The announcements were made in conjunction with the American Bar Association’s 39th National Institute on White Collar Crime in early March, in which senior DOJ leaders reaffirmed the department’s focus on corporate responsibility and provided updates on existing initiatives pursuant to its ongoing corporate enforcement efforts.
The basic elements of DOJ’s new whistleblower rewards program are derived from the department’s 2022 series of initiatives aimed at fortifying its overall corporate enforcement approach. The enhancement of corporate compliance through the implementation of financial incentives and disincentives has remained a consistent focal point for DOJ in retooling its policies. In a speech on March 7, Deputy Attorney General (DAG) Lisa Monaco introduced plans for a new incentive program intended to strengthen corporate enforcement efforts through monetary rewards.
In her introduction, the DAG referenced the historical use of whistleblower programs at the federal law enforcement level (e.g., Securities and Exchange Commission and Commodity Futures Trading Commission programs authorized under Dodd-Frank as well as similar programs implemented by the Internal Revenue Service and the Financial Crimes Enforcement Network). Monaco noted, however, that such programs only cover misconduct within their agencies’ jurisdictions. She also noted that qui tam actions, which offer their own whistleblowing incentives, are only available for fraud against the government (e.g., allegations of False Claims Act violations).
DOJ’s new whistleblower program is thus intended to fill the gaps within the patchwork of existing whistleblower programs. DOJ’s objective is to expand use of this tool and the government’s net in corporate misconduct cases. Virtually any aspect of corporate business that may not have fit within an existing federal whistleblower incentive program may now become a target for tipsters interested in a financial stake in the enforcement outcome. Monaco went so far as to reference going back to the days of “Wanted” posters across the Old West.
DOJ’s new whistleblower rewards plan will start with “a 90-day sprint to develop and implement a pilot program” with a formal start date to be announced later this year. In addition, there are some important limits to the new program. In particular, it would offer payments resulting from government forfeiture actions:
The primary areas of focus for the new whistleblower program will include (i) criminal abuses of the U.S. financial system; (ii) foreign corruption cases outside the jurisdiction of the Securities and Exchange Commission; and (iii) domestic corruption cases, especially involving illegal corporate payments to government officials. Examples offered by DOJ included a company paying bribes in exchange for regulatory approvals and “doctoring the books” to conceal those, as well as a chief financial officer forging loan documents.
The second new initiative arises from rapidly emerging technology and DOJ concerns with the potential for artificial intelligence (AI) to be used by criminals to “supercharge their illegal activities, including corporate crime.”
Monaco noted that while the department is alert to the risks of AI, the core criminal activity remains the same (e.g., “fraud using AI is still fraud; price fixing using AI is still price fixing; manipulating markets using AI is still market manipulation”). She did, however, advise that DOJ will be using its tools in new ways to address AI-enhanced corporate crime. Prosecutors will seek sentencing enhancements “where AI is deliberately misused to make a white-collar crime significantly more serious” – for both individual and corporate defendants.
The DOJ’s new AI focus may have a more practical and immediate impact on an organization’s corporate compliance program. According to Monaco, any future DOJ review of an organization’s compliance program will include the government’s assessment of how well the program manages AI-related risks as part of its overall compliance efforts.
More broadly, DOJ’s Criminal Division has been directed to incorporate the assessment of disruptive technology risks (including risks associated with AI) into its guidance on Evaluation of Corporate Compliance Programs (ECCP). This guidance is frequently considered by corporations as they review and refine their existing compliance program documents.
DOJ’s focus on AI will be supported by a new initiative – “Justice AI” – “a series of convenings with stakeholders across industry, academia, law enforcement, and civil society to address the impacts of AI.” Nevertheless, as of this writing the scope of what DOJ might consider as constituting “AI-related risks” is vague. Whether the revised ECCP will offer more specifics is unclear.
These two new initiatives, as well as related DOJ messaging on its existing corporate fraud enforcement efforts, will for several reasons likely have a notable impact on leadership’s Caremark-related responsibilities to monitor the compliance risks of an organization.
First and foremost, the initiatives are a reminder of DOJ’s continuing commitment to corporate fraud enforcement and especially of is commitments to individual accountability. Among all the strategic and tactical challenges facing a company, the importance attributed to corporate responsibility is a constant. This may affect the board’s allocation of resources to the compliance function and its expectation of coordination between legal, compliance, and executive compensation functions.
Second, officers and directors will be called on to adjust the corporate compliance program to address an entirely new regime of risks arising from potential whistleblowers who are focused on indications of corporate fraud. Internal controls with respect to potential fraud must be sharpened, and overt efforts to demonstrate “tone at the top” should be increased to convince potential whistleblowers of the organization’s commitment to effective compliance. In addition, 24 Hour “hotline” reporting systems should be improved and anti-whistleblower retaliation protections enhanced.
Third, leadership should request a significant increase in the level of coordination between those responsible for internal direction of the company’s AI efforts and appropriate compliance and risk management executives. Until DOJ more clearly defines “disruptive technology risks,” this coordination should extend not only to the known risks and harms that can arise from AI and related technology, but also to the ways in which AI can be used to facilitate corporate fraud. Without further guidance from DOJ, this could require significant time and resources from the company.
Leadership may also anticipate resistance in effecting such coordination from technology officers who may not appreciate the importance of addressing corporate compliance concerns.
The chief legal officer, teaming with the chief compliance officer and chief technology officer, can be particularly valuable advisers to the board in this regard.
This post comes of us from Michael W. Peregrine and Ashley C. Hoff at the law firm of McDermott, Will & Emery LLP.
]]>Among other requirements, the Proposed Rule would require RIAs and ERAs to (1) develop and implement anti-money laundering compliance programs (within 12 months after the effective date of a final rule) and (2) monitor for and report suspicious activity to FinCEN. FinCEN proposes to delegate its authority for examining compliance with the Proposed Rule’s requirements—on which FinCEN has solicited comments through April 15, 2024—to the SEC.
The Bank Secrecy Act (“BSA”), as amended by the USA PATRIOT Act (“PATRIOT Act”), requires “financial institutions” to establish and maintain anti-money laundering compliance programs, which at minimum must include: the development of internal policies, procedures, and controls; designation of a compliance officer; an ongoing employee training program; an independent testing function; and procedures for conducting ongoing customer due diligence. Currently, the definition of “financial institution” encompasses several categories of financial businesses, including banks, broker-dealers, and mutual funds. However, the definition does not cover RIAs or ERAs. As a result, RIAs and ERAs generally have been exempt from most affirmative anti-money laundering requirements under U.S. law.
In 2015, FinCEN published a similar proposal that would have extended affirmative anti-money laundering program requirements to certain investment advisers. The 2015 proposal was never finalized, however, and now has been formally withdrawn by FinCEN concurrent with issuance of the Proposed Rule.
The Proposed Rule would amend the BSA implementing regulations to add certain “investment advisers” (i.e., RIAs and ERAs) to the definition of “financial institution.” This, in turn, would extend certain due diligence, recordkeeping, and reporting obligations to RIAs and ERAs for the first time, as discussed in greater detail below.
The Proposed Rule would require RIAs and ERAs to adopt a written anti-money laundering compliance program, to include the following minimum requirements:
FinCEN acknowledges that the anti-money laundering compliance program requirement would be risk-based, as opposed to a one-size-fits-all requirement. RIAs and ERAs would have flexibility to tailor their programs to the specific risks associated with their businesses, subject to the minimum requirements discussed above. The Proposed Rule would require that each RIA’s and ERA’s anti-money laundering program be approved in writing by its board of directors or trustees (or, alternatively, by its sole proprietor, general partner, trustee, or other persons that have functions like a board of directors).
While aspects of an RIA’s or ERA’s anti-money laundering program may be delegated to third parties, the RIA or ERA would remain fully responsible and legally liable for the program. When delegating to a third party, the RIA or ERA would need to ensure that (1) the program complies with the minimum requirements discussed above and (2) FinCEN and the SEC are able to obtain information and records relating to the program.
Under the Proposed Rule, RIAs and ERAs would be required to develop and implement an anti-money laundering compliance program within 12 months of the effective date of a final implementing rule.
Importantly, the Proposed Rule would not require RIAs and ERAs to:
On the former, the Proposed Rule states that FinCEN expects to address customer identification and verification in a future joint rulemaking with the SEC. FinCEN contemplates that the latter will be addressed through a forthcoming revision to the Customer Due Diligence (“CDD”) Rule, pursuant to the Corporate Transparency Act, which is expected by January 1, 2025.
The Proposed Rule would introduce a suspicious activity reporting requirement for RIAs and ERAs. Under the Proposed Rule, a transaction attempted by, at, or through an RIA or ERA would be subject to reporting if:
In addition, the Proposed Rule would encourage—but not require—the voluntary reporting of other suspicious transactions, such as those that do not meet the $5,000 threshold.
