Monthly Archives: May 2009

Stealth Disclosure of Accounting Restatements

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, May 25, 2009
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This post comes from Rebecca Files of the University of Texas at Dallas and Edward P. Swanson and Senyo Tse of Texas A&M University.

In our paper, Stealth Disclosure of Accounting Restatements, which was recently accepted for publication in the Accounting Review, we investigate whether the prominence of the disclosure of a restatement is correlated with the market reaction and the likelihood of litigation. In our sample, we observe and categorize firms into three levels of disclosure. Some companies disclose their restatement prominently in the headline of a press release, usually one that is dedicated to the accounting misstatement (high prominence). Other firms provide less prominent disclosure, typically citing an earnings release in the headline, but still discussing the misstatement in the body of the press release (medium prominence). Most of the remaining firms simply restate prior-period comparative balances in an earnings release, with a footnote briefly explaining that the financial figures for the prior year have been changed (low prominence).

We investigate whether companies providing medium or low prominence disclosure of their restatement benefit from a less negative market reaction and/or a reduced likelihood of litigation. Our first finding is that the magnitude of the market response to a restatement announcement is related to press release format. Three-day returns differ substantially across the three categories of disclosure prominence, averaging -8.3 percent, -4.0 percent, and -1.5 percent for high, medium, and low prominence, respectively. Returns for the high prominence group are statistically different from those for the medium and low prominence groups. Next, we extend the return window to 20 days after the announcement to investigate post- announcement responses to restatements. We find returns of -7.9 percent, -6.4 percent, and -3.2 percent for the high, medium, and low prominence firms, respectively. These returns are considerably less dispersed than the short-window returns, and the 1.5 percent return difference between high and medium prominence is not statistically significant. Apparently, market participants initially underestimate the seriousness of some misstatements disclosed without a headline but subsequently correct their underreaction.

Next, we find that the average return for firms that have post-restatement news items is not significantly different from zero. In contrast, we find a statistically significant drift of -3.7 percent for firms with no news items in the 20-day period, which suggests that investors further evaluate the original press release information. Analysts appear to play an important role in this evaluation because most of the drift is in companies covered by three or more analysts. In addition, once we control for the seriousness of the accounting misstatement, we find that the press release remains highly significant in explaining announcement period returns (-1, +1), but not significantly associated with returns over the longer window (-1, +20).

Lastly, we find that the frequency of lawsuits declines monotonically across the three categories of disclosure prominence (27 percent, 16 percent, and 0 percent for the high, medium, and low prominence firms, respectively). The 16 percent litigation rate for medium disclosure suggests that some managers use medium prominence disclosure for an accounting misstatement that plaintiff attorneys view as serious. We estimate a logistic regression model of the likelihood of litigation in our sample, and find that the prominence index coefficient is positive and significant in the model (even after controlling for endogeneity), suggesting that the likelihood of litigation rises with disclosure prominence. Reducing disclosure prominence by one level (e.g., medium instead of high) reduces the odds of a lawsuit by about half.

The full paper is available for download here.

SEC’s proxy access proposal undermines state-federal balance

Posted by Theodore Mirvis, Wachtell, Lipton, Rosen & Katz, on
Sunday, May 24, 2009
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This post is based on a client memo from Theodore N. Mirvis, Andrew R. Brownstein, Steven A. Rosenblum, Eric S. Robinson, Adam O. Emmerich, Trevor S. Norwitz, and David C. Karp of Wachtell, Lipton, Rosen & Katz. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

At an open meeting on May 20, the Securities and Exchange Commission approved, by a vote of three to two, proposed rules to federalize shareholder access to company proxy materials. Despite strong objections by two Commissioners to this federal incursion into traditional areas of state corporate law, the majority approved the proposed rules as a means to enhance “director accountability” in response to the current economic crisis. If adopted, the new federal rules will effectively sweep aside the recent Delaware legislation allowing shareholder proxy access, as well as current efforts to modify the Model Business Corporation Act in that regard, and bring to an end the possibility of shareholders and American corporations working together to develop new norms and practices in this area.

