Monthly Archives: July 2013

The Deterrence Effect of SEC Enforcement Intensity on Illegal Insider Trading

The following post comes to us from Diane Del Guercio of the Department of Finance at the University of Oregon, and Elizabeth Odders-White and Mark Ready, both of the Department of Finance, Investments, and Banking at the University of Wisconsin.

In our paper, The Deterrence Effect of SEC Enforcement Intensity on Illegal Insider Trading, which was recently made publicly available on SSRN, we argue that dramatic changes in insider trading enforcement since the 1980s enable us to empirically identify the effects of more aggressive enforcement on trader behavior and stock price discovery. First, the types of trades that expose individuals to legal liability has broadened in scope since the 1980s, extending far beyond the original principles of those with a fiduciary duty to the stock traded (Nagy, 2009; Bainbridge, 2012). Second, punishments for successfully prosecuted traders have become more severe, while at the same time the amount of resources devoted to enforcement has increased dramatically. For example, the SEC’s budget in real terms is over four-times larger today than it was in the 1980s. Finally, high-profile insider trading cases (e.g., Galleon) and recent developments in SEC enforcement have both received extensive press coverage, suggesting that regulators have been actively signaling their increased enforcement aggressiveness. We posit that traders are aware of these developments and test whether more aggressive SEC enforcement effort deters illegal insider trading and affects price discovery.


2013 Proxy Season Review

James C. Morphy is a partner at Sullivan & Cromwell LLP specializing in mergers & acquisitions and corporate governance. The following post is based on the executive summary of a Sullivan & Cromwell publication by Glen T. Schleyer; the complete publication, including footnotes, is available here.

The 2013 proxy season saw a continued high rate of governance-related shareholder proposals at large U.S. public companies, including those calling for declassified boards, majority voting in director elections, elimination of supermajority requirements, separation of the roles of the CEO and chair, the right to call special meetings and action by written consent. As in prior years, many of these governance-related proposals received high levels of support, and a number received majority support from shareholders.

In addition, during the 2013 proxy season, U.S. public companies had, on average, slightly better results on their say-on-pay votes. Large-cap companies, in particular, showed an improved ability to avoid negative results, and most companies that failed say-on-pay votes in 2012 received strong support in 2013. These results reflect companies’ increased efforts to engage with shareholders, understand and anticipate their concerns, and communicate the company’s actions and positions.


District Court Vacates SEC Rule on Resource Extraction Disclosures

The following post comes to us from Edwin S. Maynard and Adam M. Givertz, partners in the Corporate Department at Paul, Weiss, Rifkind, Wharton & Garrison LLP, and is based on a Paul Weiss client memorandum.

On July 2, 2013, the District Court for the District of Columbia vacated Rule 13q-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which required resource extraction issuers to disclose payments made to the U.S. Federal government and foreign governments. The District Court found that the Securities and Exchange Commission (the “SEC”) incorrectly interpreted Section 13(q) of the Exchange Act, which mandated the promulgation of Rule 13q-1. A copy of the Court’s decision is available here.

Specifically, the District Court found that Congress did not specifically intend that reports filed under Section 13(q) be publicly disclosed. The District Court wrote: “Section 13(q) requires in subsection (2)(A) disclosure of annual reports but says nothing about whether the disclosure must be public or may be made to the Commission alone. Neither the dictionary definition nor the ordinary meaning of ‘report’ contains a public disclosure requirement. And section 13(q) expressly addresses public availability of information in the following subsection, (3)(A), establishing a different and more limited requirement for what must be publicly available than for what must be annually reported. Topping things off, the Exchange Act as a whole uses the word ‘report’ to refer to disclosures made to the Commission alone.”


Informed Trading through the Accounts of Children

The following post comes to us from Henk Berkman, Professor of Finance at the University of Auckland; Paul Koch, Professor of Finance at the University of Kansas; and Joakim Westerholm of the Finance Discipline at the University of Sydney.

In our paper, Informed Trading through the Accounts of Children, forthcoming in the Journal of Finance, we introduce a novel measure of the probability of information-based trading in a stock, namely, BABYPIN, the proportion of total trading through the accounts of underaged investors. We begin by empirically validating this measure by showing that underaged accountholders are extremely successful at picking stocks, especially when they trade just before large price changes, major earnings announcements, and takeover announcements. We next show that BABYPIN is priced in the cross section of stock returns, consistent with Easley and O’Hara (2004).

