Monthly Archives: October 2009

SEC Rulemaking – Advancing the Law to Protect Investors

(Editor’s Note: The post below by Commissioner Elisse Walter is a transcript of her remarks at the Annual Corporate Counsel Institute, omitting introductory and conclusory comments; the complete transcript is available here. The views expressed in this post are those of Commissioner Walter and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners or members of the staff.)

When I was sworn in as an SEC Commissioner a little over a year ago, I promised to live up to the awesome responsibility entrusted to me as the “investor’s advocate.” [1]

After all, the SEC is the only federal regulator whose mission is to protect investors.

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Harvard’s Proxy Access Roundtable

In light of the intense current debate regarding the SEC’s proposed proxy access reforms, the Harvard Law School Program on Corporate Covernance this week hosted a roundtable on the proposed reforms. The Roundtable brought together prominent participants in the debate – representing a range of perspectives and experiences – for a day of discussion on the subject.

The two morning sessions, chaired by Professor Robert Clark, focused on the question of whether the SEC should provide an access regime, or whether it should leave the adoption of access arrangements, if any, to private ordering on a company-by-company basis. The third session, chaired by Professor Howell Jackson, focused on on how a proxy access regime should be designed, assuming the SEC were to adopt such an access regime. The final session, chaired by Professor Lucian Bebchuk, went beyond proxy access and focused on whether there are any further changes to the arrangements governing corporate elections that should be considered.

The Program on Corporate Governance will be issuing a transcript of the Roundtable’s proceedings later on; a link to the transcript will be posted on the Forum.

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Boards Play A Leading Role in Risk Management Oversight

This post is based on an article from the New York Law Journal by David A. Katz and Laura A. McIntosh of Wachtell, Lipton, Rosen & Katz.

One might say that “risk management” is the new “hot topic” in corporate governance. Just as the Enron and other high-profile corporate scandals were seen as resulting from a lack of ethics and oversight, the credit market meltdown and resulting financial crisis have been blamed in large part on inadequate risk management by corporations and their boards of directors. [1] As a result, along with the task of implementing corporate governance procedures and guidelines, a company’s board of directors is expected to take a leading role in overseeing risk management structures and policies. What needs to be understood, though, is that there is no way to eliminate risk, nor would any enterprise be well-served by attempting to do so. However, it is important for directors to take steps to be well-informed as to the company’s risk profile, to discuss and evaluate risk scenarios and to satisfy themselves on an ongoing basis as to the adequacy of management’s efforts to address material risks. The goal should not be to eliminate risk, but to make sure that risks are understood and appropriately managed; the management team is responsible for managing the risks, while the board of directors’ role should be one of oversight. [2]

Elements of Effective Risk Oversight

There are a number of important elements to risk oversight by a board of directors that can be addressed through effective communication between the board of directors and members of senior management, effective communication among board members, board committees, and board advisors and effective coordination among all of the participants.

Communications between the board of directors and members of senior management. One of the most important elements in effective oversight of risk management is direct communication between members of the board and members of senior management, including senior management executives responsible for risk management. The variety and severity of risks to which a company is exposed, and the extent to which the company can “manage” such risks, depend on many factors, and it is crucial that the board and management share an understanding—which should be updated on an ongoing basis and revised as appropriate—as to the company’s overall tolerance for risk. It is the responsibility of management to provide the members of the board with sufficient information to enable them to understand the company’s risk profile, including information regarding the external and internal risk environment that the company and its industry face, the specific material risk exposures affecting the company’s current and future operations (including financial and other risks), how risks are assessed and prioritized by the management team, risk response strategies, implementation of risk management procedures and infrastructure, and the strength and weaknesses of the overall system. Through effective communications between the board and senior management, members of the board should be confident that the company’s executives understand the risks that the enterprise faces and are effective in their day-to-day management of enterprise risk.

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Investor Perceptions of Board Performance

This post comes to us from Paul Fischer of Pennsylvania State University, Jeffrey Gramlich of the University of Southern Maine and Copenhagen Business School, Brian Miller of Indiana University, and Hal White of the University of Michigan.

