Monthly Archives: April 2009

Market Reaction Surrounding SEC Filings

This post comes from Edward Li of the University of Rochester and K. Ramesh of Michigan State University.

By arguing that the SEC’s EDGAR system provides instantaneous access to information in periodic SEC filings, recent studies document significant stock price reactions surrounding both 10-K and 10-Q filings. In our forthcoming The Accounting Review paper Market Reaction Surrounding the Filing of Periodic SEC Reports, we scrutinize these findings by taking into consideration the following facts: (1) 22.7% (16.4%) of interim (annual) SEC filing dates coincide with the first release of earnings information; (2) about a quarter of the 10-K filings are made within five days surrounding calendar quarter-ends when money managers report their quarterly holding; and (3) earnings announcements are increasingly preempting financial statement disclosures in periodic SEC filings.

Our analysis provides new evidence regarding circumstances in which a market reaction is observed surrounding the filing of periodic reports. First, we find significant price and volume reactions when periodic SEC reports coincide with earnings releases. However, with the exception of 10-K reports, we find no evidence of significant market reactions for the other periodic reports (i.e., 10-Q, 10KSB, and 10QSB) that follow earnings announcements. Second, we document that the market reaction to 10-K reports is limited to those filed around calendar quarter-ends. Consistent with the incentives of money managers to window dress and to “lean for the tape” for quarterly reporting purposes, we find a calendar quarter-end effect in both price and volume reactions that is generally unrelated to the filing of 10-K reports. However, while volume reactions for calendar quarter-ends with a 10-K filing are statistically indistinguishable from those without a filing, there is some evidence of an incremental price reaction to 10-K filing after the Sarbanes-Oxley Act, possibly due to the new disclosures required under the statute. Third, while we find support for information transfer from quarter-end 10-K filers to the other firms, we find no significant equity analyst forecast revisions around any type of periodic SEC filings, and no evidence of a calendar quarter-end effect in analyst reactions, suggesting that analyst actions do not contribute to the information transfer. The results for analyst reactions corroborate our findings regarding muted price and volume reactions.

While our study finds no pervasive evidence of market reaction to periodic SEC filings (especially the 10-Q filings), we are not suggesting that SEC filings have no economic or informational value. First, the circumstances in which researchers expect significant new information in periodic reports may also be the same circumstances in which firms may have incentives to provide complementary disclosures through a different medium. For instance, we show that when firms report a lower earnings number in their periodic filings compared to the figure reported in the earnings press releases, they almost invariably provide preemptive or concurrent press releases highlighting the downward revision to mitigate disclosure risk. Consequently, although the information is valuable, the concurrent price or volume reaction may be triggered by the more salient contemporaneous disclosure rather than the periodic SEC reports. Future research using market microstructure data can provide additional insights regarding the role of different disclosure channels. Second, the demand for the services of data aggregators such as Standard & Poor’s, FactSet, and Bloomberg indicate that various market participants such as money managers, other institutional investors, and credit analysts must consider the information in periodic SEC filings collected by data aggregators to be valuable for sophisticated investment and other economic decisions. Future research examining the role of information intermediaries in spreading corporate accounting information is likely to add to our understanding of the capital market information infrastructure.

The full paper is available here.

The SEC’s Upcoming Agenda to Protect Investors

Editor’s Note: The post below by Chairman Mary Schapiro is a transcript of remarks by her to the Council of Institutional Investors, Spring Meeting, April 2009.

When I first arrived at the SEC two months ago, I noticed a very large, framed quote prominently displayed outside the Chairman’s Office. It’s a quote from former Chairman (and later Supreme Court Justice) William O. Douglas. And, it says, “We are the investor’s advocate.”

Usually, that’s the only part of his quote we ever hear. But the full statement is more enlightening. It reads:

We have got brokers’ advocates; we have got Exchange advocates; we have got investment banker advocates; and WE are the investors’ advocate.

The date of that quote is 1937. Seventy-two years later, there are even more advocates for all of the various participants in our markets, but the SEC remains the only federal agency dedicated to looking out for investors. And surely there has been no time in history that investors have been more in need of an advocate than today.

You — the trillions of dollars that are represented in this room — need an advocate that is strong and effective. In our time together this morning, I’d like to share with you my plans for ensuring both.

