Harvard Business Law Review (HBLR)

The Harvard Business Law Review (HBLR) aims to be the premier journal covering the laws of business organization and capital markets. HBLR will publish articles from professors, practitioners, and policymakers on corporate law and governance, securities and capital markets law, financial regulation and financial institutions, law and finance, financial distress and bankruptcy, and related subjects.

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The Coconundrum

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Frederick Ryan Castillo*

Digging deeper into their analytical toolbox, policymakers, academics, and regulators are increasingly exploring whether, and to what extent, a system of contingent capital can strengthen the resilience of the banking sector. The global financial crisis unearthed fragile and troubled banks, riddled with excessive leverage, poor quality capital buffers, and liquidity problems. Because these institutions were deemed “too big to fail,” governments were forced to intervene and prop them up by way of costly, taxpayer-funded bailouts. With the benefit of hindsight, regulators are now looking at contingent capital as a potentially speedy and less costly alternative for recapitalizing banks in periods of financial distress.[1]

But is contingent capital a desirable, feasible and sustainable proposition, or is it an overly-simplified theoretical concept fraught with practical difficulties and unrealistic expectations?

Contingent capital—also known as “contingent convertibles” or “CoCos,”[2] “regulatory hybrid securities,”[3] “contingent capital certificates,”[4] or “embedded contingent capital”[5]—refers to debt instruments which mandatorily convert into equity upon the happening of one or more pre-defined events or triggers.[6] Regulators have tinkered with the idea of requiring systemically important banks to issue these instruments as integral components of their capital structures. When a bank encounters a liquidity or capital crisis, the CoCos will be converted into equity, thus increasing the bank’s capital buffers and avoiding the need to seek governmental intervention.

Proponents of contingent capital, who include Mark Flannery[7], Robert McDonald[8], the Squam Lake Working Group[9], and John Coffee, Jr.[10], view it as a desirable and workable mechanism. Contingent capital, it is argued, will ease financial distress, reduce bank leverage, minimize incidents of bank insolvency, avoid costly public bailouts, set up a speedy bank resolution regime, internalize bank failure costs, and insulate the rest of the financial system from possible systemic spillover effects.[11] The Basel Committee on Banking Supervision (BCBS) also observes that the use of contingent capital would lessen moral hazard by increasing private sector involvement in the resolution of future banking crises.[12]

In contrast, critics such as Anat Admati, Peter DeMarzo, Martin Hellwig and Paul Pfleiderer point out that contingent capital and related “bail-in” mechanisms are too complicated to design, pose difficult implementation concerns, and are less effective than the straightforward approach of requiring banks to have more equity capital.[13]The Association of British Insurers has also voiced its concerns as to how the instruments would work in practice, noting that investors in CoCos would be made to absorb “haircuts” or losses when conversion takes place.[14]

However, it may be said that on the balance, the reservations critics have with respect to contingent capital focus largely on the practical difficulties likely to be encountered once these instruments are put into use, and not on the desirability of contingent capital as a potential tool for stabilizing banks. As Coffee points out, contingent capital is not an “abstract academic idea,” but “its optimal design remains open to legitimate and necessary debate.”[15]

Taking the debate a point further, it appears that the feasibility and sustainability of CoCos ultimately turns on a careful consideration and resolution of four key areas.

First, consensus with respect to the appropriate trigger (i.e. the point at which conversion of debt into equity takes place) needs to be reached. At present, there is a wide spectrum of proposals on this issue, with some advocating that the trigger be determined by a country’s regulatory authority, while others are arguing that a more objective measure, such as a reference to a market index or a specified capital ratio, be used.[16] For instance, in August, the BCBS issued a proposal that would allow capital instruments to be written off or converted to common shares at the discretion of the relevant authority if: (a) the bank was judged to be non-viable by the relevant authority or (b) the bank had received a public sector capital injection without which it would have become non-viable.[17] The Squam Lake Working Group suggests a double trigger: regulators must declare the existence of a systemic crisis, and the bank must fall below a given capital ratio.[18] In contrast, Flannery argues that the trigger should not depend on the state of the financial system, but rather on the contemporaneous market value of the firm’s outstanding common equity.[19]

Second, regulators must facilitate the market’s acceptance of CoCos by clarifying their essential investment features and, where appropriate, engaging in meaningful discourse with leading industry groups. For instance, a particular concern among investors is whether credit rating agencies are willing and able to adequately assess the risk features of CoCos.[20] In this regard, Fitch Ratings’ early November statement that it expects to be able to rate these new-generation bank hybrid securities may stimulate renewed interest in CoCos.[21] News last October that Swiss authorities are open to the use of CoCos to fund the capital requirements of UBS and Credit Suisse is also a welcome development.[22]

Third, the appropriate tax treatment of CoCos needs to be settled. The primary issue here is whether tax authorities would be willing to recognize contingent capital as debt (thereby allowing tax-deductible interest expenses) despite the instrument’s convertibility into equity.[23] If so, banks will enjoy the benefits of debt financing and will gravitate toward the use of CoCos in their capital structures.

Lastly, differences in the legal treatment of CoCos across relevant jurisdictions need to be sufficiently understood. Interestingly, the BCBS has already commenced this process by requesting feedback from market participants, including investors in bank capital instruments, on all aspects of its August proposal (on contingent capital and triggers), including “any legal or operational obstacles to their implementation.”[24] The BCBS has even encouraged industry practitioners to work with regulators in drafting terms and conditions for contingent capital instruments while “respecting relevant national constraints.”[25] Whether sufficient harmonization and acceptance of contingent capital across varying legal jurisdictions will be achieved, however, remains to be seen.

The discussion on contingent capital will likely continue and escalate in the coming weeks, but the ultimate verdict on its feasibility and sustainability will not be immediate. The conundrum of contingent capital presents broad challenges to the financial sector and to the economy as a whole, as stakeholders seek new and innovative ways of stabilizing the banking sector and preventing another financial crisis.

* LL.M. Candidate, 2011, Harvard Law School.