 

In our forthcoming Journal of Accounting and Economics paper Investor Perceptions of Board Performance: Evidence from Uncontested Director Elections, we investigate whether uncontested elections serve as meaningful polls reflecting investor perceptions of board performance. Our paper is motivated in part by the general perception that many director elections are meaningless charades of shareholder democracy due to the lack of contested elections, coupled with the widespread use of plurality voting rules.

We construct approval measures using director vote tallies for a sample of S&P 500 firms from 2000-2004, and find evidence consistent with these measures reflecting investor perceptions of board performance. In particular, we examine the relation between the approval measures and the stock price response to a change in the most focal member of the board, the CEO. We find that higher (lower) approval is associated with lower (higher) stock price reactions to subsequent announcements of management turnovers. We also show that the approval measures predict uncertain future events expected to be associated with board performance. Specifically, we find that firms with low board approval are associated with a higher likelihood of CEO turnover, greater board turnover, lower CEO compensation, fewer and better received acquisitions, and more and better received divestitures subsequent to the vote.

We also assess whether the approval measures are incrementally informative to traditional metrics of board performance, such as stock returns and return on assets. In particular, we find that the information content in the vote approval measures is largely unaffected by the inclusion of controls for traditional metrics of board performance. Hence, the vote approval metrics are uniquely meaningful measures of board performance. As such, our approval measures can be used to complement existing governance measures, such as the Gompers, Ishii, and Metrick (2003) index, which focus primarily on governance structures as opposed to the performance of the individuals operating within those structures. Overall, our findings suggest uncontested votes do reflect investor perceptions in spite of a number of countervailing forces, including the lack of diligent voting by all shareholders.

The full paper is available for download here.

Delegation and Accountability at the SEC

This post comes to us from Russell G. Ryan of King & Spalding LLP.

Investors and lawmakers have been clamoring for a more aggressive and nimble SEC, and it looks like they’re about to get it. But at what cost?

In August, the Commission and its enforcement director announced a series of bold new measures designed to expedite investigations, create specialized units to focus on priority cases, and flatten out management of the enforcement division.

Among those measures was a new SEC rule – adopted for a one-year trial period – which for the first time delegates to the agency’s enforcement director the legal authority to issue “formal orders of investigation” without first getting approval from the politically-appointed commissioners. The director himself announced that he will sub-delegate this new responsibility to other senior officials who report directly to him.

In SEC investigations, “formal orders” are significant mostly because they empower staff investigators to issue judicially enforceable subpoenas that require people and companies to turn over documents and give sworn testimony. Without such an order, the staff must rely entirely on voluntary cooperation to obtain information.

Delegation of authority to issue these orders will undoubtedly serve its intended purpose of enabling SEC enforcement staff to act more swiftly and authoritatively in the early stages of their investigations. But the move represents a dramatic departure from historical SEC practice and raises broader questions about delegation and accountability at independent federal agencies.

Like many independent federal agencies from the New Deal era, the SEC exercises a number of quasi-legislative and quasi-executive functions, yet for the most part operates autonomously from either Congressional or Presidential control. Its five commissioners (including its chairman) are appointed by the President for staggered five-year terms and must be confirmed by the Senate, but neither Congress nor the President can remove commissioners from office at will. By law, no more than three commissioners can be from the same political party at any given time.

Although this structure has been upheld by the courts, independent agencies exercise law enforcement powers on inherently shakier constitutional footing than the Cabinet departments and executive agencies operating under full Presidential control, such as the U.S. Department of Justice. Moreover, a critical safeguard in this structure is the presumption that commissioners of an independent agency – the only personnel tethered to the political process by a presidential appointment and Senate confirmation – will be accountable for significant action taken by the agency and its staff.

When it comes to the SEC, issuing formal investigation orders is a sufficiently important responsibility that it should not be delegated by the agency’s commissioners.

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Remarks Regarding Investment Companies

(Editor’s Note: The post below by Commissioner Troy Paredes is a transcript of his remarks at the Investment Company Institute’s Annual Capital Markets Conference, omitting introductory and conclusory remarks; the complete transcript is available here. The views expressed in this post are those of Commissioner Paredes and do not necessarily reflect those of the Securities and Exchange Commission or the other Commissioners.)

Since its inception in 1940 [1] — a historic year for the SEC — ICI has been an important voice, actively contributing to improving the oversight of our securities markets. In fact, many of the rules and regulations that the SEC has enacted in the subsequent decades were refined thanks to the thoughtful comments and research ICI and its members have provided. I am sure that this conference, like others before it, will spawn interesting insights that can help us achieve a well-calibrated regulatory regime that strikes appropriate balances.