The Role of Regulation in Our Markets

Now over the past many months, there’s been much talk in Washington and around the globe, about the need to rethink our regulatory system. It is a discussion that has been given urgency by the financial crisis we face — and the quest for solutions.

But as we consider how to address this crisis, I think it is useful to remember that there are myriad reasons for how we got here. The ink on the Sarbanes-Oxley Act of 2002 was hardly dry before we began to hear concerns from some quarters about the costs of “over-regulation,” the stifling of innovation, and the superior ability of markets to protect themselves from excesses.


IOSCO Report on Hedge Fund Oversight

The Technical Committee of the International Organization of Securities Commissions (“IOSCO”) recently published a consultation report (the “Hedge Fund Report”) that offers detailed recommendations for global regulation of hedge funds.

The Hedge Fund Report solicits comments on the following key recommendations:

  • Requiring prime brokers and banks, which are already regulated entities in all jurisdictions, to disclose to securities regulators certain information about their most “systemically significant” or “higher risk” hedge fund counterparties;
  • Requiring the registration and supervision of hedge fund managers, including the mandatory disclosure to regulators of information required to protect investors and to monitor system risk, with a focus on “systemically important” or “higher risk” managers, with a possible de-minimis cutoff; and
  • Imposing certain ongoing requirements on hedge fund managers, including risk monitoring and compliance functions, verification of fund valuation (according to principles proposed in a previous IOSCO report), increased protection of client fund assets, independent audits, minimum capital requirements, better management of conflicts of interests, and certain disclosures to regulators and investors.

The Hedge Fund Report also raises the issue of possible regulation at the underlying hedge fund level.

IOSCO has presented its findings to the G-20 Working Group on Enhancing Sound Regulation and Strengthening Transparency, in preparation for the meeting by G-20 national leaders in London on April 2. Comments to the Hedge Fund Report will be accepted until April 30.

In addition, the IOSCO Task Force on Short Selling published a consultation report (the “Short Selling Report”) designed to help develop a more consistent international approach to the regulation of short selling. The Short Selling Report recommends that regulation of short selling should be based on four principles:

1. Appropriate controls to reduce or minimize potential systemic risks, including at a minimum, strict settlement (such as compulsory buy-in) of failed trades;2. A regime of timely reporting to the market or to market authorities;

3. An effective compliance and enforcement system, including mechanisms for flagging systemically significant and abusive transactions and for cross-border information sharing; and

4. Appropriate exceptions for market-efficient transactions.

The Alternative Investment Management Association (“AIMA”) published a statement calling the IOSCO Short Selling Report “admirably sensible,” particularly in its recognition of the benefits of a flexible regulatory approach to allow market efficient transactions.

It should be noted that many countries have already implemented restrictions on naked short selling and enhanced reporting requirements for short sales. AIMA also supports IOSCO’s call for a consistent international approach to short selling regulation. Responses to the Short Selling Report are due by May 4.

Given recent comments by Mary Schapiro, the Chair of the U.S. Securities and Exchange Commission (the “SEC”), we expect that the SEC will likely reinstate the “uptick rule,” which allows stock to be sold short only after a rise from its immediately prior price (see related story “Exchanges propose modified uptick rule for SEC to consider in short selling meeting” below).

The hedge fund report is available here.
The short selling report is available here.
The AIMA statement is available here.

Triggering a Poison Pill

This post from Charles M. Nathan is based on a client memo by Mark Gerstein, Bradley Faris, Joseph Kronsnoble and Christopher Drewry of Latham & Watkins LLP.

Stockholder rights plans, commonly referred to as “poison pills,” were developed more than 25 years ago to fend off opportunistic “hostile” offers and other abusive takeover transactions. Poison pills traditionally have been designed to deter unauthorized share accumulations by imposing substantial dilution upon any stockholder who acquires shares in excess of a specified ownership threshold (typically 10 percent–20 percent) without prior board approval, rendering the unauthorized share acquisition prohibitively costly. More recently, rights plans with a lower trigger threshold of 4.99 percent have been deployed to protect a corporation’s net operating loss carry forwards, commonly referred to as “NOLs,” against the threat that changes in share ownership could inadvertently limit the corporation’s ability to use the NOLs to reduce future income taxes.

