July 28, 2012
Beny & Seyhun on Incidence of Insider Trading
Has Insider Trading Become More Rampant in the United States? Evidence from Takeovers, by Laura Nyantung Beny, University of Michigan Law School, and H. Nejat Seyhun, University of Michigan at Ann Arbor - Stephen M. Ross School of Business, was recently posted on SSRN. Here is the abstract:
In this paper, we investigate whether the recent increase in enforcement action against insider trading by the SEC and the Department of Justice correspond to increased illegal insider trading activity. We examine the pricing of common stocks and options around the announcement of tender offers to detect the presence of illegal insider trading. Our objective is to determine whether illegal insider trading occurs before tender offers and whether illegal insider trading has become more rampant over time. Our evidence indicates that the pre-takeover announcement run-up in stock prices has become larger over time. During the 2006-2011 sub-period, the pre-bid run-up is 50% higher than in the pre-2006 period. We also find that toehold investments by bidders do not explain the time-series variation in stock price behavior around takeovers. In contrast, increases in implied volatility of the options on target stock are consistent with increasing illegal insider trading.
Hayden & Bodie on Business Roundtable v. SEC
The Bizarre Law & Economics of 'Business Roundtable v. SEC,' by Grant M. Hayden, Hofstra University - Maurice A. Deane School of Law, and Matthew T. Bodie,Saint Louis University School of Law, was recently posted on SSRN. Here is the abstract:
Corporations are legal entities designed to foster certain kinds of collective economic activity. The decisionmaking power within a corporation ultimately rests with a board of directors elected by shareholders. Shareholders, however, do not use anything like a conventional ballot in these elections; instead, they fill out a “proxy ballot,” delivered to them by the incumbent board. This proxy ballot lists only the incumbent board’s chosen nominees, very often the board members themselves. If a shareholder wants to run for director or propose another nominee for the board, she needs to provide all other shareholders with a separate proxy ballot — an expensive and complicated proposition.
For over seventy years, the Securities & Exchange Commission has considered various means of wresting exclusive control of the proxy ballot from corporate boards. In 2010, pursuant to direct Congressional authorization, the agency finally succeeded, enacting Rule 14a-11. The rule should have given shareholders access to a corporation's proxy ballot for director nominations, thereby reducing the costs for shareholders and diminishing the longstanding barriers to a more robust corporate democracy. But within a year of the rule’s enactment, and to the surprise of almost every observer, the D.C. Circuit struck down the rule in Business Roundtable v. SEC as an arbitrary and capricious exercise of agency power.
The court’s ruling relies upon perceived failings in the Commission’s economic analysis. But it is the court's economic analysis that is open to scrutiny and criticism. Over the past few decades, corporate law and economics scholarship has become adept at containing and eliding certain contradictions of its basic principles. The reasoning in Business Roundtable represents a facile reflection of these principles — a reflection that thereby magnifies the underlying flaws. As a result, the D.C. Circuit’s decision to strike down Rule 14a-11 rests on a false version of shareholder democracy, one that undermines the very market principles that it purports to advance. It ignores the benefits of true shareholder democracy and focuses instead on costs that are routine for any functioning electoral system.
By drawing distorted conclusions from certain tropes of corporate law and economics scholarship, the court essentially codified a strange new set of requirements for administrative agencies like the Commission. We fear that, unless it is corrected over time, this bad law and economics will cow regulatory agencies, particularly the SEC, into adhering to a crabbed and inchoate vision of corporate governance. And we hope that substantive criticism of the opinion, such as that represented in this article, will demonstrate that the court’s errors need not be replicated by others.