I considered a range of topics to address today before deciding on three: custody, money market funds, and the Jones case.

Custody

Safeguarding client assets is a critical function of investment advisers. Investors must feel safe knowing that the funds and securities they own on paper exist in reality. Investors need to be confident that their returns are not fictitious and that their assets have not been misappropriated.

To this end, this past May, the Commission proposed rules under the Investment Advisers Act to enhance the safeguarding of investment adviser client assets. [2] Among other things, the Commission proposed amending the custody rule to require an annual surprise examination of client assets by an independent public accountant for registered investment advisers with custody.

Although I voted in favor of the Commission’s custody proposal, I raised certain reservations at the open meeting, particularly about extending the surprise exam to the extent proposed. [3] First, I questioned whether the surprise exam should cover investment advisers with an independent qualified custodian or be targeted to instances where the investment adviser or a related person is the qualified custodian. Given that non-affiliated custodians already serve as an important safeguard of client assets, it is not self-evident that the cost of a surprise exam is warranted. Second, I sought comment on whether the custody rules should cover investment advisers who have custody only because they withdraw fees from client accounts. Is the ability to withdraw fees a sufficient basis upon which to subject an adviser to the cost of yearly surprise exams? I expressed a related reservation that surprise exams may undercut competition if they were disproportionately costly and burdensome for smaller advisers.

Having had occasion to consider comments the Commission has received, I still question whether the proposed surprise examination requirement may reach too far. Without doubt, investors need to be secure that their investments are protected. That said, it is possible to regulate past the point of prudence. It is always possible to take another regulatory step to protect against fraud and other abuses, but is the cost of the additional regulation warranted? Given the rest of the relevant regulatory regime and the steps advisers already take to secure investor assets, the marginal benefit of a surprise examination may not outweigh the attendant cost. Not every incremental benefit of additional regulation is justified; there are diminishing returns.

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SEC Urged to Defer Adopting Proxy Access Rules

A broad cross section of commenters is encouraging the Securities and Exchange Commission (the “SEC”) to take a cautious approach with its latest proposal to allow shareholders to solicit votes for their director candidates through corporate proxy statements. [1]

The SEC received over 520 comment letters to date recommending a host of modifications to its proposal for uniform mandatory proxy access. Some commenters, including members of the investor community, have expressed concerns about the desirability of any uniform mandatory proxy access rule. Significant investor constituencies have also expressed concern about a possible compromise being advocated by companies and their representatives: deferring adoption of a uniform mandatory proxy access rule and instead allowing shareholders to propose bylaw amendments permitting proxy access through the existing shareholder proposal process. That compromise does have institutional investor support, however, with one leading investor recommending raising the ownership threshold for shareholder proxy access bylaw amendments to 5%.

In 2003 and 2007, the SEC proposed different rules to give shareholders greater access to a company’s annual proxy materials to nominate candidates for election as directors. In response to those rule proposals and investor concerns, states and corporations have taken steps to allow for proxy access and expanded shareholder influence in director elections. In addition to greater adoption of majority voting standards, states such as Delaware have recently adopted laws specifically permitting proxy access and proxy solicitation expense reimbursement bylaws. In response to a perceived need for greater director accountability arising out of the recent financial crisis, the SEC released its latest proposal that would mandate a uniform federal access right to a company’s proxy materials for shareholders who meet minimum holding period and ownership threshold criteria.

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Patterns in Corporate Events

This post comes to us from Raghavendra Rau of Purdue University and Aris Stouraitis of the City University of Hong Kong.



It has been extensively documented that corporate events occur in waves. However, existing empirical studies have examined individual types of waves separately. In our paper, Patterns in the timing of corporate event waves, which was recently accepted for publication in the Journal of Financial and Quantitative Analysis, we investigate whether a relation exists between the different types of corporate events. Our analysis focuses on the timing of five different types of corporate events (new issues – both IPOs and SEOs, mergers – both stock and cash-financed, and share repurchases) using a comprehensive dataset of corporate transactions over the 25-year period 1980-2004.