 

[1] See Damian Paletta, ‘Contingent Capital’ Idea Gaining More Steam Within Fed, Wall St. J. (Oct. 13, 2009), http://blogs.wsj.com/economics/2009/10/13/contingent-capital-idea-gaining-more-steam-within-fed; Steve Slater & Clara Ferreira-Marques, Contingent Capital: Cure or Cost for Banks?, Reuters (Oct. 27, 2009), http://uk.reuters.com/article/idUKLNE59Q01K20091027; Giuseppe De Martino, Masimo Libertucci, Mario Marangoni, & Mario Quagliariello, A Proposal for Countercyclical Contingent Capital Instruments, VOX (Oct. 30, 2010), http://www.voxeu.org/index.php?q=node/5728; BoE’s Tucker-CoCos Could Transform Bank Landscape, Reuters (Nov. 16, 2009), http://blogs.reuters.com/financial-regulatory-forum/2009/11/16/boes-tucker-cocos-could-transform-bank-landscape.  See also Press Release, Bank for International Settlements, Consultative Proposals to Strengthen the Resilience of the Banking Sector Announced by the Basel Committee (Dec. 17, 2009), http://www.bis.org/press/p091217.htm.

[2] See CoCo Nuts, The Economist (Nov. 5, 2009), http://www.economist.com/node/ 14816673?story_id=14816673.

[3] Squam Lake Working Group on Financial Regulation, An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities (Council on Foreign Relations, Center for Geoeconomic Studies, Working Paper 2009) at 2.

[4] Mark J. Flannery, Stabilizing Large Financial Institutions with Contingent Capital Certificates (2009), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1485689.

[5] Julie Dickson, Superintendant, Financial Institutions Canada, Remarks at Financial Services Invitational Forum (May 6, 2010) at 4, http://www.osfi-bsif.gc.ca/app/DocRepository/1/eng/speeches/jdlh20100506_e.pdf.

[6] Id.

[7] See Flannery, supra note 4.

[8] See Robert J. Mcdonald, Contingent Capital with a Dual Price Trigger (2010), available at http://papers. ssrn.com/sol3/papers.cfm?abstract_id=1553430.

[9] See Squam Lake Working Group, supra note 3.

[10] See John Coffee, Jr., Bail-Ins Versus Bail-Outs: Using Contingent Capital to Mitigate Systemic Risk (2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1675015.

[11] See Flannery, supra note 4, at 3; Coffee, supra note 10, at 10, 33; McDonald, supra note 8, at 2, 21.

[12] See Basel Committee on Banking Supervision, Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability (2010), available at http://www.bis.org/publ/bcbs174.pdf.

[13] See R. Admati, Peter M. DeMarzo, Martin F. Helllwig, & Paul C. Pfleiderer, Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive (2010), http://papers.ssrn.com/ sol3/papers.cfm?abstract_id=1669704.

[14] Huw Jones, UK Insurers Say CoCo Capital Poorly Thought Out, Reuters (Nov. 9, 2010), http://www. reuters.com/article/idUSLDE6A812Z20101109.

[15] Coffee, supra note 10, at 9.

[16] See Coffee, supra note 10, at 34–35.

[17] Basel Committee on Banking Supervision, supra note 12; see also Martin Dozier, Basel Committee Commences Consultation Regarding Contingent Capital Requirement, Financial Markets Blog (Aug. 19, 2010), http://www.alston.com/financialmarketscrisisblog/blog.aspx?entry=3922; Press Release, Bank for International Settlements, Basel Committee Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability (Aug. 19, 2010).

[18] Squam Lake Working Group, supra note 3, at 4.

[19] Flannery, supra note 4, at 11.

[20] See Tracy Alloway, CoComplications, Financial Times Alphaville (Nov. 18, 2010), http://ftalphaville.ft. com/blog/2009/11/18/83946/cocomplications; see also Tracy Alloway, Will Rate CoCo Bonds for Food, Financial Times Alphaville (Nov 9, 2010), http://ftalphaville.ft.com/blog/2010/11/09/398811/will-rate-coco-bonds-for-food; Tracy Alloway, Cuckoo for CoCos, Financial Times (Nov 11, 2010), http://ftalphaville.ft.com/blog/2009/11/11/ 82756/cuckoo-for-cocos.

[21] “Mark Brown, Fitch Statement on Bank Hybrid Securities Seen as Constructive, Fox Business (Nov. 8, 2010), http://www.foxbusiness.com/markets/2010/11/08/fitch-statement-bank-hybrid-securities-seen-constructive/#ixzz16QleaUzf.

[22] Jane Merriman, Swiss Give Fresh Momentum to Contingent Bonds, Reuters (Oct. 4, 2010), http://blogs.reuters.com/financial-regulatory-forum/2010/10/04/snap-analysis-swiss-give-fresh-momentum-to-contingent-bonds.

[23] See Coffee, supra note 10, at 44; McDonald, supra note 8, at 16; Humphreys & Pinedo, supra note 2.

[24] Basel Committee on Banking Supervision, supra note 12, at 3.

[25] Id.

Preferred citation: Frederick Ryan Castillo, The Coconundrum, 1 Harv. Bus. L. Rev. Online 29 (2010), https://journals.law.harvard.edu/hblr//?p=832.

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One Way That Dodd-Frank’s Liquidation Authority Could Achieve Parity With The Bankruptcy Code

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Harvey R. Miller & Maurice Horwitz*

On October 19, 2010, the FDIC published a proposed rule governing the implementation of Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).[1] Title II of Dodd-Frank creates an orderly liquidation authority for the resolution of systemically important financial institutions.[2] According to the FDIC’s Notice of Proposed Rulemaking Implementing Certain Orderly Liquidation Authority Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, “[t]he liquidation rules of Title II are designed to create parity in the treatment of creditors with the Bankruptcy Code and other normally applicable insolvency laws.”[3]

One of the criticisms of Title II, however, is that creditors lack the same degree of certainty with respect to their probable treatment under an FDIC receivership as compared with the bankruptcy process. The FDIC’s typical response to this concern is that the statute guarantees creditors no less than the amount they would have received if the covered financial company had been liquidated under chapter 7 of the Bankruptcy Code.[4]

This response is inherently flawed because it assumes that one could state objectively what a creditor’s probable recovery would be in a hypothetical chapter 7 case. All judgments of value are subjective, even if based to some extent on objective facts. It is for this reason that valuation disputes are among the most common forms of litigation in Bankruptcy Courts. However, Title II does not appear to provide any recourse to creditors who disagree with the FDIC’s determination of value in most contexts. What follow are some examples of how the subjective value determinations of the FDIC may affect creditor treatment under Title II. These examples demonstrate the lack of transparency and creditor rights that is a general issue with FDIC receiverships.

