A recent article by Dan Amiram, Andrew M. Bauer, and Mary Margaret Frank examines the issue of corporate tax avoidance as a product of incentives. The authors suggest that “corporate tax avoidance by managers is driven by the alignment of their interest with shareholders.”* The tax role of the manager is made clear by studying the “effects of corporate tax avoidance on shareholders’ after-tax cash flows” in both classical tax systems and imputation tax systems. The authors conclude that there is higher corporate tax avoidance in classical tax systems if managerial and shareholder interests are closely aligned. (more…)
The Role of Managers in Corporate Tax Avoidance
Class Action Complaint Alleges Conspiracy to Fix CDS Market
A group of institutional investors recently filed a class action complaint against some of the world’s largest banks alleging a conspiracy fix prices and monopolize the market for Credit Default Swaps (“CDS”) in violation of the Sherman Act § 1. Defendants include Bank of America, Barclays, Citibank, and Goldman Sachs. The complaint also names the International Swaps and Derivatives Association (“ISDA”), a financial trade association, which the complaint alleges is controlled by the defendant banks. The plaintiffs are claiming potentially billions of dollars in damages.
A credit default swap is a method of transferring the risk of default for a financial instrument. The purchaser pays a fixed payment to the seller in exchange for the promise to pay off the underlying debt in the event of a default. The complaint alleges that because of the CDS market structure is unregulated and over the counter, every transaction must be with one of the defendant banks.
The complaint characterizes the CDS market as “starkly divided” between the defendant banks “who control and distort the market” and the plaintiffs “who, in order to participate in the market, must abide their distortions.” The complaint alleges that this is the result of an opaque trading environment in which the defendant banks manipulate the bid-ask spreads through their negotiations with individual traders. These manipulations cost the plaintiffs billions of dollars, says the complaint. Plaintiffs allege that several of their attempts to create and regulated exchange were rebuffed by defendants.
Both the DOJ and the European Commission have been conducting their own investigations into these activities. In March, the EU indicated that “ISDA may have been involved in a coordinated effort of investment banks to delay or prevent exchanges from entering the credit derivatives business.”
Federal Reserve FBO Proposal: Will Comments on the Intermediate Holding Company Requirement Be Heeded?
[Editor’s Note: The following post is a Gibson, Dunn & Crutcher LLP Publication, authored by its Financial Institutions Practice Group.]
The comment period has now closed on the controversial proposed rule (FBO Proposal) of the Board of Governors of the Federal Reserve System (Board) implementing Sections 165 and 166 of the Dodd-Frank Act (Dodd-Frank) for foreign banking organizations (FBOs) and foreign nonbank financial companies supervised by the Board. If the FBO Proposal becomes final in the manner proposed, it will mark a sea change in the regulation of the U.S. operations of FBOs, by requiring FBOs with $50 billion or more in total global consolidated assets and $10 billion or more in total U.S. nonbranch assets to form an intermediate holding company (IHC) for almost all of their U.S. subsidiaries. In our view, the IHC requirement likely exceeds the Board’s legal authority in implementing Sections 165 and 166 of Dodd-Frank, has the tendency to increase, rather than reduce, financial instability in the United States and globally, threatens other adverse effects, and does not effectively respond to the developments that the Board perceives in the U.S. operations of FBOs and in international banking regulation generally.
Professor Paulus Speaks on Sovereign Debt Restructuring
On April 17, legal practitioners, bankers, scholars, and students met at the Federal Reserve Bank of San Francisco to discuss recent developments in sovereign debt restructuring. Sovereign debt restructurings date to at least 300 B.C. and are a practical fact of life in today’s global economy. Recent developments in the realm of sovereign debt restructurings include Greece’s recent restructuring, the Second Circuit’s potentially destabilizing decision in NML Capital v. Argentina, and the seemingly perpetual Eurozone debt crisis.
Professor Christoph Paulus, Director of the Institute for Interdisciplinary Restructuring (Berlin) and graduate of Berkeley School of Law (LLM ’84), presented his framework for creating a Eurozone sovereign debt restructuring mechanism (SDRM). The IMF proposed an international SDRM in the early 2000s, but the plan lost out to market driven approaches. Market driven approaches to sovereign debt restructuring include the use of Collective Action Clauses (CACs) in debt contracts, which allow a qualified majority of bondholders to change the terms of the contracts to effectuate a restructuring.
