Yearly Archives: 2008

Second Circuit Rejects Collective Scienter Theory

Posted by Steven M. Haas, Hunton & Williams LLP, on
Monday, September 8, 2008
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This post is from Steven M. Haas of Hunton & Williams LLP.

In a recent decision, the Second Circuit rejected a shareholder-plaintiff’s theory of collective scienter in a securities fraud suit brought against a financial services company. At issue in Teamsters Local 445 v. Dynex Capital, Inc., was a district court’s ruling that a plaintiff adequately pled scienter with respect to the corporate defendants even though it dismissed the claims brought against the defendants’ officers. The corporate defendants appealed the decision, challenging the district court’s expansive theory of “collective scienter.”

On appeal, the Second Circuit largely agreed with the defendants. It explained that “[t]o prove liability against a corporation… a plaintiff must prove that an agent of the corporation committed a culpable act with the requisite scienter, and that the act (and accompanying mental state) are attributable to the corporation.” The court stopped short of holding, as a matter of law, that a plaintiff must always plead scienter as to specific individuals in order to survive a motion to dismiss with respect to corporate defendants. But, except in highly unusual situations, the Second Circuit’s decision effectively means that securities fraud plaintiffs must plead scienter against specific corporate agents in order to recover from a corporate defendant.

Perhaps more importantly, the Second Circuit held that the plaintiff had failed to sufficiently allege any wrongful conduct by any of the defendants. Rather, the court suggested that any diminution in the value of the company’s asset-backed securities could have been caused by “the general weakness” in market conditions, particularly in the manufactured housing industry. Accordingly, the opinion is an important judicial recognition that market forces, not fraud, often cause investment losses that are the subject of securities fraud allegations. For that reason, we expect the Second Circuit’s decision to be quite significant in light of the wave of class actions that have been filed in connection with the subprime mortgage industry.

My colleagues Ed Fuhr and Terence Rasmussen represented the defendants and have prepared a case alert available here.

SEC proposes roadmap for IFRS adoption

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, September 5, 2008
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This post comes from Ernst & Young.

Ernst & Young has released a Hot Topic discussing the recent release of the SEC’s proposed roadmap for International Financial Reporting Standards (IFRS) adoption in the U.S. This step represents the most significant step to date by the SEC toward the adoption of a single set of high quality global accounting and financial reporting standards that everyone can use. The dominant language of financial reporting worldwide is fast becoming IFRS. Notwithstanding the strength and size of the U.S. capital market, the U.S. cannot afford to be left behind. A change to a common global accounting language will also benefit investors and market efficiency by increasing the transparency and comparability of information.

The proposed Roadmap anticipates mandatory reporting under IFRS beginning in 2014, 2015 or 2016 depending on the size of the issuer and provides for early adoption in 2009 by a small number of very large companies that meet certain criteria. It is also possible that the SEC will later decide to permit other companies to early adopt at some point prior to the mandatory date of conversion. In addition, the Roadmap is expected to include a number of milestones, including improvements in accounting standards, accountability and funding of the International Accounting Standards Committee Foundation, improvement in the use of interactive data for IFRS, and enhancements to IFRS training and education, that the SEC will consider in making its decision in 2011 about whether to proceed with mandatory adoption of IFRS.

While there will be many challenges associated with conversion to IFRS, a U.S. shift to the global standard will provide continuous benefit. With respect to this matter, Ernst & Young believes that with the SEC’s action, the U.S. – like the rest of the world – is on the right path. You can access the entire Hot Topic here and the SEC Press Release is available here.

SEC Issues Corporate Website Guidance

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, September 4, 2008
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The following post comes to us from Ning Chiu and Michael Kaplan of Davis Polk & Wardwell.

The Securities and Exchange Commission has issued an interpretive release on the use of corporate websites by public companies. The release provides a means of complying with Regulation FD through posting information on websites in certain circumstances, and also gives additional clarification as to the use of websites for providing other information to investors. While we do not expect the release to lead to significant changes in practice for most companies, it presents a valuable opportunity for companies to revisit their website-related practices.

Our memorandum, available here, explains the circumstances under which information posted on a company’s website will be considered “public” for purposes of Regulation FD and factors companies should consider in determining whether to alter their practices for disseminating information in view of the SEC’s new guidance. The interpretative release may be accessed here.