Until the end of 2008, the risk of economic dilution created by the poison pill had its intended deterrent effect. No stockholder had ever swallowed a modern poison pill, and the mechanics of a poison pill trigger were purely an academic exercise.

This is no longer the case. In December 2008, Versata Enterprises, Inc. and certain affiliates triggered an NOL poison pill adopted by Selectica, Inc. in what appears to have been a calculated effort by Versata to obtain leverage in an unrelated business dispute. Selectica’s board used its poison pill to dilute Versata’s position (exercising the feature that allows the board to exchange rights held by stockholders other than Versata for common stock on a one-for-one basis). Due to uncertainty regarding the issuance and ownership of Selectica shares following the rights exchange, trading in Selectica’s common stock was suspended for more than four weeks while the important “back-office” mechanics to implement the exchange were developed and implemented by Selectica and its advisors. In addition, the case of Selectica, Inc. v. Versata Enterprises, Inc. pending in the Delaware Court of Chancery presents for the first time the question of the validity of the NOL poison pill and the board’s decisions to use the poison pill against Versata. These events provide lessons applicable to all forms of rights plans.

In our memo entitled “Lessons from the First Triggering of a Modern Poison Pill: Selectica, Inc. v. Versata Enterprises, Inc.,” we provide an overview of NOL poison pills, outline the events leading to the triggering of Selectica’s NOL poison pill discuss several important lessons for corporations and their advisors arising from these events.

The memo is available here.

Evolution of Corporate Ownership

This post comes from Fritz Foley and Robin Greenwood of Harvard Business School.

In our paper, The evolution of corporate ownership after IPO: The impact of investor protection, which was recently accepted for publication in the Review of Financial Studies, we examine the ownership structure for newly public firms, and how that structure changes over time. We assemble new panel data on corporate ownership covering a large panel of firms in 34 countries between 1995 and 2006, including 2,700 firms that go public during this period.

Despite recent research which documents that ownership concentration is higher in countries with weak investor protection, we find that newly public firms tend to have concentrated ownership regardless of the level of investor protection. Next, we examine how the ownership structure changes over time. We find that firms in countries with good investor protection become widely held faster, even though ownership is concentrated for a few years around the IPO. Both new share issues and blockholder sales are more common in countries where protection is strong and private benefits of control are small. Investor protection has a particularly pronounced effect on the diffusion of ownership for firms with attractive growth opportunities. Such firms appear to be more willing to issue new shares, thereby diluting ownership. We also find that firms in countries with weak legal protection of shareholders rely more heavily on debt as a source of capital when they face growth opportunities. However, firms’ ability to substitute away from equity to debt appears incomplete. Consistent with other research on finance and growth, we find that firms in countries with weaker investor protection increase investment by smaller amounts than firms in countries with stronger investor protection in response to growth opportunities.

We next consider the implications of these findings for financing choices and patterns in firm growth. In additional tests, we conclude that our findings are not driven by four alternative hypotheses concerning the diffusion of corporate ownership which would otherwise distort our findings. The first alternative hypothesis is that changes in corporate ownership reflect blockholders’ and managers’ explicit attempts to time the market. A second alternative is that measures of investor protection capture effects of stock market liquidity, that is, the ability of blockholders to find a buyer for their shares. Third, our estimates of the impact of investor protection on ownership diffusion might reflect differences in the types of firms that go public in different environments. Lastly, growth opportunities differed across countries during our sample period in a way that is correlated with investor protection.

Our results collectively imply that one of the key reasons ownership concentration falls as firms age is that when investor protection is strong, firms can raise capital and grow, diluting blockholders in the process.

The full paper is available for download here.

The Robustness of SOX

Editor’s Note: This post comes from Thomas Bowe Hansen of the University of New Hampshire, and Grace Pownall and Xue Wang of Emory University.

In our paper, The Robustness of the Sarbanes Oxley Effect on the U.S. Capital Market, which was recently accepted for publication in the Review of Accounting Studies, we re-evaluate the effects of the Sarbanes Oxley Act (SOX) on the number of exchange-traded firms in the U.S. capital market, taking into account general market conditions and firm fundamentals, especially size and financial performance.

