Securities Law Prof Blog

Sen on 10b5-1 Plans

Are Insider Sales Under 10b5-1 Plans Strategically Timed?, by RIK SEN, New York University, was recently posted on SSRN.  Here is the abstract:

Previous research and numerous media articles suggest that sales executed under 10b5-1 trading plans are strategically timed. However, we find no significant difference in stock price performance following plan sales and non-plan sales. We demonstrate that price contingent orders (e.g. limit orders), a common feature in trading plans, give rise to empirical patterns that have been taken as evidence of strategic timing of sales. Event study methods employed in previous research on plan sales are shown to give biased estimates of post-event abnormal returns when the events are not exogenous to past returns.

Verret on SEC Certification to Delaware Court

SEC Certification to the Delaware Supreme Court, by J.W. VERRET, George Mason University - School of Law, was recently posted on SSRN.  Here is the abstract:

This essay, recently featured in the Corporate Governance Advisor, describes a recent development in the Delaware Constitution that permits the Securities and Exchange Commission to certify questions of law directly to the Delaware Supreme Court. This essay analyses the effect of this new capability and predicts its importance to proxy fights. This issue has recently come alive, with the SEC's certification of a bylaw proposal by AFSCME to the Delaware Supreme Court to determine its legality for the purposes of the SEC's consideration of a no-action request.

Davidoff on The Failure of Private Equity

The Failure of Private Equity, by STEVEN M. DAVIDOFF, University of Connecticut School of Law; Ohio State University - Michael E. Moritz College of Law, was recently posted on SSRN.  Here is the abstract:

Throughout the Fall 2007 and into the new year 2008 private equity firms repeatedly attempted to terminate pending acquisitions. The litigation surrounding these purported terminations and heightened scrutiny directed upon the terms of private equity agreements opened a revealing window on a number of supposed "flaws" in the private equity structure. This Article seeks to understand whether these failures existed, and if so, what caused them. It does so by examining the forces driving the construct and evolution of private equity and the rationale for private equity's structure and specific contractual terms. I find that the private equity contract, the structure of private equity, is a rich, textured environment. The terms of the contractual relationships between the private equity firm and the acquired company are analogous to an iceberg; they form only the publicly available view of a much deeper understanding between the parties. In the non-public sphere, parties to private equity contracts utilize norms, conventions, reputational constraints, language and relational bonding to fill contractual gaps, override explicit contractual terms, and achieve a negotiated solution beyond the four corners of the contract. The attorney as transaction cost engineer in the private equity context consequently structures the private equity contract by paying heed both to contractual terms and law, contractually created forces and non-legal factors. But attorney reliance on these extra-contractual factors and forces makes the private equity structure path dependent and resistant to change. In light of these findings, the failures of the pre-Fall 2007 private equity structure were particularly a failure by attorneys to innovate and negotiate terms in full contemplation of such events. Reliance upon extra-legal forces permitted attorneys to leave private equity contracts incomplete and otherwise justified sloppy and ambiguous drafting. The result was a number of contract breaches and purported terminations by private equity firms with uneconomic consequences for targets subject to these failed acquisition attempts.

Lehman Announces $2.8 Billion Loss

Lehman Brothers said that it lost $2.8 billion in the second quarter and plans to raise $6 billion by selling stock, $4 billion in common stock (increasing its outstanding by 25%) and $2 billion in convertible preferred shares.  The loss is Lehman's first since it went public in 1994 and is about four times worse that Wall St. had estimated.  CFO Erin Callan said that the new capital would be used to expand business.  WSJ, Lehman Plans Higher Capital Raising, Expects to Post $2.8 Billion Net Loss.

Duffie & Hu on Global Derivative Markets

Competing for a Share of Global Derivatives Markets: Trends and Policy Choices for the United States, by DARRELL DUFFIE, Stanford Graduate School of Business; National Bureau of Economic Research (NBER), and HENRY T.C. HU, University of Texas at Austin - School of Law, was recently posted on SSRN.  Here is the abstract:

This is a preliminary study on the status of the U.S. in the global market for derivatives-related services. We include some of the policy choices available to enhance this status. We begin with a review of the importance of active and efficient derivatives markets for the U.S. economy. We then analyze the status of U.S. derivatives-market service providers in both over-the-counter and exchange-based markets. We then discuss factors that play a role in determining where a provider of derivatives services is located.

By far the dominant factors are the regional concentration of customers and overall financial market activities. We also consider regulatory and legal factors, and access to specialized human resources, among other factors. We recommend the development and maintenance of a dataset bearing on the co-location advantages of financial services firms within the U.S., particularly in and near New York City, along with data pertinent to related human resources.

Our analysis departs from the view expressed in some competitiveness circles as to a presumed wholesale migration of financial activity from New York and London and as to the dominant role of regulatory differences in such migration.