The SEC is soliciting comments on issues concerning corporate use of technology in providing information to investors. Comments are due on or before November 5, 2008.

CEO and CFO Career Consequences to Missing Quarterly Earnings Benchmarks

Posted by Suraj Srinivasan, Harvard Business School, on
Wednesday, September 3, 2008
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This post is from Suraj Srinivasan of Harvard Business School.

In a recent working paper co-written with Rick Mergenthaler and Shiva Rajgopal entitled CEO and CFO Career Consequences to Missing Quarterly Earnings Benchmarks, we investigate whether missing quarterly earnings benchmarks is associated with career consequences in the form of lower compensation (bonus, equity grants) and the dismissal of the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO).

Prior research has found that a disproportionately large number of firms appear to meet or just beat quarterly earnings benchmarks relative to firms that just miss these benchmarks. Why do managers work this hard to meet or beat these quarterly earnings benchmarks? We propose that the CEO and CFO suffer negative career consequences if they repeatedly miss quarterly earnings benchmarks. We examine three earnings benchmarks – analyst consensus forecast, seasonally lagged quarterly earnings, and zero earnings. We evaluate a comprehensive set of career consequences such as the impact on compensation (bonus and equity grants) and dismissal from office for both CEOs and CFOs, conditioned on failure to meet quarterly earnings benchmarks.

Our sample includes CEOs and CFOs for the S&P 1500 firms covered in the ExecuComp database. We examine over 11,000 firm-year observations during the years 1993-2004 and investigate whether bonus changes and equity grants are associated with the failure to meet or beat quarterly earnings benchmarks after controlling for the known determinants of such compensation and for measures of firm performance such as stock returns, return on assets, and the magnitude of the earnings surprise. We use news articles to determine the circumstances surrounding each CEO and CFO’s departure to classify such turnover as forced dismissals. Our analysis seeks to predict CEO and CFO forced turnover as a function of the failure to meet earnings benchmarks. We find evidence that the failure to meet quarterly earnings benchmarks, especially the analyst consensus estimates, is associated with lower bonus and equity grants, and a higher probability of forced dismissal for both the CEO and the CFO, after controlling for several proxies for performance.

In economic terms, failing to meet two quarterly analyst consensus forecasts in a year is associated with a lower bonus equivalent to 14% (8%) of the CEOs (CFOs) salary, a lower equity grant of 24% relative to an equity grant with no misses for both the CEO and the CFO, and a 0.61% (0.62%) higher probability of being dismissed for the CEO (CFO). If the firm fails to meet all four consensus quarterly earnings forecasts in a year, the penalties jump to a lower bonus equivalent to 28% (16%) of the CEOs (CFOs) salary, a lower equity grant of 48% relative to an equity grant with no misses for both the CEO and the CFO, and a 1.51% (1.53%) higher probability of being dismissed for the CEO (CFO). Compared to the unconditional probability of forced dismissal (which is 3% for CEOs and 5% for CFOs), the dismissal penalty appears to be significant in an economic sense. We also find systematic cross-sectional and inter-temporal variation in the nature of these career consequences. In particular, career consequences for both the CEO and CFO are worse if they miss quarterly earnings benchmarks and their firms provide earnings guidance. Bonus cuts on missing quarterly benchmarks are greater if the firm has a history of consistently meeting or beating quarterly benchmarks in the past. In addition, career penalties to missing quarterly earnings benchmarks have increased in the post-Sarbanes-Oxley Act time period.

The full paper is available for download here.

Fannie and Freddie by Twilight

Posted by Peter J. Wallison, American Enterprise Institute, on
Tuesday, September 2, 2008
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This post is from Peter J. Wallison of the American Enterprise Institute.

