholders, announced in September a plan to spin off its online payments business PayPal. Similar situations targeting other large cap financial firms occurred in 2014, and are certain to follow in 2015.

Successful activists are highly sophisticated and can be expected to tune their message and strategic proposals to take into account the reality of financial institution regulation. Accordingly, activism at financial institutions in recent years has steered clear of areas likely to encounter strong regulatory objections, such as capital- depleting cash dividends or buybacks, and has instead emphasized initiatives like sales of the company, divestiture of non-core businesses, spinoffs and cost-cutting (although, here too, the OCC and other regulators have begun to sound the alarm about cost-cutting efforts that adversely affect compliance programs). As well, regulation is a two-edged sword. The public criticism that comes with a formal regulatory enforcement action, or even an event like regulatory critique of a capital or resolution plan or a stress test failure, can potentially bolster activists' campaigns to shake investor confidence in incumbent management. The other side of the coin is that superior stock price performance, while it remains a potent and vitally important weapon against activism, is no longer a guarantee of being left alone. With monetary policy continuing to keep debt yields low, assets invested in activist strategies have multiplied rapidly to approximately $200 billion, and naturally an increasing portion will find its way to this key sector of the economy.

Financial institutions will, of course, continue to take into account their special status in responding to activism. Where activist proposals would threaten to weaken the safety and soundness of an institution, regulatory considerations can be powerful. The experience, gravitas and credibility of proposed director candidates in dealing with the highly specialized realm of financial regulation has become more important than ever, with regulation playing a bigger role in financial institutions and directors personally playing a larger role in regulators' supervisory vision.

Moreover, important bank control issues can potentially be raised by some techniques used in recent activist campaigns, particularly where an activist has nominated several directors (even if they would not be an outright majority of the board) and the candidates are receiving not just expense reimbursement but compensation or financial incentives from the activist.

Also challenging is that both the sophistication and ambition of activists are increasing as the field becomes more competitive. The more accomplished players are fine-tuning their messages and demands so as to increase their odds of acceptance by other investors. They are becoming savvy users of social media and other platforms that allow them to test and continually adjust messages and campaigns. And they are expanding the scope of their remit, as exemplified by eBay's standstill agreement with activists that extends beyond eBay proper to the scope of PayPal's defensive protections once it becomes a public company. Activism is thus not a monolithic problem that can be addressed with a prescribed playbook, but a dynamic and changing process that must be met with experience and careful judgment. Careful consideration will be required to understand what constitutes the best available result, and once established, a series of difficult questions will often need to be answered to achieve it, regarding matters such as the calibration of the response (cooperative, firm, hostile), the deployment of defenses, outreach to other investors, and the timing of key strategic moves - whether, how and when to respond publicly to activist proposals and criticisms, bring litigation, or float settlement proposals.

Because no one playbook will be effective in all situations, banks must remain vigilant to pro-actively maintain positive relations with their investor base, consider resisting whenever possible pressures to further shed structural defenses, be sensitive to the early warning signs of activist activity and be prepared to keep their destinies in their own control by constructing a thoughtful, credible and effective response. Focus on the basics - improving performance and advance preparation - will position boards to have supportive and receptive shareholders in the event of an activist campaign.

Blurring line between technology and financial firms will drive deals to defend and enhance competitive positions.

The upcoming year is also likely to feature more significant developments in the continuing technology-driven evolution of the financial industry, including the particularly tumultuous world of payments. A very large portion of financial sector revenues is at stake. Financial institutions are seeing realignment among the various players in the payments space, including issuers, merchants, networks, payment processors and innovators introducing new technologies, as exemplified by the leveraging of the huge installed base of iPhones to introduce Apple Pay and secure substantial partners for its use. Equally notable was eBay's move to spin off PayPal as a standalone public company. At the same time, technology, including the transition of online to mobile banking, is fundamentally changing the way financial firms interact with customers and the range of opportunities to sell to these customers.

With all the change, banks' demand deposit accounts continue to remain at the center of the system, and payments must be seen as one part of a continuum of financial management that includes saving and investing. This positions banks to be long- term winners in the payments and larger technology battles. And, despite inroads from nontraditional sources, banks have largely been successful at protecting their traditional roles as lenders to businesses and consumers. However, continued technological change is certain and it will be essential for traditional financial institutions to maintain and creatively expand their central role in the financial sector, including in the fast-changing area of payments. Innovative partnerships with technology firms will undoubtedly be key in protecting and enhancing crucial connections to customers. Capital One, for instance, has made numerous strategic acquisitions of innovative technology companies to enhance its customers' mobile and online experience - most recently Level Money, the maker of a budgeting and spending management app.