The Proposed Rule would require RIAs and ERAs to comply with the Recordkeeping and Travel Rules, which require financial institutions to create and retain records for transmittals of funds and ensure that certain information relating to the transmittal of funds “travels” with the transmittal to the next financial institution in the payment chain. FinCEN acknowledges, however, that RIAs and ERAs operate varying business models, and they may not engage in transactions within the scope of these Rules’ requirements.
The Proposed Rule would subject RIAs and ERAs to FinCEN’s rules implementing the special information-sharing procedures of Section 314 of the PATRIOT Act. These provisions would require an RIA or ERA, upon request from FinCEN, to expeditiously search its records to determine whether the RIA or ERA maintains any account for, or has engaged in any transaction with, a party named in FinCEN’s request. RIAs and ERAs also would be able to participate in voluntary information sharing arrangements with other financial institutions, which would enable broader understanding of customer risk and inform potential suspicious activity reports.
Inclusion of RIAs and ERAs in the definition of financial institution would subject these advisers to additional requirements under the following sections of the PATRIOT Act:
The Proposed Rule is an initial step toward requiring RIAs and ERAs to comply with the anti-money laundering requirements applicable to other financial institutions. The Proposed Rule will be subject to public comment prior to finalization, followed by future rulemaking that likely would extend CIP and CDD requirements to RIAs and ERAs.
This post comes to us from Ropes & Gray LLP. It is based the firm’s memorandum, “FinCEN Proposes (New) Rule to Extend Anti-Money Laundering Requirements to Registered Investment Advisers (RIAs) and Exempt Reporting Advisers (ERAs),” dated February 13, 2024, and available here.
]]>We develop a model in which shareholders appoint the board of directors and design the directors’ compensation contract. Board composition determines whether the board is friendly or aggressive. For instance, a board that is dominated by debtholders or by former regulators or academics, who may be concerned mostly with their reputational capital, tends to be aggressive; a board dominated by directors with close social ties to the CEO tends to be friendly. The board can learn about the environment in two ways: by gathering information (e.g., combing through binders containing detailed business unit data ahead of a board meeting) and by direct communication with the CEO.
When nominating the board, the shareholders face a trade-off. On one hand, holding constant the board’s information, shareholders would best be served by an unbiased board. On the other hand, a biased board may yield informational benefits: an aggressive board has strong incentives to acquire information, whereas a friendly board communicate more effectively with the CEO. We study how shareholders should optimally navigate this tradeoff, depending on the specifics of the setting.
We show that whether the board should be biased – and if so, in what direction – ultimately depends on how well informed the CEO is. If the CEO is well informed, then the optimal board bias is weakly friendly, which allows the board to emphasize communication with such a CEO. By contrast, if the CEO is less well informed, then the optimal board bias is weakly antagonistic, which encourages the board to obtain information.
The tradeoff guiding the optimal equity stake for the board is between strengthening directors’ information gathering incentives and shareholder equity dilution. In general, our model predicts a positive relation between the severity of agency problems (empire building) on the part of management and the board’s equity stake.
Aside from assembling a friendly board, another way for shareholders to foster communication between the CEO and the board is by granting the CEO more equity, which mitigates the CEO’s empire building tendency. We show that these two options are often used in tandem: When shareholders want to foster communication between a board and a CEO, they typically choose a friendly board and grant the CEO a generous equity package. Prior literature has often viewed the positive association between board friendliness and CEO pay packages as a symptom of rent extraction by management. In contrast, our results provide an optimal contracting rationale for this situation.
Our model generates a number of predictions. First, we predict (weakly) friendly boards to be associated with CEOs who have a significant information advantage at the outset. Conversely, for CEOs with a limited information advantage, we predict (weakly) antagonistic boards. Interpreting the quality of the CEO’s information as a facet of CEO quality, this prediction is broadly in line with the empirical studies that have shown friendly boards to be associated with successful CEOs. Another way to interpret our result is by using CEO tenure as a proxy for informational advantage. The prediction of a positive relation between CEO tenure and board friendliness aligns well with empirical evidence. Second, our model predicts that the lower their cost of acquiring information, the less friendly boards will be.
A broader lesson from our paper is that interpreting a pay package as either optimal or excessive cannot be separated from the underlying incentive problem. Incentive pay not only encourages productive actions but also affects the incentives for managers and directors to share information. While higher CEO pay offered by friendly boards is commonly interpreted as a symptom of managerial rent extraction, our model provides an optimal contracting rationale. Our results highlight the importance of considering contracting frictions beyond hidden effort, especially when fostering communication among key decision-makers within the organization is crucial.
This post comes to us from professors Tim Baldenius at Columbia Business School, Xiaojing Meng at New York University, and Lin Qiu at Purdue University. It is based on their recent article, “Biased Boards,” available here.
]]>The Proposal is one of a series of recent efforts to revisit and modify bank merger standards, beginning with President Biden’s Executive Order on Promoting Competition in the American Economy in July 2021, a statement in a speech in June 2023 by Assistant Attorney General Jonathan Kanter that the Department of Justice (DOJ) would be reassessing the prevailing approach to bank merger enforcement, and a notice of proposed rulemaking in January 2024 from the Office of the Comptroller of the Currency (OCC) on its own approach to evaluating BMA applications. The Federal Reserve has, notably, been silent.
Far from representing a coordinated, interagency approach to a federal statute (the BMA) that provides for a single set of standards and criteria for acting on a bank merger application, each of these efforts reflects the different views of each agency as to how bank merger transactions should be evaluated. This fragmented approach, especially in the absence of any finalized bank merger guidelines from the DOJ in consultation with the federal banking agencies, will likely contribute to the continued uncertain outlook for bank M&A transactions and may also lead to an increased focus on choices of acquisition structures and bank charters.
Our key takeaways are below. Beyond these key takeaways, for the reasons noted below, the details of the Proposal are worth the attention of any party considering a larger transaction in the banking sector.
Comments on the Proposal will be due 60 days after publication in the Federal Register.
Although the FDIC’s jurisdiction for bank-to-bank M&A is limited to transactions in which the FDIC is the acquiring bank’s primary federal regulator, as well as all merger or consolidation transactions between any IDI of any size and an uninsured institution, the Proposal is relevant to all near-term large bank M&A. In particular, the Proposal’s discussion of how the FDIC would evaluate the competition aspects of a proposed transaction is similar to the way in which the DOJ has indicated it would do so (in the form of Assistant Attorney General Kanter’s June 2023 speech). For example, both the DOJ and the FDIC Proposal are poised to lessen emphasis on local deposit market share and, instead, focus on a wider range of metrics. The DOJ said that these factors may include fees, interest rates, branch locations, product variety, network effects, interoperability and customer service. The Proposal notes that the FDIC would: evaluate “both geographic and product markets”; “may consider concentrations in any specific products or customer segments”; and may consider “additional methods of assessing the competitive nature of markets,” such as “information on the pricing of products and services to assess the competitive effects of a proposed merger when practicable and relevant.”
Because the DOJ’s contemplated approach and the FDIC’s Proposal share intellectual provenance, and because the DOJ has separate authority to review and challenge a proposed merger, the FDIC’s Proposal provides a window into how the DOJ may approach any revisions to both its bank merger guidelines and its own analysis of any bank merger, particularly large bank M&A transactions. We therefore believe the FDIC Proposal and DOJ’s intended approach need to be read together to evaluate any near-term large bank M&A. Moreover, as discussed below, the FDIC’s broad approach to the application of the BMA to transactions with uninsured institutions makes the Proposal relevant to a wider range of deals than just bank-to-bank M&A.
Although the preamble states that the Proposal “clarifies” the FDIC’s jurisdiction to review transactions under the BMA, the Proposal makes transparent the FDIC’s very broad interpretation of its authority to review transactions between an insured depository institution (IDI) and a non-insured entity under the BMA. The Proposal notes that this broad jurisdiction reflects “clear congressional intent for the FDIC to review a wide array of transactions between IDIs and non-insured entities that have the potential to affect the safety and soundness of a resultant IDI or increase the potential liability of the Deposit Insurance Fund.”
The BMA requires FDIC approval where the acquiring or resulting bank in a merger transaction between two IDIs is a state non-member bank, as well as where any IDI merges with a non-insured entity, assumes liability to pay any deposits made in—or similar liabilities of—a non-insured entity, or transfers assets to any non-insured entity in consideration of the assumption of liabilities for any portion of the deposits made in the IDI. The Proposal emphasizes the FDIC’s expansive interpretation of what constitutes a merger or assumption of deposits requiring review.