There are two reasons to expect a high proportion of informed trading through underaged investor accounts. First, guardians who open accounts and trade on behalf of young children are likely to be above-average investors. We expect these individuals to have more wealth (to bestow on offspring) and to be more successful at investing, possibly due to superior cognitive skills or comparative advantages in obtaining value-relevant information. These attributes, combined with a basic parental instinct to share the benefits of any information advantage with one’s offspring, could lead to a disproportionate number of underaged accounts that bear the fruits of informed trading.


Rethinking Director Nomination Requirements and Conduct

Peter Atkins is a partner of corporate and securities law matters at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a Skadden, Arps memorandum by Mr. Atkins, Richard J. Grossman, and Edward P. Welch; the full text, including appendix, is available here.

This post identifies and discusses a number of steps public companies may wish to consider regarding director nomination requirements and conduct in light of the heightened potential for arrival on the board of activist shareholder-nominated directors.


Increased Incidence of Nomination Proposals: Based on publicly reported information published by Activist Insight, [1] during 2012 activist shareholders threatened to initiate or initiated 58 director election proposals, and in 45 of them succeeded in electing at least one director either in an election contest or by agreement with the target’s board. During the first quarter of 2013, activist shareholders are reported by Activist Insight [2] to have threatened to initiate or initiated 36 director election proposals and in an election contest or by agreement in 13 of them succeeded in electing at least one director. By way of comparison, in the first quarter of 2012, activist shareholders threatened to initiate or initiated only 18 director election proposals.


Volcker Rule Conformance Period for Banking Entities

This post comes to us from Douglas Landy, partner at Milbank, Tweed, Hadley & McCloy, and is based on a Milbank client alert; the full publication, including footnotes, is available here.

On April 19, 2012, the Board of Governors of the Federal Reserve System (“Board”) issued a statement of policy (the “Conformance Statement”) clarifying that a banking entity covered by Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the so-called “Volcker Rule”) has until July 21, 2014 (unless extended by the Board) to fully conform its activities and investments to the requirements of that section (the “Conformance Period”).

The Volcker Rule presents the potential for drastic change to covered banking entities through largely banning their participation in proprietary trading or hedge fund and private equity investments. The Volcker Rule itself became effective on July 21, 2012, notwithstanding the lack of a final rule adoption from the five federal agencies charged with its implementation.

In the Conformance Statement, the Board clarified for covered banking entities that they would have a two-year period—until July 21, 2014—in which to “conform all of their activities and investments.” However, the Conformance Statement also places conformance obligations on covered banking entities during the Conformance Period. Below, we review what covered banking entities must do during this period in order to conform their activities to the requirements of the Volcker Rule during the Conformance Period.


Institutional Investors and the Information Production Theory of Stock Splits

The following post comes to us from Thomas Chemmanur, Professor of Finance at Boston College; Gang Hu of the Division of Finance at Babson College; and Jiekun Huang of the Department of Finance at the National University of Singapore.

In our paper, Institutional Investors and the Information Production Theory of Stock Splits, forthcoming in the Journal of Financial and Quantitative Analysis, we analyze the incentives of analysts to produce information about a firm, by studying institutional trading and brokerage commissions around a specific corporate event, namely, a stock split. We make use of a large sample of transaction-level institutional trading data, which enables us to directly examine an extended version of the Brennan and Hughes’ (1991) information production theory of stock splits for the first time in the literature. We compare brokerage commissions paid by institutional investors before and after a split, and relate the informativeness of institutional trading to brokerage commissions paid. We also compute realized institutional trading profitability net of brokerage commissions and other trading costs.

First, we find that, both commissions paid and trading volume by institutional investors increase after a stock split. Second, institutional trading immediately after a split has predictive power for the firm’s subsequent long-term stock return performance. Further, this predictive power is concentrated in stocks that generate higher commission revenues for brokerage firms and is greater for institutions that pay higher brokerage commissions. Third, institutions make positive abnormal profits during the post-split period even after taking brokerage commissions and other trading costs into account. Further, institutions paying higher commissions significantly outperform those paying lower commissions. Fourth, the information asymmetry faced by firms decreases after stock splits: the greater the increase in brokerage commissions after a split, the greater the reduction in information asymmetry.