We start by developing a model to predict new listings based on conditions in U.S. markets for products and capital, and then invert that model to predict de-listings over time. We analyze a comprehensive dataset of new listings and de-listings from U.S. national stock exchanges over 44 years. We find that market factors that explain the frequency of new listings on U.S. exchanges from 1962 through 2005 also explain most of the variance in the frequency of de-listings over the same time period. The peak in the number of delisted firms and the rate of de-listings was in 2001. In addition, the frequency of de-listings has continued at high levels relative to the historical average subsequent to the passage and implementation of SOX. Our time series analysis uses an indicator variable as a proxy for the passage of SOX, and the SOX variable is not associated with abnormal levels of de-listings in general, conditional on market factors. However, our proxy for the implementation of SOX Section 404 in 2004 is associated with a significant decline in de-listings, contrary to the prior finding of SOX effects resulting in increased de-registrations based on shorter time series and more restrictive definitions of firms exiting the U.S. public capital market.

Next we look for changes in the propensity to delist by estimating firm-specific models including the general market conditions from our first set of tests, firm fundamentals, and the SOX proxies. We use a sample composed of all U.S. firms listed on national stock exchanges during the period 1962 to 2005. We find that the passage of SOX is associated with increased probability of delisting for publicly traded U.S. firms, but only when proxies for general market conditions are not included in the model. The implementation of SOX section 404 (for the largest firms in the U.S. capital market) in 2004 is associated with a significant increase in the probability of delisting, even after controlling for general market conditions and firm fundamentals. This result is not inconsistent with recent literature documenting an increase in the probability of delisting during the SOX time period, especially for small firms (although small firms have been granted an extension on applying Section 404 that has already rolled over several times).

Finally, we disaggregate the sample of U.S. exchange-traded firms by size to replicate earlier results suggesting that small firms were especially pushed out of the public equity market. We find that prior stock return and size are significantly negatively associated with the probability of delisting for firms in all five size quintiles, meaning that smaller firms and poorly performing firms were more likely to delist across the whole time period. We also find that, for the smallest quintile of firms in the sample, the passage of SOX was only marginally associated with an increase in the probability of delisting, and the implementation of Section 404 was not associated with the probability of delisting (consistent with the delayed applicability of Section 404 to small firms). On the other hand, the passage of SOX is either not associated with or significantly negatively associated with the probability of delisting for the largest 80% of the sample, but the implementation of Section 404 is associated with an increase in the probability of delisting for all but the smallest 20% of the sample firms.

We conclude from this evidence that there is little basis for associating the increased incidence of firms delisting from U.S. markets in the first half of this decade with the passage or implementation of SOX rather than with the general worsening of market conditions. On the other hand, the implementation of SOX Section 404 has been associated with increased probability of larger firms exiting U.S. public capital markets, especially if they are performing poorly. Increasing the probability of poorly performing firms exiting the U.S. public capital markets is a different regulatory implication of SOX than is pushing small firms out of the market.

The full paper is available for download here.

Proposed Short Sale Restrictions

This post is based on a client memorandum by Annette L. Nazareth, Lanny A. Schwartz, Gerard Citera, and Robert Colby of Davis Polk & Wardwell.

In an open meeting held yesterday, the Securities and Exchange Commission voted unanimously to issue proposals to revive restrictions on short sales in equity securities. The Commission indicated that its forthcoming release would seek comment on five proposed rules that adopt two alternative approaches to short sale restrictions:

Price Tests – These proposals include:

an “uptick” rule that would limit short selling to (A) a price above the price at which the immediately preceding sale was effected (“plus tick”), or (B) the last sale price if it is higher than the last different price (“zero-plus tick”) (the “Uptick Rule”); and an “upbid” rule that would limit short selling to a price at or above the current bid when that bid is above the previous bid (the “Modified Uptick Rule”).

Circuit Breakers – These proposals include:

a “circuit breaker” rule that would halt short selling in a security upon a substantial price decline in that security (the “Circuit Breaker Halt”); and two “circuit breaker” rules that would limit short selling in a security by applying either the Uptick Rule or the Modified Uptick Rule, in each case upon a substantial price decline in that security (respectively, the “Circuit Breaker Uptick Rule” and the “Circuit Breaker Modified Uptick Rule”).