 

Having now become explicitly government-backed entities, Fannie Mae and Freddie Mac (and their supporters in Congress) can no longer argue that they do not pose a risk to taxpayers. It is not politically feasible for the government to back private companies when their shareholders and managements keep the profits but the taxpayers cover the losses. Thus, even if they escape their current precarious financial straits, Fannie and Freddie are now operating in a kind of twilight before they will eventually have to be nationalized, privatized, or liquidated. In addition, the recent attention to covered bonds as a way to finance mortgages suggests that, in the future, Fannie and Freddie’s traditional business–buying and holding or securitizing mortgages–will no longer be essential to U.S. housing finance. An analysis of the available options for policymakers suggests that the best course–from the standpoint of taxpayers–is not to keep Fannie and Freddie alive through the injection of government funds but to allow them to go into receivership. A receiver can continue their operations in the secondary mortgage market and–using the Treasury line of credit recently authorized by Congress–meet their senior debt and guarantee obligations as they come due. A decision to nationalize, privatize, or liquidate them can be made at a later time and can be implemented more simply and efficiently through a receivership than if the companies are helped to survive through government recapitalization.
It took a hair-raising crisis in the housing and international capital markets, but for Fannie and Freddie, the wondrously generous world of Washington–the world they have dominated for so many years with threats, intimidation, and sheer financial and political muscle–is at last coming to an end. Both companies are hovering near insolvency. Whether they can avoid eventual receivership will depend on how much further housing values fall. But even if they are lucky enough to survive this current crisis, their halcyon days will never return. This is not because Congress has learned any kind of lesson. Without question, the preferred position in Congress, especially on the Democratic side of the aisle, will be to reconstitute Fannie and Freddie as newly recapitalized government-sponsored enterprises (GSEs).

But this will not fly politically. The world was irretrievably changed by the Housing and Economic Recovery Act of 2008 (HERA) signed by President Bush on July 30, 2008. The act, in effect, authorized the bailout of the companies by giving the secretary of the treasury the authority to make unlimited loans to, and equity investments in, both GSEs. Thus, HERA resolved once and for all whether Fannie and Freddie were actually backed by the U.S. government; it provided the explicit backing that investors always believed would ultimately be there and that the enterprises themselves vigorously denied. But now that they are explicitly backed by the U.S. government, the GSEs can no longer claim that they represent no risk to taxpayers. As explicitly government-backed entities, they cannot deny the obvious: that their profits will go to their managements and shareholders while their losses will be picked up by taxpayers. This fact is crucial to their future.

The privatization of profit and the socialization of risk inherent in this new arrangement is politically untenable, even though it may take some time for Congress to see the substantial difference between their former status as merely government-sponsored and their new status as explicitly government-backed. Inevitably, however, the light will dawn and their form will have to be changed. The question, then, comes down to whether Fannie and Freddie will, in the future, become government agencies, private companies, or just unpleasant memories.

Moreover, there are strong indications that a far more efficient and sensible mechanism for financing home mortgages in the United States is about to be born. In mid-July, the Federal Deposit Insurance Corporation (FDIC) issued a final policy statement on how it would treat covered bonds in the event of a bank’s failure,[1] and at the end of July, the Treasury issued a long statement on best practices for covered bonds.[2] In a covered bond transaction, mortgages remain on the books of the bank or other depository institution but serve as collateral for bonds issued to finance the acquisition of the mortgages. If the mortgages in the covered bond pool default, the bank that established the pool has an obligation to replace the assets with performing mortgages that will continue to serve as collateral for the outstanding bonds.

In other words, this structure requires lending banks to retain an interest in the quality of the mortgages they make and addresses the problem that no one in the securitization process has a continuing interest in sound underwriting after the mortgages are sold to Fannie and Freddie. Trillions of dollars in covered bonds have been issued in Europe over many years without any substantial losses. There are, of course, issues associated with the widespread use of covered bonds in the United States–mostly in balancing the interests of the FDIC and bank depositors in gaining access to the assets of a failed bank–but if these can be balanced with the need for a strong residential finance system, covered bonds could, over time, make the Fannie and Freddie business model obsolete. This is one more indication that Fannie and Freddie, both as GSEs and as essential elements of the U.S. residential finance market, are on their way out.

The Gathering Storm

It is axiomatic that Congress only acts in a crisis, and this crisis was so serious that Congress was compelled to do three important things that under ordinary circumstances it would never have done: it adopted legislation, HERA, that significantly strengthened the regulation of Fannie Mae and Freddie Mac; it authorized the appointment of a receiver to take over either company if it becomes “critically undercapitalized”; and it gave the Treasury Department a blank check, limited only in time and by the U.S. debt limit, to make loans or equity investments in both companies. With its new powers, the regulator should be able to reduce the size of the GSEs and prepare them for one of the three fates: liquidation, privatization, or nationalization.