Heminway on Materiality Guidance in Insider Trading
Just Do It! Specific Rulemaking on Materiality Guidance in Insider Trading, by Joan MacLeod Heminway, University of Tennessee College of Law, was recently posted on SSRN. Here is the abstract:
Insider trading has been in the news on a relatively constant basis in the new millennium. Raj Rajaratnam and associates, Mark Cuban, and Martha Stewart have been among the many subjects of legal actions involving insider trading since the Enron debacle in 2002. Some of these cases have been garden-variety insider trading cases; others have exposed confusing and evolving elements of U.S. insider trading doctrine. Most recently, the STOCK Act — a law providing for an express congressional prohibition on insider trading — has made headlines. Public reporting in connection with both recent legal actions and the introduction and passage of the STOCK Act also has brought to the fore long-debated questions about insider trading doctrine in the United States, including the unsettled nature of the system of regulation. This article urges the U.S. Securities and Exchange Commission (“SEC”) — or, absent action by the SEC, the federal judiciary — to adopt clarifying guidance on materiality — one unclear area of insider trading law.
In support of this agenda, the article brings together and addresses in one place a number of disparate concerns with the issuance of materiality guidance in this context (including, e.g., potential effects of the guidance on SEC enforcement discretion, interactions of the guidance with judicial deference, and determinations of the most appropriate rule maker and the optimal form of rule making for the guidance). The article also offers substantive and procedural details on two examples of materiality guidance that could be issued based on common insider trading fact patterns, updating and expanding suggestions made by the author in an earlier work. These concerns and examples illustrate significant difficulties in fashioning materiality guidance while, at the same time, showing that these difficulties are surmountable.
McShane et al. on Predicting Securities Fraud Settlements
Predicting Securities Fraud Settlements and Amounts: A Hierarchical Bayesian Model of Federal Securities Class Action Lawsuits, by Blakeley B. McShane, Northwestern University - Kellogg School of Management; Oliver P. Watson; Tom Baker, University of Pennsylvania Law School; and Sean J. Griffith, Fordham Law School, was recently posted on SSRN. Here is the abstract:
This article develops models that predict the incidence and amount of settlements for federal class action securities fraud litigation in the post‐PLSRA period. We build hierarchical Bayesian models using data that come principally from Riskmetrics and identify several important predictors of settlement incidence (e.g., the number of different types of securities associated with a case, the company return during the class period) and settlement amount (e.g., market capitalization, measures of newsworthiness). Our models also allow us to estimate how the circuit court a case is filed in as well as the industry of the plaintiff firm associate with settlement outcomes. Finally, they allow us to accurately assess the variance of individual case outcomes revealing substantial amounts of heterogeneity in variance across cases.
SEC Freezes Assets of Insider Traders in Nexen Acquisition
On July 27 the SEC obtained an emergency court order to freeze the assets of traders using trading accounts in Hong Kong and Singapore to reap more than $13 million in illegal profits by trading in advance of this week’s public announcement that China-based CNOOC Ltd. agreed to acquire Canada-based Nexen Inc.
The SEC alleges that Hong Kong-based firm Well Advantage Limited and other unknown traders stockpiled shares of Nexen stock based on confidential information about the deal in the days leading up to the announcement. Well Advantage is controlled by prominent Hong Kong businessman Zhang Zhi Rong, who also controls another company that has a “strategic cooperation agreement” with CNOOC.
According to the SEC’s complaint filed in federal court in Manhattan, CNOOC and Nexen announced before the markets opened on Monday, July 23 that CNOOC agreed to acquire Nexen for approximately $15.1 billion. Nexen’s stock subsequently rose sharply that day to close at nearly 52 percent higher than Friday’s closing price.
The SEC alleges that Well Advantage and certain unknown traders were in possession of material nonpublic information about the impending acquisition when they purchased Nexen’s stock in the days leading up to the public announcement. Well Advantage purchased more than 830,000 shares of Nexen on July 19 and had an unrealized trading profit of more than $7 million based on Nexen’s closing price on the day of the announcement. The other unknown traders used accounts located in Singapore to purchase more than 676,000 Nexen shares in the days preceding the announcement. They immediately sold nearly all of the stock once the announcement was made for illicit profits of approximately $6 million.