Campbell on Regulation D

Pernicious Economic Rules: The SEC's Inglorious Role in Limiting Small Business's Access to Capital, by RUTHEFORD B. CAMPBELL Jr., University of Kentucky - College of Law, was recently posted on SSRN.  Here is the abstract:

One of the most curious and misdirected regulatory approaches of the Securities and Exchange Commission is the Commission's relentless refusal to permit small businesses to solicit broadly for external capital. The Commission is ably assisted in this unfortunate approach by state blue sky laws and state securities regulators.

To some extent, it has always been a perfect storm for small businesses in this regard. The Securities and Exchange Commission has never understood small businesses, the way they raise capital and the obstacles they face in the capital markets, and high profile matters have left the Commission little time for (or interest in) the problems of small issuers.

State securities regulators, who hold trumps in the matter, have a notorious hostility to legitimate capital formation activities by small companies. Finally, collective action problems have made it difficult for small issuers to compete for fair and efficient governmental rules respecting capital formation.

As a result, small businesses, which are vital to our national economy and otherwise face enormous structural impediments when they compete for external capital, are further disadvantaged by burdensome, inefficient and anti-competitive governmental regulatory schemes.

The purpose of this article is to make the case for Commission action freeing small companies from regulatory rules that unfairly limit their legitimate capital formation activities. The focus of the article is Regulation D, which is the most likely path small issuers take in order to meet the requirements of the Securities Act of 1933. Regulation D, however, requires issuers in marketing their securities to refrain from any general solicitation. State blue sky laws also effectively prohibit any general solicitation by small businesses attempting to rely on Regulation D.

The Commission can - and should - eliminate both the federal and state prohibitions against general solicitations in Regulation D offerings. Permitting small issuers to solicit broadly in a Regulation D offering would improve small businesses access to external capital without any loss of investor protection.

Brickey on Media & Corporate Governance Scandals

From Boardroom to Courtroom to Newsroom: The Media and the Corporate Governance Scandals, by KATHLEEN F. BRICKEY, Washington University School of Law, was recently posted on SSRN.  Here is the abstract:

Enron and its progeny spawned an unprecedented amount of press coverage. To its credit the press has, in the main, acquitted itself well. But media coverage of the ensuing investigations and trials also has raised a host of provocative questions about judgment, professionalism and restraint. Using five high-profile criminal trials arising out of recent corporate fraud scandals as a springboard, this article provides a critical analysis of how media coverage - and defendants' efforts to spin that coverage - can influence the course and outcome of a trial. Some, but not all of the mischief originates with the press. Ever conscious of the potential for media coverage to alter the outcome, defendants in high-profile fraud trials have increasingly orchestrated costly multi-media public relations campaigns that demonize prosecutors, witnesses, and the press to exonerate themselves. The five case studies in the article highlight growing points of tension between the media and the courts and provide a concrete context for exploring the extent to which we should be concerned about the potential for aggressive media coverage and media manipulation to undermine the legitimacy of the courts, to affect the outcome of lengthy criminal trials, to play on the passions of the community from which the jury will be drawn, to subvert journalistic credibility and independence, and to invite more restrictive court-imposed rules governing media coverage of high-profile trials. The article concludes that if the press is to effectively perform its watchdog role, it should be mindful of the need to watch itself. Three appendices at the end of the article provide a media-centric postscript on coverage of the corporate governance scandals.

Arlen & Talley on Shareholder Choice

Unregulable Defenses and the Perils of Shareholder Choice, by JENNIFER ARLEN, New York University School of Law and ERIC L. TALLEY, UC Berkeley (Boalt Hall) School of Law; RAND Corporation; University of Southern California - Law School, was recently posted on SSRN.  Here is the abstract:

A number of corporate law scholars have recently proposed granting shareholders an enhanced right to oversee the use of takeover defenses. While these "shareholder choice" proposals vary somewhat in their content, they generally agree that shareholder oversight is justified if and only if shareholders hold a bona fide advantage over managers in evaluating and responding to hostile bids. This article challenges that basic premise, arguing that even if shareholders enjoy a comparative advantage over management in reacting to hostile bids, it does not follow that a shareholder choice regime is value enhancing, because it would give managers an incentive to search for ways to thwart prospective oversight, perhaps even through value-destroying managerial choices that render the firm an unattractive takeover target. We demonstrate (a) that a number of such thwarting defenses exist, (b) that managerial threats to use them are credible, and (c) that their utilization would be difficult or impossible for courts to regulate. We also find empirical support for these hypotheses. Consequently, an immutable, one-size-fits-all shareholder choice rule is likely to be an imprudent policy choice for courts.

Jagolinzer et alia on General Counsel and Corporate Governance

The Impact of the General Counsel on Corporate Governance, by ALAN D. JAGOLINZER, Stanford Graduate School of Business, DAVID F. LARCKER, Stanford University, DANIEL TAYLOR, Stanford University, was recently posted on SSRN.  Here is the abstract:

Most corporate governance research has focused on the behavior of executive officers, board members, institutional shareholders, and other similar parties. However, little research has focused on the impact of executives whose primary responsibility is to enforce and shape corporate governance inside the firm. This study examines the role of the General Counsel in restricting insider trading by corporate officers during the blackout window specified by corporate insider trading policies. We find that abnormal returns to trades within mandatory blackout windows are statistically higher than abnormal returns to trades outside such windows, by 15.48% over a 180-day period. However, when General Counsel approval is required to execute a trade, abnormal returns to trades within these windows are statistically lower than abnormal returns to trades outside these windows by 5.26% over a 180-day period. Thus, when given the authority, it appears the General Counsel can effectively limit the extent to which officers use their private information to extract rents from shareholders.