It need not have been this way. Congress was warned over two decades, by both Democratic and Republican administrations, about the dangers presented by Fannie and Freddie. But Congress, under both Democratic and Republican control, did nothing. The same process is now unfolding with respect to Social Security, Medicare, energy, securities class actions, and probably a dozen other long-term problems that Congress is seemingly unable to address. It makes you wonder why 98 percent of them are reelected.

Not that this and previous administrations are blameless. Although at their higher reaches–usually in the Treasury–they recognized the dangers, their bank regulatory arms continued to allow banks to invest in Fannie and Freddie securities without the percentage limitations normally applied to investments in privately owned business corporations. The regulators obviously believed that the government would eventually stand behind Fannie and Freddie and thus permitted U.S. banks to load up on Fannie and Freddie debt in preference to U.S. government securities. Now, thousands of banks hold more than their total Tier 1 capital in the form of Fannie and Freddie debt. A 2004 FDIC report showed that the holdings of GSE-related securities by commercial banks and savings associations aggregated more than 11 percent of the total assets of these institutions and more than 150 percent of their combined Tier 1 capital.[3] Holding Fannie and Freddie debt gave the banks some extra earnings over what they would receive from Treasuries, but it also sent signals to the capital markets that the government saw Fannie and Freddie as virtually risk-free. And when the prospect arose a few weeks ago that Fannie and Freddie debt might decline in value, Uncle Sam had to step in to prevent thousands of U.S. banks from becoming insolvent because of their GSE investments.

In any event, the Fannie and Freddie crisis has now arrived, and, in order to avert a disaster in the housing and financial markets, the United States government has been forced to put its credit behind these two ill-conceived and badly managed institutions. During the past month, as the dimensions of the problem have become clear, sensible people have actually wondered whether the credit of the United States might actually be impaired by the obligations it might be required to assume on Fannie and Freddie’s behalf. That idea, previously unthinkable, is still highly unlikely, but what is clear is that the size of the taxpayers’ losses will grow as housing prices continue to decline. There is no telling how deep into insolvency Fannie and Freddie might sink, and the further down they go, the more potential losses they will impose on the government and ultimately the taxpayers.

This, of course, is all water over the dam. The damage–allowing two privately owned companies to grow so large that they become both wards of the government and threats to the financial system–has been done. Now the only relevant question is how we get out of this mess with minimal cost to taxpayers. In the end, the options available to the Treasury Department and the new GSE regulator, the Federal Housing Finance Agency (FHFA), are both unpleasant and few. They are outlined below.

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Securities Laws, Disclosure, and National Capital Markets in the Age of Financial Globalization

Posted by René Stulz, Ohio State University Fisher College of Business, on
Monday, September 1, 2008
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This post is from René Stulz of Ohio State University.

I have recently completed a paper titled Securities Laws, Disclosure, and National Capital Markets in the Age of Financial Globalization. The paper examines the following question: If capital can move freely between countries to take advantage of the best investment opportunities, are national capital markets still relevant?

With complete capital market integration across countries, there would be no national interest at stake for a country in having well-functioning capital markets. If capital can flow freely among countries, firms raise capital where it is cheapest. In a fully integrated world, we would therefore expect national capital markets to be irrelevant. If a country’s capital markets functioned poorly in such a world, firms would simply ignore these capital markets as sources of capital. The welfare consequences from having poorly functioning national capital markets would be extremely limited because firms and investors could bypass these markets freely.

As far as the trading of securities is concerned, the role of location has decreased dramatically because of the replacement of pit trading with electronic trading. With electronic trading, the location of the trader is operationally irrelevant and so is the location of the exchange.

The fact that portfolios of investors are still heavily biased towards securities issued and traded in their own country, a phenomenon described as the home bias, shows that, despite the free flow of capital, we are far from a fully integrated world in which countries are irrelevant for the issuance and trading of securities. A major reason for why countries are not irrelevant is that they have different laws and enforce them differently. The laws that apply uniquely to publicly traded securities are securities laws.