The emergency court order obtained by the SEC freezes the traders’ assets valued at more than $38 million and prohibits the traders from destroying any evidence.
Implementing the Global Research Analyst Settlement: Judge Pauley and the SEC
Nine years ago, the SEC announced, with great fanfare, the Global Research Analyst Settlement with ten leading investment banks. The resulting consent judgments had laudable purposes: to compensate aggrieved investors, untangle investment banking and research, and establish an investor education fund. Judge William H. Pauley III is the judge with oversight responsibility over the consent judgment, and he has over the years expressed his frustration over the SEC’s lack of diligence in implementing the Settlement. In a recent memorandum and order, SEC v. Bear Stearns (S.D.N.Y. July 25, 2012), he reviews the settlement’s troubled history and reminds us of the importance of judicial supervision. (Download SECvBearStearns)
Three years ago, the judge reluctantly transferred more than $79 million of disgorgement funds to Treasury because the parties were not able to identify harmed investors that were the intended beneficiaries of the fund.
More than two years ago, the judge refused to approve the parties' request to permit "research personnel and investment banking personnel to communicate with each other ... regarding market or industry trends, conditions, or developments." The court concluded that the parties' proposal ''would deconstruct the firewall between research analysts and investment bankers[,] ... be inconsistent with the Final Judgments[,] and contrary to the public interest."
In the July 25, 2012 memorandum and order, the court addresses once again the Settlement’s commitment to establish a $55 million foundation for investor education, intended “to finance efficient, cost-effective programs designed to educate the investing public.” The judge has devoted considerable attention to the investor education aspect of the consent judgment, and, as the court notes, “resolution of this aspect of the parties' consent decrees remains elusive.” Originally the SEC planned for the creation of a grant-making investor education entity. When that plan fizzled because of “agency torpor,” the consent judgment was modified in 2005 to transfer those funds to the NASD Investor Education Foundation (now the FINRA Foundation). In 2009 the court criticized the Foundation's ratio of administrative expenses to grant disbursements over the prior three year period. During that period, the Foundation paid $800,000 in administrative expenses while disbursing only $6.5 million to grantees, and paid administrative expenses of more than $21,800 per grant, with an average grant totaling $200,000. The court sought to prod the SEC into action and posed two rhetorical questions: "Is this the efficient and cost-effective program the SEC had in mind when it urged this Court to adopt it? When will the SEC exercise its responsibility to ensure that these substantial sums are expended to educate the investing public?"
In its recent opinion the court acknowledges that “over the last three years, a majority of the corpus has been disbursed,” but continues to have concerns about “whether the Foundation's management of the funds measures up to the SEC's promise of a cost-efficient and expeditious disbursement…. The Foundation's operational expenses, opaque project expenditures, internal audits, and the SEC's lack of oversight all contribute to this Court's skepticism.” The court directs both the SEC and the Foundation to comply with the court's September 2, 2005 Order requiring "an accounting of receipts and expenses in reasonable detail."
The court’s concerns related to the following areas:
1. Operational expenses. The Foundation’s 2011 audit showed expenditures of $16 million, of which $4.2 million were for “operational expenses” (of which $3.6 million were services provided by FINRA to the Foundation for free). The court observes that “Had the Foundation been responsible for its own costs in these areas, it would have distributed roughly seventy-three cents of each dollar directly on its mission programs. Neither the Foundation nor the SEC provides any guideposts to evaluate the efficacy of these expenditures.”
2. Opaque Project Expenditures. The court observes that generally “the amount of money the Foundation spends on a project often seems disproportionately high compared to the nature and scope of the activities undertaken” and provides some specific examples. For example, $683,000 (of which $500,000 came from the investor education fund) was spent on the “Investor Protection Campaign” in 2011 that consisted of “a press release, an e-newsletter, five one-to-two-hour events presenting existing programming, various ad campaigns, distributing copies of its DVDs, a strategy session, and possibly sixty-three partner events.” The court has similar concerns about the $775,000 (of which $542,000 came from the investor education funds) spend on the Investor Protection Campaign in 2010. In particular, the court questions “how Alabama, Colorado, Florida, Maine, North Carolina, Vermont, Washington, and West Virginia evolved to be the "eight primary states" in the campaign.