As the FDIC itself clearly articulates in the Proposal: “In all cases, the FDIC will evaluate the substance of all of the facts and circumstances of the transaction and any related transactions, identify which aspects of the transaction(s) are subject to FDIC approval, and fully evaluate the statutory factors applicable to each transaction” (emphasis added). The underlined text is consistent with our own experience with the FDIC in recent years, in which the FDIC takes the position that, in order for the FDIC even to determine whether a BMA application is necessary, a BMA application must be filed.
The Proposal reflects a more expansive assertion of authority than the FDIC’s existing 2008 statement of policy, which states that “[t]ransactions that do not involve a transfer of deposit liabilities typically do not require prior FDIC approval under the [BMA], unless the transaction involves the acquisition of all or substantially all of an institution’s assets.” The FDIC’s more expansive view of its jurisdiction is evidenced in several instances, such as:
The Proposal notes that “transactions that result in a large IDI (e.g., in excess of $100 billion) are more likely to present potential financial stability concerns with respect to substitute providers, interconnectedness, complexity, and cross border activities, and will be subject to added scrutiny.”
Although the Proposal states that “the FDIC will not view the size of the entities involved in a proposed merger transaction as a sole basis for determining the risk to the U.S. banking or financial system’s stability,” in practice it seems obvious that the FDIC’s intention is to make it more difficult for transactions involving or resulting in an IDI with more than $100 billion in total consolidated assets to be approved. In case anyone missed the point, Consumer Financial Protection Bureau (CFPB) Director and FDIC Board member Rohit Chopra stated in prepared remarks: “By codifying this [$100 billion threshold], boards of directors and management at large firms can understand that the likelihood of approval of megamergers will be low.”
The FDIC declined to adopt thresholds for when a resolution plan or single-point-of-entry resolution strategy would be required from a large newly merged IDI. At the same time, it appears clear that an enhanced resolution plan strategy may be required for the approval of larger transactions. The preamble clearly states the FDIC’s view that “regardless of the strategy selected, the challenges associated with resolving a large bank would be significant, both operationally and financially,” and specifically identifies “potential resolution impediments,” including the resulting IDI’s organizational structure and the “necessity and difficulty of: (i) continuing the IDI’s operations and activities until they can be sold or wound down, (ii) marketing and selling key business lines and asset portfolios at the least cost to the DIF [Deposit Insurance Fund], and (iii) separating business lines and other assets to enable their sale or other disposition.” The inability of the FDIC to execute these same three resolution options due to the IDI’s organizational and funding structure are repeated in the Proposal itself as potentially precluding a favorable finding on the financial stability factor of complexity.
The preamble also notes that staff from the FDIC’s Division of Resolutions and Receiverships and, potentially, the Division of Complex Institution Supervision and Resolution will assist in reviewing proposed larger transactions. In doing so, the FDIC “could consider the presence of support agreements from the resulting IDI’s ultimate parent company, strengthened risk governance procedures, and capital maintenance requirements for the IDI.” These concepts all come from U.S. global systemically important bank resolution planning practices and very well may become a prerequisite to the approval of any larger bank M&A.
The Proposal notes that the FDIC generally would consider it is in the public interest to hold a hearing for merger applications resulting in an IDI with greater than $50 billion in assets or for which a significant number of Community Reinvestment Act protests are received. The Proposal does not provide further detail on what will constitute a significant number that merits a hearing.
In addition, the FDIC notes that the agency would consider the views of relevant state and federal regulators regarding the ability of the applicant to meet the convenience and needs of the community to be served. In his speech on the same day the Proposal was released, CFPB Director Chopra was somewhat more pointed, stating that the FDIC “will carefully evaluate the banks’ compliance records, especially with respect to consumer law. The agency will consult with the relevant state and federal authorities, including the CFPB. Repeat offenders of consumer protection and fair dealing laws will face a steep climb to satisfy this factor.”
The Proposal indicates a clear intention on the part of the FDIC to take a broad approach to assessing the competitive effects of any bank merger transaction. The Proposal generally acknowledges the reality of greater competition in the provision of banking and related financial services. For example, the FDIC will consider “all relevant market participants,” including “any other financial service providers that the FDIC views as competitive with the merging entities, including providers located outside the geographic market when it is evident that such providers materially influence the market.” The FDIC will also identify all relevant geographic markets based both on where the merging entities operate and where customers “may practically turn to competitors for alternative products and services.”
On the other hand, the FDIC states that it will use deposits as an “initial proxy for commercial banking products and services” and will “initially” measure the respective shares of total deposits held by the merging entities and various other participants with offices in the geographic market, confirming that the traditional measure of deposit concentrations based on the presence of offices in geographic markets, as measured by the Herfindahl-Hirschman Index (HHI), will continue to be an important metric. The Proposal does not, however, signal the adoption of any new HHI threshold as part of the FDIC’s competitive analysis.
The Proposal also reflects the FDIC’s intention to consider concentrations in products or services that go beyond and are narrower than deposits, including “concentrations in any specific products or customer segments” (emphasis added), such as small business or residential lending or “activities requiring specialized expertise.” The Proposal specifies that the FDIC’s analysis may incorporate other products offered by the merging entities based on whether consumers retain meaningful choices, and will also consider both the emergence of new competitors for products or services in relevant markets, as well as the expansion of products and services offered by the merging entities and other market participants.
The Proposal states the FDIC may require divestitures to mitigate competitive concerns before allowing the transaction to be consummated and generally will not permit any non-compete agreements with any employee of the divested entity. At the FDIC’s open meeting on the Proposal, FDIC staff stated that the reason for the requirement is to minimize the risk that divestiture, as a remedy for the competitive concerns, will be ineffective.
In his statement on the Proposal, Vice Chairman Travis Hill noted his concern that “[r]equiring divestitures in advance of the merger may add significant delays to the merger process [while] failing to successfully divest post-merger is extremely rare, and the FDIC has other supervisory tools to address such a concern.” Vice Chairman Hill also stated that prohibiting non-compete agreements with the employees of a divested entity is a “policy which seems far outside the FDIC’s jurisdiction and expertise.”
The Proposal states that “[t]he FDIC expects that a merger between IDIs will enable the resulting IDI to better meet the convenience and the needs of the community to be served than would occur absent the merger” (emphasis in original). In other words, unless the merger results in an improvement in the resulting IDI’s ability to meet the convenience and needs of the community to be served compared to the IDI’s current ability without the merger, the FDIC’s expectation for approval on this factor would not be met. The “better than current” standard appears to be an expansion of the statutory mandate to assess an institution’s record of meeting the credit needs of its community and evaluating that record. The preamble to the Proposal lists specific metrics that would satisfy this standard: “higher lending limits, greater access to existing products and services, introduction of new or expanded products or services, reduced prices and fees, increased convenience in utilizing the credit and banking services and facilities of the resulting IDI, or other means.” The FDIC’s expectation of increases in some of these metrics will need to be balanced with the potential impact of purchase accounting principles, which may result in reduced values of loans or other assets or increased expected credit losses.
In order to meet this burden, “[t]he FDIC expects applicants to provide specific and forward-looking information to enable the FDIC to evaluate the expected benefits of the merger on the convenience and needs of the community to be served.” This specific information is expected to include a three-year plan for all projected or anticipated branch expansion, closings or consolidations following the closing of the merger, “including the timing of each closure, the effect on the availability of products and services, particularly to low- or moderate-income individuals or designated areas, any job losses or lost job opportunities from branching changes, and the broader effects on the convenience and needs of the community to be served.” In addition, “claims and commitments made to the FDIC to support the FDIC’s evaluation of the expected benefits of the merger may be included in the Order [approving a transaction], and the FDIC’s ongoing supervisory efforts will evaluate the IDI’s adherence with any such claims and commitments.”
The dissenting FDIC Directors offered several criticisms of the Proposal’s approach to reviewing the convenience and needs factor. Vice Chairman Hill characterized this as “imposing an affirmative burden on applicants to ‘demonstrate how the transaction will benefit the public’” and noted that “[b]urden-shifting can make a big difference for a legal regime.” In his statement on the Proposal, Director Jonathan McKernan similarly questioned whether there was a legal basis for the “new expectation . . . that the post-merger bank do ‘better’ on the convenience and needs factor.”
Vice Chairman Hill also pushed back on the Proposal’s focus on proposed branch closures because “we should avoid presuming that more branch presence is always in the best interest of the community to be served … [because of] the tradeoffs between benefits such as more in-person service and higher costs that are passed on to customers.” Director McKernan expressed a similar concern as to whether the FDIC “legally may consider ‘any job losses or lost job opportunities’ from branching changes” (emphasis in original). Finally, Vice Chairman Hill noted his skepticism that “it is the FDIC’s role to ‘closely evaluate[]’ whom the resulting entity chooses to employ.”
