Yearly Archives: 2012

Codifying FINRA’s Front-Running Policy

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, July 1, 2012
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The following post comes to us from Robert Buckholz, partner and co-coordinator of the Corporate and Finance Group at Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication.

FINRA has proposed to codify its front-running policy, originally adopted by the NASD in 1987, as new FINRA Rule 5270. [1] The new rule would expand the policy to prohibit member firms and their associated persons from engaging in a broader range of front-running transactions ahead of a customer block order in securities. The rule would apply to most derivative transactions, not just those in futures and options, when the block involves the underlying security, as well as to transactions in the block security itself. In addition, block orders subject to the rule would include those in most derivatives, not only futures and options. FINRA believes that the additional trading activity that would now be covered by the broader prohibition would already violate other FINRA rules. The new provisions would also state that front-running activity ahead of non-block orders may violate other FINRA rules or the federal securities laws. FINRA originally proposed these changes in 2008 and expects to announce an implementation date within 90 days after SEC approval.

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Corporate Political Spending: Why the New Critics Are Wrong

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, June 30, 2012
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The following post comes to us from Robert J. Shapiro, chairman of Sonecon, LLC, and is based on the executive summary of a Manhattan Institute Legal Policy Report by Mr. Shapiro and Douglas Dowson, available in full here. Work from the Program on Corporate Governance about corporate political spending includes Corporate Political Speech: Who Decides? by Lucian Bebchuk and Robert Jackson, discussed on the Forum here. A committee of law professors co-chaired by Bebchuk and Jackson submitted a rulemaking petition to the SEC concerning corporate political spending; that petition is discussed here.

Since the Supreme Court’s 2010 Citizens United decision held that corporate political expenditures are free speech under the First Amendment, various groups and individuals have advocated imposing new limits on corporate political activity. These efforts include calls on shareholders to demand that corporations refrain from involvement in the political process. Such demands have been buttressed by an emergent academic literature which, in contrast to what had been an established perspective, has questioned whether corporate financial contributions and even lobbying are actually in the interest of corporate shareholders. This paper reviews this new literature, contrasts it with previous work on this subject, and determines that the new studies ultimately fail to establish that corporate political activity adversely affects shareholder returns.

Corporate political activities take a variety of forms, including direct campaign contributions, joining and supporting trade associations, lobbying, the hiring of former public officials, advertising to move public opinion, and grassroots advocacy promotions. Lobbying has long been the dominant form for political participation by corporations and other interests: In the 2010 election cycle, for example, firms and other interests spent $6.8 billion on lobbying, compared with PAC expenditures of $1.3 billion.

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Using Economic Analysis in SEC Rulemaking

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, June 29, 2012
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Editor’s Note: Elisse B. Walter is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Walter’s recent remarks at the Conference on Current Topics in Financial Regulation, which are available here. The views expressed in the post are those of Commissioner Walter and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

As you may know, the SEC has recently enhanced its economic firepower, through, for example, significantly increasing the number of PhD economists in the Division of Risk, Strategy, and Financial Innovation. Lately much of the external focus on the role of economic analysis at the SEC has been on cost-benefit analysis – which is certainly an important part of economic analysis. However, it is not the only way that the Commission is using economic analysis in our work. Increasingly, our economists are getting involved earlier and more comprehensively in the rulemaking process, not just to help the Commission weigh the ultimate costs and benefits of our regulatory decisions, but to provide a reasoned framework for making those decisions. Examples include providing up-to-date information about the current state of the markets, and helping us think of alternative ways to meet our regulatory goals.

I believe that these efforts are bearing fruit, and I would like to provide a recent example of a significant regulatory action where, in my view, we used economic analysis effectively to guide our decision-making. This was in our adoption of the rule defining “security-based swap dealer” under Title VII of the Dodd-Frank Act, as part of a joint rulemaking with the CFTC. Further defining the term “security-based swap dealer” was one of the many tasks that Congress assigned to us as part of creating a new regulatory regime for security-based swaps. Congress also mandated that the Commission exempt from the dealer designation an entity that engages in a de minimis quantity of dealing activity. Again, however, Congress left it to us to hammer out the details of what would constitute a de minimis level of dealing activity. Considering that the over the counter derivatives market is still a largely unregulated space, determining an appropriate de minimis level seemed like a daunting task, and the comments we received reflected a diversity of views on what this de minimis level should be.

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Insider Trading and Stock Splits

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, June 29, 2012
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The following post comes to us from Vinh Nguyen and Anh Tran both of the School of Public and Environmental Affairs at Indiana University Bloomington, and Richard Zeckhauser, Professor of Political Economy at Harvard University.

In our paper, Insider Trading and Stock Splits, which was recently made publicly available on SSRN, we examine whether stock splits create value to shareholders. Inside traders capitalize on their edge in information. Typically, they buy before good news is released or sell before bad. Insiders have an even greater advantage if they can create news that moves a stock, even when no real news is available. There is strong evidence that this is precisely the strategy that inside traders in Vietnam have employed in recent years. They have purchased stock, and then announced stock splits. As is common in stock markets, these stock splits led to price rises, likely with help from manipulation. Quite suspiciously, all excess returns from split announcements had vanished in 240 trading days. This provides strong evidence that the splits were employed to create a bubble, rather than serving as value-creating corporate events.

