Monthly Archives: March 2022

Trading Ahead of Barbarians’ Arrival at the Gate: Insider Trading on Non-Inside Information

Posted by Georgy Chabakauri (London School of Economics), Vyacheslav Fos (Boston College), and Wei Jiang (Columbia University), on
Thursday, March 17, 2022
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Georgy Chabakauri is Associate Professor of Finance at the London School of Economics; Vyacheslav Fos is Associate Professor of Finance at Boston College Carroll School of Management; and Wei Jiang is Arthur F. Burns Professor of Free and Competitive Enterprise in the Finance Division at Columbia Business School. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation by Jesse Fried (discussed on the Forum here).

All major securities markets have developed laws, rules, and systems that regulate trades by insiders and their affiliates who have privileged access to material nonpublic information, and criminalize insider trades that are based on, or misappropriate, such information. While the theory and practice of insider trading law and regulation have evolved over time, the boundary of insider trading remains blurry and becomes more so with new developments of the market. In this study, we explore the possibility of insider trading on non-insider information in a setting where an insider (i.e., a CEO) makes trading decisions on their firm’s stock based on assessed possibilities of trading by activist shareholders. Though the insider does not have direct information about the arrival of the “barbarians at the gate,” privileged information about their own firm’s fundamentals helps the insider to filtrate public information and eventually trade on public information with a distinct advantage.

In recent decades, real-time trades/orders have essentially become public information. Modern “tape readers” specialize in looking at electronic order and trade books to hypothesize the motives underlying any unusual trading patterns and to analyze where a stock price may be headed. Compared to other forms of informed trading by outsiders (such as those betting on takeover prospects or earnings surprises), activists are better positioned to camouflage their trades due to their ability to spread the trades to time market liquidity. This is because the deadline of the private information, in the form of a Schedule 13D, is largely self-imposed. However, given the concentration of trades in the relative short period of time (usually 2—3 months), and a hard deadline of ten calendar days after the 5% crossing-date (the disclosure triggering event), it becomes increasingly difficult for activists to hide their trades in market liquidity as they approach Schedule 13D filing. Now the question becomes: Are insiders better equipped to detect activist trading than outside investors and the market makers prior to Schedule 13D filing?

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What Exactly Is an Independent Director?

Posted by Shana Elberg, Lisa Laukitis, and Maxim Mayer-Cesiano, Skadden, Arps, Slate, Meagher & Flom LLP, on
Thursday, March 17, 2022
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Shana Elberg, Lisa Laukitis, and Maxim Mayer-Cesiano are partners at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a Skadden memorandum by Ms. Elberg, Ms. Laukitis, Mr. Mayer-Cesiano, Joseph O. Larkin, and Caroline S. Kim. Related research from the Program on Corporate Governance includes Independent Directors and Controlling Shareholders by Lucian Bebchuk and Assaf Hamdani (discussed on the Forum here).

Takeaways

  • Independence is neither a fixed condition nor a universal status for all purposes. Events and relationships can disqualify an otherwise independent director from participating in decisions.
  • No matter how pure a director’s motives, if they are not alert to independence issues, plaintiffs may portray them as compromised, which could jeopardize board actions.
  • Courts are sensitive to personal and business relationships they fear could make directors too deferential to management or controlling shareholders.

Independence is not as simple as it sounds. As a director, you may be considered independent for one purpose but not another, and the fact that you qualified as independent in the past does not mean you will in all future situations. It is essential to understand the rules governing director independence and to be sensitive to the circumstances that can trip up boards and directors.

The most important thing to bear in mind is that independence is not a once-and-for-all test, something to consider when you are appointed and then treat as settled. Circumstances change for both individual directors and companies, and independence is situational: It must be reassessed as events unfold, particularly where a company enters negotiations or transactions or makes decisions about management.

Who Sets the Rules?

There are several sources of standards governing director independence: stock exchange listing requirements, Securities and Exchange Commission (SEC) regulations, proxy advisories and the laws of the state of incorporation.

The SEC regulations and stock exchange rules are relevant mainly when directors are appointed and named to key committees. However, once on a board, the issue of whether a director is independent comes up primarily in litigation, when board actions are challenged by shareholders claiming that directors had ulterior motives, divided loyalties or conflicts of interest. Most often, these cases are heard in the courts of Delaware, where more than two-thirds of Fortune 500 companies are incorporated.