While we continue to believe that broad proxy access may well dangerously weaken boards of directors and American public companies, it is now clear that it will become a part of our public company landscape. However, we strongly support the view expressed by Commissioner Paredes that the SEC should act judiciously, and with appropriate respect and comity for the role of the states in our federal system, by amending Rule 14a-8 to support the efforts of Delaware and other states to allow companies and their shareholders to agree on proxy access approaches that make sense for each company, rather than adopting a one-size-fits-all mandatory federal rule. This is especially the case as the premise of the SEC’s rulemaking initiatives – that corporate governance mechanisms facilitating greater shareholder oversight may have mitigated some of the causes of the recent economic crisis – is a subject of hot debate. Indeed, Commissioner Casey vociferously rejected this premise and her view is supported by academic and other commentators. See our recent memorandum “A Crisis is a Terrible Thing to Waste: The Proposed “Shareholder Bill of Rights Act of 2009” Is a Serious Mistake.”

As outlined at the SEC meeting, proposed new Rule 14a-11 would allow shareholders or groups of shareholders owning as little as one percent of a company’s shares for one year to require inclusion on the company’s proxy card and in its proxy statement for each meeting director candidates for up to one-quarter of the board. For companies that are not large accelerated filers, the thresholds would be either 3% or 5% depending on size. The SEC is proposing a first-to-file rule if more than the permitted number of nominations is received. By contrast, in our model Delaware bylaw, we proposed that 5% shareholders each be able to nominate one director, up to one-third of the directors to be elected at each election; and we proposed that deference be given to larger stockholders if nominations are oversubscribed. Under the SEC proposal, candidates will be required to be independent under the applicable stock exchange standards, but will not have to be independent of their nominators. The Staff has indicated that the proposal is not intended to enable shareholder access to be used as a “Trojan Horse” for takeover activity and would require nominators to certify that they do not have a current intent to take control of the company (although they may change their minds once their candidates are on the board). Our proposed bylaw, by contrast, seeks to prevent the access regime being abused to support takeover bids by, inter alia, requiring nominating shareholders to agree that they will not take any steps towards a takeover for one year following the election.

The SEC will be issuing its proposed rules shortly and will provide a 60-day period for public comments. While comments are expected to be substantial, the SEC may seek to adopt final rules in time for the 2010 proxy season.

Financial Markets in Crisis: A 9/11-Style Commission

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, May 23, 2009
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This post is by Michael Bopp of Gibson, Dunn & Crutcher LLP.

The Gibson, Dunn & Crutcher Financial Markets Crisis Group is closely tracking government responses to the turmoil that has catalyzed a dramatic and rapid reshaping of our capital and credit markets.

We are providing updates on key regulatory and legislative issues, as well as information on legal and oversight issues that we believe could prove useful as firms and other entities navigate these challenging times.

This update focuses on Congress’ expected creation of an independent commission to examine the domestic and global causes of the current U.S. financial and economic crisis. While various bills have been introduced this Congress and last to create a commission or other entity to investigate the financial markets crisis, none have moved as standalone measures. We called for the creation of a 9/11-style independent commission back in March,[1] and now it appears that Congress is poised to act.

Congress Acts to Create a Financial Crisis Inquiry Commission
The House and Senate have each acted to add language to a fraud enforcement bill that would create an independent bi-partisan financial crisis inquiry commission to investigate the domestic and global causes of the current financial and economic crisis in the United States. On May 6, 2009, the House voted 367-59 to adopt its version of S. 386, the Fraud Enforcement and Recovery Act of 2009 (“FERA”), which is intended to provide the federal government with additional tools to investigate and prosecute mortgage fraud. Cong. Rec. H5262-H5264 (May 6, 2009).

On April 22, 2009, the Senate added a financial markets commission of its own to FERA. Cong. Rec. S4591-S4592 (Apr. 22, 2009). In a press release, Senators Johnny Isakson (R-GA) and Kent Conrad (D-ND), the co-sponsors of the Senate amendment to create the commission, stated that “[t]he only way to get an objective evaluation of where mistakes were made is to create an independent commission of experts to ask what went right, what went wrong and what could we have done to prevent this. We need a forensic audit of the laws of the United States as it relates to the financial markets and our economy.” See here. The Isakson/Conrad amendment was adopted by a vote of 92-2.