Some special features of the Vietnam market, presumably found in markets of other countries that have weak enforcement practices, help to explain its vulnerability to such manipulation. First, in Vietnam, the State Securities Commission (SSC), the government’s agency enforcing the securities laws and regulating the securities industry, imposes strict restrictions and reporting requirements on the trading activity. However, these requirements are not followed and violations are punished, if at all, rarely and lightly. During the eleven-year history of Vietnam’s stock market, only one illegal insider trading case has been criminally prosecuted. Violators in other cases have paid a minimal fine, usually less than 10% of the illegal trading profits. Clearly, inside trading is a profitable activity. Second, Vietnam has many companies that are vulnerable to manipulation because they have substantial state ownership and low capitalizations, and thus few outside shareholders to arbitrage prices into line. (Limited participation by major investment firms in these types of companies and prohibitions on short sales inhibit arbitrage by others.) Management in state-owned firms often represents the state ownership in board of director and investor meetings. However, the government has no effective mechanism to supervise its representatives. Thus management in such firms has significant control power but a small share interest. Managements thus often elect to reward themselves through share trading rather than through creating value for the firms.

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Most Influential People in Finance

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, June 28, 2012
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Professor Lucian Bebchuk has been named as one of the 100 most influential people in finance by Treasury & Risk magazine. The list prepared by the magazine puts together individuals who had significant impact on the world of finance this year.

Individuals on the list include Federal Reserve Board chairman Ben Bernanke, Berkshire Hathaway CEO Warren Buffett, Public Company Accounting Oversight Board chairman James Doty, European Central Bank President Mario Draghi, Business Roundtable President John Engler, Blackrock CEO Laurence Fink, Treasury Secretary Timothy Geithner, Commodity Futures Trading Commission chairman Gary Gensler, Pimco founder Bill Gross, International Monetary Fund head Christine Lagarde, SEC chair Mary Schapiro, and former Federal Reserve Board chairman Paul Volcker.

The full list is available here.

Proxy Access Proposals: Review of 2012 Results and Outlook for 2013

Posted by James Morphy, Sullivan & Cromwell LLP, on
Thursday, June 28, 2012
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James Morphy is a partner at Sullivan & Cromwell LLP specializing in mergers & acquisitions and corporate governance. This post is based on a Sullivan & Cromwell publication, available here. Work on proxy access from the Program on Corporate Governance includes Private Ordering and the Proxy Access Debate by Bebchuk and Hirst.

Update: An updated version of the memo on which this post is based is available here.

Pursuant to SEC rule changes that took effect in September 2011, shareholders are now permitted to submit and vote on “proxy access proposals” – that is, proposals to give shareholders the right to include director nominees in the company’s proxy materials. Over 20 such shareholder proposals (half of which were binding) were submitted during the 2012 proxy season, of which only eight have come to a vote. Many of the proposals that did not come to a vote were deemed excludable from proxy statements by the staff of the SEC for a variety of technical reasons. We have included on the following page a chart of the terms and outcomes of proxy access proposals submitted to date.

The vote results from this limited pool suggest that shareholders are hesitant to approve proposals that would give a proxy access right to holders of a small number of shares, but are more supportive of proposals that have ownership requirements that are similar to the 3%/3-year threshold that would have applied under the SEC’s now-vacated mandatory proxy access rule.

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Should the SEC Tighten its 13(d) Rules?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, June 27, 2012
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Editor’s Note: Lucian Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School. Robert J. Jackson, Jr. is Associate Professor of Law at Columbia Law School.

The upcoming issue of the Harvard Business Law Review will feature our article The Law and Economics of Blockholder Disclosure. The article is available here, and PowerPoint slides describing the paper’s main points are available here.

The Securities and Exchange Commission is currently considering a rulemaking petition submitted by Wachtell, Lipton, Rosen & Katz (available here) that advocates tightening the rules under the Williams Act and, in particular, reducing the amount of time before the owner of 5% or more of a public company’s stock must disclose that position from ten days to one day. Our article explains why the SEC should not view the proposed tightening as a merely “technical” change necessary to meet the objectives of the Williams Act or modernize the SEC’s regulations. The drafters of the Williams Act made a conscious choice not to impose an inflexible 5% cap on pre-disclosure accumulations of stock to avoid deterring investors from accumulating large blocks of shares. We argue that the proposed changes to the SEC’s rules require a policy analysis that should be carried out in the larger context of the optimal balance of power between incumbent directors and these blockholders.

We discuss the beneficial role that outside blockholders play in corporate governance, and the adverse effect that any tightening of the Williams Act’s disclosure thresholds can be expected to have on such blockholders. We explain that there is currently no evidence that trading patterns and technologies have changed in ways that would make it desirable to tighten these disclosure thresholds. Furthermore, since the passage of the Williams Act, the rules governing the balance of power between incumbents and outside blockholders have already moved significantly in favor of the former—both in absolute terms and in comparison to other jurisdictions—rather than the latter.