With the rapid pace of change and development in financial technology, it should be no surprise that a substantial portion of financial dealmaking in 2014 was concentrated in this sector. The largest U.S. financial technology deals of the year included Vantiv's acquisition of Mercury Payments and FleetCor's acquisition of Comdata, each marking a private equity firm's profitable exit from a long-term investment. Historically, growth among payments and other financial technology firms has relied upon constant investment in acquisitions to gain scale and enhance product offerings. Additional examples of portfolio-enhancing acquisitions in 2014 include Global Payments' acquisitions of Ezidebit and PayPros, FIS's acquisition of Clear2Pay and Heartland Payment Systems' acquisition of TouchNet. With financial technology firms constantly evolving and expanding their offerings, and the high level of private equity presence and continued interest in the sector, deals in 2015 should continue apace.

January 29, 2015
Understanding Director Elections
by R. Christopher Small

Editor's Note: The following post comes to us from Yonca Ertimur of the Accounting Division at the University of Colorado at Boulder; Fabrizio Ferri of the Accounting Division at Columbia University; and David Oesch of the Department of Financial Accounting at the University of Zurich.

In the paper Understanding Director Elections: Determinants and Consequences, which was recently made publicly available on SSRN, we provide an in-depth examination of uncontested director elections. Using a hand-collected and comprehensive sample for director elections held at S&P 500 firms over the 2003–2010 period, we examine the factors driving shareholder votes in uncontested director elections, the effect of these votes on firms' actions and the impact of these actions on firm value. We make three contributions.

First, it is well known that recommendations by the proxy advisory firm Institutional Shareholder Services (ISS) play a key role in determining the voting outcome. Yet, the question of what factors drive ISS recommendations and, thus, shareholder votes in uncontested director elections remains largely unanswered. To fill this gap, we use the reports ISS releases to its clients ahead of the annual meeting and identify the specific reasons underlying negative ISS recommendations. We find that 38.1% of the negative recommendations target individual directors (reflecting concerns with independence, meeting attendance and number of directorships), 28.6% target an entire committee (usually the compensation committee), and the remaining 33.3% target the entire board (mostly for lack of responsiveness to shareholder proposals receiving a majority vote in the past). A withhold recommendation by ISS is associated with about 20% more votes withheld, in line with prior research. More relevant to our study, there is substantial variation in votes withheld from directors conditional on the underlying reason. A board-level ISS withhold recommendation is associated with 25.48% more votes withheld, versus 19.73% and 16.44%, respectively, for committee- and individual-level withhold recommendations. The sensitivity of shareholder votes to ISS withhold recommendations is higher when there are multiple reasons underlying the withhold recommendation for the director (a proxy for more severe concerns) and at firms with poorer governance structures. These results suggest that shareholders do not blindly follow ISS recommendations but seem to take into account their rationale, their severity and other contextual factors (e.g. governance of the firm). However, cases of high votes withheld without a negative proxy advisor recommendation are rare, suggesting that voting shareholders only focus on the issues singled out by proxy advisors, potentially at the expense of other value-relevant factors (e.g. directors' skill set, expertise and experience) for which proxy advisors have not (yet) developed voting guidelines (perhaps due to lack of sophistication or the inherent complexity of the issue).

Second, while previous studies find that shareholder votes at director elections are associated with subsequent firm-level outcomes, it is not clear whether these outcomes are a response to the negative votes or result from omitted factors correlated with negative votes (e.g. behind-the-scene pressure from large institutional investors). We take a more direct approach and examine the actions firms take in response to the specific concerns underlying the negative vote, relying on the ISS reports to identify such concerns. Using this hand-collected data, we estimate firms' responsiveness to shareholder votes and examine the determinants of responsiveness. In doing so, we provide the first comprehensive evidence on the direct effect of director elections on firms' governance practices.

Overall, the estimated rate of responsiveness ranges between 39.0% and 47.7%, a remarkable finding given that votes withheld rarely exceed 50%. The rate of responsiveness varies significantly across individual-, committee- and board-level recommendations, as well as within each category. Notably, firms respond to 48.9% of the withhold recommendations arising from lack of responsiveness to majority-vote shareholder proposals. By definition, these are firms that ignored a shareholder proposal supported by a majority vote in the past and yet implement it in response to a (less than 50%) withhold vote, highlighting the greater effectiveness of a vote cast directly against directors themselves. In multivariate analysis, we examine responsiveness to the most frequent type of withhold recommendation in each category, focusing on (i) turnover on key committees, (ii) changes in abnormal CEO pay and (iii) the likelihood of declassifying the board. Across all three tests, we find a statistically and economically significant association between the withhold recommendation and the subsequent governance change addressing the underlying issue. While establishing causality in our setting remains difficult, overall our analyses suggest that the documented governance changes are a direct response to the votes withheld. In addition, our evidence on firms' responsiveness provides an explanation for why higher votes withheld are generally not associated with subsequent director turnover. Shareholders use their votes on uncontested director elections to get directors to address specific problems, rather than to vote them off the board.

Finally, we examine the performance consequences of firms' responsiveness to votes withheld, thereby speaking to the broader question of the valuation effects of greater shareholder involvement in corporate governance. We find that firms are more likely to respond when shareholder pressure (proxied for by the percentage of votes withheld and the number of withhold recommendations) is higher and when performance is lower. However, we fail to find a difference in subsequent operating and stock performance between responsive and non-responsive firms, even in the most severe cases (e.g., board-level recommendations, high votes withheld). One explanation for these findings is that the items proxy advisors and voting shareholders focus on have little effect on firm value, consistent with the claim that activists misdirect their efforts towards "symbolic" governance issues (Kahan and Rock, 2014).