Winship on Fair Funds

Fair Funds and the Compensation Conundrum, by VERITY WINSHIP, Fordham University School of Law, was recently posted on SSRN.  Here is the abstract:

The Fair Fund provision of Sarbanes-Oxley allows the Securities and Exchange Commission ("SEC") to direct money penalty amounts to injured investors. Because of the provision, large penalties mean potentially large SEC-obtained investor compensation, heralding a new compensatory role for the agency. The SEC has announced that it will direct money to injured investors whenever possible, but has not articulated clear priorities. This Article fills the gap by introducing terms of debate and proposing a framework for the SEC's exercise of its discretion under Fair Funds.

The Article introduces the concept of "public class counsel," a public actor that has the dual function of deterrence and victim compensation. The concept describes - and suggest limits to - the SEC's role in a system in which public and private remedies for securities law violations increasingly converge. The Article then draws on the analogy between the "public class counsel" and the "private attorney general" to propose an answer to the following question: When should the SEC exercise its discretion to create a Fair Fund? It suggests that the SEC focus on distributing penalties gathered from aiders and abettors of securities fraud because such an approach would minimize two significant concerns with investor compensation: first, that compensation of injured investors often amounts to a transfer of money among equally innocent investors and, second, that giving the SEC and private actors a role in compensation risks duplication of costs.

Jordan & Hughes on Self-Regulation

Which Way for Market Institutions? The Fundamental Question of Self-Regulation, by CALLY E. JORDAN, University of Melbourne - Law School, and PAMELA S. HUGHES, Blake, Cassels & Graydon LLP, was recentlly posted on SSRN.  Here is the abstract:

It is a fundamental question. How should financial market institutions be regulated? Is self-regulation alive and well, at least in some parts of the world, for some market functions? Or, despite a last gasp here and there, is self-regulation shuffling towards extinction? In particular, the wave of demutualizations and consolidations of exchanges has prompted questions as to traditional roles, governance models and the nature of regulation of exchanges. Demutualization of exchanges has been a catalyst for these debates, but the debates are not new. Although numerous studies have discussed the advantages and disadvantages of a self-regulatory structure for exchanges and other market institutions, few have considered the interaction of factors that have determined the traditional allocations of regulatory powers: market history, business culture, legal system, the concept of public interest, the corporate form, the political system, forces of internationalization. How have these factors affected the allocation of regulatory power? Will the self-regulatory model of market institution, where it has been dominant, be pushed to the margins by the interplay of these various factor, as in the UK? Do unitary regulators oust self-regulatory principles? Is self-regulation in the US merely a façade? Are small and emerging markets adopting outdated self-regulatory models at the behest of the international financial institutions? Do self-regulatory organizations have a new role to play as liaison between national and supranational regulators? It may be too soon to definitively answer the questions posed by this paper, but for the moment, self regulation is here to stay; it just might not be staying where it used to.
 

Bainbridge on Investor Activism

Investor Activism: Reshaping the Playing Field?, by STEPHEN M. BAINBRIDGE, University of California, Los Angeles - School of Law, was recently posted on SSRN.  Here is the abstract:

Shareholders of U.S. corporations historically tended towards rational apathy. Holding small blocks that were unable to affect the outcome of the vote and faced with the considerable costs associated with gathering sufficient information to make an informed decision, they adopted the so-called Wall Street Rule (it was easier to switch than fight). In the last 15 years or so, a growing number of commentators and investor activists have claimed that the rising importance of institutional investors has the potential to reshape the field by empowering shareholders to become active players in corporate governance.

This paper situates investor activism in the so-called director primacy theory of corporate governance. In so doing, it demonstrates that the separation of ownership and control typical of U.S. public corporations has significant efficiency benefits. It then argues that shareholder activism threatens to undermine the advantages of director primacy without offering significant countervailing gains.

Accordingly, the paper concludes that pending regulatory proposals to expand shareholder governance rights should be viewed with suspicion.

Broome & Krawiec on Board Diversity

Signaling Through Board Diversity: Is Anyone Listening?, by LISSA L. BROOME, University of North Carolina at Chapel Hill - School of Law, and KIMBERLY D. KRAWIEC, University of North Carolina at Chapel Hill - School of Law, was recently posted on SSRN.  Here is the abstract:

The ethnic and gender make-up of corporate boards has been the subject of intense public and regulatory focus in many countries, including the United States, in recent years. Of particular interest has been quantitative research on the impact, if any, of board diversity on corporate performance. This body of work leaves substantial gaps in our understanding of the precise mechanisms by which board diversity may alter the corporate environment, if indeed it does. In this symposium, we discuss some preliminary findings from our first 21 of a series of confidential, semi-structured interviews of 45 to 90 minutes in length with corporate directors. Due to multiple board service, these interviews represent 60 public company board experiences.