Professor Paulus’s proposed Europe-centered SDRM envisions a “resolvency” proceeding for sovereigns – a more optimistic and palatable vision of restructuring than an “insolvency” proceeding. The proposal includes three key requirements: (1) the inclusion of a resolvency clause in bond contracts that would trigger resolvency proceedings under certain circumstances; (2) the creation of a resolvency court overseen by a president who would in turn select 30–40 elder statespersons to serve as judges in potential resolvency proceedings, and; (3) the development of the resolvency court rules of procedure. The envisioned resolvency process is roughly comparable to insolvency proceedings under most country’s corporate laws and would be intended to promote orderly negotiations between sovereigns and bondholders.
Following Professor Paulus’s presentation, Professor Barry Eichengreen facilitated a lively discussion detailing the limitations and virtues of an institutional approach as compared to market driven approaches, including CACs. Professor Eichengreen described the moral hazard argument against the creation of an SDRM – that such an institution could make it too easy for sovereigns to write down their debt. Nonetheless, Professor Eichengreen pointed out that the moral hazard argument now cuts the other way out of concerns that sovereigns borrow too much, and the market for sovereign debt requires greater discipline. The group also considered Contingent Convertibles (CoCos), an additional market driven approach, as a means to facilitate smooth sovereign debt restructurings. CoCos would convert sovereign debt to equity on the occurrence of certain measurable conditions, such as sustaining a particular GDP.
The ideas and issues raised at the Federal Reserve Bank provided a useful framework for understanding the potential of a Europe-centered SDRM to facilitate sovereign debt restructurings in the future. Limitations and questions remain. There are hurdles to applying resolvency clauses in non-European jurisdictions. Certification is required for ensuring the legitimacy of the elder statespersons who would serve as judges. Methodological questions remain about calculating accurately the effect of an SDRM on liquidity in the bond market, and an account of the insufficiency of market-based solutions (especially CACs) to shore up the argument that an SDRM is in fact needed. Indeed, these ideas are still being developed and stakeholders are not in consensus about the best way forward.
Experience from the Anti-Monopoly Law Decision in China – Part II
[Editor’s note: This post continues yesterday’s article, found here.]
3.2. Methodology and Assumptions
This “legal discount” test provides how much Coca Cola may lose in the acquisition of Huiyuan Juice if the application were rejected because of improper enforcement of law.
The potential loss Coca Cola suffered was the potential net income of the Huiyuan Juice for fiscal year 2009, the first year of operation if the transaction were approved.
It was difficult to predict whether the profit of the new company would increase because it was a component of the Coca Cola (by economies of scale, for example) or decrease (as actually occurred with Huiyuan in year 2010). We assumed that the annual profit of the new company was stable.
It was not sufficient that we merely estimated the profit if Coca Cola successfully purchased Huiyuan, because Coca Cola’s funding does not exist in a vacuum, i.e., Coca Cola would not be required to pay for the costs of funding, whether dividends to shareholders or interest expense to creditors, if it did not spend the USD24 billion for the deal.
Thus, potential income should be divided by the weighted average cost of capital (WACC) of Coca Cola.
Because legal risk is variable case by case, the analysis only examines the highest level of loss caused by uncertainty in the rule of law in the Chinese legal environment. This assumption also matches the conservatism in accounting principle, which suggests that expenses should be over-estimated at their highest possibility when the amount is not certain.
To reflect the possibility of judicial intervention, the discount should be multiplied by 1/67, which reflects the highest legal risk.
The potential return on the project resulting from the assumptions made above is that made for USD24 billion in investment funds.
Experience from the Anti-Monopoly Law Decision in China – Part I
1. Introduction – Reasons of Estimating Cost of Legal Risks
The general public typically has a positive view of liberty, democracy, and a reliable legal system. For their part, analysts are likely to take the legal system for granted because they have a positive view of the rule of law and are able to construct airtight arguments explaining why a reliable legal environment is important for investors.
However, simply stating that having the rule of law is always better than not having it may not be sufficient. Scholars rarely evaluate the magnitude of the positive effect of the rule of law. Certain studies may consider that legal risk increases costs at the operating level, such as the risk of suffering litigation expenses, but these studies have not analyzed how legal risk may cause investment loss.