I construct a model where I show that securities laws can reduce agency costs and therefore increase share prices. I model a firm led by an entrepreneur who decides whether to take the firm public or not. I show that the entrepreneur wants to commit ex ante to a level of disclosure that is not optimal for her ex post. By committing to disclosure, the entrepreneur increases the cost of consuming private benefits and of taking decisions that are not optimal for shareholders. After the IPO, the entrepreneur would like to consume private benefits and would like to take decisions that are optimal for her but not for shareholders. It is therefore optimal for the entrepreneur to renege on disclosure commitments after the IPO. I examine private solutions to this problem and show that under some circumstances strong securities laws dominate private solutions. Strikingly, securities laws help entrepreneurs in the model rather than shareholders. Shareholders buy the shares for what they are worth, so that poor securities laws do not hurt them. Poor securities laws hurt entrepreneurs because they reduce the value of the firms that they take public.

I use the model to show that differences in securities laws across countries explain differences in share values and in the distribution of share ownership. In the model, some firms from countries with poor securities laws will choose to subject themselves to stronger securities laws. Some have argued that U.S. laws protecting shareholders have become too costly and inefficient. I model this argument by considering the case where strong securities laws have deadweight costs. I show that, to the extent that firms can choose the securities laws they are subject to, firms with poor growth opportunities choose weak securities laws with no deadweight costs while firms with strong growth opportunities choose strong securities laws even if they have some deadweight costs.

A key conclusion of my paper is that securities laws are more beneficial if they are not at risk of being watered down over time through lobbying by incumbents. However, incumbents have strong motivations to reduce the strength of securities laws since doing so increases their ability of consuming private benefits.

Financial reporting and conflicting managerial incentives: The case of management buyouts

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, August 29, 2008
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This post comes from Paul E. Fischer and Henock Louis from the Smeal College of Business at Pennsylvania State University.

In our forthcoming Management Science paper, Financial reporting and conflicting managerial incentives: The case of management buyouts, we analyze the effect of external financing considerations on manager’s financial reporting behavior prior to management buyouts (MBOs). Our main motivation for choosing the MBO setting is the potential conflicting financial reporting incentive associated with external financing considerations. Managers planning to undertake an MBO want to purchase their firms‚ equity at as low a price as possible. Consequently, previous studies hypothesize that managers have an incentive to release less favorable earnings reports to equity market participants prior to an MBO in an attempt to reduce the MBO purchase price. We consider the possibility that managers have a conflicting earnings management incentive prior to MBOs that is attributable to external financing concerns, which are thought to be substantial.

In the framework we employ for our analysis, the financing related reporting incentive is driven by management’s concerns regarding their ability to obtain MBO financing from external parties and their desire to obtain that financing at a favorable cost. The financing incentive conflicts with the equity market incentive because the financing incentive suggests that managers should manage earnings upward. Consequently, to the extent that an external financing incentive exists, we expect it to temper the equity market incentive. Based upon our framework, we hypothesize that financing related earnings management incentives are more pronounced when the funds needed to execute the buyout must be raised to a greater extent from external parties. In addition, we hypothesize that the increase in financing related incentives arising from increased external financing is greater when there are fewer fixed assets available to secure loans.

Using a sample of 138 MBOs that occurred between 1985 and 2005, we find evidence consistent with both hypotheses. We find that firms that use more external funds to finance their MBO report less negative abnormal accruals. We also find that the positive effect of external financing on earnings management decrease as the amount of fixed assets increases, which is consistent with the conjecture that the effect of external financing on the marginal cost of managing earnings down prior to MBOs increases as the firm has fewer physical assets that it can use as collateral.

The full paper is available here.

New York Courts Dismiss ‘Grasso’ Compensation Case

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, August 28, 2008
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Editor’s Note: This article from Joseph E. Bachelder appeared in the New York Law Journal this week.

Courts do not like being arbiters of disputes over what is reasonable compensation. The recent, abrupt conclusion of the state of New York’s lawsuit against Richard A. Grasso is a case in point.