We limit our discussion in this Symposium to an analysis of the rationale for board diversity that figured most prominently in the interviews with our initial sample of respondents: signaling theory. Although signaling is frequently mentioned by our respondents and other researchers as a rationale supporting board diversity, we conclude that the distribution of costs and benefits of board diversity in "good" firms versus "bad" firms is unknown. We thus are unable to conclude that "bad" firms are not mimicking the signal, undermining the stability of board diversity as a meaningful signal. We, therefore, approach blanket assertions of the signaling benefits of board diversity with caution. We conclude that the signaling rationale for board diversity is at its strongest under particular conditions that may not exist at all corporations at all times.

 

Black on Empirical Evidence of Institutional Investor Monitoring

The Value of Institutional Investor Monitoring: The Empirical Evidence, by BERNARD S. BLACK, University of Texas at Austin School of Law; McCombs School of Business, University of Texas at Austin; European Corporate Governance Institute (ECGI), was recently posted on SSRN.  Here is the abstract:

This Article collects the available evidence as of 1992 on the potential value of institutional investor monitoring of large U.S. public companies. The evidence is suggestive rather than conclusive. There are a number of systematic shortfalls in the functioning of large public firms. Institutions could potentially address some of these shortfalls. The institutions are best able to address issues that are common to a number of companies, and less able to respond to company specific failures. Large institutions do little monitoring, but there is some evidence that other large outside shareholders can engage in valuable monitoring, and little evidence that greater shareholder oversight is harmful. Monitoring by financial institutions in Germany, Japan, and Great Britain appears to have significant benefits

Black on Institutional Investor Voice

Agents Watching Agents: The Promise of Institutional Investor Voice, by BERNARD S. BLACK, University of Texas at Austin School of Law; McCombs School of Business, University of Texas at Austin; European Corporate Governance Institute (ECGI), was recently posted on SSRN.  Here is the abstract:

This article discusses the potential promise and limits of oversight of corporate managers by major institutional investors. I discuss the reasons to believe that, at least for systemic issues that arise at many firms, there can be value is assigning one set of loosely watched agents (institutional money managers) to watch another set (corporate managers). This is partly because, as long as it takes a number of institutions to strongly influence corporate actions, the institutions can also watch each other, thus reducing the risk that any one of them will extract private benefits from the firm. The case for shared institutional voice (with six or ten institutions, often different types of institutions, exercising joint influence) is stronger than the case for direct institutional control of a firm by a particular institution.

Haslem on Mutual Fund Arbitrage

Mutual Fund Arbitrage and Other Practices: Sources of Explicit and Opportunity Costs, by JOHN A. HASLEM, University of Maryland - Robert H. Smith School of Business, was recently posted on SSRN.  Here is the abstract:

Mutual fund advisors often approve frequent trading arbitrage and late trading that may or may not be consistent with any specific limits on redemptions over a specific period of time. To increase advisor profits, these arrangements normally also require trader investment of "sticky assets" to "grow" fund assets.

However, these actions lower both actual and potential long-term shareholder returns. When this occurs, independent directors either have not been informed or they have acquiesced in the decision. In any case, independent directors have not performed their primary fiduciary duty as shareholder watchdogs.

In addition, mutual fund advisors engage in various other practices to increase their profits, again, knowingly at the price of lower long-term shareholder returns. These high cost practices include illegal "late trading" arbitrage; distribution and marketing (and advertising) costs, including 12b-1 fees; commissions and implicit trading costs plus "revenue sharing" payments to brokers for "shelf space," and other undisclosed practices; "soft dollar" commissions (and implicit trading costs) paid to brokers in return for research studies and data; increased brokerage commissions and implicit trading costs from larger trade sizes that further offset economies of scale; and high portfolio risk to boost annual returns to maintain shareholders and attract "performance chasers."

These costly mutual fund advisor practices reflect strong agency conflicts with shareholders that should be specifically prohibited. Independent directors need to assert control over advisor intentions and actions to allow these practices and provide disclosure for each. Disclosure should include complete normative transparency of disclosure to shareholders, independent director analysis of fund actions and behaviors relative to "best use" industry guidelines, and disclosure of all advisor intentions or decisions to use any practices that are costly to shareholder interests and returns.

 

Baer on Corporate Policing & Corporate Governance

Corporate Policing and Corporate Governance: What Can We Learn from Hewlett-Packard's Pretexting Scandal?, by MIRIAM H. BAER, New York University School of Law, was recently posted on SSRN.  Here is the abstract:

When Hewlett Packard (HP) announced in September 2006 that its Board Chairman, Patricia Dunn, had authorized HP's security department to investigate a suspected Board-level press leak and that the investigation included tactics such as obtaining HP Board members' and reporters' telephone records through false pretenses (conduct known as "pretexting"), observers vehemently condemned the operation as illegal and outrageous. In congressional testimony, however, Dunn defended the investigation as "old fashioned detective work." Although Dunn would later claim that she was unaware of key aspects of the investigation, her description was not so far off. The police routinely rely on deception to investigate and apprehend wrongdoers. Although it is tempting to view HP's pretexting episode as a one-time scandal, the episode illuminates a more important, largely unexplored, conflict between corporate policing and corporate governance.