The starting point in our analysis is the observation that most corporate events are combinations of two activities that have been central to corporate finance: financing decisions and investment decisions. The academic literature has traditionally argued that financing and investment decisions are driven by one of two hypotheses: (1) The neoclassical efficiency hypothesis which suggests that managers undertake corporate transactions for efficiency reasons, issuing equity or buying targets to take advantage of growth opportunities or to invest in positive NPV projects, and (2) the market misvaluation hypothesis which suggests that rational managers take advantage of irrational market misvaluations by issuing stock in exchange for cash or other firms.

What distinguishes the events we study is the extent to which they involve either the financing decision or the investment decision. Theories that describe why firms choose investment or financing decisions imply that related corporate events should be affected by the same factors. If we consider pure financing decisions for example, SEOs, IPOs, and stock repurchases are related, in that the former two both involve firms issuing equity while the last involves buying back equity.

The first part of our analysis consists of three tests that explore the correlation structure of event activity, that is, how activity in one type of event correlates with activity in other events. First, we find strong positive correlations at the industry level in contemporaneous activity within stock issuance events of different types (SEOs, IPOs, stock-financed M&A), and negative correlations between all three stock issuance events and stock repurchases. Second, we find that lagged SEO volume predicts future IPO volume, and that lagged SEO and IPO volume both predict future stock-financed M&A volume. Third, we show that waves of events follow the same pattern. We find, therefore, a previously undocumented pattern in the timing of corporate events.

The second part of our analysis involves regressions where we explain the likelihood of different types of waves using explanatory variables that proxy for neoclassical efficiency or misvaluation factors. Our analysis suggests that waves are driven by both neoclassical and misvaluation factors and the relative importance of these factors changes in different periods, leading to differing conclusions in the different studies that look at this issue.

The full paper is available for download here.

Patterns in Corporate Events

(Editor’s Note: This post comes to us from Raghavendra Rau of Purdue University and Aris Stouraitis of the City University of Hong Kong..)

It has been extensively documented that corporate events occur in waves. However, existing empirical studies have examined individual types of waves separately. In our paper, Patterns in the timing of corporate event waves, which was recently accepted for publication in the Journal of Financial and Quantitative Analysis, we investigate whether a relation exists between the different types of corporate events. Our analysis focuses on the timing of five different types of corporate events (new issues – both IPOs and SEOs, mergers – both stock and cash-financed, and share repurchases) using a comprehensive dataset of corporate transactions over the 25-year period 1980-2004.

The starting point in our analysis is the observation that most corporate events are combinations of two activities that have been central to corporate finance: financing decisions and investment decisions. The academic literature has traditionally argued that financing and investment decisions are driven by one of two hypotheses: (1) The neoclassical efficiency hypothesis which suggests that managers undertake corporate transactions for efficiency reasons, issuing equity or buying targets to take advantage of growth opportunities or to invest in positive NPV projects, and (2) the market misvaluation hypothesis which suggests that rational managers take advantage of irrational market misvaluations by issuing stock in exchange for cash or other firms.

What distinguishes the events we study is the extent to which they involve either the financing decision or the investment decision. Theories that describe why firms choose investment or financing decisions imply that related corporate events should be affected by the same factors. If we consider pure financing decisions for example, SEOs, IPOs, and stock repurchases are related, in that the former two both involve firms issuing equity while the last involves buying back equity.

The first part of our analysis consists of three tests that explore the correlation structure of event activity, that is, how activity in one type of event correlates with activity in other events. First, we find strong positive correlations at the industry level in contemporaneous activity within stock issuance events of different types (SEOs, IPOs, stock-financed M&A), and negative correlations between all three stock issuance events and stock repurchases. Second, we find that lagged SEO volume predicts future IPO volume, and that lagged SEO and IPO volume both predict future stock-financed M&A volume. Third, we show that waves of events follow the same pattern. We find, therefore, a previously undocumented pattern in the timing of corporate events.

The second part of our analysis involves regressions where we explain the likelihood of different types of waves using explanatory variables that proxy for neoclassical efficiency or misvaluation factors. Our analysis suggests that waves are driven by both neoclassical and misvaluation factors and the relative importance of these factors changes in different periods, leading to differing conclusions in the different studies that look at this issue.