With respect to a third initiative, the Foundation's "Smart investing@your library" program, the court observes that of the seventeen new grants, “many of these libraries do not appear to be in major population areas or places evidencing the greatest need for investor education, and the grants they received could be significant additions to their budgets. Moreover, a random review by this Court of several participating libraries' online event calendars reveals little evidence of any investor education initiatives. And to the extent that some libraries appear to be scheduling investor education events, the disparities in apparent progress among various libraries suggest that the Foundation's and the SEC's oversight of these grants is far from uniform.”
3. Internal audits. The court details some troubling inadequacies in the Foundation's reporting structure.
Finally, the court makes clear its displeasure with the SEC’s continual lack of oversight over the Foundation’s activities:
The SEC has let fall to this Court the task of raising questions about the Foundation's reports, its disbursements, and the results of its funded grants and projects. The SEC appears to place its imprimatur reflexively on each and every quarterly report, no matter the content. This Court once again directs the agency to perform its duty (emphasis added).
ADDENDUM: After publication of the above post, George Smaragdis, spokesman for FINRA, sent me the following statement:
We strongly disagree with many of the Court’s statements and will provide the Court with the additional detailed information it requests. We are confident that the Investor Education funds from the Global Research Analyst Settlement are being used for maximum public good. We are proud of the FINRA Foundation’s work and look forward to addressing the Court’s concerns.
July 26, 2012
Research Analyst in Expert Networks Investigation Pleads Guilty
John Kinnucan, a key figure in the government's investigation into "experts network" insider trading, pleaded guilty yesterday to charges of securities fraud and conspiracy to commit securities fraud. Kinnucan, owner of Broadband Research, an investment research firm, admitted that he persuaded employees of public companies to provide him with inside information which he then sold to hedge funds and money managers. Kinnucan had aggressively proclaimed his innocence and threatened harm to the prosecutors investigating the matter. NYTimes, Analyst Who Taunted Authorities Pleads Guilty
No SRO for Investment Advisers Anytime Soon
Controversial legislation that would create an SRO for investment advisers -- a proposal that investment advisers hate -- has been put on hold, says its sponsor, Rep. Spencer Bachus, Chairman of the House Financial Services Committee, because of lack of consensus about how to improve the examination of investment advisers. Yesterday Rep. Maxine Walters introduced a bill that would allow the SEC to charge user fees for exams, an approach that in the past has gone nowhere. InvNews, SRO bill dead for now
July 24, 2012
Happy Birthday to Dodd-Frank
On the second anniversary of the enactment of Dodd-Frank, Treasury has posted on its website an "overview of where reform stands and the changes it has affected. According to the report (Download Reforming Wall Street):
Since Wall Street Reform was enacted in July 2010…
…our financial system is safer and stronger.
…consumers are more empowered and protected.
…financial markets are more transparent.
…regulators have new tools to monitor and mitigate threats to the financial system.
…implementation steadily continues despite attempts by opponents to roll back, delay, and defund reforms.
These reforms are helping build a sound foundation to support economic growth.
If only wishing could make it so.
Bipartisan Legislation Introduced in Senate to Increase SEC Penalties
Senator Charles Grassley (R-IA) has been a vocal critic of the SEC, but on Monday he joined forces with Senator Jack Reed (D-RI) and introduced legislation that would give the SEC something it has asked for -- an increase in the statutory limits on civil monetary penalties. The Stronger Enforcement of Civil Penalties Act of 2012 would increase the per violation cap applicable to the most serious violations to $1 million for individuals (up from $150,000) and $10 million for entities (up from $750,000). (In most instances, the SEC alleges multiple violations, so the total amount can be considerably more.) In cases where the penalty is tied to the amount of illicit gains, the penalty can be tripled. Alternatively, the losses incurred by the victims as a result of the violation could serve as the maximum amount. In addition, the penalty can be tripled for recidivists who have been convicted of securities fraud or subject to SEC administrative relief within the past five years.