This Article analyzes the tension between the board's competing responsibilities of overseeing its internal corporate police and implementing the norms and structures that presumably create ethical (and therefore "good") corporate governance. As the HP scandal aptly demonstrates, law enforcement techniques that rely primarily on deception are likely to conflict with corporate governance norms such as trust and transparency. After outlining the problem, the Article considers its broader policy implications.

Mitchell on Morals of the Marketplace

The Morals of the Marketplace, by LAWRENCE E. MITCHELL, George Washington University - Law School, was recently posted on SSRN.  Here is the abstract:

This brief essay explores the economic and social legitimacy of modern financial markets, with particular attention to the relationship between risk and responsibility. Using the markets for corporate common stock and mortgaged-backed securities as illustrations, and modern portfolio theory as its theoretical base, it raises questions about the links between capital markets and the real economy, and their effects upon each other. It concludes that capital markets largely have become disconnected from the real economy and have created a context in which finance finances finance rather than production.

This theoretical essay introduces a larger empirical project in progress in which I am attempting to understand in detail and nuance the relationships between capital markets and the formation of productive capital.

Heminway on SOX and Ethics

Does Sarbanes-Oxley Foster the Existence of Ethical Executive Role Models in the Corporation?, by JOAN MACLEOD HEMINWAY, University of Tennessee College of Law, was recently posted on SSRN.  Here is the abstract:

If compliance with, or the efficacy of, Sarbanes-Oxley and other corporate governance initiatives requires that executives (or other firm leaders) be good ethical role models, then it is important to ask whether Sarbanes-Oxley - or any other attribute of existing corporate governance regulation - in fact promotes or permits the production or preservation of ethical role models in the executive ranks of public companies. An absence of support for ethical role models in public companies may signal the failure of broad-based federal corporate governance initiatives like Sarbanes-Oxley.

This Article assumes that ethical roles models may be important to the maintenance of good corporate governance (in general) and the success of Sarbanes-Oxley as a corporate governance initiative (in specific). With that in mind, the Article preliminarily analyzes, using legal and social sciences literature, whether Sarbanes-Oxley may encourage or discourage the existence of ethical role models in the corporation.

Bartlett on Going Private

Going Private But Staying Public: Reexamining the Effect of Sarbanes-Oxley on Firms' Going-Private Decisions, by ROBERT P. BARTLETT III, University of Georgia Law School, was recently posted on SSRN.  Here is the abstract:

This article examines whether the cost of complying with the Sarbanes-Oxley Act of 2002 (SOX) contributed to the rise in going-private transactions after its enactment. Prior studies of this issue generally suffer from a mistaken assumption that by going private, a publicly-traded firm necessarily immunizes itself from SOX. In actuality, the need to finance a going-private transaction often requires firms to issue high-yield debt securities that subject the surviving firm to SEC-reporting obligations and, as a consequence, most of the substantive provisions of SOX. This paper thus explores a previously unexamined natural experiment: To the extent SOX contributed to the rise in going-private transactions, one should observe after 2002 a transition away from high-yield debt in the financing of going-private transactions towards other forms of SOX-free finance.

Using a unique dataset of going-private transactions, this paper examines the financing decisions of 468 going-private transactions occurring in the eight year period surrounding the enactment of SOX. Although SOX-free forms of subordinated debt-financing were widely available during this period, I find no significant change in the overall rate at which firms used high-yield debt in structuring going-private transactions after SOX was enacted. Cross-sectional analysis, however, reveals that the use of high-yield financing marginally declined after 2002 for small- and medium-sized transactions, while significantly increasing for large-sized transactions. These findings are consistent with the hypothesis that the costs of SOX have disproportionately burdened small firms. They also strongly suggest that non-SOX factors were the primary impetus for the name brand buyouts commonly evoked as evidence that SOX has harmed the competitiveness of U.S. capital markets.

Karmel on SROs as Government Agencies

Should Securities Industry Self-Regulatory Organizations be Considered Government Agencies?, by ROBERTA S. KARMEL, Brooklyn Law School, was recently posted on SSRN.  Here is the abstract:

Securities industry self-regulatory organizations (SROs) began as private sector membership organizations of securities industry professionals. This article addresses the questions of whether, and to what extent, securities industry SROs have become government agencies, and whether, and to what extent, they should be subject to constitutional and statutory controls on government agencies. It focuses principally on the Financial Industry Regulatory Agency (FINRA), a new entity which combined the National Association of Securities Dealers, Inc. (NASD) and the member regulation functions of NYSE Group, Inc. (NYSE).

The cases addressing these critical issues are contradictory, and generally not based on any overriding constitutional law principles. In some areas, the courts have just stated that an SRO is exercising delegated governmental power. In other areas, the courts have just stated that an SRO is a private membership organization. Sometimes, courts have distinguished between the commercial and regulatory functions of SROs, in order to draw lines separating the laws applicable to government agencies from private sector organizations.