Our analysis provides a framework for the comprehensive examination of the rules governing outside blockholders that the SEC should pursue. In the meantime, we argue, the SEC should not adopt new rules that would tighten the disclosure rules that apply to blockholders. Existing research and available empirical evidence provide no basis for concluding that the proposed tightening would protect investors and promote efficiency. Indeed, there is a good basis for concern that such tightening would harm investors and undermine efficiency.

Below is a more detailed account of the analysis in our article:

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Corporate Law and the Team Production Problem

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, June 27, 2012
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The following post comes to us from Margaret M. Blair, Professor of Law at Vanderbilt University.

In the paper, Corporate Law and the Team Production Problem, which was recently made publicly available on SSRN, I discuss an alternative framework to the principal-agent model for understanding corporate law. For much of the last three decades, the dominant perspective in corporate law scholarship and policy debates about corporate governance has adopted the view that the sole purpose of the corporation is maximizing share value for corporate shareholders. But the corporate scandals of 2001 and 2002, followed by the disastrous performance of financial markets in 2007-2009, have left many observers uneasy about this prescription. Prominent advocates of shareholder primacy such as Michael Jensen, Jack Welch, and Harvard’s Lucian Bebchuk have backed away from the idea that maximizing share value always and everywhere has the effect of maximizing the total social value of the firm. Shareholders, they concede, may often have incentives to take on too much risk, thereby increasing the share of firm value they capture by imposing costs on creditors, employees, taxpayers, and the economy as a whole.

In response to the problems with shareholder primacy revealed by corporate and financial market crises in recent years, some scholars and practitioners have considered the “team production” framework for understanding the social and economic role of corporations and corporate law (Blair and Stout, 1999) as a viable alternative. Whereas the principal-agent framework provided a strong justification for the focus on share value, the team production framework can be seen as a generalization of the principal-agent problem that is symmetric: all of the participants in a common enterprise have reasons to want all of the other participants to cooperate fully. A team production analysis thus starts with a broader assumption that all of the participants hope to benefit from their involvement in the corporate enterprise, and that all have an interest in finding a governance arrangement that is effective at eliciting support and cooperation from all of the participants whose contributions are important to the success of the joint enterprise. A team production-based analysis of corporate law then points to a number of features of corporate law and the corporate form that do not seem consistent with shareholder primacy but that may provide a workable solution to the team production problem.

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The Shareholder Value Myth

Posted by Lynn A. Stout, Cornell Law School, on
Tuesday, June 26, 2012
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Lynn Stout is the Distinguished Professor of Corporate and Business Law at Cornell Law School. This post discusses Professor Stout’s book The Shareholder Value Myth, available for purchase here and for preview here.

Shareholder-value thinking dominates the business world today. Professors, policymakers, and business leaders routinely chant the mantras that public companies “belong” to their shareholders; that the proper goal of corporate governance is to maximize shareholder wealth; and that shareholder wealth is best measured by share price (meaning share price today, not share price next year or next decade).

This dogma drives directors and executives to run public firms with a relentless focus on raising stock price. In the quest to “unlock shareholder value” they sell key assets, fire loyal employees, and ruthlessly squeeze the workforce that remains; cut back on product support, customer assistance, and research and development; delay replacing outworn, outmoded, and unsafe equipment; shower CEOs with stock options and expensive pay packages to “incentivize” them; drain cash reserves to pay large dividends and repurchase company shares, leveraging firms until they teeter on the brink of insolvency; and lobby regulators and Congress to change the law so they can chase short-term profits speculating in high-risk financial derivatives. Yet many individual directors and executives feel uneasy about such strategies, intuiting that a single-minded focus on share price may not serve the interests of society, the company, or shareholders themselves.

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Fiduciary Duties to 401(k) Plans

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, June 25, 2012
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The following post comes to us from Michael Frank, partner and head of the Compensation, Benefits & ERISA practice group at Morrison & Foerster LLP, and is based on a Morrison & Foerster client alert by Mr. Frank and Paul Borden.

On March 31, 2012, the U.S. District Court for the Western District of Missouri awarded plaintiffs more than $35 million in a class action suit over certain breaches of duty related to 401(k) plan expenses.

The case was brought on behalf of participants in two 401(k) plans sponsored by a major manufacturer of power and automation equipment with operations in around 100 countries and more than 135,000 employees.

In Tussey v. ABB, Inc., [1] the District Court held that ABB, Inc. and its benefit and investment committees (collectively, “ABB”) violated their fiduciary duties to the plans when they failed to monitor record-keeping costs, failed to negotiate rebates from investment companies on the plans’ investment platform, selected mutual fund share classes that were more expensive than necessary, and replaced a mutual fund with a fund offered by an affiliate of the record keeper for the plans. In addition, the District Court found that the employer and its benefits committee violated their fiduciary duties to the plans by agreeing to pay the record keeper above market record-keeping fees in order to subsidize other corporate services provided to the employer by the record keeper, such as payroll and record keeping for other employee benefit plans.

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