Bifurcation of Secured Claims. To the extent that the FDIC determines that a claim is undersecured, Title II gives the FDIC the authority to bifurcate claims and treat the undersecured portion as an unsecured claim.[5] The FDIC may make payments to a secured creditor pursuant to the disposition of its collateral, but is under no obligation to make any payment with respect to the undersecured portion of the claim.[6] One cannot imagine a more likely scenario for a valuation dispute. If the FDIC cannot dispose of a secured creditor’s collateral, then the FDIC will value the underlying security and determine to what extent the security is insufficient, and pay the secured creditor based on that valuation. Moreover, even if the FDIC disposes of a secured creditor’s collateral, secured creditors may wish to be involved in the development and administration of the sale process, as well as the determination of the price that the FDIC decides is acceptable. Creditors whose claims are secured by highly illiquid or distressed assets will be particularly disadvantaged, both by the FDIC’s absolute discretion in valuing or disposing of such assets and by its relative inexperience in managing such assets.

Transfer of Assets To A Bridge Financial Company. Title II gives the FDIC the ability to organize a “bridge financial company,”[7] and transfer any assets and liabilities of the covered financial company to the bridge financial company without assignment, consent, or obtaining any approval under federal or state law.[8] It is not clear, however, what sort of value a bridge financial company would be required to provide in exchange for such assets. The statute provides that a bridge financial company may either “assume” liabilities, or “purchase” assets of the covered financial company.[9] Presumably, therefore, Congress intended that the bridge financial company would provide some consideration for the transferred assets. But what consideration? This question will be crucial for those unsecured creditors whose liabilities are not assumed by the bridge financial institution, as they will be left to rely on the proceeds of such a transfer in the subsequent distribution of the remaining assets. Title II does not appear to provide any recourse for creditors who believe that the bridge financial institution has not paid fair value.

Adequate Protection for Priming Liens. Title II may also affect secured claims if the FDIC transfers encumbered assets to a bridge financial company. In these circumstances, the FDIC may authorize the bridge company to issue debt with first priority liens (i.e., “priming liens”) on such assets.[10] Fortunately, in such circumstances and unlike for other actions by the FDIC, a hearing is required before a federal district court: the FDIC must demonstrate to the court that secured creditors’ preexisting liens are adequately protected.[11] However, the statute does not define the nature of this process, even though it is an area likely to give rise to significant litigation over valuation of the collateral security and what would constitute adequate protection for the secured creditor.

Liquidation Analysis. Under Title II, the FDIC may favor certain creditors over others that are similarly situated, or pay certain creditors before others.[12] Similar results can be obtained in a chapter 11 case, but typically require creditor consent and court approval. Not so under Title II: the FDIC has complete discretion in making this decision. To allay creditor fears, the FDIC cites the statutory “guarantee” that creditors will receive no less, in any event, than they would have received in a chapter 7 liquidation. To ensure that this guarantee is met, however, will require a comparison of the distributions proposed by the FDIC in a Title II liquidation with the probable distributions that would be available to creditors in a chapter 7 liquidation. Who will make this comparison? Who will prepare the liquidation analysis to demonstrate that the FDIC has met its burden? The FDIC should craft rules not only to address these questions, but also to ensure that the liquidation analysis is credible—ideally, performed by an independent third party—and not dependent on the FDIC’s subjective view of an institution’s liquidation value.

 

If, through the rulemaking process, value determinations such as the foregoing can be placed in the hands of independent third party arbiters, Title II may yet achieve parity with the Bankruptcy Code. Meaningful dialogue on this subject will require the FDIC, industry executives, investors, and academics to recognize that any potential outcome for creditors under Title II, as it currently stands, depends disproportionately more on the subjective value determinations of a single party—the FDIC receiver—than would ever be the case in a chapter 7 bankruptcy

* Mr. Miller is a Partner, and Mr. Horwitz is an Associate, at Weil, Gotshal & Manges LLP.

 

[1] Pub. L. No. 111-203, 124 Stat. 1376 (2010) (to be codified at 15 U.S.C. § 78o-7).

[2] §§ 201–217.

[3] 75 Fed. Reg. 64,182, 64,175 (proposed Oct. 19, 2010) (to be codified at 12 C.F.R. pt. 380).

[4] See §§ 210(a)(7)(B), (d)(2)(B).

[5] See § 210(a)(3)(D)(ii).

[6] § 210(a)(2)(D).

[7] See § 210(h)(1)(A).

[8] See § 210(h)(5)(A), (D).

[9] See § 210(h)(1).

[10] See § 210(h)(16)(C).

[11] See § 210(h)(16)(C)(ii).

[12] See § 210(b)(4).

Preferred citation: Harvey Miller & Maurice Horwitz, One Way That Dodd-Frank’s Liquidation Authority Could Achieve Parity With The Bankruptcy Code, 1 Harv. Bus. L. Rev. Online 1 (2010), https://journals.law.harvard.edu/hblr//?p=350.