The Importance of the SEC Disclosure Regime

Daniel M. Gallagher is a Commissioner at the U.S. Securities and Exchange Commission. The following post is based on Commissioner Gallagher’s remarks to the Society of Corporate Secretaries and Governance Professionals, which are available here. The views expressed in the post are those of Commissioner Gallagher and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

The SEC is first and foremost a disclosure agency. As stated on the Commission’s website: “[t]he laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it.” [1] The federal corporate disclosure regime was established by Congress and serves as a cornerstone of the Commission’s tripartite mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. The underlying premise of the Commission’s disclosure regime is that if investors have the appropriate information, they can make rational and informed investment decisions. This is not to say that the disclosure regime was meant to guarantee that investors receive all information known to a public company, much less to eliminate all risk from investing in that company. Instead, the point has always been to ensure that they have access to material investment information. One of the underpinnings of this approach is the expectation that through this disclosure regime, companies and their management benefit from the oversight and interaction with the companies’ owners. President Franklin D. Roosevelt, in a message to Congress encouraging the enactment of the Securities Act, also noted that a mandatory disclosure regime “adds to the ancient rule of caveat emptor, the further doctrine, ‘let the seller also beware.’ It puts the burden of telling the whole truth on the seller. It should give impetus to honest dealing in securities and thereby bring back public confidence.” [2]


Final Bank Capital Rules and Basel III Implementation

The following post comes to us from Sullivan & Cromwell LLP, and is based on a memorandum by H. Rodgin Cohen, Mark J. Welshimer, Samuel R. Woodall III, Joel Alfonso, Simon Rasin, and Lauren A. Wansor.

On July 2, 2013, the Board of Governors of the Federal Reserve System (the “FRB”) unanimously approved final rules (the “Final Rules”) establishing a new comprehensive capital framework for U.S. banking organizations [1] that would implement the Basel III capital framework [2] as well as certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). The Final Rules largely adhere to the rules as initially proposed in June 2012 (the “Proposed Rules”), [3] notwithstanding that the industry objected, sometimes strenuously, to certain aspects of the Proposed Rules. Most of the changes made in response to the industry’s most fundamental concerns were effectively limited to community banks and other smaller banking organizations; the most stringent rules for “advanced approaches banking organizations”—those with $250 billion or more in total consolidated assets or $10 billion or more in foreign exposures—were maintained. For example:


Deferred Prosecutions and Corporate Governance

The following post comes to us from Lawrence A. Cunningham, Henry St. George Tucker III Research Professor of Law at George Washington University Law School.

“Prosecutors in the boardroom” is a slogan reflecting an unintended early 21st century overlap of corporate governance and corporate criminal liability. Although exaggerated, the phrase reflects how prosecutors increasingly demand corporate governance reforms when settling criminal cases using deferred prosecution agreements (DPAs). While a growing body of scholarship seeks to put governance beyond the purview of prosecutors, ousting prosecutors from the boardroom, I explain why prosecutors should consider governance carefully in determining how to proceed ex ante and state rationales for governance changes in DPAs ex post.

Prosecutorial failure to consider governance ex ante can have adverse consequences, including activating governance mechanisms not designed to the purpose and imposing on corporate actors to hastily adopt changes they would ordinarily evaluate dispassionately. Subsequent prosecutorial prescriptions of governance changes are rarely the product of articulated rationales and can seem like ransoms or trophies created on the fly by prosecutors seeking victory. Irreconcilable criticisms result: some say DPAs are coerced extractions of overzealous prosecutors, others that they are mere whitewash that let corporate crooks off the hook.

Prosecutors should publicly articulate the rationales for the governance changes they propose ex post and that articulation should be based on their assessment of the target’s governance profile ex ante. Creating such an ex ante profile would involve modest incremental costs while improving the quality of prosecutorial decisions on how to proceed with a case. Subsequent articulation of rationales would add systemic benefits by increasing rationality, building credibility, deflecting criticism and creating a catalogue of useful. I thus part with critics of prosecutors in the boardroom by explaining the value of prosecutorial investment in corporate governance.


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