The full paper is available for download here.

January 29, 2015
CFIUS Practice Tips: How Investors Can Successfully Manage CFIUS Risks
by Staff

by Edward L. Rubinoff & Christian C. Davis
Mergers & Acquisitions, Congress, Disclosure

In recent years, the Committee on Foreign Investment in the United States (CFIUS) has acted to thwart or constrain various foreign investments in U.S. businesses. However, other similar investments have been permitted to proceed without significant interference from CFIUS. Below we discuss practice tips, based on lessons learned from past deals, to help investors successfully navigate these risks and obtain clearance from CFIUS.

As background, CFIUS is an interagency committee that reviews the national security implications of a wide range of foreign acquisitions and investments in U.S. businesses. Specifically, CFIUS has jurisdiction to review "covered transactions" that result in a foreign person's control of a U.S. business. CFIUS has the authority to review, block and unwind transactions, either prior to or after closing that threaten to impair the national security of the United States.

With that in mind, investors that assess CFIUS risks at the outset of a contemplated transaction and take appropriate measures are best positioned to successfully complete their deals. We provide the following practice tips for cases that raise potential national security concerns:

(1) Integrate CFIUS into the Investment Strategy: At the outset of a transaction, investors should consider whether the deal has any possible national security implications that might trigger CFIUS review. Investments that involve any of the following have been viewed as potentially implicating national security concerns: classified programs, critical technology (e.g., telecommunications, aerospace and military technology), government contracts, critical infrastructure (e.g., energy and transportation), facilities located near sensitive government bases and foreign government-owned entities. If possible, investors may need to consider altering the transaction structure, ownership interests and/or operational roles to minimize perceived national security risks.

(2) Assemble the CFIUS Team: A well-rounded CFIUS team should include not only regulatory lawyers for the CFIUS process, but, in appropriate cases, also lobbyists, to engage with Congress and state/local groups, and public relations experts to manage the media. These consultants should work together to prepare an integrated legal, political and media strategy targeting both potential supporters and opponents of the transaction and be prepared for a quick response to any CFIUS concerns that may arise.

(3) Define and Deliver the Message: Prior to filing the voluntary notice, investors should thoroughly assess the CFIUS requirements and the related political issues that could arise in Congress, as well as state and local governments. The parties should define the message for the transaction that explains the business rationale, and they should also prepare a political and media strategy before the deal is announced.

(4) Assess the Political Dynamics: Prior to filing the voluntary notice, investors should build local, state and congressional support for the transaction. It is also important to anticipate possible criticism and develop a strategy with which to respond.

(5) Prepare an Acceptable Mitigation Strategy: Investors should discuss possible mitigation measures that might be acceptable to both parties before CFIUS compels them to do so. Advance discussion and preparation can help avoid situations in which parties are pressed to accept unfavorable mitigation measures under extreme time pressure at the end of the CFIUS review.

(6) Engage in the CFIUS Prefiling Process: Investors should engage CFIUS in prefiling consultations about the proposed transaction. They should prepare overview presentations and other related materials that describe the proposed transaction and the parties involved to familiarize CFIUS with the transaction prior to filing. As a best practice, they should submit a draft notice to CFIUS for preliminary review.

(7) Be Proactive with the CFIUS Voluntary Notice: Investors should draft and submit a robust, voluntary notice to CFIUS that addresses any potential national security concerns. The parties should also be prepared to quickly respond to follow-up requests from CFIUS and other U.S. government agencies that must be addressed typically within three days.

(8) Work with CFIUS on an Acceptable Mitigation Agreement: If CFIUS requires a mitigation agreement, the parties should be prepared to assess the impact of these requirements on business operations and communicate any burdensome constraints to CFIUS. It is also helpful to identify proposed solutions that address CFIUS's concerns.

Taking these factors into account can mean the difference between a transaction that clears CFIUS and one that encounters obstacles or outright opposition.

View today's posts

1/30/2015 posts

Blogmosaic: Two-fer Week At The SEC: Two No-Action Letters; Two New CDIs; and Two New Volcker Rule FAQs
Conglomerate: The "Successful" Shake Shack IPO
Conglomerate: The Ethical Slide, Train Tickets, and Helping the Next Generation of Corporate Leaders to Choose Differently
SEC Actions Blog: This Week In Securities Litigation (Week ending January 30, 2015) Blog: House Bill: Repeal of Pay Ratio
Race to the Bottom: Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 5)
HLS Forum on Corporate Governance and Financial Regulation: The M&A Landscape: Financial Institutions Rediscovering Themselves
HLS Forum on Corporate Governance and Financial Regulation: Understanding Director Elections
AG Deal Diary: CFIUS Practice Tips: How Investors Can Successfully Manage CFIUS Risks

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