The Blog has now moved to http://joyesh.in/blog/

The SEC’s latest proposal to allow shareholders to solicit votes for their director candidates through corporate proxy statements has received quite a few comments urging it to be cautious in its approach. Some even question the desirability of any uniform mandatory proxy access rule.

In 2003 and 2007, the SEC proposed different rules to give shareholders greater access to a company’s annual proxy materials to nominate candidates for election as directors. As a response to the same, the investors and the state have taken steps to allow for proxy access and expanded shareholder influence in director elections.

The consensus that comes out is that the shareholder Proposed Bylaw Amendments in Corporate Proxy Materials while some have also recommended Higher Eligibility Criteria. There seems to be an acceptance towards an Amendment to Rule 14a-8 to allow shareholders to propose proxy access bylaws in a company’s proxy materials. This would provide time to test whether corporate and shareholder action would be sufficient to respond to investor concerns regarding greater proxy access.

Quite a few of the investors have recommended that the SEC postpone adopting a uniform mandatory proxy access rule until the corporate community and shareholders can respond to investor demands for greater proxy access. Some have raised concerns over the fact that it will be difficult or impossible to implement any newly adopted proxy access rules in time for the 2010 proxy season.

Focus Areas:

1. Opt Out

2. Ownership Threshold

3. Holding Period

4. Number of Nominees

5. Nominee Independence and Disclosure

Conclusion:

A number of fundamental issues with the mandatory uniform proxy access rule as proposed by the SEC has been brought forward. It is clear that the SEC ought to take cautious approach to the subject. A rushed refinement of the rule would likely lead to unintended consequences. Therefore, the SEC should defer adopting the same and allow corporations and the investors to respond to the concerns of the SEC.

Sources:

Comments on Proposed Rule: Facilitating Shareholder Director Nominations

Access to bidding for the PE Investors is a critical issue and will affect the attraction of capital for the banking industry. Taxpayer bailouts is also an important factor to be considered if capital infusion is hampered. What the policy document does not clarify is why the PE Investors have been singled out to pose “peculiar risks to insured depository institutions” and as to why have additional regulatory requirements been imposed upon them. It is now clear though that the PE Investors can access the bidding process in failed institutions  based on the investments’ financial merits.

Implications of the Statement:

1. Second-class status: The PE investors have been accorded a second-class status and in case they acquire more than a de minimis investment then the process will have to be capitalized at approx double the ratio of any strategic bidder.

2.  Confusion: Broad discretion has been granted to the FDIC to alter the terms and applicability of the Statement which makes it difficult to understand the rules for PE investors’ participation.

3. Forced Ventures: the FDIC is encouraging the PE investors to enter into partnerships and joint ventures. The FDIC in the past has also demonstrated that when it has been unable to arrange for the requisite capital it has encouraged transactions in the nature of structured investment vehicles or call on the PE Investors to enter into partnerships with the depositories.

4. Offshore access will be limited: The statement makes it difficult to attract offshore funds as it prohibits them from the bidding process if they are a domicile of the “secrecy law jurisdiction”.

5. Innovations: If the PE Investors are not effectively barred from such investments then it will definitely encourage new structures of investments.

Summary of the Statement:

1. Applicability: The statement applies to “Private Investors” that is acquired to facilitate bidding on a failed bank and would in turn acquire FDIC-insured deposits. No more clarification on the term has been provided for. The statement does not apply to, and “strongly encourages” partnerships and joint ventures among the PE investors and banks.

2. Capital Infusion: The PE Investors are mandated to maintain a minimum ratio of common equity to total assets of 10% for 3 years. This puts the PE Investors at a disadvantage considering that the a higher capital ratio is imposed on the PE Investors.

3. Cross Support Liability: In case PE investors hold more than 80% in a bank then they must pledge their stock in order to pay any losses suffered due to failure of the institution. Interestingly, the FDIC has not mentioned the types of investment instruments to which the 80% threshold applies.

4. Transactions with consorts: The statement prohibits extension of credit by a bank to any PE Investor in that institution covered by the Statement. Moreover, such investors must provide reports to the bank periodically.