The lawsuit began on May 24, 2004 at the initiative of then-Attorney General Eliot L. Spitzer, claiming that the payment of a lump-sum amount of $139.5 million to Mr. Grasso was unreasonable compensation.(1) The action was brought under the New York Not-For-Profit Corporation Law (N-PCL).

Earmarks of Dubious Behavior

This case appeared to offer an ideal opportunity for New York courts to address the issue of what is reasonable compensation. It had all the earmarks of an egregious case of overpayment of compensation to an executive together with evidence of dubious corporate behavior in the setting of that compensation. Earmarks included:

• The payment of $139.5 million, in a lump sum, to the CEO of a relatively small not-for-profit trade organization and regulator (albeit a well-known and very powerful one).

• According to the complaint (and there is substantial publicly available data to support this) the compensation and benefits for Mr. Grasso expensed over the period of 2000-2002 equaled slightly less than 100 percent of the New York Stock Exchange’s (NYSE) net income over this same period. Complaint, para. 34. Over these three years, this represented $130.3 million of compensation and benefits to Mr. Grasso compared to $132.8 million of net income. Id.

• Many of the directors of the NYSE (including members of the Compensation Committee) were subject to regulation by Mr. Grasso himself, as chairman and CEO of the NYSE. During the periods relevant to the litigation, Mr. Grasso was authorized to appoint the members of the Compensation Committee (subject to board approval) and to select one of the members as the chairperson of the committee (the selection of the committee chairperson did not require board approval). See, for example, Charter: Human Resources and Compensation Committee, adopted June 7, 2001; see also Complaint, paras. 5, 6 and 25.

• For the Aug. 7, 2003 meeting of the board that approved Mr. Grasso’s 2003 compensation arrangements, including the lump-sum payment of $139.5 million, no advance notice (or virtually none) was given to board members. Statement by the Director of Human Resources of the NYSE (HRD Statement), Exhibit A to Exhibit 1 to Complaint, paras. 37-38. Apparently due to this lack of notice neither of the outside consultants who had been working on the matter was available to attend the meeting. HRD Statement, Id. at para. 41. It would appear that, at the Aug. 7, 2003 meeting, the board had very little time (and very little information) before voting to approve Mr. Grasso’s compensation package including the lump-sum payment of $139.5 million.

• The NYSE Compensation Committees that approved Mr. Grasso’s compensation arrangements over several years, including 2003, apparently were not given accurate and complete information on Mr. Grasso’s compensation. HRD Statement, Id. at para. 50; see also Assurance of Discontinuance Agreement with Consultant, Exhibit 2 to Complaint at pp. 1-2.(2)

Attorney General’s Standing

Apart from the facts and alleged facts in this case, the attorney general appeared to have standing to bring this action. The bases for this conclusion were as follows:

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New Rules for Investors in German Listed Companies

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on
Wednesday, August 27, 2008
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This post is from John F. Olson of Gibson, Dunn & Crutcher LLP.

Recently, the German legislature adopted the Risk Limitation Act (Risikobegrenzungsgesetz, the “Act”) aimed at the limitation of perceived risks deriving from financial investors. Following the notorious “locust debate” in Germany, the new law is the result of the still ongoing discussions about the impact of foreign hedge funds and private equity investors. It provides for a number of amendments to securities law and corporate law applicable to domestic and international investors in public companies. The Act is scheduled to be formally announced later this summer or fall.

Acting in Concert

The Act will modify the existing rules on “acting in concert”, i.e., the rules under which the shareholdings of investors forming a “group” must be aggregated. This is relevant in two areas, namely (i) the reporting thresholds for shareholdings in German listed companies and (ii) the rules on public offers:

• Regarding the former, an investor reaching, exceeding or falling short of 3%, 5%, 10%, 15%, 20%, 25%, 30%, 50% or 75% of the voting rights attached to shares must notify the company and the German financial supervisory authority within four trading days at the latest. Otherwise the shareholder’s rights are suspended and it can be fined. The company is required to publish such notification within three trading days.

• The rules on public offers also refer to an important threshold: An investor holding less than 30% of the voting rights must launch a public takeover offer once it decides to acquire (additional) shares aimed at reaching or exceeding the 30% threshold. An investor who reaches the 30% threshold other than in the course of a takeover offer must launch a mandatory public offer to acquire all outstanding shares in the target.