The full paper is available for download here. [link to full paper on SSRN]

 

The Consumer Financial Protection Agency: Sorting the Critiques

(Editor’s Note: This post is based on an article from Lombard Street.)

On June 30, 2009, the Obama Administration delivered to Congress the draft Consumer Financial Protection Agency (CFPA) Act of 2009. On July 8, House Financial Services Committee Chairman Barney Frank unveiled the Consumer Financial Protection Agency Act of 2009 (HR 3126), which shares key features with the President’s proposal. The proposal to create a new agency to police consumer financial products has been the subject of much debate. My goal, in this article, is to sort out and evaluate the different critiques levied against the proposed CFPA Act, in light of the underlying case for a new agency charged with the regulation of Consumer Financial Products (CFPs). To that end I begin by recounting the arguments for a CFPA. I then examine the critiques of the CFPA Act, reframed as challenges or counterarguments to the arguments for a CFPA. I conclude that there is broad agreement on the need for institutional reform, which would include a CFPA. At the same time, there is much disagreement about what mandate and authority the CFPA should have. I end with an optimistic note, suggesting that even a CFPA with less power than envisioned in the proposed Act could do much good. Specifically, I argue that a presumably less controversial section of the proposed CFPA Act – the section establishing a consumer right to access information – could promote efficiency and consumer welfare in the market for CFPs.

A. The Case for a CFPA

I begin by recounting the main reasons for the creation of a new federal agency with the mandate and authority to police consumer financial products. [1] A new agency is needed because (1) market forces fail to maximize welfare in important CFP markets, and (2) the current regulatory structure that was supposed to deal with this market failure has proved inadequate. I discuss these two elements in turn.

1. Market Failure

The proposed CFPA Act is a solution to a problem – excessively risky CFPs, or, more accurately, CFPs that impose underappreciated risks on consumers. The claim is that market forces have not worked to constrain CFP risks. This claim is based on theoretical arguments about the limits of market discipline in the CFP context. More importantly, the claim is supported by empirical evidence that many consumers do not make informed, welfare-maximizing choices in CFP markets. READ MORE »

Remarks Regarding Market Structure

(Editor’s Note: The post below by Commissioner Troy Paredes is a transcript of his remarks at the Securities Industry and Financial Markets Association’s 14th Annual Fixed Income Legal and Compliance Conference, omitting introductory and conclusory remarks; the complete transcript is available here. The views expressed in this post are those of Commissioner Paredes and do not necessarily reflect those of the Securities and Exchange Commission or the other Commissioners.)

I’ve had the honor and privilege of serving at the SEC since August of last year, and it is hard to believe how quickly the time has flown by. It goes without saying that the past year has been challenging. Collectively we have confronted difficulties and uncertainties recalling the stresses and turbulence of the Great Depression. Among other things, the steady flow of concern has prompted a serious reconsideration of the financial regulatory framework both in the U.S. and abroad. The SEC itself has been very active, advancing a number of initiatives relating to such matters as credit rating agencies; money market funds; custody of investment adviser client assets; proxy access; corporate governance and executive compensation disclosures for public companies; and short selling.

* * *

I’d like to focus the balance of my brief remarks this morning on an additional — and complex — area that is under active consideration both inside and outside the SEC: market structure. There are many interconnected aspects of market structure, all of which need to fit together for our markets to function smoothly and efficiently.

Last week, the Commission took up one aspect of our markets: flash orders. The Commission’s flash order proposal would amend Rule 602 of Regulation NMS to prohibit the flashing of marketable orders. [1] Let me take a moment to reiterate a few of the points I highlighted at the Commission’s open meeting. [2] As always, I look forward to considering the comments we receive on all of the agency’s ongoing rulemakings.

First, a thorough and unbiased assessment of flash orders must account for the potential benefits of flash orders that are lost if a ban is imposed. Flash orders present certain concerns, such as the prospect of discouraging displayed liquidity, but these concerns need to be weighed against the benefits of flash orders to determine the net impact of a ban and whether one is warranted at this time.

The identified benefits of flash orders include the potential to induce liquidity into the market from those who are unwilling to have their quotes displayed publicly, leading to opportunities for better execution; affording market participants lower fees than charged for executing against displayed liquidity; and otherwise reducing transaction costs for investors who are unwilling to display. The proposal release describes these benefits in more detail.

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