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The Russian Invasion of Ukraine: A Lesson in Stakeholder Capitalism?

Posted by Peter Essele, Commonwealth, on
Wednesday, March 16, 2022
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Peter Essele is Vice President of Investment Management and Research at Commonwealth. This post is based on his Commonwealth memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders? both by Lucian A. Bebchuk and Roberto Tallarita; and For Whom Corporate Leaders Bargain (discussed on the Forum here) and Stakeholder Capitalism in the Time of COVID, both by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here).

It’s possible that the autocratic regime in Russia didn’t fully appreciate the power of stakeholder capitalism. In the wake of the invasion, stakeholders have clearly chosen sides—and they do not include the Kremlin. Corporations have responded, and many have decided to sever Russian ties through divestment. Shell and BP recently announced their intention to abandon their involvement in Russia. Further, Sberbank (Russia’s largest lender) says it is leaving the European banking market in the face of Western sanctions against Moscow.

The actions are a clear signal that the world is pivoting toward a stakeholder capitalism model, one that is designed to benefit all parties. Those parties include customers, suppliers, employees, shareholders, and, most importantly, communities. Stakeholder capitalism proponents argue that serving the interests of all stakeholders, as opposed to only shareholders, offers superior long-term success to businesses. Many believers assert that it is a sensible business decision, in addition to being an ethical choice.

Shareholder Primacy Vs. Stakeholder Capitalism

For decades, shareholder primacy has reigned, which is the notion that corporations are only responsible for increasing shareholder value. In that model, profits are maximized at all costs through open and free competition without deception or fraud. Put simply, corporations are solely motivated by profit potential. End of story.

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The False Promise of ESG

Posted by Jurian Hendrikse (Tilburg University), on
Wednesday, March 16, 2022
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Jurian Hendrikse is a PhD Candidate at the Tilburg School of Economics and Management. This post was co-authored by Mr. Hendrikse; Elizabeth Demers, Professor of Accounting at the University of Waterloo; Philip Joos, Professor of Accounting at the Tilburg School of Economics and Management; and Baruch I. Lev, Philip Bardes Professor Emeritus of Accounting and Finance at NYU Stern School of Management.

Millions of investors and countless fund managers direct their investments to companies that are highly-rated on the basis of their environmental, social, and governance (“ESG”) activities in an attempt to do good. The claim by ESG advocates, pundits, and many academics that highly-rated ESG companies and funds also deliver superior returns bolsters this move: Doing better by doing good. The best of all worlds.

But do ESG ratings really deliver on the promise? Are highly-ranked ESG businesses really more caring of the environment, more selective of the societies in which they operate, and more focused on countries with good corporate governance? In short, is ESG really good? The answer is no.

We demonstrate this by focusing on a group of companies that are now at the center of the world’s attention: businesses with substantial operations in Russia. Russia’s disregard for the environment, appalling social norms and behaviors, and extremely poor corporate governance are well-known and widely-documented. So one might reasonably expect that business involvement in such a country would detract from the ESG rating of the involved company. To our great surprise, this is not the case.

We examine the ESG scores and response to the Russian invasion of Ukraine for all European firms with a substantial presence in Russia, which we define as companies with Russian subsidiaries that generate more than US$100 million in sales and that have more than US$100 million in total assets. We focus on Russian subsidiaries of large European firms because these represent significant investments of economically important firms that are unambiguously identifiable from standard sources. We search the Amadeus database of Bureau van Dijk for firms that meet these activity thresholds and intersect this with Refinitiv’s EIKON database to generate a list of 75 non-financial European firms that have significant subsidiary activities in Russia with available Refinitiv ESG scores. On average these firms earned 6% of their sales in Russia.

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ESG Leader or Laggard?

Posted by Hannah Orowitz, Georgeson LLC, on
Wednesday, March 16, 2022
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Hannah Orowitz is Senior Managing Director of ESG at Georgeson LLC. This post is based on her Georgeson memorandum.

​Companies are opening their eyes to their obligations for action and disclosure on environmental, social and governance (ESG) issues, either as a response to investor demand, recognition of the risk mitigation benefits and opportunities, or because of financial impact. Understanding your ESG rating is key to staying one step ahead of your competitors. It shows how you compare in your industry and helps identify where you need to improve on ESG.

How does a strong ESG position create value?

