Monthly Archives: October 2013

Insider Trading in the Derivatives Markets

The following post comes to us from Yesha Yadav of Vanderbilt Law School.

In my paper, Insider Trading in the Derivatives Markets, recently made available on SSRN, I argue that the prohibition against insider trading is becoming increasingly anachronistic in markets where derivatives like credit default swaps (CDS) trade. I demonstrate that the emergence of credit derivatives marks a profound development for the prohibition against insider trading, problematizing conventional theory and doctrine like never before. With the workability of current rules subject to question, this paper advocates for a rethinking of the present regulatory framework for one better suited to modern markets.

Lenders use CDS to trade the risk of the loans they make. And, when they engage in such trading, they are usually privy to vast reserves of confidential information on their borrowers. From a doctrinal perspective, CDS appear to subvert insider trading laws by their very design, insofar as lenders rely on what looks like insider information to transfer the risk of a loan to another institution. Fundamentally, insider trading rules prohibit trading based on information procured at an unfair advantage by those in a privileged relationship to a company. And, increasingly, insider trading laws are taking a fairly broad approach in preventing misuse of confidential information by those who acquire this information through their special access or through deception. For example, Rule 10b-5(2) can ground a claim for insider trading where someone trades on information obtained through a relationship of trust and confidence. In the CDS market, lenders usually buy and sell credit protection based, at least in part, on information they obtain in their relationship with the borrower, one ordinarily protected by restrictive confidentiality clauses. From the doctrinal viewpoint then, old laws and new CDS markets appear to exist in a state of serious tension. Put differently, either this thriving market is operating outside or at the margins of existing law—or the law itself has not adapted to the existence of these markets.


SEC Grants Request to Exclude Rule 14a-8 Shareholder Proposal

Amy Goodman is a partner and co-chair of the Securities Regulation and Corporate Governance practice group at Gibson, Dunn & Crutcher LLP. The following post is based on a Gibson Dunn alert by Ms. Goodman, Elizabeth A. Ising, and Ronald O. Mueller.

Gibson Dunn successfully represented DeVry Inc. in obtaining no-action relief from the SEC staff (the “Staff”) for the exclusion of a shareholder proposal requesting that DeVry “annually report to shareholders on the expected ability of students at Company-owned institutions to repay their student loans.” The shareholder proposal, which was submitted by the New York City Comptroller’s Office on behalf of several New York City pension funds, specified particular quantitative and other information to be included in the requested report.


Directors Survey: Boards Confront an Evolving Landscape

Mary Ann Cloyd is leader of the Center for Board Governance at PricewaterhouseCoopers LLP. The following post is based on the executive summary of PwC’s Annual Corporate Directors Survey; the complete publication is available here. A previous PwC survey, concerning board composition, was discussed on the Forum here.

We are witnessing unprecedented change in the corporate governance world: new perspectives on boardroom composition, higher levels of stakeholder engagement, more emphasis on emerging risks and strategies, and the increasing velocity of change in the digital world. These factors, coupled with calls for enhanced transparency around governance practices and reporting, the very active regulatory and lawmaking environment, and the enhanced power of proxy advisors, are all accelerating evolution, and in some cases creating a revolution, in the boardroom.

In the summer of 2013, 934 public company directors responded to our 2013 Annual Corporate Directors Survey. Of those directors, 70% serve on the boards of companies with more than $1 billion in annual revenue. As a result, the survey’s findings reflect the practices and boardroom perspectives of many of today’s world-class companies. The focus of this year’s research not only reflects in-depth analysis of contemporary governance trends, but also emphasizes how boards are reacting to a rapidly evolving landscape. These are the highlights:


CalSTRS Releases First Annual Corporate Governance Report

Anne Sheehan is Director of Corporate Governance at the California State Teachers’ Retirement System. The following post relates to the CalSTRS Corporate Governance 2013 Annual Report, available here.