At the same time it created a financial markets commission, the Senate also passed an amendment offered by Senators Byron Dorgan (D-ND) and John McCain (R-AZ) to establish a Senate select committee with full subpoena power to investigate the circumstances leading to the financial crises and to make recommendations for change. The Dorgan/McCain amendment was adopted by voice vote. The House did not pass a companion amendment.

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Securities Litigation and the Housing Market Downturn

Posted by Allen Ferrell, Harvard Law School, on
Friday, May 22, 2009
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This post is by Allen Ferrel of Harvard Law School.

Atanu Saha and I have recently completed a paper analyzing the issue of (1) when the housing market downturn occurred (on a sustained, statistically significant basis); (2) when the market foresaw this housing market downturn; and (3) why the issue of the “foreseeability” of the housing market downturn is legally central to much of the securities litigation that has been filed by investors against financial institutions in the wake of the credit market crisis. The paper is forthcoming in the Journal of Corporation Law and was presented at ILEP’s Scottsdale, Arizona conference on securities litigation.

Based on our analysis of housing prices (regional and nationwide) as well as housing sales (the time series of which begins in January of 1969) we conclude that the housing market downturn began in September of 2007, despite common claims that it began in the 4Q of 2006 or 1Q of 2007. To address when the market foresaw the housing market downturn, we analyze, in addition to housing price and sales data, housing futures contract pricing data and various market spreads such as the ABA triple A indexes. We conclude that the housing market downturn was in fact not foreseen by the market prior to the fourth quarter of 2007.

As we explain in detail in our paper, the issue of when the housing market downturn was foreseen by the market is legally central to much of the securities litigation that has been filed because plaintiffs’ claims as to why there were disclosure deficiencies by financial institutions, scienter for those deficiencies and “loss causation” for damages as a result of those deficiencies typically hinge on the claim that the housing market downturn was foreseeable.

Our paper, which is entitled Securities Litigation and the Housing Market Downturn, can be downloaded here.

The Authorizing the Regulation of Swaps Act

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Friday, May 22, 2009
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Editor’s Note: This post is based on a client memorandum by Daniel N. Budofsky, Robert Colby, Annette L. Nazareth and Lanny A. Schwartz of Davis Polk & Wardwell.

On May 4, 2009, Senator Carl Levin (D-Michigan) and Senator Susan Collins (R-Maine) introduced the Authorizing the Regulation of Swaps Act, sweeping legislation that, if adopted, would free multiple federal regulators to regulate swap agreements without mandating how that regulatory authority is to be exercised. While the Levin-Collins bill is intended to fill a regulatory hole, it risks creating a regulatory free-for-all, introducing jurisdictional ambiguities and changes and raising possible questions about the federal preemption of state gaming and bucket shop laws with respect to swaps.

This memorandum provides background on the historical treatment of swaps, summarizes the most significant provisions of the Levin-Collins bill and provides preliminary analysis of the issues raised by the bill.

The memorandum is available here.

Near-Sighted Stress Tests

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, May 21, 2009
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Editor’s Note: This post by Professor Lucian Bebchuk is based on an op-ed piece just published on Forbes.com.

Buoyed by the results of the “stress tests” conducted by banks’ supervisors, markets now appear optimistic about the capital positions of U.S. banks. Unfortunately, however, this renewed optimism has a shaky foundation. By design, the stress tests have avoided estimating the declines in the value of many toxic assets owned by banks. As a result, U.S. banks could well be in much worse shape than has been suggested by the stress tests.

The report announcing the results of stress tests stresses that supervisors conducted “a deliberately stringent test” and examined the ability of banks to absorb losses even under an “adverse” scenario with a deeper and more protracted downturn than under the current consensus estimate. The report concludes that, with a modest aggregate addition of $75 billion in common equity, the banks will be well capitalized at the end of 2010 even under the adverse scenario.