Regardless of how ESG considerations currently factor into your strategy and operations, it doesn’t have to be difficult to make progress. It’s no secret that companies with strong ESG practices reap the rewards. It is becoming increasingly clear that strong company performance on ESG matters is closely aligned with increased investor interest and reduced risk. It can also help reduce costs, improve top-line growth, increase productivity and minimize legal intervention. Developing a strong ESG position is vital to the long-term success of your business.

Compare and keep pace

With ESG issues top of mind for investors, it’s important to know how your company’s position is perceived in comparison to investor favored standards and frameworks, as well as your sector peers. Many investors often make their investment decisions based on peer group comparison, so it’s important to ensure that your disclosures are up to standard. Benchmarking is not only useful in helping you keep pace, but it’s integral in helping you identify key areas for improvement. Studying industry leader best practices can assist you in managing and reducing ESG risks, while also highlighting new opportunities for success.

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EU Publishes Draft Corporate Sustainability Due Diligence Directive

Posted by Dr. Johannes Weichbrodt, James Ford, and Libby Reynolds, Mayer Brown LLP, on
Tuesday, March 15, 2022
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Dr. Johannes Weichbrodt is partner and James Ford and Libby Reynolds are associates at Mayer Brown LLP. This post is based on a Mayer Brown memorandum by Dr. Weichbrodt, Mr. Ford, Ms. Reynolds, Sam Eastwood, Musonda Kapotwe and Peter Pears. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders?, both by Lucian A. Bebchuk and Roberto Tallarita; and For Whom Corporate Leaders Bargain (discussed on the Forum here); and Stakeholder Capitalism in the Time of COVID, both by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here).

On 23 February 2022, the European Commission published its much-anticipated draft corporate sustainability and due diligence directive (the Draft Directive), after a number of delays (see our Previous Blog). The Draft Directive sets out a proposed EU standard for human rights and environmental due diligence (HREDD). This includes an obligation for companies to take appropriate measures to identify actual and potential adverse human rights and environmental impacts arising from their own operations or those of their subsidiaries and, where related to their value chains, from their “established business relationships”. The Draft Directive also provides a mechanism for sanctions to be imposed for non-compliance with the due diligence obligations and provides for director responsibility and accountability in relation to a company’s HREDD programme.

Whilst the Draft Directive remains subject to further legislative scrutiny and approval, it provides the most detailed insight yet as to the scope and form of the prospective EU HREDD obligations, and it provides a helpful template for corporates to continue developing their due diligence policies and procedures designed to identify, assess and mitigate adverse human rights and environmental impacts—both in their operations and in their supply chains.

Furthermore, the Draft Directive will have implications for banks, insurers and other financial institutions, which will have to undertake further due diligence on clients and their subsidiaries to whom they extend loans, credit and other financial services [1] in light of the obligations set out therein.

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Countercyclical Corporate Governance

Posted by Aneil Kovvali (University of Chicago), on
Tuesday, March 15, 2022
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Aneil Kovvali is a Harry A. Bigelow Teaching Fellow and Lecturer in Law at the University of Chicago Law School. This post is based on his recent paper, forthcoming in the North Carolina Law Review.

As the economy lurched from the global financial crisis, to the period of prolonged stagnation and elevated unemployment that followed, to the suspension of economic activity in the COVID-19 crisis, and now to a period of dislocation and elevated inflation, the limits of traditional macroeconomic tools were revealed. Governments looked to existing fiscal and monetary policy tools for solutions to each challenge, but found that those tools were often unavailable or ineffective. A new wave of legal scholarship has sought to expand the toolkit by identifying ways that legal rules could be altered to induce businesses and individuals to increase investment and spending in times of economic trouble. But, with a few exceptions, relatively little has been done to use insights from the study of corporate governance to mobilize the capacity of corporations to move the economy out of a crisis.

A new paper forthcoming in the North Carolina Law Review seeks to explore this gap. The conceptual and practical tools the paper develops could have a substantial impact. Corporations command extraordinary financial resources and have enormous operational scope. And because corporations can act flexibly and with dispatch, they can readily respond to changing circumstances from high unemployment to high inflation. Harnessing corporate capacity would dramatically improve the economy’s ability to recover from a variety of serious economic crises.