July 23, 2012
Treasury's Office of Financial Research Issues Progress Report
The Office of Financial Research, within the U.S. Dept. of Treasury, was created by Dodd-Frank to serve the needs of the Financial Stability Oversight Council and member agencies, to collect and standardize financial data, to perform essential research and to develop new tools for measuring and monitoring risk in the financial system. It has issued its first Annual Report to describe how it is working to meet its statutory mandate in four areas:
- to analyze threats to financial stability
- to conduct research on financial stability
- to address data gaps
- to promote data standards
Its agenda going forward includes
work to develop more robust analytical frameworks for analysis to assess and monitor threats to financial stability, to evaluate mitigants to those threats, and to improve the scope and quality of financial data required for that work. Accordingly, we will focus on the forces that promote the migration of financial activities, including maturity transformation and the creation of money-like liabilities, into unregulated or lightly regulated markets—the so-called shadow banking system—and we will investigate in depth the behavior of short-term funding markets and collect better data on repo markets. We will build on the work on the three topics outlined in this report— indicators of threats to financial stability, stress testing, and risk management. We will employ network analysis and new data to research interconnectedness among financial institutions. Our data agenda is tied closely to our research agenda and includes further work on data standards to improve the quality of existing and new information.
SEC Charges Stock Promoter in Internet-Based Scalping Scheme
The SEC recently filed a civil fraud action against former Connecticut resident Jerry S. Williams, a stock promoter, and two companies that he controlled, Monk’s Den, LLC and First In Awareness, LLC. The Commission charged Williams with running a scalping scheme from which he made over $2.4 million.
According to the SEC, from at least early 2009 through at least the end of 2010, Williams recommended two stocks, Cascadia Investments, Inc. and Green Oasis Environmental, Inc., to a large group of potential investors who followed his trading recommendations and strategies. According to the Complaint, Williams, who was known to his followers as “Monk,” used his internet-based message board (called “Monk’s Den”), in-person seminars (called “Monkinars”), and other means to encourage people to buy, hold, and accumulate Cascadia and Green Oasis stock. In particular, the Complaint alleges that Williams told potential investors that by buying up the outstanding shares, or float, of these companies, they could collectively trigger a “short squeeze” that would allow them to sell their stock to “market makers” that had shorted the stock. The Commission’s Complaint alleges that Williams falsely stated that he had previously used this strategy to make himself and others enormous profits.
The Complaint alleges that in fact, unknown to potential investors, Williams had been hired by Cascadia and Green Oasis to promote their stock and had been compensated with millions of free and discounted shares of these stocks. According to the Complaint, Williams secretly sold millions of Cascadia and Green Oasis shares at the same time he was encouraging potential investors to buy, hold and accumulate these stocks. Through this scheme, the Complaint alleges, Williams made over $2.4 million.
The Commission is seeking permanent injunctions, disgorgement, prejudgment interest, and civil penalties against each defendant and, as to Williams only, a penny stock bar.
July 22, 2012
Choi et al. on the Influence of Arbitrator Background and Representation on Outcomes
The Influence of Arbitrator Background and Representation on Arbitration Outcomes, by Stephen J. Choi, New York University (NYU) - School of Law; Jill E. Fisch, University of Pennsylvania Law School - Institute for Law and Economics; and Adam C. Pritchard, University of Michigan Law School, was recently posted on SSRN. Here is the abstract:
We study the role of arbitrator background in securities arbitration. We find that arbitrator background is correlated with arbitration outcomes. Specifically, industry experience, prior experience as a regulator, and status as a professional arbitrator are correlated with statistically significant differences in arbitration awards. We find that the impact of these characteristics is affected by whether the arbitrator in question serves as the panel chair and by whether the parties to the arbitration are represented by counsel.