While the focus on the “adverse” scenario might represent a conservative approach, another estimation choice led to under-counting of banks’ expected losses. In reaching an estimate of $600 billion for banks’ aggregate losses, the report focuses on estimating “losses due to failure to pay obligations” rather than “discounts related to mark-to-market values.”

Thus, for a bank with a $1 billion portfolio of real estate loans due in 2010, if the supervisors estimated that only half of the face amount will be repaid, they added $500 million to their estimate of losses. However, for a bank that has “troubled assets” with $1 billion face value that do not become due until after 2011, supervisors did not attempt to come up with a precise estimate of the extent to which, at the end of 2010, the economic value of the troubled assets will fall below the $1 billion face value.

This approach overlooks a substantial amount of economic damage imposed on banks by the crisis. Indeed, to the extent that the government’s new program for restarting the market for troubled assets will provide market transactions for troubled assets with long maturities, mark-to-market rules might require banks to recognize this or next year the declines in economic value of their troubled assets with long maturities. But even if banks are able to avoid recognizing these declines in value on their financial statements until after 2010, there will still be such economic losses. A bank may be an economic zombie even if its financial statements do not yet show it.

The report acknowledges this major problem in a footnote, noting that its estimated losses “are not full lifetime losses … because the projections are for a two-year forward horizon and thus do not capture losses occurring beyond the end of 2010.” Trying to defend this limitation, it notes that the profile of the adverse scenario “includes a return to positive real GDP growth within the two years,” and that a two-year horizon thus “seems likely to capture a large portion of losses from positions held as of the end of 2008.”

Even if positive real GDP growth resumes after 2010, however, some of the assets backing banks’ 2008 positions–residential and commercial real estate, as well as the assets of nonfinancial firms–may remain far below their 2008 levels, and banks may consequently have to bear large losses on their long-maturity assets for years to come.

Furthermore, even accepting that the two-year horizon does capture a “large portion” of aggregate losses to banks’ 2008 positions, it still fails to include the remainder and possibly large portion of these losses. For example, if the “large portion” happens to be 60%, then the banks’ total estimated losses, and the additional capital that they need, are higher by $400 billion than the report’s estimates of $600 billion and $75 billion respectively.

The report also adds that the “the impact of some losses after 2010 is also captured through the calculation of the need of 2010 reserves.” But without estimating the economic losses to troubled assets with post-2010 maturities, which the supervisors did not do, it is not possible to stipulate the level of reserves that will fully cover these losses.

To get a full picture of the banks’ situation, bank supervisors should estimate also the decline in the economic value of banks’ positions with longer maturities. Only then will the stress tests be able to deliver reliable figures for the additional capital necessary to make the banking sector healthy and vigorous. Until such an analysis is done, it would be important to avoid the premature conclusion that the U.S. baking system is largely out of the woods.

Auditing the Auditors

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, May 20, 2009
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This post comes to us from Clive Lennox of Nanyang Technological University Singapore and Jeffrey Pittman of the Memorial University of Newfoundland.

The recent major reforms to the external monitoring of U.S. audit firms which resulted in the independent inspection of audit firms by the Public Company Accounting Oversight Board (PCAOB) motivates our paper, Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms, which was recently accepted for publication in the Journal of Accounting and Economics.

We begin our analysis by dissecting the transition from self-regulation to impartial inspection under the PCAOB. We find that the PCAOB relied on peer review reports to target lower-quality audit firms in their initial round of inspections. In addition, our data reveal that many firms elected to leave the peer review program after the PCAOB began conducting inspections despite the fact that audit firms with public company clients can submit to both PCAOB inspections and peer reviews. Indeed, we find that the worst audit firms, which we measure with the presence of an adverse or modified opinion and the number of weaknesses in their prior peer review report, were more likely to abandon the program. Further, our tests suggest that the probability of a reviewer switch is significantly higher in the event of a modified or adverse opinion. Apart from corroborating prior research that peer review reports are informative, this evidence implies that audit firms were avoiding reviewers who previously gave unfavorable opinions against them. In contrast, the PCAOB prevents such opportunism since audit firms cannot influence the selection of their inspectors, the inspectors do not have current ties to audit firms, and the PCAOB is an independently funded organization.