The California State Teachers’ Retirement System (CalSTRS) was established in 1913 for the benefit of California’s public school teachers. This year we celebrate our 100th anniversary serving the retirement needs of our 862,000 members and beneficiaries. The long-term nature of CalSTRS liabilities, and our responsibilities as fiduciaries to the educators of California, makes us keenly interested in governance issues that affect our investment portfolio. We expect the companies in our portfolio to be responsible stewards of our capital and we have an obligation to effectively engage those companies while balancing risks and rewards.

This year, CalSTRS published its inaugural corporate governance report to communicate our governance program priorities to the investment community. While we pursue a variety of initiatives throughout the year, our engagements focused on four main themes:

Blockholder Heterogeneity and Financial Reporting Quality

The following post comes to us from Yiwei Dou of the Department of Accounting, Taxation & Business Law at New York University; Ole-Kristian Hope, Professor of Accounting at the University of Toronto; Wayne Thomas, Professor of Accounting at the University of Oklahoma; and Youli Zou of the Accounting Area at the University of Toronto.

An issue of considerable interest to accounting researchers is the association between shareholders and firms’ financial reporting quality (FRQ). In our paper, Blockholder Heterogeneity and Financial Reporting Quality, which was recently made publicly available on SSRN, we examine a specific type of shareholder, blockholders, because (1) they offer a sample of shareholders that are expected to have a significant impact on firms’ financial reporting decisions and (2) we are able to track individual blockholders and their association with FRQ. As discussed in more detail below, these two sample design features allow us to provide a test of the extent to which (large) shareholders influence FRQ. Blockholders also provide an interesting and economically important sample because of their large presence in U.S. capital markets in recent years.


Don’t Cry for Me Argentine Bondholders: Avoiding Supreme (Court) Confusion

The following post comes to us from Antonia E. Stolper, partner in the Capital Markets-Americas group at Shearman & Sterling LLP, and is based on a Shearman & Sterling client publication by Ms. Stolper, Henry Weisburg, Stephen J. Marzen, and Patrick Clancy.

Argentina is in hot pursuit of multiple audiences before the Supreme Court: two petitions for writs of certiorari filed by Argentina are pending in the NML v. Argentina cases, and another is almost certainly on the way. In addition, a writ of certiorari has already been issued in another case against Argentina. With so much action involving Argentina in the high court, there is the potential for confusion between these multiple proceedings, which we clarify in this post.

NML Capital, Ltd. v. Argentina (Supreme Court Docket No. 12-1494): Review of the Second Circuit’s October 26, 2012 Decision (Pari Passu)

On June 24, 2013, Argentina filed a certiorari petition with respect to the Second Circuit’s October 26, 2012 decision, in which the Second Court affirmed Judge Griesa’s interpretation of the pari passu clause, his determination that the plaintiffs were entitled to a “Ratable Payment,” and his conclusion that the Injunction did not violate the Foreign Sovereign Immunities Act (“FSIA”). However, the Court remanded the case to Judge Griesa to address certain issues relating to the operation of its Injunction.


Equity Vesting and Managerial Myopia

The following post comes to us from Alex Edmans, Professor of Finance at the London Business School, Vivian Fang of the Department of Accounting at the University of Minnesota, and Katharina Lewellen of the Tuck School of Business at Dartmouth College.

In our paper, Equity Vesting and Managerial Myopia, which was recently made publicly available on SSRN, we study the link between real investment decisions and the vesting horizon of a CEO’s equity incentives. We find that research and development (“R&D”) is negatively associated with the stock price sensitivity of stock and options that vest over the course of the same year. This association continues to hold when including advertising and capital expenditure in the investment measure. Moreover, CEOs with significant newly-vesting equity are more likely to meet or beat analyst consensus forecasts by a narrow margin. However, the market recognizes such CEOs’ incentives to inflate earnings—the lower announcement returns to meet or beating earnings forecasts are decreasing in the sensitivity of vesting equity. These results provide empirical support for managerial myopia theories.