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FINRA Proposed Rule Change Would Give Customers Option of All-Public Arbitration Panels

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Barbara Black*

Brokerage firms customarily include in their customers’ agreements a predispute arbitration agreement requiring that investors arbitrate their disputes before an arbitration panel of the Financial Industry Regulatory Authority (FINRA). Current rules governing customers’ claims over $100,000[1] require each three-person panel to include one non-public, or industry, arbitrator in addition to one public arbitrator and one chair-qualified public arbitrator.[2] Investor advocates long have argued that the mandatory inclusion of an arbitrator with ties to the securities industry was unfair to investors and gave the securities industry one decision-maker who would be sympathetic to its position.[3] Indeed, a recent study of participants’ perceptions of the securities arbitration process that I co-authored found that investors have a far more negative perception of securities arbitration than all other participants in the process and perceive a strong bias in arbitrators.[4]

On October 25, 2010, FINRA filed a proposed rule change with the Securities and Exchange Commission (SEC) to respond to these negative perceptions.[5] FINRA’s proposed rule change would give customers the option to choose an arbitration panel consisting entirely of public arbitrators. FINRA stated that giving customers this option would “enhance customers’ perception of the fairness of FINRA’s rules and of its securities arbitration process.”[6] The proposed rule change requires SEC approval; the period for public comment will expire on December 3, 2010.[7]

Under the proposed rule change, customers can choose between two panel selection options: the Majority Public Panel, which retains the current panel composition method, or the Optional All Public Panel, which would guarantee that any party could select an all-public panel. Customers must affirmatively elect the Optional All Public Panel procedures early in the process; otherwise, FINRA would apply the procedures for the Majority Public Panel option.

The Majority Public Panel option retains the current three-arbitrator panel. The parties select their panel by striking names from three lists of ten arbitrators (one list per arbitrator type) and then ranking the remaining arbitrators. Each party may strike up to four names from each list. FINRA appoints the panel from among the names remaining on the lists that the parties return.

The process for striking non-public arbitrators, however, is different under the Optional All Public Panel approach. Instead of limiting strikes to four non-public arbitrators (the current approach, which would continue under the Majority Public Panel option), each party could strike all ten names. Taking this option would guarantee that no non-public arbitrator would be appointed to the panel. In that case, FINRA would appoint the next highest-ranked public arbitrator to complete the panel.

In October 2008, FINRA launched a voluntary pilot program with a number of brokerage firms that allowed eligible claimants to select all public panels.[8] FINRA designed the program to run for two years, from Oct. 6, 2008 through Oct. 5, 2010. Participating firms recently agreed to extend the pilot program for a third year.[9] FINRA reported interim findings as of June 1, 2010. Investors in 485 of a total of 853 cases eligible for the pilot program chose to participate. In the 361 cases (of 485) where parties completed arbitrator rankings, the investor chose to rank one or more non-public arbitrators on the list in 187, or 52%.[10] Panels have not yet issued a sufficient number of awards to enable accurate statistical analysis of the effect of the alternative panel structure.[11] However, FINRA cited the positive reaction from participants in the pilot program as a motivating factor for its proposed rule change.[12]

The SEC must approve the proposed rule change if it is “consistent” with the Securities Exchange Act of 1934 and the regulations that are applicable to FINRA.[13] In particular, section 78o-3(b)(6) requires the SEC to ensure that FINRA rules are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest; and also that they are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers.[14]

Previously, the Securities Industry and Financial Markets Association (SIFMA) strongly defended the mandatory inclusion of an industry arbitrator, asserting that the industry arbitrator’s expertise benefits both parties[15] and that there is no evidence that the presence of an industry arbitrator “somehow infuses pro-industry bias into the process.”[16] SIFMA and other leaders in the securities industry have not yet publicly commented on FINRA’s proposed rule change, and it is not certain that the industry will speak with a united voice on this issue. At least some in the industry may object that the proposed rule change unfairly discriminates against brokerage firms and registered representatives.

The proposed rule change will not satisfy the critics who continue to doubt the fairness of requiring customers to agree ex ante to FINRA securities arbitration. I personally would prefer a rule that made the All Public Panel approach the default choice. The experience with the pilot program indicates that a majority of customers want the option of an all-public panel, even if ultimately they do not strike all the names of industry arbitrators on their list. Nevertheless, adoption of the proposed rule change should help to improve investors’ perceptions of FINRA arbitration’s fairness. Such a result will advance the goals of protecting investors and increasing investor confidence in the capital markets.

Charles Hartsock Professor of Law and Director, Corporate Law Center, University of Cincinnati College of Law

 

[1] Fin. Indus. Regulatory Authority, FINRA Manual r. 12401 (2009), available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=4139. Claims under $100,000 are heard by a single arbitrator.

[2] FINRA Manual r. 12100(p) (2010), available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=4099.

[3] NASAA Pro-Investor Legislative Agenda for the 111th Congress, N. Am. Sec. Adm’rs Ass’n (Jan. 2009), http://www.nasaa.org/issues___answers/legislative_activity/10147.cfm.

[4] Jill I. Gross & Barbara Black, When Perception Changes Reality: An Empirical Study of Investors’ Views of the Fairness of Securities Arbitration, 2008 J. Disp. Resol. 349.

[5] Notice of Filing of Proposed Rule Change Relating to Amendments to the Panel Composition Rule, and Related Rules, of the Code of Arbitration Procedure for Customer Disputes, Exchange Act Release No. 34-63,250, 75 Fed. Reg. 69,481 (Nov. 12, 2010).

[6] Id. at 69483.

[7] Id. at 69484.

[8] See Public Arbitrator Pilot Program Frequently Asked Questions, FINRA, http://www.finra.org/ ArbitrationMediation/Parties/ArbitrationProcess/NoticesToParties/P116995 (last visited Oct. 29, 2010).

[9] Id.

[10] Kenneth L. Andrichik et al., The Financial Industry Regulatory Authority’s Dispute Resolution Activities, 1829 Practising L. Inst. Corp. L. & Prac. Course Handbook Series 37, 45 (2010).

[11] Id.

[12] Proposed Rule Change Relating to Amendments to the Panel Composition Rule, 75 Fed. Reg. at 69,482.

[13] 15 U.S.C. § 78s(b)(2) (2006).

[14] §§ 78o-3(b)(6).

[15] Sec. Indus. & Fin. Mkts. Ass’n, White Paper on Arbitration in the Securities Industry 36 (2007), available at http://www.sifma.org/issues/item.aspx?id=21334.