Our findings offer some preliminary insights into the debate over arbitrator bias. On the one hand, they suggest that the party selection process is relatively effective in screening for potential bias. FINRA has imposed increasingly more rigorous qualification requirements, specifically with respect to the independence of public arbitrators, but our study suggests that these requirements are unlikely to affect outcomes in most cases. On the other hand, party selection appears to be most effective when the parties are represented by counsel. Our findings highlight the importance of legal representation in the arbitration process.
Larcker et al. on Economic Consequences of Proxy Advisor's Say on Pay Policies
The Economic Consequences of Proxy Advisor Say-on-Pay Voting Policies, by David F. Larcker, Stanford University - Graduate School of Business; Allan L. McCall, Stanford University - Graduate School of Business; and Gaizka Ormazabal, IESE Business School of the University of Navarra, was recently posted on SSRN. Here is the abstract:
This paper examines changes in executive compensation programs made by firms in response to proxy advisory firm say-on-pay voting policies. Using proprietary models, proxy advisory firms, primarily Institutional Shareholder Services and Glass, Lewis & Co., provide institutional shareholders with a “for” (positive) or “against” (negative) recommendation on the required management say-on-pay proposal in the annual proxy statement.
Analyzing a large sample of firms from the Russell 3000 that are subject to the initial say-on-pay vote mandated by the Dodd-Frank Act, we find three important results.
First, proxy advisory firm recommendations have a substantive impact on say-on-pay voting outcomes. Second, a significant number of firms change their compensation programs in the time period before the formal shareholder vote in a manner consistent with the features known to be favored by proxy advisory firms apparently in an effort to avoid a negative recommendation. Third, the stock market reaction to these compensation program changes is statistically negative.
Thus, the proprietary models used by proxy advisory firms for say-on-pay recommendations appear to induce boards of directors to make choices that decrease shareholder value.
Pistor on Regulating Financial Markets
On the Theoretical Foundations for Regulating Financial Markets, by Katharina Pistor, Columbia University School of Law, was recently posted on SSRN. Here is the abstract:
How we think about financial markets determines how we regulate them. Since the 1970s modern finance theory has shaped how we think about and regulate financial markets. It is based on the notion that markets are or can be made (more) efficient. Financial markets have been deregulated when they were thought to achieve efficient outcomes on their own; and regulation was designed to lend crutches to them when it appeared that they needed support. While modern finance theory has suffered some setbacks in the aftermath of the global crisis, defenders hold that improving market efficiency should still be the overriding concern for regulation. This essay raises the question whether this is indeed the case. What if other factors besides information costs affect the vulnerability of markets to crises? Two factors have been identified in the literature: Imperfect Knowledge and the Liquidity Constraint. This essay introduces the relevant theories that focus on these factors and discusses their regulatory implications.
SEC & Chicago Consulting Firm Settle Accounting Charges
The SEC recently charged Huron Consulting Group Inc., a Chicago-based consulting firm, and two of its former executives with accounting violations that overstated the company’s income for multiple years.
The SEC found that Huron failed to properly record redistributions of sales proceeds by the selling shareholders of four firms acquired by Huron. The selling shareholders redistributed the money to employees at those firms who stayed on to work at Huron as well as other Huron employees and themselves. Because the redistributions were contingent on the employees’ continued employment with Huron, based on the achievement of personal performance measures, or not clearly for a purpose other than compensation, Huron should have recorded the redistributions as compensation expense in its financial statements. By failing to do so, Huron overstated its pre-tax income to the public. Former chief financial officer Gary Burge and former controller and chief accounting officer Wayne Lipski oversaw these accounting decisions at Huron.
Huron agreed to settle the SEC’s charges by paying a $1 million penalty, and Burge and Lipski agreed to pay a total of nearly $300,000 in disgorgement and penalties to settle the charges against them.