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IPO Readiness: Establishing an Initial Equity Program and Share Reserve Pool

Posted by Mike Kesner, Tara Tays, and Brian Lane, Pay Governance LLC, on
Tuesday, March 15, 2022
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Mike Kesner, Brian Lane, and Tara Tays are partners at Pay Governance LLC. This post is based on their Pay Governance memorandum.

Pay Governance reviewed 368 initial public offerings (IPOs) in 2021 to understand equity program practices which included: dilution at IPO, new share pools, evergreen provisions, and overhang levels.

Companies typically enter into an IPO with pre-IPO equity awards to management/employees representing approximately 5.4% of shares outstanding (commonly referred to as dilution).

Virtually all companies request additional shares for a new equity plan prior to or at IPO, with the typical new share request representing 8.2% of fully-diluted shares outstanding.

Within these new equity programs, the vast majority of IPOs in 2021 (73% across all IPOs as well as 85% and 90% among Biotech/Pharma and Tech IPOs, respectively) included an automatic annual refresh provision (i.e., an evergreen).

Our analysis found considerable differences by industry, with certain industries — namely, Bio-Tech/Pharma, Health Care Equipment/Services and Tech — leading others in terms of equity dilution and overhang.

For example, Tech companies had the highest overhang (17.2%) and Financial Services had the lowest overhang (8.8%) at IPO, with median overhang for all 368 companies at 14.4%.

Conversely, our research showed that market capitalization appears not to be a significant factor in differentiating equity award pools although Boards typically factor in relative size when making equity pool decisions.

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2022 Proxy Season Preview

Posted by Chuck Callan (Broadridge), Paul DeNicola (PwC) and Matt DiGuiseppe (PwC), on
Monday, March 14, 2022
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Chuck Callan is Senior Vice President of Regulatory Affairs at Broadridge Financial Solutions; Paul DeNicola is Principal of the Governance Insights Center, PricewaterhouseCoopers LLP; and Matt DiGuiseppe is Managing Director of the Governance Insights Center, PricewaterhouseCoopers LLP. This post is based on their Broadridge/PwC memorandum.

This post provides insights into key corporate governance and shareholder voting trends in the 2022 proxy season. We include data on the results of 4,125 public company annual meetings held between January 1 and June 30, 2021, along with five-year trends.

The 2022 proxy season is shaping up to be an especially active one, with environmental, social, and governance (ESG) matters. Given the SEC’s recent revisions to guidance regarding shareholder resolutions, it’s likely that many more proposals targeting climate change, diversity and inclusion, and other hot-button social issues will come to a vote. And, based on commentary from proxy advisory firms and large institutional investors, directors on boards of companies that are not taking proactive steps in these areas may face increased opposition.

From climate change to racial injustice, expectations that companies will take these matters seriously have never been higher. The 2022 proxy season will show just how focused investors are on making sure the companies they invest in are addressing them.

Against that backdrop, the key issues we’re watching include:

  • A “race to the top” on climate change
  • Evolving expectations around human capital
  • The shifting landscape of shareholder activism
  • Trends in retail and institutional shareholder voting

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Preliminary Procedures in Shareholder Derivative Litigation: A Beneficial Legal Transplant?

Posted by Martin Gelter (Fordham University), on
Monday, March 14, 2022
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Martin Gelter is Professor of Law at Fordham University School of Law. This post is based on his recent paper.

Shareholder derivative suits, which shareholders bring to enforce claims of the corporation, are a perennial subject of debate. While it is often seen as a nuisance in jurisdictions where it is frequent, such as in the United States, derivative suits are notably scarce in many countries. In principle, derivative suits can have a beneficial impact by creating incentives for a corporation’s directors and officers to comply with their legal duties. Enforcement of fiduciary duties may reduce agency costs and increase investors’ confidence. However, derivative suits sometimes exhibit the problem of litigation agency cost: Plaintiffs or, more likely, their lawyers, may pursue goals different from those of shareholders collectively and may attempt to coerce the company into a settlement benefiting themselves. The international debate about derivative suits has been important enough for the OECD to make it a significant part of a reform recommending reforms for shareholder litigation in Brazil.

Demand futility and the need for balance

My paper, which is based on the part of the OECD report that I prepared, explores the significance of preliminary procedures as a mechanism to balance the goals of enforcing corporate law and screening out non-meritorious litigation at an early stage. By “preliminary procedures,” the paper refers to court decisions early in the process to decide whether a derivative suit should go forward or whether the board’s prerogative to litigate on behalf of the corporation should be respected.

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