Monthly Archives: February 2012

Decoding Inside Information

The following post comes to us from Lauren Cohen and Christopher Malloy, both of Harvard Business School, and Lukasz Pomorski of the Department of Finance at the University of Toronto.

In our paper, Decoding Inside Information, forthcoming in the Journal of Finance, we employ a simple empirical strategy to decode the information in insider trading. Our analysis rests on the basic premise that insiders, while possessing private information, trade for many reasons, and that by identifying ex-ante those insiders whose trades are “routine” (and hence uninformative), one can better isolate the true information that insiders contain about the future of firms. Using simple definitions of routine traders, we are able to systematically and predictably identify insiders as either opportunistic or routine throughout our sample. We show that stripping away the uninformative signals of routine traders leaves a set of information-rich opportunistic trades that are powerful predictors of future firm returns, news, and events.

We show that while the abnormal returns associated with routine traders are essentially zero, a portfolio strategy that instead focuses solely on opportunistic insider trades yields value-weighted (equal-weighted) abnormal returns of 82 basis points per month (180 basis points per month). Similarly, in a regression context the combined differences in the coefficients between opportunistic trades and routine trades translate into an increase of 158 basis points per month in the predictive ability of opportunistic trades relative to routine trades. Further, this effect increases with the strength of the opportunistic signal (as measured by the number of trades or trade-size intensity), but is unrelated to the strength of the routine signal.

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SEC Disclosure Guidance on Exposures to European Sovereign Debt

The following post comes to us from Brian V. Breheny, partner at Skadden, Arps, Slate, Meagher & Flom LLP, and is based on a Skadden memorandum by Mr. Breheny and Andrew J. Brady.

On Friday, January 6, 2012, the staff of the SEC’s Division of Corporation Finance issued the fourth installment in its new Disclosure Guidance Topic series. Topic No. 4 focuses on the exposures of registrants to the debt of certain European countries. The staff specifically highlighted its concern about “the risks to financial institutions that are SEC registrants from direct and indirect exposures to” European sovereign debt.

Enhanced Disclosures

The goal of this new guidance is to expand and enhance the disclosures that registrants provide related to sovereign debt exposures, to ensure that investors have transparent and comparable information about the uncertainties of these exposures. This information generally is included in registrants’ disclosures about risk factors, qualitative and quantitative market risks, and management’s discussion and analysis. Bank holding companies and other registrants engaging in similar lending and deposit activities also are required to make the disclosures required by the SEC’s Industry Guide 3 (Statistical Disclosure by Banking Holding Companies).

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Board Focus 2012: Issues and Developments

Victor Lewkow is a partner at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb alert memorandum by Mr. Lewkow, David Becker, Alan Beller, Janet Fisher, Arthur Kohn, and Ethan Klingsberg.

Governance developments in 2011 brought some good news. Shareholder governance proposals were at their lowest level since 2002. Support declined for controversial proposals, such as shareholders’ right to call special meetings or act by written consent, and ISS conceded that its recommendations about written consent proposals should reflect the company’s governance as a whole. Even say-on-pay voting had some worthwhile effects. It gave shareholders the means to express more targeted dissatisfaction, driving a decline in opposition to director incumbents, and it prompted more and better dialogue between many companies and their major shareholders and better disclosure about the business rationale for pay decisions.

But regulators and shareholders remain energized. The SEC brought a record number of enforcement proceedings in 2011, a trend likely to continue, and it and the PCAOB have several important regulatory initiatives underway. For their part, shareholders remain acutely focused on stock performance as the yardstick to evaluate a company’s execution, despite market swings experienced in 2011 that reflected more than anything else fragile economic and political conditions worldwide. The Eurozone crisis and election year politics will keep business prospects extremely challenging and uncertain. In this context, it is critical for boards to frame their deliberative processes in a way that assures the protection of the business judgment rule, while positioning themselves and management to meet expectations of regulators and investors alike. We highlight below some of the issues we believe boards should keep in mind in 2012.

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A New Playbook for Global Securities Litigation and Regulation

The following post comes to us from Paul A. Ferrillo, counsel at Weil, Gotshal & Manges LLP specializing in complex securities and business litigation, and is based on a Weil Alert by Mr. Ferrillo, Robert F. Carangelo and Catherine Y. Nowak.

Key developments in both the litigation and regulatory context are compelling multinational corporations to reassess their global securities litigation and regulatory compliance strategies. In the litigation context, recent U.S. Supreme Court activity has limited the ability of overseas plaintiffs to bring securities class action claims within the United States. As such, plaintiffs have shifted litigation to more flexible jurisdictions in Europe and overseas, thereby forcing global firms listed on multiple exchanges to increasingly defend against securities class action claims and regulatory investigations in numerous jurisdictions. At the same time, governments around the world have responded to the recent financial crisis by bolstering their regulatory capability. Governments have not only adopted more robust legislative regimes with respect to securities regulation, but they have also invested heavily in stronger enforcement protocols.

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A Blueprint for Contingent Convertible Securities?