The Proposal would require BMA applicants to provide more detailed information as part of their applications, whether to meet the requirement of a “substantially complete” application or to enable the FDIC to assess one or more of the statutory factors, than the FDIC has generally required in the past. While these categories of information may have been included in past applications, either on the initiative of the applicant or pursuant to additional information requests from the FDIC, the Proposal indicates a clear expectation on the part of the FDIC to receive this information in all BMA applications to the extent relevant. For example:
In the preamble to the Proposal, the FDIC states that it is seeking comment on proposed revisions to its supplement to the Interagency BMA application form. Although these proposed revisions have not yet been published, we expect them to include the information requirements described above and to be published concurrently with the Proposal in the Federal Register. CFPB Director Chopra suggested in his prepared remarks that the revisions may adopt certain items from the Hart-Scott-Rodino Act premerger notifications, such as requiring “production of the analyses of the deal conducted for the banks’ directors and officers, either internally or by third-party investment bankers or consultants” because these deliberations “are critical to understand deal rationale and may reveal anticompetitive intent.”
The Proposal states that although the FDIC will approve applications subject to standard and non-standard conditions, which may include higher capital requirements or written agreements addressing capital maintenance requirements, liquidity or funding support, affiliate transactions or “other relevant provisions,” it will not use conditions as a means for favorably resolving any statutory factors that otherwise present material concerns. In his statement on the Proposal, OCC Comptroller and FDIC Board member Michael J. Hsu agreed generally with the FDIC’s approach to conditions, but also stated his view that, “[a]t the same time, in some instances targeted conditions can mitigate specific risks from a proposed merger transaction. These should be considered when they will be effective and where appropriate.”
As part of the managerial resources factor, the Proposal notes that the FDIC expects management to have sufficient managerial and operational capacity to integrate the acquired entity, including with respect to: “human capital; products and services; operating systems, policies and procedures; internal controls and audit coverage; physical locations; information technology; and risk management programs.” As a result, up-front evidence to the FDIC of the applicant’s record in integrating prior acquisitions and its integration planning for the merger covered by the application will become more important during the application process.
The Proposal states that “[i]f an applicant withdraws their filing, the FDIC Board of Directors may release a statement regarding the concerns with the transaction if such a statement is considered to be in the public interest for purposes of creating transparency for the public and future applicants.” This is a departure from current practice where an applicant may choose to withdraw an application to avoid a public denial, even though the fact of a withdrawal is publicly disclosed by the FDIC.
CFPB Director Chopra also provided viewpoints on this issue. For instance, CFPB Director Chopra stated that: “[r]ather than deny mergers and publish orders describing the rationale for denial, there has been an informal understanding between the regulators and the industry that applicants will be allowed to withdraw their application instead of receiving a denial. Under many, if not most, circumstances, this has struck me as quite inappropriate.” Even when applications are withdrawn, CFPB Director Chopra was concerned that “the banking agencies do not provide any public communication about the rationale for non-approvals depriving the public and market participants of transparency.”
Although he “appreciate[d] the desire to provide more transparency to the public regarding why certain mergers do not get approved,” Vice Chairman Hill was concerned about “imposing reputational damage on applicants.” Furthermore, he noted that the Proposal was “consistent with longstanding practice” in that applicants could withdraw an application rather than face a public denial. Public statements on withdrawals, according to Vice Chairman Hill, “would seem to defeat the purpose of allowing an institution to withdraw.”
This post comes to us from Davis, Polk & Wardwell LLP. It is based on the firm’s memorandum, “Key takeaways from the FDIC’s proposed statement of policy on bank mergers,” dated March 25, 2024, and available here.
]]>So what should be done? Some argue that we should dispense entirely with deposit insurance caps (currently set at $250,000 in the United States) to ensure that even the largest depositors have no incentive to run. Proponents of this kind of policy point out that existing caps have been rendered largely meaningless – there are now expectations that uninsured deposits will be guaranteed after the fact, just as they were with SVB. But others worry about unlimited deposit insurance creating incentives for riskier behavior by banks and about the cost of unlimited deposit insurance (even if we increase the premiums banks pay, taxpayers will remain the ultimate backstop) – not to mention the optics of what might look like a bailout for millionaires.
Both sides of this debate make extremely good points, and if they are both right, then perhaps we are simply asking deposit insurance to do too much and need to explore other policy options for responding to bank panics. For example, we might need to dust off the concept of the “bank holiday” and consider whether authorities might ever need to implement one (or more limited transaction restrictions) in response to a banking panic.
I’m using the term “bank holiday” to mean a suspension of banking activity, as President Franklin Roosevelt used it in 1933 (not in the modern UK usage of “a day off work”). The disruptions of a bank holiday would be extreme, to be sure, but we may nonetheless face circumstances in which one is necessary to buy time to develop and deploy other confidence-inducing measures. Back in 1933, implementing a bank holiday could be more or less effected by keeping banks’ doors closed. The way we bank has changed dramatically, though, and implementing any transaction restrictions would be much more complicated in this day and age.
Many accounts of the SVB run ascribe its speed to social media activity. These accounts need to be taken with a grain of salt: In a bank run, the first movers have the advantage, and so rational depositors will keep their concerns off social media – at least until they’ve withdrawn all their funds. While I readily concede that not all depositors will act rationally, there is contemporaneous reporting that many SVB customers did try to hush up their withdrawals. Incentives shifted once it was clear that SVB would not survive, though. Then, the community of venture capitalists and startups served by SVB had incentives to convince authorities that guaranteeing SVB’s uninsured deposits was critical to preventing a broader banking panic. From March 10-12, 2023, social media certainly seemed to be fanning concerns about such a broad panic. Whether or not that was intentional, in our era of misinformation and generative AI, the possibility of bad actors using social media to instigate future bank runs cannot be discounted.
Even unlimited deposit insurance may not be able to protect against a coordinated attack on confidence in a bank’s liquidity or solvency. And in the future, we may face new kinds of prompts for runs that deposit insurance is not even responsive to. For example, as we move towards open banking, it may become much easier to switch from one bank to another: What if a widely used app recommends that all of its users switch funds to a bank that pays a higher interest rate? Depositors may have no concerns about the liquidity or solvency of their old banks but still move their deposits away. It doesn’t matter how things kick off; once significant deposit outflows start, a bank (even one in excellent financial condition with fully insured deposits) will be forced to sell its best and most liquid assets to satisfy withdrawal requests, which could ultimately cause it to fail.
If confronted with an unfamiliar emergency, authorities may need to buy time to develop and implement new kinds of responses. A digital bank holiday, or lesser transaction restrictions, could prove extremely valuable in such circumstances. Some might fear that online and mobile banking have made withdrawals so speedy that no such intervention could ever be timely enough – but U.S. banks don’t allow their customers to make million-dollar withdrawals through instantaneous payment services like Zelle. A withdrawal of that magnitude still requires a wire transfer, and wire transfers still take time to process (just read the contemporaneous reports of SVB depositors panicking as they waited for their wires to go through). If U.S. authorities ever needed to implement a digital bank holiday, wires would be the transactions to target, and disabling banks’ Federal Reserve master accounts would be the most expedient way of preventing wires from being processed.
As former Treasury Secretary Tim Geithner used to say, “plan beats no plan,” and if there’s ever a chance we will need to implement some kind of emergency transaction restrictions, we should start thinking through the legal and operational aspects of implementing a digital bank holiday (or lesser restrictions) now. The more quickly they are implemented the better – if rumors start to swirl that such restrictions are coming, damaging runs will only increase in the interim. With my article, Digital Bank Holidays, I hope to kickstart advance planning for practical implementation and legal authority issues. With regard to legal authority, although congressional authorization would be ideal, it’s quite possible that Congress will not be able to agree on such authorization in a timely fashion. I therefore consider existing legal authorities that could support the Federal Reserve in acting unilaterally in an emergency, or in compelling other participants in the payments system to participate in transaction restrictions.
I want to stress again how dire conditions would need to be to justify these kinds of steps. Restrictions on Federal Reserve master accounts are already a political hot potato and digital bank holidays (or even lesser transaction restrictions) will inevitably have damaging unintended consequences. But in the future, it’s possible that the only meaningful response to a fast-moving run or broader bank panic will be to hit the pause button – and plan beats no plan.
This post comes to us from Professor Hilary J. Allen at American University’s Washington College of Law. It is based on her recent article, “Digital Bank Holidays,” available here.
]]>In December 2023, President Biden vetoed …
]]>In December 2023, President Biden vetoed the congressional challenge to the rule. And as long as the Supreme Court rules in CFPB v. Community Financial Services Association of America that the CFPB’s funding structure does not violate the Appropriations Clause of the Constitution, we also expect the rule to survive the legal challenges currently pending in Texas and Kentucky.