The article will conclude that as long as the securities industry, rather than the SEC, controls the governance of FINRA and the selection of its Board of Governors, FINRA should not be held to be a government entity. This conclusion may be surprising to scholars and lawyers who have not considered the implications of changed SRO governance. Nevertheless, when FINRA is exercising investigative and disciplinary functions it should be treated like a government agency. Furthermore, to the extent practicable FINRA should operate according to transparency standards applicable to government bodies. Striking the right balance between private sector flexibility and constitutional and administrative law protections is critical to the future operation of FINRA and other securities industry SROs.

Krawiec on Risk Management

Operational Risk Management: An Emergent Industry, by KIMBERLY D. KRAWIEC, University of North Carolina at Chapel Hill - School of Law, was recently posted on SSRN.  Here is the abstract:

Financial institutions have always been exposed to operational risk - the risk of loss from faulty internal controls, human error or misconduct, external events, or legal liability. Only in the past decade, however, has operational risk risen to claim a central role in risk management within financial institutions, taking its place alongside market and credit risk as a hazard that financial institutions, regulators, and academics seriously study, model, and attempt to control and quantify. This newfound prominence is reflected in the Basel II capital accord, in numerous books and articles on operational risk, and in the emergence of a rapidly expanding operational risk management profession that is expected to grow at a compound annual rate of 5.5%, from US$992 million in 2006 to US$1.16 billion in 2009.

This increased emphasis on operational risk management corresponds to a much wider trend of responsive or enforced self- regulation, both in the United States and internationally, that attaches significant importance to the internal control and compliance mechanisms of business and financial institutions. Driven by legal changes and well-organized compliance industries that include lawyers, accountants, consultants, in-house compliance and human resources personnel, risk management experts, and workplace diversity trainers (hereafter, legal intermediaries), internal compliance expenditures have increased substantially throughout the past decade, assuming an ever-greater role in legal liability determinations and organizational decision-making, and consuming an ever-greater portion of corporate and financial institution budgets.

This chapter situates operational risk management - particularly those components of operational risk related to legal risk and the risk of loss from employee misconduct - within the broader literature on enforced self-regulation, internal controls, and compliance, arguing that the increased focus on operational risk management portends both positive and negative effects. On the one hand, business and financial institutions that are law abiding and avoid unforeseen and unaccounted for disasters are an obvious positive. At the same time, however, all operational risk management is not created equally. Some operational risk expenditures may prove more effective at enhancing the profits or positions of particular firm constituencies and legal intermediaries, or luring regulators and firm stakeholders into a false confidence regarding operational risk management, than at significantly reducing operational risk losses. Indeed, recent rogue trading losses such as those at Société Générale and MF Global Ltd. demonstrate that operational risk measures such as those embraced in Basel II are no substitute for sound firm management and regulatory oversight.

Johnsen on Directed Brokerage

Directed Brokerage, Conflicts of Interest, and Transaction Cost Economics, by D. BRUCE JOHNSEN, George Mason University School of Law, was recently posted on SSRN.  Here is the abstract:

This paper relies on the economics of transaction costs to assess the likely effect on investor welfare of the U.S. Securities and Exchange Commission's (SEC's) prohibition on an innovative business practice known as directed brokerage. Its key insight is that the quality of a broker's execution of portfolio trades is difficult for a mutual fund adviser to assess until it is too late - that is, execution quality is an experience good. In the meantime, low-quality brokerage can substantially reduce investor returns. To have the incentive to provide high-quality execution, a broker must expect to receive a stream of premium portfolio commissions in excess of his execution costs, much along the lines of a Klein-Leffler quality-assuring price premium. Competition between brokers for premium commissions leads them to post a performance bond with advisers equal to the present value of the expected premium stream. With directed brokerage, the bond takes the form of up-front broker effort devoted to marketing the fund's retail shares. Once having posted the bond, any broker that provides low-quality execution will eventually be terminated by the adviser and lose the premium stream that provides a normal return on the up-front bond. Low-quality brokerage is thus screened out. Contrary to its intended effect, the SEC's prohibition on directed brokerage likely reduces investor welfare by failing to recognize the problems inherent in transacting experience goods.

 

Johnsen on SEC's Soft Dollar Guidance

The SEC's 2006 Soft Dollar Guidance: Law and Economics, by D. BRUCE JOHNSEN, George Mason University School of Law, was recently posted on SSRN.  Here is the abstract:

After some two years of deliberations, in July 2006 the SEC released its long-awaited Guidance on the scope of the soft dollar safe harbor. Passed as part of the Securities Acts Amendments in May, 1975, the safe harbor has protected fund advisers and other money managers for over 30 years from criminal actions and civil suits for breach of fiduciary duty when they use client assets to pay more than the lowest available brokerage commissions in exchange for brokerage and research services. During this time the SEC has interpreted and re-interpreted the safe harbor's scope, largely owing to the public controversy soft dollars engender as a form of illicit kickback designed to subvert advisers' loyalty. The SEC's 2006 Guidance attempts to dramatically narrow the permissible use of soft dollars by prescribing a laundry list of protected and unprotected services. Yet the SEC is now considering further interpretation, and its chairman has petitioned Congress for an outright repeal of the soft dollar safe harbor. This paper shows that soft dollars are an innovative and efficient form of economic organization that benefits fund investors. According to economic theory now well-established in antitrust law, the SEC's Guidance is hopelessly misguided. Were the Guidance to come under the scrutiny of a federal court, the SEC would very likely experience another in its recent string of embarrassing legal defeats.