Additionally, scholars may attempt to show that the rule of law is not a foundational concern for investors by developing models based on the interaction between governments and investors; however, these studies may miss the mark when investors hesitate to enter the market because of the perception of an unfair legal environment or when the same model is applied to a variety of industries.
In reality, it is not easy to calculate accurate figures of profit or loss resulting from the stability of the legal environment for an entire society, but a test estimating a rough ceiling of loss that might be caused by the improper application of the rule of law in a particular circumstance might be a valuable indicator for investors.
Robert Hahn et al. suggest a cost-and-benefit approach to examine the enactment of regulations; they apply it to the question of whether legislators should prohibit drivers from using cellphones while driving in 2001 and 2007.
Subject to assumptions and adjustments, such an approach might provide investors with a general idea about how much the application of the rule of law affects profitability by applying the analysis to judicial matters.
SEC Staff Provides New Guidance Regarding the Rule 15a-6 Registration Exemption for Foreign Broker-Dealers
[Editor’s Note: This post is a Latham & Watkins Client Advisory. The Network has further coverage in another post.]
On March 21, 2013, the Staff of the Division of Trading and Markets of the US Securities and Exchange Commission published guidance in the form of Frequently Asked Questions on Rule 15a-6 under the Securities Exchange Act of 1934.
The FAQs resulted from the efforts of a Task Force assembled by the Trading and Markets Subcommittee of the American Bar Association to discuss and seek clarification from the Staff with respect to certain recurring issues regarding Rule 15a-6. This clarification was requested in the form of published FAQs to provide greater transparency to the industry and to resolve certain inconsistencies created by, among other things, Staff turnover and general confusion by the industry and other regulators as to the proper application of the Rule’s rather complex provisions to a marketplace that has become markedly more global and technologically advanced in the nearly 25 years since the Rule’s adoption.
In the FAQs, the Staff affirms the general applicability of certain previously issued interpretive guidance and addresses certain aspects of the operation of Rule 15a-6, primarily with respect to issues concerning solicitation, the dissemination of research reports, recordkeeping requirements and chaperoning arrangements between foreign broker-dealers and SEC-registered broker-dealers. Although necessarily limited in scope, the FAQs provide much welcome guidance at a time when cross-border transactions have become an integral part of the securities markets.
Background
Rule 15a-6 permits foreign broker-dealers to conduct certain limited activities in the United States and with US persons without having to register as a broker or dealer under the Exchange Act. Under Rule 15a-6, foreign broker-dealers may (i) effect “unsolicited” transactions with any person; (ii) solicit and effect securities transactions with SEC-registered broker-dealers, US banks acting in compliance with certain exceptions from the definitions of “broker” and “dealer”, certain supranational organizations, foreign persons temporarily present in the United States, US citizens resident abroad and foreign branches and agencies of US persons; and (iii) subject to a number of conditions, provide research to and effect resulting securities transactions with certain types of large institutional investors. Rule 15a-6 also provides that a foreign broker-dealer may engage in a broader scope of activities, including soliciting and entering into transactions with specified categories of institutional investors, with the assistance or intermediation of an SEC registered broker-dealer (the establishment of such an arrangement is typically referred to as a “chaperoning arrangement” and the SEC-registered broker-dealer is often referred to as the “chaperoning broker-dealer”).
To read the rest of this Client Advisory, please click here and search the Advisory number “1495.”
From the Bench: Second Circuit denies class certification in lawsuit against J.P. Morgan
In Levitt v. J.P. Morgan Sec., Inc., 10-4596-CV, 2013 WL 1007678 (2d Cir. Mar. 15, 2013), the Second Circuit reversed a district court’s grant of class certification to a group of plaintiffs who alleged that Bear Sterns (subsequently bought by J.P. Morgan) had violated its duty to disclose when it did not notify investors of a fraudulent scheme by Sterling Foster, a now-defunct brokerage firm.
The case concerned allegations of fraud arising from a September 1996 IPO of ML Direct, a television marketing firm. Sterling Foster orchestrated the IPO as the introducing broker, with Bear Sterns (subsequently acquired by J.P. Morgan) acting as the clearing broker. In general, the clearing broker in a transaction owes no duty of disclosure to the customers of the introducing broker. However, the plaintiffs sought to overcome this hurdle by establishing that Bear Sterns actively participated in the fraudulent scheme.