It is not a foregone conclusion that the Commission will adopt any of these proposals. In their prepared remarks, some of the Commissioners noted that the Commission had only recently, in 2007, eliminated price test restrictions for short sales after studying their impact and effectiveness over a period of several years, and also noted the success of other recent initiatives to address short sale issues, particularly Interim Final Temporary Rule 204T concerning fails to deliver. The Commission is under considerable public pressure from members of Congress and others to impose constraints on short selling, and Commissioner Paredes in particular warned against taking action in response to political pressure. The discussion at the open meeting also suggested that the Commissioners were aware of the possibility of a court challenge to any steps they may take to reimpose restrictions on short selling, given the lengthy administrative record developed in connection with the Commission’s 2007 rulemaking.

The proposing release is expected to ask nearly 200 questions, including questions that pose alternatives to the five proposed rules. In all, Commissioner Walter stated that there are at least 14 alternative approaches covered in the release. The release will be published in the Federal Register shortly, and comments will be due within 60 days of publication.

Uptick Rule

The Uptick Rule is substantially similar to the original short sale rule, Rule 10a-1 under the Securities Exchange Act of 1934, which was recently eliminated by the Commission after an extended pilot program (the “Original Uptick Rule”). Rule 10a-1 was in effect from 1938 to 2007. Like the Original Uptick Rule, the Uptick Rule would permit short selling only when the short sale price is at a plus tick or a zero-plus tick.


Managerial Incentives and Hedge Fund Performance

This post comes from Vikas Agarwal of Georgia State University, Naveen Daniel of Drexel University, and Narayan Naik of London Business School.

In our recently accepted Journal of Finance paper Role of Managerial Incentives and Discretion in Hedge Fund Performance, we demonstrate empirically that, in the case of hedge funds, managerial incentives and discretion are associated with better performance. While the prior corporate finance literature has examined this question, the results are hard to interpret given significant endogeneity concerns. We believe that the hedge fund industry offers a more appropriate setting to examine these issues for a number of reasons. First, we are able to empirically test theoretical predictions that are difficult to test in the corporate finance setting, such as the incentive effects of out-of-the-money options. Second, we believe that our measures of managerial incentives and managerial discretion create fewer endogeneity concerns than typically arise in a corporate finance setting, since the compensation contract are set at the fund’s inception and do not change during the life of the fund. Similarly, the durations of the lockup period, the notice period, and the redemption period—our proxies for managerial discretion—are chosen at the inception of the fund.

We examine our research questions using a comprehensive database created by the union of four large hedge fund databases: CISDM, HFR, MSCI, and TASS. Our findings are as follows. First, we find that higher values of delta, our overall pay–performance sensitivity measure, and not higher incentive fee rates, are associated with higher future returns. In support, we find that the incentive fee rate has no explanatory power for future returns once we control for delta, whereas delta continues to be a significant predictor of future returns. This finding holds even when we use a subsample of funds charging the same incentive fee rate of 20%. Second, when we use managerial ownership as well as the manager’s option delta to capture incentives, we find both to be positively related to performance. This lends support to the industry wisdom that requires co-investment by the manager. Third, we find that funds with high-water mark provisions produce higher returns. Also, the presence of a hurdle rate provision is positively related to future returns, although this relation is not statistically significant. Fourth, we find that our proxies for managerial discretion are always positively related to performance. This suggests that providing flexibility to the manager should be beneficial, provided that appropriate incentives are in place.

Our results are robust to various alternate specifications, including the use of alternative performance measures (such as gross-of-fees returns and risk-adjusted returns) and controlling for different data-related biases. Our findings demonstrate the efficacy of financial contracts in alleviating agency problems, and we believe that they have important implications for contracting not only with asset managers but also with executives managing corporations.

The full paper is available for download here.

Expanding EU Role in Financial Regulation

The economic crisis has produced a bewildering array of regulatory and economic responses at all levels of government. It is difficult, if not impossible, to have a complete overview of all these responses. A pattern that has emerged in European responses to the crisis, however, is the increased role the EU plays in laying down common guidelines for Member State actions and in identifying and attempting to remedy shortcomings in the regulation of banks and other market participants.