Many academics and practitioners believe that managerial myopia is a first-order problem faced by the modern firm. While the 20th century firm emphasized cost efficiency, Porter (1992) argues that “the nature of competition has changed, placing a premium on investment in increasingly complex and intangible forms,” such as innovation, employee training, and organizational development. However, the myopia theories of Stein (1988, 1989) show that managers may fail to invest due to concerns with the firm’s short-term stock price. Since the benefits of intangible investment are only visible in the long run, the immediate effect of such investment is to depress earnings and thus the current stock price. Therefore, a manager aligned with the short-term stock price may turn down valuable investment opportunities.


Tone at the Top (of the SEC): Tough

Richard J. Sandler is a partner at Davis Polk & Wardwell LLP and co-head of the firm’s global corporate governance group, and David L. Caplan is a partner and global co-head of the firm’s mergers and acquisitions practice. This post is based on a Davis Polk client memorandum.

As the fiscal year comes to a close—even while the Securities and Exchange Commission, amidst the government shutdown, continues to fund its operations through a carryover balance from FY 2013—it is a good time to review recent signs of SEC skepticism regarding financial statement reporting practices and the SEC’s current focus on public company officers, directors, and auditors as targets of potential enforcement actions. Since Mary Jo White was confirmed as the new Chairman in April, and George Canellos and Andrew Ceresney were named Co-Directors of the Division of Enforcement later that month, a number of enforcement actions and SEC statements suggest a heightened vigilance, particularly with respect to potential corporate accounting failures.


Director Independence: Interplay Between Delaware Law and Exchange Rules

The following post comes to us from Jay P. Lefkowitz, senior litigation partner and member of the Global Management Executive Committee at Kirkland & Ellis LLP, and is based on a Kirkland publication by Mr. Lefkowitz, Andrew B. Clubok, Yosef J. Riemer, and Matthew Solum. 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.

The MFW decision that was issued earlier this year by the Chancellor of the Delaware Chancery Court has been the subject of much discussion with respect to transactions involving controlling shareholders. [1] But the decision also addressed another important topic: the interplay between the exchange rules and Delaware law with respect to director independence. MFW seemed to align the Delaware law test for director independence with the specific, detailed independence requirements in the exchange rules, but Delaware decisions since MFW continue to reflect highly fact-intensive inquiries that look beyond the bright-line exchange rules. Accordingly, it is important to consider both the exchange rules and the latest guidance from Delaware courts when assessing director independence.


Governance Through Threat

The following post comes to us from Massimo Massa, Professor of Finance at INSEAD, Bohui Zhang of the Australian School of Business at the University of New South Wales, and Hong Zhang of the Finance Area at INSEAD.

The last decade has witnessed a renewed interest in the role of financial markets in disciplining managers. Shareholders—particularly blockholders—may induce good managerial behavior by exiting and pushing down stock prices when bad managerial actions are taken (e.g., Admati and Pfleiderer, 2009; Edmans, 2009; Edmans and Manso, 2011). In this regard, informed trading (“exit”) provides an alternative governance mechanism that shareholders can adopt in addition to the traditional “intervention” type of internal governance (e.g., Parrino et al., 2003; Chen et al., 2007; McCahery et al., 2010). Indeed, to some extent, exit and intervention offer substituting governance mechanisms that shareholders can select based on their trade-off between benefits and costs (e.g., Edmans and Manso, 2011; Edmans et al., 2013).

In our paper, Governance Through Threat: Does Short Selling Improve Internal Governance?, which was recently made publicly available on SSRN, we study how “trading-based governance” affects internal governance through the channel of short selling. Using a simple model, we argue that the threat of short-selling attacks triggered by bad managerial actions pushes existing shareholders to better control management, either through improved internal governance or via enhanced equity compensation. Thus, short-selling-based discipline mechanisms are complementary with, instead of substituting for, internal governance.


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