The district court agreed with the plaintiffs that Bear Sterns’s participation was extensive enough to trigger a duty to disclose. However, the Second Circuit held that the plaintiffs had failed to allege “sufficiently direct involvement” by Bear Sterns.
The Second Circuit noted that providing “normal clearing services” do not give rise to a duty to disclose, even when the broker providing those services is aware of the introducing broker’s fraudulent intentions. Rather, to trigger a disclosure duty, the clearing broker would have to actively depart from its normal passive clearing functions and affirmatively exert “direct control” over the introducing broker and the fraudulent trades. The court found that Bear Sterns, by merely “allowing” such trades to proceed, had not assumed such a level of control.
The plaintiffs’ counsel characterized the ruling as “a sad day for investor protection,” stating that the court had “has for the first time held that a clearing firm has no duty to disclose that it is knowingly participating in market manipulation by its introducing broker.”
The court, however, carefully declined to address the legal implications of “market manipulation itself” on the duty to disclose, confining itself to its factual conclusion that Bear Sterns did not directly engage in such manipulation. Underscoring the narrowness of the Second Circuit’s ruling, the New York district court refused to apply Levitt to a case where a defendant had made misleading statements, holding that the making of misleading statements constituted direct involvement. The same district court has also recently observed that the question of market manipulation remains open.
SEC Reminds Private Funds of Broker-Dealer Registration Requirements
[Editor’s Note: The following is an Arnold & Porter LLP Client Advisory, written by Robert E. Holton, Lily J. Lu, D. Grant Vingoe, and Lauren R. Bittman.]
SEC official reminds private funds, including contacts private equity funds, that certain fund-raising and marketing activities and fees for “investment banking activities” require broker-dealer registration.
On April 5, 2013, David Blass, Chief Counsel of the Division of Trading and Markets of the Securities and Exchange Commission (SEC), spoke before the Trading and Markets Subcommittee of the American Bar Association on broker-dealer registration issues that arise in the private funds context. In his remarks, Mr. Blass warned that acting as an unregistered broker-dealer is a violation of the Securities Exchange Act of 1934, as amended (the Exchange Act), and can have serious consequences, including sanctions by the SEC and rescission rights, even when no other wrong-doing is found. Mr. Blass also noted that the SEC staff has increased its attention to the issue of broker-dealer registration, and he reminded the audience that compliance by private fund advisers with the requirements of the Investment Advisers Act of 1940, as amended, is not enough. In light of the significant consequences of acting as an unregistered broker-dealer and the SEC staff’s increased attention to this issue and the private fund space in general, private fund advisers should review their fund-raising and marketing activities, policies and procedures and contracts and arrangements with portfolio companies and solicitors to ensure compliance.
Click here to read the entire Arnold & Porter Advisory.
Are All MOEs Created Equal?
[Editor’s Note: The following post is a Kirkland & Ellis M&A Update, authored by Daniel E.Wolf, Sarkis Jebejian, Joshua M. Zachariah, and David B. Feirstein.]
With valuations stabilizing and the M&A market heating up, a rebirth of stock-for-stock deals, after a long period of dominance for all-cash transactions, may bein the offing.
If this happens, we expect to see renewed use of the term “merger of equals” (MOE) to describe some of these all-equity combinations. As a starting point, it may be helpful to define what an MOE is and, equally important, what it isn’t. The term itself lacks legal significance or definition, with no requirements to qualify as an MOE and no specific rules and doctrines applicable as a result of the label. Rather, the designation is mostly about market perception (and attempts to shape that perception), with the intent of presenting the deal as a combination of two relatively equal enterprises rather than a takeover of one by the other. That said, MOEs generally share certain common characteristics. First, a significant percentage of the equity of the surviving company will be received by each party’s shareholders. Second, a low or no premium to the pre-announcement priceis paid to shareholders of the parties. Finally, there is some meaningful sharing or participation by both parties in “social” aspects of the surviving company.
While each of the aspects of an MOE deal will fall along a continuum of “equality” for the shareholders of each party, there are a handful of key issues that require special attention in an MOE transaction.
Click here to read the entire Kirkland & Ellis LLP publication, discussing Social Issues, Change of Control, Shareholder Vote/Fiduciary Issues, Consideration, and Agreements.