Assuming it survives, large lenders must begin complying with the rule’s extensive and detailed provisions by October 2024, with smaller lenders to follow in 2025 and 2026. 12 CFR §1002.114(b). Those dates of compliance are currently stayed pending the ongoing litigation, but financial institutions may need to prepare for the possibility that the rule will soon come into effect.
The Small Business Rule, issued on March 30, 2023, implements Section 1071 of the Dodd-Frank Act, which requires creditors to determine whether a business “is a women-owned, minority-owned, or small business.” Specifically, Section 1071(e) requires financial institutions to request 13 particular data points from businesses, such as the race, sex, and ethnicity of the principal owners of the business.
But the CFPB’s final rule implementing Section 1071 goes further, requiring financial institutions to request dozens of additional data points, including LGBTQI+ data. 12 CFR §1002.107. Gathering this detailed information would allow the CFPB to determine whether any enforcement or other actions are warranted against lenders.
The financial services industry has expressed numerous concerns about the CFPB’s rule:
Under the Congressional Review Act, agencies are required to report rules to Congress, which can then consider legislation to overturn these rules. 5 U.S.C. §801(a). If a resolution disapproving of a rule is passed by both houses of Congress and signed by the President — or Congress overrides a Presidential veto — the rule cannot go into effect. 5 U.S.C. § 801(b).
On October 18, 2023, the Senate passed Senate Joint Resolution 32 to disapprove the Small Business Rule.1 The bipartisan 53-44 majority included three Democrats and two independents. On December 1, 2023, the House passed the disapproval resolution in a 221-202 vote, with six Democrats voting to overturn the rule.2
President Biden vetoed the disapproval on December 19, 2023. The President’s veto message stated that the CFPB rule “would bring much needed transparency to small business lending and improve the ability of lenders and community organizations to meet the most critical needs of America’s small businesses” as there are “acute gaps in capital access for minority- and women-owned businesses.”
On January 10, 2024, the Senate voted 54-45 to override the veto, but that fell short of the two-thirds required.3
Although the Small Business Rule survived congressional disapproval, it continues to face judicial challenges by financial institutions and interest groups that argue that the rule constitutes regulatory overreach. Prior to the congressional action, the rule suffered two adverse judicial rulings.
Should the Supreme Court hold that the CFPB’s funding structure is permissible under the Constitution, the Texas and Kentucky courts will still need to address the APA and First Amendment arguments. Although those courts have yet to signal their view of those arguments, APA and First Amendment claims are often difficult to prove. If, however, the Supreme Court eliminates Chevron deference when it decides the Loper Bright Enterprises v. Raimondo case this term, that could strengthen the plaintiffs’ APA claims.
We expect that the rule will ultimately survive legal challenge, but it could still come under fire in a future administration led by a Republican president and CFPB director. Nevertheless, any potential proposal to roll back the rule would still need to go through lengthy notice-and-comment rulemaking. In sum, the CFPB’s Small Business Rule is likely here to stay, at least for the foreseeable future.
ENDNOTES
This post comes to us from Skadden, Arps, Slate, Meagher & Flom LLP. It is based on the firm’s memorandum, “Lenders May Soon Need To Prepare To Comply With the CFPB’s Small Business Rule,” dated March 18, 2024, and available here.
]]>Nearly all community banks use technology services from Fiserv, FIS, and Jack Henry for their core banking needs (The Conference of State Banking Supervisors Annual Surveys in 2019, 2020, 2021, and 2022 report that under 1 percent of the respondents rely exclusively on in-house resources to support their technology). These core service providers (CSPs) handle back-end support for everyday transactions, updating accounts, and processing deposits, loans, and credits. Middleware layers add support for essential functions like loan and payment management, customer relationship management, regulatory reporting, and mobile banking (see here). Despite high ratings in security, technology, and risk management, community bankers find CSPs lacking in cost efficiency, contract flexibility, and innovation speed (Conference of State Banking Supervisors Annual Survey, 2019). While services from the three main CSPs are similar, transitioning between them or integrating third-party systems involves significant costs and challenges (Shevlin, 2021a).
In an ideal market where all community banks access the same technology, there’s no inherent advantage to investing in technology investment to create economies of scale. Yet, there are market frictions such as long-term contracts with CSPs that mix fixed and variable fees and penalize early termination during mergers (Shevlin, 2021b). Additionally, desired technology upgrades are often bundled with unwanted products (The source for this information is multiple informal conversations with community bank executives by one of the authors). Therefore, the fixed costs of tech investments can lead to scale economies (or diseconomies), depending on the bank’s ability to enhance customer revenue or operational efficiency. Banks poised for growth can achieve economies of scale and boost profitability through strategic tech investments, while those investing merely to maintain their customer base may struggle to do so.
The impact of technology investments on community bank mergers and acquisitions is ambiguous due to two conflicting effects. On one hand, the economies of scale effect suggests that banks with significant technology investments become attractive acquisition targets if these investments do not enhance productivity on their own, offering acquirers a chance to integrate these banks and extend their product offerings. This makes technology-rich community banks appealing for M&A activity. On the other hand, the high cost of integration suggests that banks with advanced technology may deter acquirers if the technology presents significant integration challenges or compatibility issues, particularly when the CSPs differ between the target and acquiring banks. Those costs could outweigh the benefits, potentially reducing the likelihood of technology-heavy banks being acquired.
To analyze the effects of technology investments on community banks, we use the data processing cost (DPC) from annual call reports, scaled by total assets, as an indicator. Unlike larger banks, community banks’ DPC, a significant noninterest, reflects fees paid to CSPs. From 2010 to 2019, DPC for banks with under $10 billion in assets grew by 4.9 percent annually, outpacing the -0.62 percent and 2.18 percent growth rates for other noninterest and total noninterest expenses, respectively. Despite typically being categorized as a capital expense subject to depreciation, the reliance of nearly all community banks on CSPs translates these technology investments directly into operational data processing expenses.
Our empirical analysis employs logistic regressions to examine how technology investments influence the probability of community banks becoming targets or acquirers in M&A transactions. We categorize community banks as those with assets under $10 billion, with a robustness check for banks under $1 billion. Our analysis accounts for various bank characteristics – size, profitability, equity capitalization, riskiness, efficiency, and ownership type – that could affect both technology investment decisions and M&A activity. Additionally, we adjust for local demographic and economic conditions and include year, state, and bank category fixed effects to ensure comprehensive control.
Our analysis from the 2010s demonstrates that community banks with greater technology investments had a higher likelihood of being acquisition targets, supporting the economies of scale argument. Specifically, each 1 percent increase in technology investments raised the chance of being acquired the next year by 0.2 percent, a significant impact given the baseline acquisition probability of 3.6 percent. A bank’s technology investment did not influence its likelihood of being an acquirer. Targeted banks were typically smaller, less profitable, and posed lower risks than those not involved in mergers. Furthermore, our research underlines the importance of market structure, showing a positive correlation between a bank’s merger target probability and the population and income of the county, suggesting that acquirers from smaller markets aim to enter larger, more promising markets.
To address potential endogeneity in our analysis of community banks’ technology investments and their acquisition likelihood, we implement two strategies: coarsened exact matching and an instrumental variable approach. Using coarsened exact matching, we categorize banks into treatment and control groups based on technology investments, matching them on state, year, and bank category, along with coarsening other characteristics for precise one-to-one comparison. This refined analysis confirms that higher technology investments increase a bank’s acquisition likelihood. Additionally, we employ an instrumental variable approach, using the local senior population proportion and broadband internet availability in each county as instruments. These factors indirectly affect technology investments without directly influencing M&A activity, controlling for demographic and economic conditions. These technology investments significantly raise a community bank’s chance of being targeted for acquisition.
To evaluate the effect of mergers on acquirer banks’ performance, we adopt a treatment effect methodology following Cattaneo (2010), treating the merger as the treatment. Through propensity score matching, we identify a comparable non-M&A-involved bank for each acquirer bank. Our analysis reveals that acquirers’ operational efficiency improves in the second and third years after a merger, supporting the economies of scale hypothesis. This suggests that acquirer banks initially spend time integrating the target’s technology investments, achieving operational efficiencies and economies of scale in subsequent years.
We also perform various robustness checks, including alternative definitions of community banks, different technology investment measures, estimation models, and a sample limited to banks with at least some technology investments. These checks consistently reinforce our main finding: Technology investments increase the likelihood of community banks being acquired.