Although the PCAOB is insulated from the accounting profession, several commentators cast doubt on whether the PCAOB and its inspectors have adequate technical expertise to properly regulate audit firms. In univariate tests, we document that the audit engagement weaknesses disclosed in PCAOB reports fail to predict subsequent changes in audit firms’ market shares, suggesting that the reports do not affect clients’ audit firm choices. In the multivariate analysis, we estimate a model that predicts the expected number of reported weaknesses and find that PCAOB reports identify more weaknesses if audit firms: (1) have more clients, and (2) previously received unfavorable peer review opinions. Next, we construct an unexpected opinion variable, which equals the number of weaknesses disclosed in the PCAOB report minus the number of weaknesses predicted by the model. Reinforcing our univariate evidence, we continue to find that audit firms’ market shares are insensitive to their PCAOB reports.

After the PCAOB began its inspections of public company audits, the scope of peer reviews was largely confined to the audits of private companies to avoid duplication in regulatory monitoring. Our evidence indicates that audit firm choice by public companies hinges less on the peer review reports issued in recent years, implying that the perceived information content of peer reviews falls under the restricted reporting format. Moreover, audit firms began leaving the peer review program after the introduction of PCAOB inspections, especially if their previous peer review opinions had been unfavorable. Accordingly, we conclude that peer reviews have become less relevant to public companies for gauging differential audit firm quality. We also demonstrate that the PCAOB’s failure to disclose certain information—specifically, the quality control weaknesses and overall ratings of audit firms—explains why clients do not find the inspection reports to be informative. Collectively, our findings suggest that the reporting model adopted by the PCAOB is not viewed by audit clients as being informative about audit firm quality.

The full paper is available for download here.

Did Corporate Governance “Fail” During the 2008 Stock Market Meltdown?

Posted by Brian R. Cheffins, University of Cambridge, on
Tuesday, May 19, 2009
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This post is by Brian R. Cheffins of the University of Cambridge.

In my paper Did Corporate Governance “Fail” During the 2008 Stock Market Meltdown? The Case of the S&P 500, a draft of which is currently available here, I provide the first detailed empirical analysis of the operation of U.S. corporate governance during the stock market turmoil of 2008. The study focuses on a sample of companies at “ground zero” of the stock market meltdown, namely the 37 firms removed from the iconic S&P 500 index. The results indicate that, despite U.S. stock markets experiencing their worst year since the 1930s, corporate governance performed tolerably well. This in turn implies it would be premature for policymakers to overhaul existing arrangements.

As the paper describes, over the past few decades U.S. corporate governance has been re-oriented towards the promotion of shareholder value. The sharp decline in share prices that occurred in 2008 implies this shareholder-focused corporate governance model “failed” and that reform is correspondingly justified. However, corporate governance is not the primary determinant of share prices, as reflected by the fact academic testing of the hypothesis that good corporate governance improves corporate financial performance has yielded inconclusive results. It therefore is possible that in 2008 corporate governance in public companies generally functioned satisfactorily amidst general market trends that inexorably drove share prices downwards. The paper examines whether this in fact might have been the case by examining corporate governance in companies removed from the S&P 500 index.

Over the next while there likely will be numerous studies of how corporate governance functioned during the recent financial crisis. However, the 37 companies removed from the S&P 500 in 2008 provide an apt starting point. One reason is that big public companies are markedly more important from an economic and investment perspective than their smaller counterparts — the S&P 500 index covers approximately 75% of the total value of the U.S. equities market. Another is that among any sample of publicly traded firms “troubled” companies will likely be the center of the action with respect to corporate governance controversies (e.g. Enron), and companies dropped from the S&P 500 index are apt to fall into this category. Among the 37 companies removed in 2008 20 can be categorized as “at risk”, with 13 of the companies having been dropped due to a dramatic fall in their market value, six due to “rescue mergers” (i.e. mergers where the company would have likely otherwise ended up bankrupt) and one due to Chapter 11 bankruptcy. Of the 10 industrial sectors represented in the S&P 500, firms from the “financials” sector dominated both the overall sample (15 out of 37 firms) and the “at risk” cohort (12 out of 20).