5. Anti-Flipping: The PE Investors are prohibited from transferring their securities for 3 years without FDIC approval. The recipient must agree to be bound by the same conditions as applicable to its transferee. This does not apply to open-end mutual funds though.

6. Offshore Secrecy Law Jurisdiction: Domicile in a jurisdiction classified as  a “bank secrecy jurisdiction” renders the PE Investor ineligible for bidding.

7. Disclosures: The Statement mentions that the PE Investors may be notified to provide extensive information.

8. Bidder Eligibility: A PE Investor who holds 10% or more (directly or indirectly) of the total equity of a failed bank will be ineligible for bidding.

The Statement suffers from the interpretive and conceptual flaws. It does no mention what makes PE Investors different from the other non-controlling investors. Also, the Statement does not provide any analysis of the short-term cost or the presumption of a long term benefit.

It is apparent that the FDIC does not want to completely let loose the PE Investors but it may also be seen that the FDIC is encouraging joint ventures wherein, the PE Investors may reap better benefits.

References:

FDIC Board Approves Final Statement of Policy on the Acquisition of Failed Depository Institutions

Final Statement of Policy on Qualifications for Failed Bank Acquisitions

Interestingly, both the deals were a result of acquisition financings. The electricity distribution network, Electricity North West, previously owned by United Utilities was sold last year to North West Electricity Networks for £ 1.78 billion. Initially, the plan was to take a certain chunk of the debts out by way of structured financing in 2008 itself. It wouldn’t be hard to guess that the market conditions prevented this from happening even when Electricity North West was in a clear danger of being downgraded from a B+++ rating if the debt take-out did not take place. Improved market conditions seem to be a major contributor towards this deal and to add to the perils, the firm had been under pressure to reduce its acquisition leverage.

The uniqueness of the deal is in the fact that it is the first securitization of any electricity distribution utility and also a holding company. Accordingly, two debt programmes were created that accounted for a total of £500 million. The debt programmes are one at the level of opco while the other is at the level of holdco. The opco deal matures in 2021 worth £200 million and has been priced 240 basis points over gilts. The holdco deal matures in 2015 and was priced 375 basis points premium. By the way, both the deals have been rated B+++.

At this point one must compare the market conditions prevalent let’s say, in 2007. An A-rated utility would usually range between 90 – 100 basis points over gilts but now it would be somewhere around 200 basis points. One must also keep in mind the fall in the gilts since 2007.

The other product in the market is the Yorkshire Water deal. It is part of the £8 billion senior secured multicurrency MTN programme. 2007 saw the purchase of Yorkshire Water from the Kelda Group for £3 billion by a consortium. The deal involves a new investment of £650 million along with an exchange offer for the £1.5 billion outstanding bonds from the Yorkshire Water Services Finance into new A-rated bonds.

These deals have attracted a considerable amount of activity and interest even though the monolines (insurers) are nowhere in vogue in this sector. Long term push on maturities by the issuers might turn out to be nasty. The plus point of this sector is that there is regulated cash flow making it a very safe as well as attractive asset class for the investors looking to get back into action.

The Yorkshire Water deal is on the lines of a whole-business securitization model that have been brought to effect in earlier times as well which means that the investors are accustomed to such structures. On the other hand, the Electricity North West is a new structure. The opco tranche has a vanilla structure but has also included a leverage covenant for the sake of the investors. And, the holdco tranche provides the ratings and has therefore included many investor protections.

One must understand that these deals have been backed by secured cash-flows from regulated assets, something which not many investors are comfortable with.

Directive for Alternative Investment Fund: — Cause and Effect

The European Commission has proposed a Directive for Alternative Investment Fund that was published in May 2009. Drawing a lot of criticism, it may be presumed that lobbyists will be working overtime for some amendments. Apparently, there have been some ill-founded fears in the industry considering the fact that some investors are wary of investing in non-EU domicile funds under the mistaken belief that those funds would be forced out when the Directive for AIMF is implemented.

The Directive for AIMF is all about transparency and Fund Manager’s liabilities. Accordingly, for any alternative investment fund manager with assets under € 100m shall mandatorily be required to take authorisation from their home member state. The directive not only covers the funds but also funds of funds. The UK already has a system of this kind in place wherein these managers are required to take proper authorisation from the Financial Services Authority (FSA). There should not be any major change in which the fund managers operate in the UK as a result of the Directive for AIMF.