Our study contributes to the literature in three significant ways. First, it provides statistical evidence of the critical role of technology investments in the consolidation of community banks, illustrating how such investments influence their acquisition likelihood. This aspect introduces a new dimension to achieving economies of scale, especially in the context of digital infrastructure and Banking-as-a-Service (BaaS), laying groundwork for future research on technology’s impact on community banks’ sustainability. Second, it enhances understanding of bank mergers and acquisitions by highlighting how bank size, profitability, credit risk, and demographic factors like local population and income levels affect M&A dynamics, identifying technology investments as a key attractor for acquirers – a novel insight in the field. Lastly, the findings inform practitioners, including regulators and policymakers, about the importance of technology investment strategies for community banks. As the sector evolves amidst fintech advancements and consolidation, our research underlines the need for supportive policies and frameworks that enable community banks to leverage technology for growth and efficiency, suggesting that strategic technology investments are crucial for their continued relevance and competitive edge.
REFERENCES
Shevlin, R. (2021a) Can Banks’ Relationship with FIS, Fiserv, and Jack Henry be Fixed? Forbes.
Shevlin, R. (2021b), What’s Going On in Banking 2021: Rebounding from the Pandemic. Cornerstone Advisors.
Cattaneo, M. D. (2010). Efficient semiparametric estimation of multi-valued treatment effects under ignorability. Journal of Econometrics, 155(2): 138–154
This post comes to us from Cheng Jiang at Boston College’s Carroll School of Management and Jonathan Scott and Zhaowei Zhang at Temple University’s Fox School of Business. It is based on their recent article, “Community Bank Consolidation and the Role of Technology Investment,” available here.
]]>On March 5, 2024, the IRS proposed Treasury regulations (the Proposed Regulations) that would allow an applicable entity to claim these elective tax credit payments with respect to investments in LLCs and limited partnerships that own and operate clean electricity projects so long as the LLC or partnership validly elects for its owners to be taxed as if they directly owned the assets of the LLC or partnership (rather than be taxed under the rules generally applicable to LLCs and partnerships).
The IRS also finalized a broader set of regulations last week governing renewable energy credits (the Final Elective Payment Regulations). Under these final regulations, an applicable entity that owns an interest in a renewable energy project through a partnership is generally not permitted to claim elective payments. As a consequence, an applicable entity that co-invests in a renewable energy project generally cannot monetize the resulting tax credits through the elective payment procedure unless either the co-investors own the credit-producing property as tenants in common or a valid election out of partnership tax treatment is made.1
Existing regulations under Section 761 of the Internal Revenue Code permit an “unincorporated organization” to elect out of partnership tax treatment in limited circumstances. Under these rules, an unincorporated organization that is engaged in the joint production, extraction or use of property (such as natural resources) may elect out of partnership tax treatment if, among other requirements, the property is owned by the organization’s participants as co-owners, either in fee or via lease or other contractual interest, such as a joint operating agreement. In other words, the co-investors must own their interests in the property directly rather than through a partnership or LLC.
Under the existing regulations, the co-owners are not permitted to elect out of partnership tax treatment if they jointly sell the property that is produced or extracted. The co-owners may delegate authority to a third party to sell their shares of the produced or extracted property, but not for a period longer than one year (or, if shorter, the minimum needs of the industry).
Whether co-investments in renewable energy projects can be structured as a practical matter to satisfy these existing regulatory standards for electing out of partnership tax treatment is unclear. In particular, the requirement that the co-investors must own their interests in the credit-producing property directly, rather than through a legal entity such as an LLC, presents significant complexity in structuring commercially acceptable financing and other agreements. In addition, electricity produced by these projects is typically sold under contracts that have terms that are significantly longer than one year. To address these concerns, the Proposed Regulations would add a special provision expanding these rules for clean electricity projects.
Under the Proposed Regulations, participants in a clean electricity project do not need to hold direct ownership interests in the property or in leases or other contracts relating to the property. Instead, they may hold their interests collectively in a single legal entity such as an LLC or partnership if the following requirements are met:
If the partnership or LLC meets these requirements, the partnership or LLC itself may enter into a long-term contract for sale of the electricity generated by the project. In addition, the owners of the partnership or LLC may delegate authority to negotiate such long-term contracts on their behalf, so long as the delegation of authority does not exceed one year (or, if shorter, the minimum needs of the industry).
The Proposed Regulations therefore would, if finalized, allow governments and other tax-exempt investors to hold interests in a single legal entity (such as a limited partnership or LLC) alongside taxable investors in clean electricity projects, and to enter into long-term power purchase agreements with utilities to sell their respective shares of the electricity produced, so long as the other requirements described above are met.
The Proposed Regulations are proposed to apply to taxable years ending on or after March 11, 2024.
The Treasury Department and the IRS have requested comments regarding the scope and requirements of the rules set forth in the Proposed Regulations, including whether similar exceptions are necessary for property that does not produce electricity. They have also requested comments regarding whether these elections should terminate if any interest in the applicable unincorporated organization is sold or exchanged absent a new election by all resulting members; whether certain “deemed election” rules should apply for these purposes; and whether additional anti-abuse rules are needed.
In addition to requesting comments on the Proposed Regulations, in a separate notice (Notice 2024-27), the IRS requested comments on situations in which an applicable entity may claim an elective payment with respect to a tax credit that it receives through a transfer under the Section 6418 tax credit transfer provisions (also enacted as part of the IRA). This so-called “chaining,” which would be another potential path for an applicable entity to monetize renewable energy tax credits, is prohibited under the final regulations under Section 6417. The Treasury Department and the IRS recognize, however, that a robust market for transferred credits is consistent with Congress’s intent in enacting the IRA, and they are continuing to consider potential chaining rules that would be consistent with the statutory framework and legislative purpose, while evaluating administrability challenges and potential for fraud.
This post comes to us from Davis, Polk & Wardwell LLP. It is based on the firm’s memorandum, “IRS guidance offers path for tax-exempts to claim renewable energy tax credits through LLCs,” dated March 15, 2024, and available here.
]]>In our recent paper, we address the main factors that have shifted the European takeover environment away from its original pro-market stance.
Initially, the EU aimed to promote a unified market for corporate control, emphasizing the need for a level playing field and expressing a preference for contestability of corporate control. This vision included facilitating takeover bids, even hostile ones, as integral components. The European Commission endorsed a model based on board neutrality, allowing shareholders to decide on takeover outcomes without undue interference from target company boards. However, this approach faced challenges early on.
An earlier proposal famously succumbed before the European Parliament in 2001. Inspired by the pro-takeover regulation of the British City Code, the proposal found fierce opposition from German lawmakers, highlighting the clash between different national perspectives on hostile takeovers. Historically opposed to hostile takeovers, Germany grew even more averse after the loss of its national champion Mannesmann at the hands of British competitor Vodafone. The compromise that ultimately helped broker the approval of the Directive made some of its core provisions optional for member states and reflected a shift towards preserving national prerogatives over pan-European takeover policies.
Around the time the Directive was adopted, several high-profile cross-border deals (both hostile and negotiated) upset national socio-economic circles, reinforcing pressures towards an even less takeover-friendly legal environment, as the ensuing paragraphs illustrate.
Stakeholderism. The corporate governance landscape significantly evolved after the adoption of the Directive. Shifts towards stakeholderism since the late 2000s have challenged the primacy of shareholder value maximization, affecting attitudes towards takeovers. Stakeholderism may justify non-shareholder-based defenses, especially in jurisdictions that do not impose board neutrality and offer effective defenses against takeovers. But even in other jurisdictions the expressive force of stakeholderism questions the benefits of takeovers and the market for corporate control.
Changes in geopolitical landscape and macroeconomic shocks. Geopolitical turmoil, epitomized by events like the Brexit referendum, fostered economic nationalism and protectionist sentiments, influencing corporate governance policies. Macroeconomic shocks, including the financial crisis and the covid pandemic, have further justified interventions aimed at protecting existing ownership structures at corporations and limiting foreign direct investment. This resulted in a series of changes in takeover and financial markets laws, in company laws and corporate governance practices, and in various foreign direct investment controls legislation throughout the European Union.
Changes in corporate and securities law. Changes to takeover and financial market laws have had an impact on takeovers. First, Member States made use of the optionality of some of the main features of the Directive. For instance, the board neutrality rule has moved from mandatory to optional in France and Italy. EU securities laws were also significant. For instance, the revised Transparency Directive has required disclosure of long positions held via derivatives, which made intentions of potential hostile bidders and activists known to the public earlier. The Market Abuse Regulation increased the risk of violating insider trading bans for prospective bidders building a toehold, leading to ambiguity and potential prosecution risks. Against this background, some Member States also engaged in “goldplating” by requiring holders of significant stakes to declare their intentions vis-à-vis the company.
Company laws and corporate governance practices also changed. On the one hand, several European countries, including Belgium and Italy, amended their company laws, introducing tenure voting as a tool hitherto unavailable to insulate companies from hostile takeovers, with France going one step forward and making tenure voting the default rule for listed companies. On the other hand, some large issuers, including Fiat (now Stellantis) and Ferrari, reincorporated in the Netherlands to take advantage of the greater leeway to fend off hostile takeovers that Dutch corporate law provides. All the while, dual-class share structures started to appear in Europe as bans on multiple voting shares were lifted with the goal of making companies more takeover-proof.