When several shareholders are found to be “acting in concert”, their shareholdings are mutually attributed; therefore, each of them is subject to notification and offer duties if the aggregate of their shareholdings reaches, exceeds or falls short of one of the above thresholds. Until now, the Federal Supreme Court held that only investors who coordinate their voting within the general meetings of the company were acting in concert.

The Act will broaden the scope of the rules on acting in concert. The new rules will also apply to cooperating in a way that aims at a steady and substantial change of the strategic orientation (unternehmerische Ausrichtung) of the company. Thus, the scope of application will no longer be limited to coordination with regard to the exercise of voting rights, but will also include cooperation on the level of the supervisory board or even outside any corporate bodies, provided that the investors concerned intend to steadily and substantially change the business of the company. Fortunately, the German legislature abstained from further extensions of the rules: Pursuant to initial draft bills of the Act, the mere cooperation of investors with respect to the acquisition of shares would have been considered acting in concert, too. What is more, it would have been sufficient if the coordination referred to an individual case or had an either steady or substantial influence on the business of the company. The German legislature changed its opinion after harsh criticism from legal scholars and international investors.

As a result, the impact of the changes will be limited. For example, investors will generally still be able to initiate public takeovers by agreeing on standstill agreements with shareholders or accepting irrevocable undertakings from them. Until German courts begin to interpret the new rules, however, there will be legal uncertainty for some time about what shareholders may agree on regarding the business and strategy of the company without triggering a mutual attribution of voting rights.

Aggregation of Voting Shares and other Securities giving the Right to Acquire Shares

Holders of marketable securities giving the right to acquire voting shares (e.g., marketable call options) have similar notification duties if their securities refer to a shareholding which reaches, exceeds or falls short of the above thresholds (except for the 3% threshold). Under the current rules, the positions in voting shares and other financial instruments are not aggregated. Presently, an investor who acquires (i) up to 2.99% of voting shares of the company and (ii) other securities giving the right to acquire up to 4.99% of the voting shares does not need to make any notification.

The Act provides for the aggregation of these two positions with the effect that in the above example, the investor will be obligated to report the excess of the 3% and the 5% threshold. Nonetheless, the 3% threshold will still be irrelevant for an investor who only holds marketable securities other than voting shares.

Extension of Sanctions in Case of Violation of Notification Duties

In the past, non-compliance with the aforementioned notification requirements, apart from the risk of administrative fines, has only led to a suspension of the shareholder rights (in particular, voting rights and rights to dividends) until the missing or wrongful notification was made or corrected. Hence, verifying compliance with the notification duties immediately prior to a general meeting was sufficient to avoid any impact on these rights. Under the Act, the suspension of shareholder rights would only be lifted six months after the late or corrected notification, provided the violation (i) was due to gross negligence or intent and (ii) reached a certain degree of non-compliance: If the investor did not completely fail to make a required notification and the deviation of the notified shareholding from the actual shareholding was less than 10% of the actual shareholding, the six months period will not apply.

New Disclosure Duties Relating to Significant Shareholdings

Further, the Act will implement new disclosure duties for investors holding at least 10% of the voting rights in a German listed company. Such significant shareholders will be required to disclose to the company their intentions with respect to the shares and the origin of the funds used to purchase the shares. These duties (as well as the existing notification duties) will not only apply to direct shareholders but also to investors to which the shares of third parties are attributed due to certain circumstances. Examples of such attribution are: (i) controlling influence over the direct shareholder, (ii) holding shares of a third party in trust without further instructions of the third party with regard to the exercise of voting rights, and (iii) acting in concert (see above). The new disclosure duties also apply to investors who already hold 10% or more of the voting rights in a German listed company once they reach or exceed another threshold.

These significant shareholders will be required to disclose their intentions with respect to the shares and the origin of the funds within 20 trading days unless the articles of association of the company waive such duty. Significant shareholders must also disclose all changes to their intentions.

With regard to its intentions each requested investor will be required to disclose whether:

• the investment aims to attain strategic goals or to achieve trading profits,

• it plans to obtain further voting rights within the next 12 months by way of purchase or otherwise,

• it strives for representation in corporate bodies of the company, and

• it strives for substantial changes of the capital structure of the company, in particular with regard to the ratio of equity financing and debt financing as well as to the dividend policy.