[16] Id. at 35.

Preferred citation: Barbara Black, FINRA Proposed Rule Change Would Give Customers Option of All-Public Arbitration Panels, 1 Harv. Bus. L. Rev. Online 4 (2010), https://journals.law.harvard.edu/hblr//?p=256.

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Normalizing Match Rights: Comment on In re Cogent, Inc. Shareholder Litigation

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Brian JM Quinn*

Early in October of this year the Chancery Court handed down its opinion in In re Cogent, Inc. Shareholder Litigation.[1] In many respects, the ruling was pedestrian. Shareholders of Cogent, a Delaware corporation in the business of providing automated fingerprint identification systems, challenged management’s decision to sell the corporation to the 3M Company for $10.50/share in cash.[2] The essence of the shareholders’ challenge focused on supposed inadequacies in the sales process that, according to the plaintiffs, resulted in a breach of the directors’ Revlon obligations.[3] The shareholders further alleged that deal protections and other provisions in the merger agreement were preclusive, arguing that such provisions made it unlikely that a potential bidder lurking on the edges of the transaction might come forward.[4]

Of course, not every flaw in a company’s sales process necessarily runs afoul of Revlon analysis. Rather, courts will make a determination “regarding the adequacy of the decisionmaking process employed by the directors,” as well as a determination as to the “reasonableness of the directors’ [decisions]” in light of information known to them at the time they made those decisions.[5] “Reasonableness” is the touchstone for a court’s review of director decisions under Revlon, not perfection.[6] Given that standard, it was not surprising that Vice Chancellor Parsons ruled, at the preliminary injunction stage, that the plaintiff shareholders did not have a reasonable probability of success on the merits, thereby declining to prevent the transaction from moving forward.[7]

What is more remarkable about the recent Cogent opinion is the extent to which the Chancery Court accepts, without much of a critical eye, the use of matching rights in merger agreements that implicate Revlon duties. Matching rights permit the bidder who holds them to preempt any subsequent, higher bid and step into the second bidder’s shoes. These rights come in many forms. Explicit, or formal, matching rights require that the seller engage in good faith negotiations with the initial bidder upon receipt of a second bid for a period of time to allow the initial bidder to meet the higher, subsequent bid. Less formal matching rights simply buy the initial bidder time and information about the second bid, during which time the initial bidder can consider whether to make a matching bid or not. To the extent that such rights in their various forms work to advantage initial bidders over subsequent bidders, their use should at least raise apprehensions under Revlon, precisely because Revlon was animated by the court’s concern that directors treat second bidders fairly. Instead, beginning with In re Toys “R” Us Shareholder Litigation[8] in 2005, the Chancery Court institutionalized what can only be understood as a per se acceptance of matching rights in merger agreements.[9]

The Chancery Court regularly eschews the adoption of bright-line rules in favor of highly contextualized, fact-specific analyses of director decisions to agree to deal protections in merger agreements. Indeed, the Chancery Court has consistently rejected arguments from defendants that deal protection measures, such as termination fees, are simply customary deal terms.[10] Thus, the court understands and acknowledges that, when they are sufficiently large, termination fees can act as a deterrent and be unfair to subsequent bidders. In some circumstances, it might be unreasonable for Boards to agree to large termination fees and still act in a manner consistent with their Revlon duties. While the court has avoided setting out bright-line rules with respect to termination fees, it has not refrained from looking at such fees carefully before passing judgment.[11] The same cannot be said of the court’s increasingly lax scrutiny of matching rights.

And this is where the recent Cogent opinion is remarkable. Rather than engage in a nuanced analysis of the reasonableness of matching rights within the context of each merger agreement, the court has apparently come to accept matching rights in their various forms as almost non-negotiable standard terms. Vice Chancellor Parsons dealt with matching rights in the agreement, thusly:

After reviewing the arguments and relevant case law, I conclude Plaintiffs are not likely to succeed in showing that the no-shop and matching rights provisions are unreasonable either separately or in combination. Potential suitors often have a legitimate concern that they are being used merely to draw others into a bidding war. Therefore, in an effort to entice an acquirer to make a strong offer, it is reasonable for a seller to provide a buyer some level of assurance that he will be given adequate opportunity to buy the seller, even if a higher bid later emerges.[12]

Unlike the Cogent court’s exacting discussion of the appropriateness of the termination fee, which included a lengthy discussion of the correct approach to calculating such fees,[13] the court’s review of the use of matching rights in the merger agreement was anything but nuanced. While the courts in In re Dollar Thrifty and Toys R Us were ultimately dismissive of the deterrent power of matching rights, the court in those cases at least attempted to put matching rights in the context of the Board’s considerations. Before Cogent, the court was willing to seriously entertain claims that matching rights were unreasonable. The Cogent decision suggests the beginnings of a body of case law that treats matching rights as a customary term, per se acceptable, and therefore not the proper subject of an exacting judicial review. This is unfortunate.

Unlike discussions of macroeconomic policy, there are no two-handed economists when it comes to the incentives generated by matching rights.[14] Matching rights work to deter subsequent bids when held by an initial bidder. In the context of common value auctions (e.g., with financial buyers), the effect of a matching right is to deter subsequent bidders and appropriate rents to the initial bidder. Of course, given that common value buyers place roughly equal value on the seller, society is agnostic as to who ultimately wins a bidding contest.[15] The seller’s directors are under an obligation to obtain the highest price reasonably available for shareholders, but should not be agnostic to the distribution of the surplus created as a result of the transaction. Reasonable boards should not agree to transaction mechanisms that systematically result in the distribution of a transaction surplus to initial buyers by deterring subsequent buyers with a comparable willingness to pay.

On the other hand, where matching rights are present with private value bidders (e.g., strategic acquirers), the presence of the matching right deters subsequent bidders from making offers, thus making it possible for lower valuing initial bidders to acquire the seller. Such a result is inefficient from a societal standpoint and results in systematically lower prices for selling shareholders.[16] The economic analysis of the effects had by an initial bidder’s matching rights on subsequent bidders in both cases is clear: they tend to deter subsequent bids in favor of the initial bidder.