Foreign direct investment legislation. Moreover, in an overall more protectionist environment, legislation on foreign direct investment (FDI) tightened. Although the EU Screening Regulation aimed to harmonize FDI review mechanisms, Member States implemented the rules differently, with variations in thresholds, sectors, and assessment criteria, reflecting concerns about investments from countries like China and Russia but often also applying to acquisitions by EU buyers. While FDI reviews are crucial for national security, they are objectively at odds with an open takeover market.
As we question who ultimately benefits from a more interventionist political economy that hampers deal-making, we note that the market for corporate control of large European firms has historically elicited a lot of attention from the public and national politicians and that the new ecosystem favors corporate insiders and politicians, leading to greater insulation from hostile takeovers but potentially higher agency costs for European businesses.
This post comes to us from professors Luca Enriques at the University of Oxford and Matteo Gatti at Rutgers University. It is based on their recent paper, “Death by a Thousand Cuts: The Hostile Bids Regime in Europe, 2004-2023,” available here. A version of this post appeared on the Oxford Business Law Blog, here.
]]>I’m going to focus on one of Jack’s earlier works from 1984 when the SEC was just 50 years old. Now, I know this likely is before all the students in the room were born. Maybe even some of the professors, too! I was working on Wall Street at the time. Jack’s paper was called “Market Failure and the Economic Case for a Mandatory Disclosure System.”[1]
We’ve all taken tough positions: Beatles vs. Stones; Yankees vs. Mets; Coke vs. Pepsi. Jack was focused on mandatory vs. voluntary disclosure. He was on the side of the founding principles of the federal securities laws. The basic bargain that President Franklin Roosevelt and Congress laid out 90 years ago was that investors get to decide which risks to take so long as those companies raising money from the public make what Roosevelt called, “complete and truthful disclosure.” In 1933, the year the Securities Act was enacted, Roosevelt said, “It changes the ancient doctrine of caveat emptor to ‘let the seller beware,’ and puts the burden on the seller rather than on the buyer.”[2]
Jack had three main points in that seminal 1984 paper about the benefits of mandatory disclosure, the first of which may have been the most important.
First, information about securities is a public good. In essence, companies bear the cost of providing the information while they do not necessarily receive all of the benefits. Jack detailed a number of reasons for this, but fundamentally, anyone can use the information and benefit from it once it is produced.[3] Relying solely on market-based incentives would lead to under-production of the public good of information about securities. Thus, there is a role for the official sector, as Congress embedded in our securities laws 90 years ago.[4]
Second, given the imperfect alignment between the interests of management and shareholders, management may not be fully incentivized to give correct signals to shareholders about their companies.[5]
Third, Roosevelt’s “complete and truthful disclosure,” achieved in the securities laws, enables more efficient valuation and price discovery of issuers’ securities.[6]
When Jack wrote his paper four decades ago, there were others who suggested voluntary disclosure would work just as well because if something is valuable to disclose, companies would do so. These scholars contended if companies were value-maximizing, then mandatory disclosure wouldn’t be necessary. Companies with good news would be incentivized to put that information out to distinguish themselves. On the other hand, companies that don’t have good news wouldn’t disclose, and everyone would know the company didn’t have a good story. This line of reasoning often now is called the “unraveling argument.”
The unraveling argument, though, unravels for the reasons Jack noted. Public company disclosure is a public good. Further, the interests of companies, run by managers, and shareholders aren’t always aligned. In essence, companies won’t always provide investors important information, even if it is worth it to investors.
I’m with Roosevelt and Jack on this.
The benefits from investors having access to disclosure required by laws and rules are numerous.
First, disclosure promotes more efficient markets. It promotes better price discovery. Providing more information results in prices that more accurately reflect a company’s prospects.
Second, such prices provide valuable signals, helping capital flow to its most productive use, and thus promoting capital formation.
Third, disclosure promotes trust in markets and the companies that are raising money from the public. Investors are more likely to entrust their capital to a stranger if they are in receipt of consistent, comparable, and reliable disclosure. As U.S. Supreme Court Justice Louis Brandeis said in 1913, “Sunlight is said to be the best of disinfectants.”[7]
A mandatory disclosure-based regime helps protect investors. It reduces information asymmetries and helps them make more informed investment decisions. It also helps issuers access the markets. In fact, decades of economic literature support the value of securities disclosure.[8]
Materiality represents a fundamental building block of the disclosure requirements under the federal securities laws. The Supreme Court articulated the meaning of materiality in cases in the 1970s and 1980s.[9] It is this standard of materiality that is reflected in Commission rules.[10]This materiality standard is reflected when materiality appears in numerous disclosure rules governing registration statements and public company periodic and current reports.[11]
In the 90 years since Roosevelt described the intent of the federal securities laws and the 40 years since Jack’s paper, the core benefits of a mandatory disclosure-based regime haven’t changed. Technology, business models, and risks, however, do change. Thus, what investors find important to their investment decisions can change over time.
To that end, the SEC has updated, from time to time, the disclosure requirements underlying the basic bargain and, when necessary, provided guidance with respect to our disclosure requirements. We did it in the 1960s when we first offered guidance on disclosure related to risk factors.[12] We did so in the 1970s regarding disclosure related to environmental risks.[13] We did so in 1980 when the agency adopted Management’s Discussion and Analysis sections in Form 10-K.[14] We did it again in the 1990s when we required disclosure about executive stock compensation[15] and in 1997 regarding market risk.[16]
Of course, there was lively debate about each of these disclosure requirements. Today, though, they have become integral to our disclosure regime, and it’s hard to imagine investors not having access to them.
Just as we’ve done in the past, these last two years we’ve adopted rules providing investors with disclosures on emerging risks like climate and cybersecurity; capital raising technologies, like special purpose acquisition companies (SPACs); and an age-old topic—executive compensation.
In each of these rulemakings, the Commission has sought to enhance information disclosed to investors so that they can make informed investment and voting decisions. Each of these rulemakings is grounded in materiality. In each rulemaking, the Commission seeks to ensure investors have consistent, comparable, and reliable information.
Already today, 90 percent of the Russell 1000 issuers are publicly providing climate-related information, though that’s generally in sustainability reports outside of their SEC filings.[17] Further, nearly 60 percent of those top 1,000 companies are publicly providing information about their greenhouse gas emissions.[18] Investors ranging from individual investors to large asset managers have indicated that they are making decisions in reliance on that information.[19]
It’s in this context that we have a role to play with regard to climate-related disclosures. Our agency, though, was set up to be merit neutral. Thus, the SEC has no role as to climate risk itself.
Earlier this month, the Commission adopted rules, not just guidance, and ones that require disclosures be filed in annual reports and registration statements, not just posted online.[20] These rules enhance the consistency, comparability, and reliability of disclosures.
The final rules provide specificity on what must be disclosed, which will produce more useful information than what investors see today.
Increasingly, cybersecurity risks and incidents are a fact of modern life. When material incidents occur, they can have a range of consequences—including financial, operational, legal, or reputational.
Thus, last year, we finalized rules that enhance and standardize disclosures to investors with regard to public companies’ cybersecurity practices as well as material cybersecurity incidents.[21] The rules require periodic disclosures regarding companies’ risk management, strategy, and governance with respect to cybersecurity risks. This will help investors more effectively assess these risks and make informed investment decisions. The rules also require disclosure of material cybersecurity incidents, which will help with price discovery.
Whether a company loses a factory in a fire—or millions of files in a cybersecurity incident—it may be material to investors. These rules started to become effective in December 2023.
In January 2024, we finalized rules that will better align the protections investors receive when investing in SPACs with those provided to them when investing in traditional initial public offerings (IPOs).[22] The federal securities laws provide a range of protections for investors in traditional IPOs—through disclosure, marketing standards, as well as gatekeeper and issuer obligations.
The SPAC rules ensure that similar protections apply to investors in these non-traditional IPOs of private companies as much as they do for investors in traditional IPOs. Just because a company uses an alternative method to go public does not mean that its investors are any less deserving of time-tested investor protections. IPOs are IPOs, and as Aristotle once said, “treat like cases alike.”
Whether you are doing a traditional IPO or a SPAC target IPO, SPAC investors are no less deserving of our time-tested investor protections.
These rules become effective in July of this year.
We adopted a number of rules in 2022 taking on unfilled Dodd-Frank mandates related to executive compensation.
For instance, we adopted rules requiring companies to make clear disclosure to investors on the relationship between a company’s executive compensation actually paid and the company’s financial performance.[23] It helps investors understand which factors may influence the compensation of its executives.