In its conclusions published on March 20, 2009, the European Council endorsed a greatly expanded European Union role in the regulation of the European financial system, as laid out in the report of the de Larosière Group published on February 25, 2009 (the “de Larosière Report”) and the Commission’s communication of March 4, 2009 (the “Commission Communication”). The EU program will form part of the discussions to be undertaken by G-20 members at their meeting in London on April 2, 2009. The European Council will take the first decisions to strengthen the regulation and supervision of the European financial sector at the June 2009 European Council meeting.

The Commission’s program calls for the adoption of a wide range of regulatory reforms over the course of 2009 and 2010, complementing the regulatory initiatives already launched in response to the financial crisis. Specifically, the Commission proposes to establish a new European financial supervisory body to be operational by the end of 2010; to adopt a number of specific legislative measures to fill gaps in the existing financial regulatory structure; and to create a comprehensive legal framework for retail financial services. If the European institutions adhere to the Commission Communication timetable, a new European supervisory framework will be created by the end of this year and operational in 2010, and an ambitious program of new and amended legislation will be in place to strengthen and harmonize the regulation not only of banks and investment banks, but also of hitherto largely unregulated entities such as hedge funds, private equity firms and CRAs. The Commission’s proposals mirror thematically similar initiatives by Member State governments.

Our firm has prepared a memorandum entitled “Expanding EU Role in European Financial Regulation,” which summarizes the initiatives proposed by the Commission to reshape the European financial regulatory system, together with related initiatives already launched by the European institutions in response to the financial crisis.

The memorandum is available here.

Tunnel-Proofing the Executive Suite

This post comes from Thomas Noe of the University of Oxford.

In my forthcoming Review of Financial Studies paper “Tunnel-Proofing the Executive Suite: Transparency, Temptation, and the Design of Executive Compensation”, I model the problem of providing incentives for the faithful performance of the CEO’s role as a custodian of a complex bundle of assets whose value is opaque to outsiders. In particular, I model a CEO who has an opportunity to divert corporate resources to personal consumption, an activity I term “tunneling.” Although I assume that the financial accounting system makes total output observable and contractible, I impose two conditions that make tunneling feasible. First, the firm’s investment capital is subject to diversion. Second, only the CEO knows the marginal return on invested capital. Outsiders only know the distribution of possible marginal rates of return. Because outsiders only know the distribution of project returns, not the return realization, they cannot distinguish between low returns caused by tunneling and low returns caused by bad luck.

If the CEO did not have private information regarding the firm’s production process, then my analysis would produce the standard result—high-powered compensation for risk-neutral CEOs. In this case, very high cash flows would be a very strong signal that the CEO did not divert funds. In which case, high-powered compensation would optimally link compensation with the desired CEO action—not diverting funds. However, when CEOs have intimate knowledge of the production process, very high cash flows indicate not only that (a) the CEO did not divert but also that (b) the marginal return of capital (observed privately by the CEO) is very large. However, when the marginal return on capital is relatively large, the “bribe” required to induce the CEO not to divert capital from investment is smaller as each dollar diverted “under the table” lowers output and thus the CEO’s “over the table” compensation more. Hence, when the marginal return on capital is opaque to outsiders, the optimality of high-powered compensation is no longer obvious.

In fact, when I derive shareholder-value maximizing compensation contracts for CEOs, I find that these contracts are very different from high-powered option-like compensation. Optimal designs have the following form: They fix a minimum output threshold. When the CEO is unable to prevent output from falling below this threshold, which I term the “cutoff rate,” it is optimal for the CEO to divert corporate resources to private consumption. Otherwise, the CEO does not divert. At the cutoff threshold, the CEO receives base rate compensation. Above the cutoff, CEO compensation increases with firm output but at a decreasing rate; in fact, the asymptotic rate of increase is zero. Thus, the optimal custodial design resembles the 80/120 bonus components of executive compensation documented in, for example, Murphy (1986). My conclusion that this sort of nonlinear bonus-like compensation is the optimal is opposed to the conclusion of Jensen (2003) that nonlinear contracting misaligns incentives and generates corporate malfeasance. The base rate of compensation above the cutoff is an increasing linear function of firm size. My work also shows that the better the firm’s ex ante prospects, the higher the cutoff return the firm sets for deterring diversion. This implies that an increase in ex ante firm prospects can actually increase the ex post likelihood of tunneling, and, consequently, make high market/book growth firms more susceptible to tunneling.

The full paper is available for download here.

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