Economic theory suggests that courts should employ a more nuanced and serious approach to reviewing the use of matching rights. At the very least, courts should subject matching rights to the same level of scrutiny as that applied to termination rights. Indeed, there are circumstances—for example, in transactions with controlling shareholders—where courts should be quite circumspect of the use of such rights. In such circumstances, the presence of matching rights would be preclusive of a competitive topping bid. On the other hand, where the directors have shopped the company and have negotiated the matching rights for additional value from an acquirer, or to end a played out auction, then courts should not stand in the way of a well informed Board deciding to accept them. In either situation, the court should refrain from treating matching rights as a standard contract term that requires little analysis.

* Assistant Professor of Law, Boston College Law School. Thanks to Joel Friedlander and Michael Klausner for their insights on the question of matching rights. Thanks also to Elizabeth Johnston (BCLS, ’11) for her editorial assistance.

 

[1] __ A.3d __, No. 5780-VCP, 2010 WL 4491331 (Del. Ch. Oct. 5, 2010).

[2] Id. at *1.

[3] Id. at *5.

[4] Id.

[5] Paramount Commc’ns, Inc. v. QVC Network, Inc., 637 A.2d 34, 45 (Del. 1994).

[6] Id.

[7] In re Cogent, Inc., 2010 WL 4491331 at *22.

[8] 877 A.2d 975 (Del. Ch. 2005).

[9] See, e.g., In re 3Com S’holders Litig., No. 5067-CC, 2009 WL 5173804 (Del. Ch. Dec. 18, 2009); In re Lear Corp. S’holder Litig., 926 A.2d 94, (Del. Ch. 2007); La. Mun. Police Emps.’ Ret. Sys. v. Crawford, 918 A.2d 1172 (Del. Ch. 2007); see also In re Dollar Thrifty S’holder Litig., No. 5458-VCS, 2010 WL 3503471 (Del. Ch. Sept. 8, 2010).

[10] See, e.g., La. Mun. Police Emps.’ Ret. Sys., 918 A.2d at 1181 n.10 (Del. Ch. 2007).

[11] See id.

[12] In re Cogent, Inc., 2010 WL at 4491331 *9 (internal citation omitted).

[13] Id. at *11.

[14] See, e.g., Sushil Bikchandani, Steven A. Lippman & Reade Ryan, On the Right-of-First-Refusal, 5 Advances Theoretical Econ. 1 (2005); Jeremy Bulow & Paul Klemperer, Why Do Sellers (Usually) Prefer Auctions?, 99 Am. Econ. Rev. 1544 (2009); Albert H. Choi, A Rent Extraction Theory of Right of First Refusal, 57 J. Indus. Econ. 252 (2009); Hayley Chouinard, Auctions With and Without Rights of First Refusal and National Park Service Concession Contracts, 87 Am. J. Agric. Econ. 1082 (2005); A. Preston McAfee & John McMillan, Auctions and Bidding, 25 J. Econ. Lit. 699, 714 (1987); David I. Walker, Rethinking Rights of First Refusal, 5 Stan. J.L. Bus. & Fin. 1 (1999).

[15] See generally Choi, supra note 14.

[16] Id.

Preferred citation: Brian JM Quinn, Normalizing Match Rights: Comment on In re Cogent, Inc. Shareholder Litigation, 1 Harv. Bus. L. Rev. Online 7 (2010), https://journals.law.harvard.edu/hblr//?p=345.

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Is the “Tax Poison Pill” the Last Stand for Protecting NOLs After Health Care Reform?

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Michael R. Patrone*

The Delaware Court of Chancery’s recent Selectica opinion[1] garnered substantial attention, but the court’s decision upholding the tax poison pill may be of even greater importance with the passage of the Health Care and Education Reconciliation Act of 2010 (H.R. 4872)—less than a month after Vice-Chancellor Noble issued his opinion. During the global economic recession, many companies accrued substantial tax losses that can be carried forward for up to twenty years and used to offset future income for federal tax purposes, called net operating loss carryforwards (“NOLs”). These valuable tax assets will provide substantial financial benefits for companies down the road but are vulnerable to spoilage from significant changes in company ownership. The passage of H.R. 4872 and Vice-Chancellor Noble’s ruling in Selectica are both newsworthy events, but upon further scrutiny they collectively present an important question: How can companies protect their deferred tax assets, namely NOLs?

H.R. 4872, specifically Section 1409, codifies the economic substance doctrine for federal taxation purposes and introduces a strict test for what qualifies as “economic substance” in a transaction.[2] Essentially, the economic substance doctrine requires that a transaction have some legitimate business purpose other than favorable tax benefits in order to obtain preferential tax treatment.[3] The economic substance doctrine has existed in common law since the Supreme Court’s Gregory v. Helvering decision in 1935,[4] but courts applied the doctrine as a standard rather than a rule. Additionally, prior to H.R. 4872 courts had flexibility to find a business purpose in a transaction, and at least one professor jokes that tax lawyers “had drawers full of them.” Under H.R. 4872, the economic substance doctrine becomes codified in the Internal Revenue Code (“Code”) and the Code will now include a rigid two-part, rule-based test for applying the economic substance doctrine to a transaction. The first part of the test requires a meaningful change in economic position and the second part requires a substantial purpose for entering into the transaction.[5] Both parts of the test, however, explicitly list “apart from Federal income tax effects” in the newly-amended Code.[6] Because the provision is codified in statute, litigants cannot appeal to courts for exceptions in special tax-related circumstances. To raise the ante, if the transaction fails either element of the economic substance test, the Act prescribes substantial penalties (either 20% or 40%) even if the transaction meets all other requirements of a particular Code provision.[7]

