Yearly Archives: 2013

Informed Trading through the Accounts of Children

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, July 18, 2013
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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.

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Rethinking Director Nomination Requirements and Conduct

Posted by Peter Atkins, Skadden, Arps, Slate, Meagher & Flom LLP, on
Wednesday, July 17, 2013
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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.

Background

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.

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Volcker Rule Conformance Period for Banking Entities

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, July 17, 2013
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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.

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Institutional Investors and the Information Production Theory of Stock Splits

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, July 17, 2013
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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.

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The Importance of the SEC Disclosure Regime

Posted by Daniel M. Gallagher, Commissioner, U.S. Securities and Exchange Commission, on
Tuesday, July 16, 2013
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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]

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Final Bank Capital Rules and Basel III Implementation

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, July 16, 2013
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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:

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Deferred Prosecutions and Corporate Governance

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, July 16, 2013
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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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Court Orders Company to Provide Privileged Communications to Dissident Director

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, July 15, 2013
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The following post comes to us from Michael O’Bryan, partner in the Corporate Department at Morrison & Foerster LLP. This post is based on a Morrison & Foerster Client Alert, and 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 Delaware Court of Chancery, in Kalisman v. Friedman (Apr. 17, 2013), ordered the respective counsels for a company and for a special committee of the company’s board of directors to provide to a dissident director copies of their communications with the company’s other directors, as well as internal law firm communications. The dissident director was a member of a large stockholder that had announced an intent to nominate a competing slate of directors at the company’s next annual meeting, and was a member of the special committee as well as of the board. The communications related to actions taken by the board and the special committee that might otherwise be protected from disclosure to third parties by the attorney-client privilege or the work product doctrine.

Background

The opinion arises from the proxy contest and related litigation over Morgans Hotel Group. The dissident director, Kalisman, is a member of a large stockholder, OTK, and was first appointed to the Morgans board early in 2011. Later that year, the board formed a special committee to evaluate strategic alternatives, and Kalisman was put on the committee. No significant alternative was adopted, however, and early this year OTK announced that it would nominate a competing slate of directors for the Morgans board.

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Optimal CEO Compensation with Search: Theory and Empirical Evidence

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, July 15, 2013
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The following post comes to us from Melanie Cao of the Finance Area at York University and Rong Wang of the Finance Group at Singapore Management University.

Two issues concerning executive compensation deserve particular attention. The first is how a firm’s risk affects the executive’s pay-to-performance sensitivity (hereafter PPS), i.e., the ratio of incentive pay to firm performance. Standard agency models predict that the PPS does not change with the firm’s risk if the agent is risk neutral and decreases with the firm’s risk if the agent is risk averse. Notable examples are Bolton and Dewatripont (2005), Holmstrom (1982), and Murphy (1999). In contrast to this theoretical prediction, the empirical evidence on the effect of the firm’s risk on the PPS is ambiguous. For example, Core and Guay (1999) and Oyer and Shaefer (2005) find a positive relationship while Aggarwal and Samwick (1999) document a negative relationship.

The second issue is the large increase in CEO compensation along with the increase in firm size in the past three decades. This large increase has generated an intense debate in the public and the academia on whether CEOs are over-compensated. Although the increase in firm value contributed partly to the increase in CEO pay, a closer look at the data reveals two notable features (see section IV for a detailed description of the data). First, incentive pay, which is the predominant component of CEO pay, has increased more rapidly than the increase in firm value. From 1994 to 2009, median incentive pay increased by 244% in real terms, compared with a 40% increase in median firm value, and its share in total pay increased from 41% to 78.8%. Second, and related to the first feature, total CEO pay outpaced firm value. The ratio between CEO pay and firm value increased from $1.59 in 1994 to $1.73 in 2009 per a thousand dollars. These features suggest that the key to understanding the increase in CEO compensation is to understand what factors determine the PPS.

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Court of Chancery Criticizes Recommendation Provision in Merger Agreement

Posted by Allen M. Terrell, Jr., Richards, Layton & Finger, on
Sunday, July 14, 2013
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Allen M. Terrell, Jr. is a director at Richards, Layton & Finger. This post is based on a Richards, Layton & Finger publication, and is part of the Delaware law series, which is co-sponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In In re NYSE Euronext Shareholders Litigation, C.A. No. 8136-CS (Del. Ch. May 10, 2013) (TRANSCRIPT), Chancellor Strine of the Court of Chancery, ruling from the bench following oral argument, declined to enjoin preliminarily a stockholder vote on the proposed merger between NYSE Euronext (“NYSE”) and IntercontinentalExchange, Inc. (“ICE”). The Court found that plaintiffs had not established any of the necessary elements for injunctive relief, but nonetheless criticized a provision in the merger agreement that restricted the NYSE board’s ability to change its recommendation when faced with a partial-company competing bid.

The proposed $9.5 billion merger between NYSE and ICE offered NYSE stockholders a mix of cash and stock valued at $33.12 per share. The stock portion of the consideration represented 67 percent of the total consideration offered to NYSE’s stockholders. Based on the Delaware Supreme Court’s decision in In re Santa Fe Pacific Corp. Shareholder Litigation, 669 A.2d 59 (Del. 1995), the Court rejected plaintiffs’ argument that Revlon applied to the mixed-consideration deal. After concluding that Revlon did not apply, the Court considered the reasonableness of the board’s process and concluded that plaintiffs did not have a reasonable probability of success on the merits.

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