The matters on which these fund managers shall be required to report to their respective regulators include risk profile, short-selling position and exposures. As a consequence of the Directive, these fund managers will be required to provide all such relevant information not only previous to the investment but on a regular basis post-investment.

The Directive also mandates that the managers must put into place measures or policies to mitigate risk and to prevent conflict of interest. Liquidity management and stress testing are also important aspects covered by the Directive.

The USA has also been working on the lines of stricter disclosure policies and regulations for the hedge funds. Proposals have been brought forward which require the hedge funds to register as investment advisers with the SEC and such advisers are anyways, subject to the disclosure regulations. In the light of the concern of the investors for increased transparency and disclosures, the move of the regulators seem address this concern.

UCITS:

Another way of going about the investor concerns and fears is to adopt the model of UCITS. This is so because the UCITS model has a higher degree of transparency and disclosure regulations. This has helped mitigate investor concerns. Accordingly, it is preferable to structure the strategies within the UCITS-model.

It must be kept in mind that the UCITS model requires a certain amount of restrictions which the hedge fund manager must be comfortable with. With a careful thought given to it, a variety of hedge fund strategies may be incorporated within the UCITS framework. The new UCITS III permits a portfolio of derivatives too that include swaps and contracts for difference.

The major challenge or concern for a hedge fund manager to structure his product on the UCITS framework would be ensuring the compliance to the disclosure regulations and the liquidity requirements. The directors of the UCITS are responsible for ensuring the maintenance of liquidity standards.

The investors perceive the UCITS-structured products to be more liquid and transparent and are therefore more open to investment in this pattern. To add to it, the regulatory requirement standards are set to a high which means more investor resilience.

Another important factor to be kept in mind by both fund managers and the regulators is to device mechanisms to protect client’s assets. One of the means of doing so is to deal with a third party custodian bank. The prevalent practice had been to deal with only one third-party custodian bank but with the diversification of the funds and the increasing complexities lead to a practice of dealing with multiple third-party custodians.

In the light of the Lehman Brothers debacle and the ongoing economic downturn, it is pertinent to maintain liquidity with the funds. As a result the hedge funds have started maintaining their independent liquidity policies which seems like a positive step to mitigate risks.

Point must be noted that the UK insolvency laws have turned out to be inadequate in the sense that they treat the creditors as one unit while in the USA, the creditors are treats as customers which provides for a better relief and security to the assets.

A lot of strategic changes are being brought about in the hedge funds given the evolving landscape of regulatory regime. It would be interesting to note how the hedge funds evolve and regain investor confidence.

This rule, Rule 204, that came into effect from the 31st of July, 2009 has the following requirements:

· FTD that may arise out of short selling: The participants have to closeout their FTD positions which may have resulted from short sales either by buying or by purchasing the securities not any later than the beginning of the trading hours of the next day to the regular settlement date, that is, T+4.

· FTDs created as a result of Long Sales: The same regulation exists as mentioned earlier except for the relaxation that a three day extension is provided beyond the settlement date, that is, T+6.

· Borrowing requirements: If the participant is not in a position to abide by the above mentioned requirements, the participant is required to settle the FTD position by purchasing security else the participant shall not be able to effect any further short sales.

· Extension on “Owned Securities”: Let us say that the FTD position was generated by the sale of security that the person is deemed to own then the participant shall not be required to close-out any such FTD position till the end of 35 days after which the trade was made.

The SEC has made a statement to the effect that they shall not be renewing the current regulations in terms of reporting short sales on a weekly basis. As a result, these requirements shall have no effect from August 1, 2009.

Alternatively, the SEC has mentioned that Self-Regulatory Organizations shall publish the relevant short sale information.

Some of the information include the aggregate short selling, individual short sales transactions but the identity of the person who will effect short-sale shall not be revealed.

The SEC is also organizing a round-table in September which will discuss about how to increase transparency and also matters related to “enhanced locate” and compensation arrangements.

What has the SEC effectively done?

Will the close-out requirement reduce FTDs?

The objective of the SEC behind making Rule 204 permanent is to reduce FTDs.