Under Selectica and the Code’s new two-part economic substance test, NOL shareholder rights plans (“tax poison pills”) may be the only effective, tax-free way for companies to protect their valuable tax assets. As illustrated by Selectica, the Code contains an unforgiving 5% “change of ownership” trigger that limits, and impairs, NOLs.[8] Presumably, this provision exists to prevent profitable companies from acquiring and exploiting these tax assets through acquisitions. In Selectica, management sought to protect its NOLs from a statutory change of ownership by adopting a tax poison pill.[9] The pill operated much like a traditional flip-in poison pill, except that it triggered at 4.99% ownership rather than the usual 15%.[10] (A flip-in poison pill, triggered when a shareholder accumulates more than a defined threshold of a company’s stock, allows all other shareholders to purchase the company’s shares at a greatly-discounted price—severely diluting the triggering shareholder’s ownership interest.)[11] Soon after, Trilogy, a competitor, intentionally triggered Selectica’s pill and litigation ensued. Under Delaware law, corporate defensive tactics are subject to the Unocal enhanced scrutiny analysis, under which management’s action must be in response to a legitimate threat to the company, not preclusive or coercive, and “reasonable in relation to the threat . . . posed.”[12] Vice-Chancellor Noble, applying this framework, upheld Selectica’s tax poison pill as reasonable in relation to the threat of Trilogy’s continued stock purchase invalidating Selectica’s NOLs.[13] Vice-Chancellor Noble emphasized the heavy restriction a 4.99%-trigger poison pill places on shareholders, but proclaimed that Selectica’s fragile $160 million NOLs outweighed the burden.[14] It is worth noting that Vice-Chancellor Noble was less concerned about the “omnipresent specter” of management acting in self-interest because Selectica was already in play and actively seeking a buyer for the company, which may explain his rather deferential scrutiny under the Unocal doctrine.[15] It is possible that Trilogy, an interested buyer, wanted to wipe out Selectica’s NOLs so that it could pay a lower price for Selectica, rather than compensate Selectica’s shareholders for deferred tax assets that the Code precluded Trilogy from using.

If H.R. 4872’s new two-part economic substance test applied to tax poison pills, they would fail. However, poison pills have a unique saving grace because they only trigger a stock transaction between a company and its shareholders. Thus, a company need not satisfy the economic substance doctrine when implementing a tax poison pill because certain Code provisions, immune to the economic substance doctrine under longstanding judicial precedent, clearly mandate that company distributions of its own shares to shareholders are nontaxable events. H.R. 4872 explicitly states that it does not disturb the determination of “whether the economic substance doctrine is relevant to a transaction,” so it is highly unlikely that this established rule will change.[16] Conversely, if a company were to explore tax-free reorganizations or other transactions to protect its NOLs, it would need an additional substantial business purpose to satisfy the new two-part economic substance test. Except for dealing in its own stock, most company transactions are taxable unless a specific exception in the Code applies and the economic substance doctrine is satisfied. Consequently, but for Vice-Chancellor Noble’s opinion upholding the tax poison pill in Selectica four weeks prior to H.R. 4872’s passage, companies might not have nontaxable means of protecting their NOLs.

Although there has been a steep decline in the number of companies with active poison pills, H.R. 4872’s passage should compel companies to evaluate their NOLs and determine whether a tax poison pill is an appropriate protective mechanism for these valuable tax assets. Further, because the SEC’s beneficial ownership and reporting threshold is 5%, companies that do not take proactive measures may not learn that their NOLs are in jeopardy until it is too late.

Traditionally, activist shareholders and corporate insiders have clashed over the poison pill in scholarship, shareholder proposals, and the courts. In light of the Delaware Court of Chancery’s Selectica decision and Congress’ passage of H.R. 4872, however, companies and investors may discover a newfound need for this modern version of the established takeover defense. And considering the value and delicacy of NOLs, perhaps shareholder activists and management will find occasion to unite behind this twenty-first century takeover defense to preserve that which, once lost, is gone forever.

* J.D. Candidate, 2011, Harvard Law School.

 

[1] Selectica, Inc. v. Versata Enters., Inc., No. 4241-VCN, 2010 WL 703062 (Del. Ch. Feb. 26, 2010), aff’d, 5 A.3d 586 (Del. 2010).

[2] Health Care and Education Reconciliation Act of 2010, H.R. 4872, 111th Cong. § 1409(a) (2010) (codified at 26 U.S.C. § 7701(o)(5)(a) (2010)).

[3] Id.

[4] Gregory v. Helvering, 293 U.S. 465, 470 (1935).

[5] H.R. No. 4872 § 1409(a) (codified at 26 U.S.C. § 7701(o)(1) (2010)).

[6] Id.

[7] § 1409(b)(2) (codified at 26 U.S.C.A. § 6662(i)(1) (2010)).

[8] Selectica, Inc. v. Versata Enter., Inc., No. 4241-VCN, 2010 WL 703062, at *6 (Del. Ch. Feb. 26, 2010), aff’d, 5 A.3d 586 (Del. 2010).

[9] Id.

[10] Id. at *8.

[11] Id. at *23; see, e.g., Michael R. Patrone, An International Comparison of Corporate Leeway to Ward-off Predators, 25 Buttorworths J. Int’l Banking and Fin. L. 355, 355–56 (2010).

[12] Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 949–58 (Del. 1985).

[13] Selectica, 2010 WL 703062 at *19.

[14] Id. at *15, *24.

[15] Id. at *12.

[16] H.R. No. 4872 § 1409(a) (codified at 26 U.S.C. § 7701(o)(5)(c) (2010)).

Preferred citation: Michael R. Patrone, Is the “Tax Poison Pill” the Last Stand for Protecting NOLs After Health Care Reform?, 1 Harv. Bus. L. Rev. Online 11 (2010), https://journals.law.harvard.edu/hblr//?p=567.

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Distilling the Debate on Proxy Access

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David Page*

In August 2010, the SEC issued its final rule on proxy access, which gives shareholders the right to place director nominees directly on the company’s proxy card, thereby sparing shareholders a large part of the expense of waging a traditional proxy contest.[1] This rulemaking, and the SEC’s subsequent decision in October to delay implementing the rule pending a challenge from the Business Roundtable, has fueled a vigorous debate on the merits of proxy access and the details of its implementation.[2] Some of the arguments made by commentators and academics are particularly interesting and useful in framing the contours of the debate.