Leahy on Underwriters' Due Diligence

What Due Diligence Dilemma? Re-Envisioning Underwriters' Continuous Due Diligence after Worldcom, by JOSEPH KIERAN LEAHY, Brooklyn Law School , was recently posted on SSRN.  Here is the abstract:

The recent WorldCom decision is widely believed to pose a due diligence dilemma. This dilemma supposedly forces underwriters for large, established corporations to choose between their clients' desire to issue securities quickly in shelf-registered offering and the obligation to exercise reasonable care in due diligence. According to most commentators, the bar for due diligence set by WorldCom is simply too high to surmount during a shelf takedown. As a result, underwriters will either lose lucrative business or lose their defense to liability for misstatements or omissions in the offering document. And the stakes are high: in WorldCom, the underwriters settled for $6.1 billion rather than test their due diligence defense at trial.

Underwriters could avoid this purported quandary if they investigated clients on a continuous basis, and thus, largely completed due diligence before each offering. Yet, scholars generally agree that underwriters perform little such continuous due diligence.

This article casts doubt on that scholarly consensus. This article urges that underwriters for giant corporations may perform more far continuous due diligence than most writers suppose.

This article sheds light on a source of continuous due diligence that has, to date, entirely escaped scholarly attention: investigation outside of the context of securities offerings. The bulge bracket investment banks that underwrite securities for giant corporations typically are organized into client relationship teams. These teams serve all of the bank's clients' financing needs, not just securities underwriting. As such, the team has reason to investigate its clients in many contexts other than securities offerings. This investigation is continuous due diligence by another name - and it may well provide an escape from the underwriter conundrum.

Choi, Fisch, & Kahan on Proxy Advisors

Director Elections and the Influence of Proxy Advisors, by STEPHEN J. CHOI, New York University - School of Law, JILL E. FISCH, Fordham University - School of Law, and MARCEL KAHAN, New York University - School of Law, was recently posted on SSRN.  Here is the abstract:

Using a dataset of proxy recommendations and voting results for uncontested director elections from 2005 and 2006 at S&P 1500 companies, we examine how advisors make their recommendations and how these recommendations and other factors affect the shareholder vote. Of the four firms we study, Institutional Shareholder Services (ISS), Proxy Governance, Glass Lewis, and Egan Jones, ISS is widely regarded as the most influential and its recommendation is claimed to sway 20-30% of the vote. We find that the four proxy advisory firms differ systematically from each other both in their willingness to issue a withhold recommendation and in the factors that affect their recommendation.

We further find that all the proxy advisors, but particularly ISS, base their recommendations largely on factors that shareholders take into account (independent of the recommendation) in casting their vote. Once these factors are controlled for, overall voting outcomes are substantially similar whether or not a proxy advisor has issued a recommendation. Our analysis demonstrates that the reported influence of ISS is substantially overstated. Our evidence is consistent with the view that proxy advisors act primarily as agents or intermediaries which aggregate information that investors find important in determining how to vote in director elections rather than as independent power centers.

Hamermesh on Shareholders' Inspection Rights

Twenty Years after Smith v. Van Gorkom: An Essay on the Limits of Civil Liability of Corporate Directors and the Role of Shareholder Inspection Rights, by LAWRENCE A. HAMERMESH, Widener University School of Law, was recently posted on SSRN.  Here is the abstract:

With director monetary liability for lack of care (appropriately, in the author`s view) fading or disappearing altogether since Smith v. Van Gorkom, litigation invoking the duty of care seems increasingly unlikely to serve as a vehicle for public scrutiny of, and reputational sanctions for, director conduct that is substandard but does not involve self-interest or lack of good faith. It is therefore increasingly important to examine when information obtained through the exercise of stockholder inspection rights can be made public. A recent case involving the Walt Disney Company - but not the well-known litigation involving Michael Ovitz' termination compensation - addresses the issue of confidential treatment of such information. Prompted by the Court of Chancery's treatment of the issue, this Article proposes that the courts review and balance a number of factors - the subject matter of the information, the level of public interest in the information, the motives of the stockholder in seeking the information and (perhaps) ultimately seeking to make it public, and the context in which the information was generated - to determine whether information afforded pursuant to stockholder inspection rights should remain confidential.