When disclosing the origin of the funds, the investor will be obliged to indicate whether and to what extent it has used equity or debt.

The company will be required to publish (i) the information received from the investor or (ii), if applicable, non-compliance of the investor with the disclosure duties. The Act does not provide for any additional consequences in case of non-compliance and the above mentioned suspension of shareholder rights will not apply. Please note, however, that non-compliance with these duties may, under certain circumstances, violate the prohibitions on market manipulation and insider trading.

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Voluntary Disclosures Regarding Insiders’ Rule 10b5-1 Trading Plans

Posted by M. Todd Henderson, University of Chicago Law School, on
Tuesday, August 26, 2008
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This post is from M. Todd Henderson of the University of Chicago Law School.

If a firm insider has private information and intends to trade on the basis of this information, the conventional wisdom is that the insider garners no strategic advantage from disclosing in advance of the trade the information or the intention to trade. This account, however, ignores the potential litigation benefit from pre-trade disclosure of trading plans. If an insider discloses many months in advance the intent to trade at certain times, this can be expected to reduce the likelihood of a lawsuit (either alleging insider trading alone or as an element of a securities fraud suit), since disclosure may rebut any allegation that the insider was acting with the requisite scienter when the trade executed. The insider who pre-discloses may be turning Brandeis’s aphorism that “sunlight is the best disinfectant” on its head – the insider is using transparency for strategic advantage, what we might call “hiding in plain sight.”

In a new paper, entitled Scienter Disclosure, Alan D. Jagolinzer, Karl A. Muller and I show the existence of the strategic advantage from disclosure – what we call “scienter disclosure” – in a study of insider voluntary disclosure under Rule 10b5-1 trading plans. The SEC promulgated Rule 10b5-1 in 2000 to provide an affirmative defense for insiders who pre-commit to trades in the future at times when they do not possess inside information, even if they do possess such information when the trades ultimately execute. There is evidence, however, that Rule 10b5-1 may provide insiders with strategic trade opportunities that generate abnormal trade returns. Insiders may, for example, pre-plan trade based on longer-term nonpublic information because of perceived lower legal risk. Insiders may also strategically modify the content or timing of disclosure to increase profitability of previously planned trades. Finally, insiders may also terminate Rule 10b5-1 plans when they possess material nonpublic information that indicates a hold strategy would be more profitable than allowing pre-planned sales to continue. We show insiders use these features of the Rule to earn abnormal returns.

The paper has two primary findings based on insiders’ voluntary disclosure choices. First, we show Rule 10b5-1 disclosure increases with firm litigation risk and insider strategic trade potential. Firms with higher expected litigation risk and greater opportunities for insiders to earn profits from private information are much more likely to disclose, meaning insiders see disclosure as a litigation prophylactic.

Second, we show Rule 10b5-1 disclosure is associated with greater abnormal returns to insiders’ trades, especially for firms disclosing specific plan details. The SEC intended Rule 10b5-1 to provide insiders greater opportunities (than the normal blackout windows allow) for uninformed, diversification trades, but we present data showing that insiders who use the Rule earn large abnormal returns compared with those not using the Rule, and that these returns are increasing in the amount of disclosure. (The returns are about 12 percent in six months for insiders making specific disclosures.) The intuition here is that disclosure is not just a litigation risk reducer, but also has costs. Making specific disclosures, say about the dates and amounts of trades, provides the most litigation protection but it also raises the costs for insiders who may terminate their plans if it turns out a hold strategy is superior. Therefore, only the most bearish insiders will adopt a specific disclosure strategy, since the termination option is less valuable to them. Insiders making limited disclosures get less litigation protection, but they preserve the termination option. These insiders are less confident of negative private information, so their expected abnormal returns are lower than the specific disclosure group.

The paper also presents findings about the interaction of disclosure choice and firm governance, and makes some preliminary policy recommendations for regulators, firms, and other corporate stakeholders. Most obviously, a disclosure requirement is unlikely to provide much benefit, since it is the insiders not disclosing who are acting the way the SEC intended.

The paper is available here.

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