The central arguments that support proxy access are founded in enhanced board accountability and responsiveness. Supporters contend that proxy access will make board elections more competitive and less of a rubber stamp for the board’s nominees.[3] In turn, this should make boards more responsive to shareholders and increasingly vigilant in performing their oversight duties to avoid potential election defeats.[4] Supporters also argue that since board oversight lapses played a significant role in the recent financial crisis, the time is ripe for governance reforms that increase board accountability.

A second and related line of arguments used by supporters is that shareholders need proxy access to adequately exercise their state law right to elect and remove board members.[5] Without proxy access, supporters claim that shareholders cannot effectively exercise this right given the prohibitively high expenses of a traditional proxy contest. The numbers support this assertion: Marcel Kahan and Edward Rock report that over 99% of elections are uncontested,[6] which does not comport with the notion of shareholders effectively exercising their role in board elections.

Proxy access opponents have a number of compelling rebuttal arguments. A primary contention is that proxy access will lead to the nomination of “special interest directors,” such as individuals representing unions or those with social or environmental agendas.[7] Even if these individuals do not win election, dissenters contend that their presence on the ballot will force companies to become overly focused on politically charged issues at the expense of creating long-term shareholder value, thereby harming the firm’s competitiveness.[8] Dissenters envision that these candidates, for example, might attempt to extract concessions from boards in exchange for removing their name from the ballot – a form of “proxy access greenmail.”[9] A recent study by Bo Becker, Daniel Bergstresser, and Guhan Subramanian that examines stock price effects surrounding the SEC’s proxy access rule announcements, however, finds that firms most likely to be affected by proxy access have experienced abnormal positive gains as a result of the announcement, suggesting value in proxy access.[10]

Other opposition arguments include the contention that proxy access is not required in order to promote board responsiveness in light of the recent shift by many companies to majority voting rules,[11] as well as the claim that high-quality directors might be discouraged from serving on boards if they are more likely to face electoral competition from shareholder nominees.[12] Finally, some dissenters take issue with the requirement that shareholders (or a group of investors) must own 3% of the company’s shares for a minimum of three years before gaining proxy access to nominate directors, claiming that these requirements improperly discriminate between shareholders holding the same class of stock.[13]

In contrast to the interesting points made by the supporters and dissenters, perhaps the most intriguing argument comes from Kahan and Rock: that the proxy access rules will have little to no impact on the status quo, particularly for large, widely held firms.[14] They bolster this contention in several ways. First, they argue that the 3%, three-year requirement is a tough obstacle that will limit proxy access.[15] Given that the twenty largest public retirement funds combined own only 2.8% ofGoldman Sachs and the ten largest pension funds hold less than 2.5% of Bank of America, this claim seems plausible, especially with respect to large corporations.[16] Kahan and Rock also contend that not many shareholder concerns under the current status quo go unaddressed—in 2009, only eleven firms in the Russell 3000 index received a majority withhold vote and failed to make a satisfactory response[17]—suggesting a limited number of situations in which proxy access will be useful. Finally, Kahan and Rock argue that shareholders who want to take an activist position already have a sizeable array of tactics available to them, such as sponsoring shareholder resolutions, campaigning for withhold votes, running a traditional proxy contest, or asking a company to place a certain person on the board.[18] They argue that the availability of proxy access, though a new option for activism, is not enough to induce activism by investors, such as mutual funds, that have not been active in the past or have only been active in very limited high-stakes situations.[19]

Essentially, the proxy access debate will generate heightened shareholder awareness of corporate governance issues, but it is not clear that the rule will produce real governance changes. If Kahan and Rock are right, proxy access may be more of a symbolic corporate governance reform than one of practical consequence.

* J.D./M.B.A. Candidate, 2012, Harvard Law School & Harvard Business School.

 

[1] 17 C.F.R. pts. 200, 232, 240, and 249 (2010).

[2] Bus. Roundtable & Chamber of Comm. of U.S., Securities Act Release No. 9149, Exchange Act Release No. 63,031, Investment Company Act Release No. 29,456 (Oct. 4, 2010).

[3] Proxy Access, Council of Institutional Investors, http://www.cii.org/resourcesKeyGovernanceIssuesProxyAccess (last visited Nov. 20, 2010).

[4] Id.

[5] See, e.g., Paul Atkins, The SEC’s Sop to Unions, Wall St. J., Aug. 27, 2010, at A15.

[6] Marcel Kahan & Edward B. Rock, The Insignificance of Proxy Access 18–19 (U. Pa., Inst. for Law & Econ. Research Paper No. 10-26; N.Y.U. Law and Econ. Research Paper No. 10-51), available at http://ssrn.com/abstract=1695682.

[7] See Atkins, supra note 5.

[8] Id.

[9] See Kahan & Rock, supra note 6, at 84.

[10] Bo Becker, Daniel Bergstresser & Guhan Subramanian, Does Shareholder Proxy Access Improve Firm Value? Evidence from the Business Roundtable Challenge 14 (Harvard Bus. Sch. Fin., Working Paper No. 11-052), available at http://ssrn.com/abstract=1695666.

[11] 17 C.F.R. pts. 200, 232, 240, and 249 (2010).

[12] See Becker, Bergstresser & Subramanian, supra note 5, at 2, 14.

[13] See Atkins, supra note 5.

[14] See generally Kahan & Rock, supra note 6.

[15] Id. at 2.

[16]Alain Sherter, SEC “Proxy-Access” Rule Won’t Really Help Shareholders Manage Big Companies, BNET (Aug. 26, 2010, 10:29 AM), http://www.bnet.com/blog/financial-business/sec-8220proxy-access-8221-rule-won-8217t-really-help-shareholders-manage-big-companies/7233.

[17] Kahan & Rock, supra note 6, at 86.

[18] Id. at 87–88.

[19] Id. at 88.

Preferred citation: David Page, Distilling the Debate on Proxy Access, 1 Harv. Bus. L. Rev. Online 15 (2010), https://journals.law.harvard.edu/hblr//?p=585.