The following post comes to us from Michael O’Bryan, co-chair of the global M&A Group and a partner in the Corporate Finance Group at Morrison & Foerster LLP, and is based on a Morrison & Foerster Client Alert by Peter Green and Jeremy Jennings-Mares.

It has probably not escaped the attention of the reader that European banks, and their ability to meet their continuing funding needs, have been some of the principal victims of the continuing uncertainty surrounding the future of the Eurozone, due to their exposures to Eurozone sovereign debt. As part of its general efforts to increase market confidence in European banks, the European Banking Authority (EBA) published a Recommendation [1] on 8 December 2011 as to the creation and maintenance of temporary capital buffers by European banks.

The EBA recommends that European banks should have created, by 30 June 2012, a temporary capital buffer by attaining a Core Tier 1 capital ratio of at least 9 percent.

The Core Tier 1 capital ratio is to be calculated by comparing a bank’s Core Tier 1 capital to its risk-weighted assets. “Core Tier 1 capital” is defined to include ordinary shares or similar instruments, but also newly-issued contingent convertible instruments if their terms comply with a new common term sheet for such instruments (“Buffer Convertible Capital Securities” or “BCCS”) set out by the EBA in Annex III to the Recommendation. This represents the first time that a European banking authority has laid down in such detail the core terms that such an instrument should possess in order to count as Tier 1 capital. Existing convertible capital instruments of European banks will not be counted towards the 9 percent ratio, unless they convert into Core Tier 1 capital by the end of October 2012.

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Executive Pay and the Financial Crisis

Editor’s Note: Lucian Bebchuk is Professor of Law, Economics, and Finance and Director of the Corporate Governance Program at Harvard Law School. This post is the opening statement in an online debate at a World Bank forum between Lucian Bebchuk and René Stulz on the question: Has executive compensation contributed to the financial crisis? The moderator’s introduction to the debate is available here, Lucian Bebchuk’s statement is available here, and René Stulz’s opening statement is available here, with responses by Bebchuk and Stulz expected next week. Bebchuk’s post refers to several studies on the subject issued by the HLS Program on Corporate Governance, including Regulating Bankers’ Pay, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, and Paying for Long-Term Performance.

Yes, there is a good basis for concern that executive pay arrangements have contributed to excessive risk-taking during the run-up to the financial crisis. To be sure, other factors were clearly at work: the environment within which firms operated grew riskier due to asset bubbles generated by macro policies and global factors, and regulatory constraints on risk-taking and capital requirements were too lax. As financial economists generally recognize, however, for any given environment and outside constraints, the performance and risk choices of firms depend substantially on the incentives of firms’ executives. Unfortunately, rather than provide incentives to avoid excessive risk-taking, the design of pay arrangements in financial firms encouraged such risk-taking.

Of course, despite incentives to take excessive risks, some executives might have avoided doing so due to professional integrity, reputational concerns, or fiduciary duty norms. And some executives taking excessive risks might have done so due to their under-estimation of the risks taken. But economics and finance teach us that incentives often matter. Thus, to the extent that pay arrangements provided significant incentives to take excessive risks, the possibility that such incentives in fact contributed materially to the excessive risks taken in the run-up to the crisis should be seriously considered.

In fact, pay arrangements did provide substantial incentives for excessive risk-taking. Under the standard design of pay arrangements, executives were fully exposed to the upside of risks taken but enjoyed substantial insulation from part of the downside of such risks. As a result, executives had incentives to increase risk-taking beyond optimal levels.

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REIT and Real Estate M&A and Restructurings

Adam Emmerich is a partner in the corporate department at Wachtell, Lipton, Rosen & Katz focusing primarily on mergers and acquisitions and securities law matters. This post is based on a Wachtell Lipton firm memorandum by Mr. Emmerich and Robin Panovka.

Despite a sluggish year-end, overall deal activity in 2011 was strong, continuing the recovery from the post-crisis slump. In addition to strong overall volume (roughly $70 billion of deals), 2011 was impressive for its range of deals, from large-scale public-to-public mergers in the consolidating industrial and healthcare sectors, to major private-to-public acquisitions as private (often over-levered) assets and companies continued to undergo major ownership changes across many sectors, including distressed hotel and retail portfolios that were over-levered in the last cycle. There was even some leveraged opportunistic buying, at enterprise values much reduced from the peak, with credit windows opening for brief periods on a spot basis depending on the deal and buyer involved.

While the uncertainty caused by the European crisis and other economic conditions has created a wait-and-see attitude in many boardrooms, our sense is that things are warming up and that the conditions that generated impressive deal volume in the first half of 2011 will again drive a healthy volume of deals in 2012. Many boards and CEOs who hit “pause” in the last few months have their fingers hovering over the “play” button, ready for action when the time is right on the lineup of deals that have been percolating for some time. The balance sheets of most of the larger REITs remain strong, dry powder is still plentiful, and opportunities continue to arise, especially given the low supply of new development product, strong investor appetite, and the distressed pools possibly coming on line as the first big wave of pre-financial crisis 2007 debt matures in 2012.

We list below some themes and issues we are keeping an eye on as 2012 begins:

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