In addition, we adopted rules related to clawbacks of executive compensation.[24] In essence, if a company makes a material error in preparing a financial statement, an executive may receive compensation for reaching a milestone that was never actually hit. It’s common sense to require issuers to “claw back” that erroneously awarded pay. We also required certain disclosures around companies’ clawback policies as well as actions taken pursuant to those policies. Under the new rules, the stock exchanges adopted new listing standards related to clawbacks that became effective in December 2023.
A few months shy of the SEC’s 90th birthday and 40 years since Jack’s paper, there still are those who would like to whittle away at the SEC’s disclosure regime.
To those who seek to reduce information available to investors, I stand with Roosevelt and Jack. The 1920s didn’t have federal disclosure requirements. The markets were rife with fraud, manipulation, and abuse. What happened? Investors got hurt. They lost confidence in the integrity of the capital markets. And the market imploded.
Some voices today are calling for further expanding the exemptions to our core 1933 and 1934 Act rules requiring registration of public offerings and ongoing disclosures.
There are participants in crypto securities markets that seek to avoid these registration requirements. No registration means no mandatory disclosure. Many would agree that the crypto markets could use a little disinfectant.
Roosevelt’s views have stood the test of time. Jack Coffee’s views have stood the test of time.
Full, fair, and truthful disclosure helps protect investors, lowers cost of capital for issuers, and promotes efficiency in the markets.
ENDNTOES
[1] See John C. Coffee Jr., Columbia Law School Scholarship Archive, “Market Failure and the Economic Case for a Mandatory Disclosure Regime” (1984), available at https://scholarship.law.columbia.edu/cgi/viewcontent.cgi?article=1567&context=faculty_scholarship.
[2] See The American Presidency Project, “Franklin D. Roosevelt: White House Statement On Securities Legislation” (March 29, 1933), available at https://www.presidency.ucsb.edu/documents/white-house-statement-securities-legislation.
[3] In his introduction, Coffee identified four arguments in favor of a mandatory disclosure regime. The first two points pertain to the public-good nature of information, which I merge together here. Coffee’s second point specifies that having companies disclose information reduces the need for multiple entities to produce the same information, which would lead to waste. See John C. Coffee Jr., Columbia Law School Scholarship Archive, “Market Failure and the Economic Case for a Mandatory Disclosure Regime” (1984), available athttps://scholarship.law.columbia.edu/cgi/viewcontent.cgi?article=1567&context=faculty_scholarship.
[4] See John C. Coffee Jr., Columbia Law School Scholarship Archive, “Market Failure and the Economic Case for a Mandatory Disclosure Regime” (1984), pages 723-737 available athttps://scholarship.law.columbia.edu/cgi/viewcontent.cgi?article=1567&context=faculty_scholarship.
[5] Ibid. See pages 738-747.
[6] Ibid. See pages 747-751.
[7] See Louis D. Brandeis School of Law Library, “Other People’s Money – Chapter V” (1913) available at https://louisville.edu/law/library/special-collections/the-louis-d.-brandeis-collection/other-peoples-money-chapter-v.
[8] See Craig Doidge, G. Andrew Karolyi, et al., “Why Are Foreign Firms Listed in the U.S. Worth More?” (2004), available athttps://tspace.library.utoronto.ca/bitstream/1807/96821/1/Why%20Are%20Foreign.pdf. See also Luzi Hail and Christian Leuz, Journal of Accounting Research, “International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?” (June 2006), available athttps://www.jstor.org/stable/3542332.
[9] See Basic Inc. v. Levinson, 485 U.S. 224, 231, 232, and 240 (1988) (holding that information is material if there is a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision; and quoting TSC Industries, Inc. v. Northway, Inc., 426 U. S. 438, 449 (1977) to further explain that an omitted fact is material if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”)
[10] See 17 CFR 230.405 (defining the term “material”); 17 CFR 240.12b-2 (same).
[11] See, e.g., 17 CFR 229.101 (Description of business); 17 CFR 229.103 (Legal proceedings); 17 CFR 229.105 (Risk factors); 17 CFR 229.303 (MD&A); Form 8-K, Items 1.01 (Entry into a Material Definitive Agreement), 1.02 (Termination of a Material Definitive Agreement), and 2.06 (Material Impairments). See also, e.g., 17 CFR 229.101(c)(2)(i) (requiring discussion of “[t]he material effects that compliance with government regulations, including environmental regulations, may have upon the capital expenditures, earnings and competitive position of the registrant and its subsidiaries”); 17 CFR 229.101(h)(4)(x) (“Briefly describe the business and include, to the extent material to an understanding of the smaller reporting company . . . [c]osts and effects of compliance with environmental laws (federal, state and local) . . . .”); 17 CFR 229.103(c)() (requiring disclosure of “[a]dministrative or judicial proceedings (including proceedings which present in large degree the same issues) arising under any Federal, State, or local provisions that have been enacted or adopted regulating the discharge of materials into the environment or primarily for the purpose of protecting the environment” if, among other things, “[s]uch proceeding is material to the business or financial condition of the registrant”); Form 8-K, Item 1.01 (“If the registrant has entered into a material definitive agreement not made in the ordinary course of business of the registrant, or into any amendment of such agreement that is material to the registrant, disclose [among other things] . . . a brief description of any material relationship . . . [and] a brief description of the terms and conditions of the agreement or amendment that are material to the registrant.”).
[12] Guides for the Preparation and Filing of Registration Statements, Release No. 33-4936 (Dec. 9, 1968) [33 FR 18617 (Dec. 17, 1968)].
[13] Disclosure Pertaining to Matters Involving the Environment and Civil Rights, Release No. 33-5170 (July 19, 1971) [36 FR 13989 (July 29, 1971)].
[14] Amendments to Annual Report Form, Related Forms, Rules, Regulations and Guides; Integration of Securities Acts Disclosure Systems, Release No. 33-6231 (Sept. 2, 1980) [45 FR 63630 (Sept. 25, 1980)].
[15] Executive Compensation Disclosure, Release No. 33-6962 (Oct. 16, 1992) [57 FR 48126 (Oct. 21, 1992)].
[16] Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information About Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments, Release No. 33-7386 (Jan. 31, 1997) [62 FR 6044 (Feb. 10, 1997)].
[17] See G&A, 2023 Sustainability Reporting in Focus, available at https://www.ga-institute.com/research/ga-research-directory/sustainability-reporting-trends/2023-sustainability-reporting-in-focus.html; See also past reports, available at https://www.ga-institute.com/research/ga-research-directory/sustainability-reporting-trends.html.
[18] See Just Capital, “The Current State of Environment Disclosure in Corporate America: Assessing What Data Russell 1000 Companies Publicly Share,” available at https://justcapital.com/wp-content/uploads/2022/04/JUST-Capital_Environment-State-of-Disclosure-Report_2022.pdf.
[19] See, e.g., E. Ilhan, et al., Climate Risk Disclosure and Institutional Investors, 36 Rev. Fin. Stud. 2617 (2023) (“Through a survey and analyses of observational data, we provide systematic evidence that institutional investors value and demand climate risk disclosures”); Morrow Sodali, Institutional Investor Survey (2021), available at https://morrowsodali.com/uploads/INSTITUTIONAL-INVESTOR-SURVEY-2021.pdf (surveying 42 global institutional investors managing over $29 trillion in assets and finding that 85 percent of those investors cited climate change as the leading issue driving their engagements with companies, and 61 percent indicated that they would benefit from disclosures that more clearly link climate-related risks to financial risks and opportunities).
[20] See Securities and Exchange Commission “SEC Adopts Rule to Enhance and Standardize Climate-Related Disclosures for Investors” (March 6, 2024), available at https://www.sec.gov/news/press-release/2024-31.
[21] See Securities and Exchange Commission, “SEC Adopts Rules on Cybersecurity Risk Management, Strategy, Governance, and Incident Disclosure by Public Companies” (July 26, 2023), available at https://www.sec.gov/news/press-release/2023-139.
[22] See Securities and Exchange Commission “SEC Adopts Rules to Enhance Investor Protections Relating to SPACs, Shell Companies, and Projections” (Jan. 24, 2024), available at https://www.sec.gov/news/press-release/2024-8.
[23] See Securities and Exchange Commission, “SEC Adopts Pay Versus Performance Disclosure Rules” (Aug. 25, 2022), available at https://www.sec.gov/news/press-release/2022-149.
[24] See Securities and Exchange Commission, “SEC Adopts Compensation Recovery Listing Standards and Disclosure Rules” (Oct. 26, 2022), available at https://www.sec.gov/news/press-release/2022-192.
These remarks were delivered on March 22, 2024, by Gary Gensler, chair of the U.S. Securities and Exchange Commission, before the Columbia Law School conference in honor of John C. Coffee, Jr., the the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.
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