The primary search strategy I used to assess the operation of corporate governance in the 37 companies removed from the S&P 500 during 2008 was a thorough analysis of press and newswire coverage. A wide-ranging set of searches was conducted for each of the sample companies using Factiva, which offers extensive coverage of newspapers, business magazines and trade journals. The searches were structured to find out what corporate governance mechanisms were activated in the six months before and six months after a company’s removal from the S&P index, with the objective being to assess how responsive and effective corporate governance was during the stock market turmoil.

Due to the prominence of companies that are part of the S&P 500, the Factiva searches should have brought to light most material corporate governance developments concerning the sample companies. Nevertheless, the Factiva searches were supplemented by analysis of Georgeson’s 2008 Annual Corporate Governance Review, the Stanford Law School Securities Class Action Clearinghouse database and an AFL-CIO website offering data on CEO pay for 2007.

The key findings of the study are as follows:

• There was little evidence of Enron-style fraud• Only a minority of the sample companies experienced overt criticism of the board or publicized boardroom turnover, with the firms involved almost exclusively being in the “at risk” category

• A sizeable minority of “at risk” companies experienced publicized turnover of senior management

• The executive pay policies of a sizeable minority of the sample companies were criticized, with the controversies being restricted to at risk companies and companies that paid their CEOs more than the S&P 500 average

• Private equity went AWOL in a difficult climate for public-to-private buyouts

• Institutional investors (i.e. mutual funds and pension funds) were largely silent

• Hedge fund activism affected only a small minority of the sample companies, though the interventions produced results when they occurred

To the extent that corporate governance did “fail” among the companies removed the S&P 500, the difficulties were restricted largely to the financials sector. Boards of a number of banks and thrifts were subjected to intense criticism and bonus-driven executive pay may well have provided senior managers of major financial companies with incentives to take risks that were ill-advised due to the hit their firms would take if things went wrong. The corporate governance challenges financial companies pose, however, are likely to diminish over the next while, with the entire sector retrenching due to a combination of market trends and regulatory factors.

Once the financials are removed from the equation, the case in favor of a regulatory overhaul of corporate governance is weakened considerably. Based on what happened with the companies removed from the S&P 500 during 2008, corporate governance performed tolerably well. Moreover, while the U.K. already has in place a number of the features of corporate governance popular among those who advocate reform in the U.S., the stock market meltdown was worse in Britain than in America. Future studies perhaps will uncover damning evidence of corporate governance breakdowns during the stock market meltdown of 2008. However, at this point the case for radical reform has not been made out.

The paper is available here.

Market Conditions and the Structure of Securities

Posted by Michael S. Weisbach, Fisher College of Business at The Ohio State University, on
Monday, May 18, 2009
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This post is by Michael S. Weisbach of the Ohio State University.

In a recent working paper Market Conditions and the Structure of Securities my co-authors, Isil Erel, Brandon Julio and Woojin Kim, and I investigate whether market downturns can affect both the ability and manner in which firms raise external financing. Our study was motivated in part by Richard Passov, the longtime treasurer of Pfizer, who argued that the possibility of being shut out of the capital markets during market downturns is the primary reason why Pfizer and other technology companies often place such importance on a high bond rating. The extent to which this concern is justified and macroeconomic factors can affect access to capital is an important issue in finance and has clear policy implications.

To evaluate the extent to which these predictions hold in practice, we assemble a database containing information on alternative ways in which firms can raise capital. Our sample contains detailed information on 21,657 publicly-traded debt issuances and 7,746 seasoned equity offerings in the U.S. between 1971 and 2007. The latter part of our sample (from 1988 to 2007) also includes data on 40,097 completed and mostly syndicated loan tranches. Analysis of this sample provides stylized facts on the nature of public and private debt securities that have been issued recently in the US. The vast majority of external financing is supplied by debt rather than equity. Consequently, understanding the choice between alternative types of debt is likely to be equally important as, or even more important than, the choice between debt and equity. We first provide statistics documenting the average quantity of capital raised though issuance of different kinds of securities during different market conditions. A complicating factor when interpreting these numbers is the enormous increase in the total value of funds raised during our sample period. Nonetheless, there are some noticeable differences in the average proceeds per month raised during weak and strong economic conditions. For example, average proceeds raised per month through SEOs tend to drop during poor market conditions. However, short-term and highly-rated public debt increases noticeably relative to longer-term and lower-rated issues during poor market conditions.