No extension on the close-out: In the cloud of various voices being raised to provide for an extension on making a close-out, the SEC has chosen to ignore them. The provisions remain the same as they were in the temporary provision.

Credit-worthiness of a short sale may attract a more liberal approach from the SEC. But it is necessary to demonstrate that the purchase was bonafide and also that the quantity of purchase would cover the entire amount of the FTD rendering it a net flat position.

Penalty-Box: The concept of a penalty box simply put, means, that the participant shall not be able to effect any more or further short sales in that particular security unless the FTD position is closed either by way of purchasing or borrowing the security.

The SEC has categorically mentioned that the only means of exiting the penalty box if to close-out the FTD positions.

Rolling of the FTD position: Rolling the FTD position basically means to enter into an agreement with another person to purchase securities. The SEC deprecates such a practice and has accordingly disallowed the same.

By the way, Rule 204 applies only to equity securities.

This might strike as a reminder that the federal anti-trust agencies are continuing to enforce and implement Section 8 of the Clayton Act that prohibits any individual from serving on the Board of Director or as an officer of two or more corporations that are competitor, under certain circumstances. Accordingly, private plaintiffs may institute an action under section 8 of the Clayton Act for not only an injunctive relief but also press for damages. It is interesting to note that as of yet no court has awarded damages in a private suit under section 8 of the Act.

The FTC investigation of Apple and Google was announced in May 2009. Since then, a growth in the competition has been observed between Apple and Google in certain filed of operation namely, mobile phone applications, browsers and operating systems.

A press release from the Apple CEO Steve Jobs states “as Google enters more of Apple’s core businesses, with Android and now Chrome OS, Eric’s effectiveness as an Apple Board member will be significantly diminished, since he will have to recuse himself from even larger portions of our meetings due to potential conflicts of interest. Therefore, we have mutually decided that now is the right time for Eric to resign his position on Apple’s Board.”

FTC has praised this move though. In another press release the FTC Competition Bureau Director Richard Feinstein stated that the FTC has been “investigating the Google/Apple interlocking directorates issue for some time and commends them for recognizing that sharing directors raises competitive issues, as Google and Apple increasingly compete with each other.”

Well, it seems that the resignation of Schmidt from Apple’s board was now enough. The FTC has announced in a press release that it “will continue to investigate remaining interlocking directorates between the companies”. The use of “remaining interlocking directorates” might be in reference to the fact that Levinson continues to serve on the boards of both Apple and Google. Though it appears that the FTC is not intent at continuing the investigation against Schmidt, it does not mean that the case loses its legal value. Reference may be made to the case of U.S. v. W.T. Grant Co. (1953 case) for the same.

It must be kept in mind that Section 8 investigations may appear with little warning as may be observed from the Apple-Google investigation. This happens when corporations that were not competitors previously enter into a market where they become competitors. Also, it must be noted that a Section 8 issue may arise in cases of merger or acquisition as in when an acquirer enters into/absorbs a new area of business, or let us say, when a private equity fund acquires a corporation and therefore has representations on the boards of two rival companies.

Section 8 has a wider reach – much beyond situations involving individuals serving the boards of two competing corporations (direct interlocks), and may include what is generally referred to as “indirect interlocks” where different individuals serve the boards of competing corporations but are in effect agents to the same individual.

I would like to draw attention to Section 5 of the FTC Act wherein even if the technical requirements of Section 8 of the Clayton Act are not satisfied, the FTC may challenge the interlock using this other provision.

1. The statute contains a one-year “safe-harbour” provision to cover all such situations where a competitive overlap id created once a particular director is appointed.

2. The statute contains provides for an annually adjusted de minimis provision for overlapping “competitive sales” that may be below a specified marker.

Well, looking at the bright side, it must be applauded that the federal anti-trust agencies have stepped up enforcement considering the rarity of the invocation of Section 8 investigation.

Resources:
IOSCO – Regulation of short selling: final report (June 2009)
CESR – Proposal for a pan-European short selling disclosure regime: consultation paper (July 2009)
UK Government – Reforming financial markets: white paper (July 2009)
FSA – Short selling: discussion paper DP09/01 (February 2009)

hope you all like it and please leave comments.