Our multivariate analysis suggests that macroeconomic conditions affect both firms’ abilities to raise capital and the manner in which they choose to raise it. We find that the conditional probability of issuing less information sensitive securities, i.e., convertibles rather than equity, increases when credit markets are tight. We do not observe an increase in the demand for bank loans during economic downturns. However, we document that the borrowers of our sample of private loans tend to be of higher quality during bad economic times, consistent with the view that capital available to intermediaries goes down, leading them to tighten lending standards during these periods. In addition to the choice of securities, we also find that market-wide factors affect the structure of debt contracts. In particular, market downturns decrease the expected maturity of public bonds and private loans and increase the likelihood that these bonds and loans are secured. These findings are consistent with the view that market downturns lead firms to structure securities in ways that lessen their information sensitivity. Finally, we consider the quality of the public securities, measured by their ratings. For our sample of public bonds, our results suggest that market downturns do not reduce the issuances of high quality bonds, but are associated with a substantial drop in the likelihood of a junk or unrated bond issue. This pattern suggests that lower quality firms tend to be shut out of the credit markets during poor market conditions.

The full paper is available for download here.

SEC Brings First Insider Trading Case Regarding CDSs

Posted by John F. Savarese, Wachtell, Lipton, Rosen & Katz, on
Sunday, May 17, 2009
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This post is based on a client memo by John F. Savarese and David B. Anders of Wachtell, Lipton, Rosen & Katz.

For the first time, the SEC has brought an insider trading case involving the market for credit default swaps (“CDS”). In a civil complaint filed yesterday in the Southern District of New York, the SEC alleged that a CDS salesman with inside information regarding an upcoming bond offering improperly shared information about it with a portfolio manager for a hedge fund. SEC v. Rorech and Negrin, No. 09-Civ-4329 (May 5, 2009). According to the complaint, the portfolio manager used that information to trade in CDS that referenced bonds of the same issuer, and after the bond restructuring was publicly announced, the price of CDS referencing those bonds rose substantially, leading to a substantial profit.

The CDS market trades over the counter and its participants typically are sophisticated institutional players, and for those reasons, among others, it has not historically been a focus of SEC insider-trading enforcement activity, at least until now. In yesterday’s complaint, however, the SEC asserted that the CDS involved in this case qualified as security-based swap agreements under the Gramm-Leach-Bliley Act and hence are subject to the anti-fraud provisions of the federal securities laws — a proposition that has yet to be tested in court.

This broadening of the reach of SEC enforcement efforts against insider trading is consistent with signals sent in recent speeches by SEC Chairman Mary Schapiro and Division of Enforcement Director Robert Khuzami that they intend to expand and increase the Commission’s enforcement activities in this area. It is also worth pointing out that enforcement activity and private litigation regarding CDS may not be limited to insider trading actions, but may also extend to charges of market manipulation and other theories of liability. One example of a potentially manipulative use of the CDS market would be trading strategies designed to generate profits from short sales by widening CDS spreads and intentionally sending misleading signals on the company’s creditworthiness. CDS can form an effective part of a liability management or hedging strategy and the CDS market and participants in it can serve a helpful purpose in the capital formation process. However, writers and purchasers of CDS are well advised to be extremely careful in today’s volatile environment, where the distinction between appropriate market activity and improper speculation and manipulation is thin, and highly political.

This enforcement action is also a timely reminder of the critical importance of ensuring that public companies and financial institutions adopt and maintain state-of-the art antiinsider trading compliance policies and procedures, as well as implementing regular training and effective controls to prevent and detect employee misconduct. Especially in periods of market volatility and economic distress, a program of prudent vigilance is necessary and appropriate.

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