Zitzewitz on Mutual Fund Settlements

An Eliot Effect? Prosecutorial Discretion in Mutual Fund Settlement Negotiations, 2003-7, by ERIC ZITZEWITZ, Dartmouth College, was recently posted on SSRN.  Here is the abstract:

This paper examines the negotiated settlements of 20 market timing and late trading cases, comparing the restitution obtained for shareholders with an estimate of shareholder dilution. This restitution ratio varies from 0.04 to 5, or from 0.1 to 10 if penalties are included. While some of this variation is explained by differences in the defendants' conduct, controlling for this, settlement negotiations that involved New York as well as the Security and Exchange Commission (SEC) resulted in restitution ratios that were higher by a factor of 5-10. An analysis that uses the firms' headquarters location and customers' state of residence as an instrument for New York's involvement suggests that this difference is causal, and not the result of New York involving itself in cases likely to lead to large settlements. Given the much larger staff and institutional expertise of the SEC, it is likely that these differences in outcomes are due to differences in aggressiveness, not prosecutorial resources. Differences in aggressiveness are consistent with popular conceptions of the regulators' career concerns, as well as with theories of industry focus and regulatory capture.

Harner on Activist Debt Investing

The Corporate Governance and Public Policy Implications of Activist Distressed Debt Investing, by MICHELLE M. HARNER, University of Nebraska College of Law, was recently posted on SSRN.  Here is the abstract:

Activist institutional investors traditionally have invested in a company's equity to try to influence change at the company. Some of these investors, however, are now purchasing a company's debt for this same purpose. They may seek to change a company's management and board personnel, operational strategies, asset holdings or capital structure.

The chapter 11 bankruptcy cases of Allied Holdings, Inc. and its affiliates exemplify the strategies of activist distressed debt investors. In the Allied cases, Yucaipa Companies, a distressed debt investor, purchased approximately 66% of Allied's outstanding general unsecured bond debt. Yucaipa used this debt position to exert significant influence over Allied's chapter 11 cases and business operations, including its labor contract with the Teamsters. Yucaipa emerged as Allied's majority shareholder under Allied's confirmed plan of reorganization.

Allied is not an isolated example. In 2006, distressed debt investors raised a record $19 billion in investment funds. The research shows that some investors are using these investment funds for activist purposes. Indeed, activist distressed debt investing is on the rise in both the United States and the United Kingdom. This activism is changing the dynamics of corporate restructurings and presenting new challenges for corporate management and public policymakers.

Rosen on Executive Compensation

Who Killed Katie Couric? And Other Tales from the World of Executive Compensation Reform, by KENNETH M. ROSEN, University of Alabama - School of Law, was recently posted on SSRN.  Here is the abstract:

With average Americans perturbed about executive pay, government officials are taking action. Officials appear to be racing against each other to battle corporate excess. The U.S. Securities and Exchange Commission (SEC) engaged in major rulemaking related to the disclosure of executive compensation, and Congress quickly considered executive compensation legislation. More reform, however, is not always better. Concurrent reform by multiple regulators presents perils.

This Article adds to the dialogue about scandal-driven reform. While much discussion exists about the advisability of particular reforms, the focus here is on the process of reform. The Article conducts a comparative analysis of the SEC and House of Representatives' reform processes, which reveals that different policy-making processes may be more or less likely to yield positive reforms. The Article argues that promoting distinct, more delineated roles for certain public actors could improve synergies between regulatory reform efforts.

Part I explores how the SEC's response to the public notice and comment process for its compensation disclosure rulemaking shows how administrative agencies properly can tailor regulation in a deliberative fashion. Part II then provides the contrasting story of the House's passage of H.R. 1257 that illustrates the pitfalls of scandal-driven reform. Unfortunately, the House's actions followed disturbing trends in mandating content for SEC regulation and in failing to account adequately for synergies between concurrent regulatory efforts.

Part III concludes by suggesting a framework identifying when congressional action on business regulation seems most appropriate given concurrent regulatory efforts. The Article identifies Congress's important potential role in settling authority issues, providing oversight to administrative agency reforms, and being prepared to intervene when agencies are recalcitrant about enacting necessary rule changes. In offering this framework, the Article moves beyond executive compensation issues to see how Congress might deal with other crises of confidence in business regulation. Areas for potential application of the framework include the regulation of hedge funds, imported toys and other consumer products, proxy voting, and subprime lending.

Wanted: Cash for Banks

Is there enough SWF and private equity money out there to bail out every financial institution that needs capital?  It is reported that as many as 42 firms may need a capital infusion before the crisis is over.   The final figure for bank writedowns could exceed $750 billion. WSJ, So Far, So Good on Bailouts, but How Long Will They Last?, NYTimes, Banks Hunting for More Cash.
 

Gross & Black on Perceptions of Fairness in SRO Securities Arbitration

When Perception Changes Reality: An Empirical Study of Investors' Views of the Fairness of Securities Arbitration, by JILL GROSS, Pace Law School, and BARBARA BLACK, University of Cincinnati - College of Law, was recently posted on SSRN.  Here is the abstract:

Arbitration in securities industry-sponsored forums is the primary mechanism to resolve disputes between investors and their brokerage firms. Because it is mandatory, participants debate its fairness, and Congress has introduced legislation to ban pre-dispute arbitration clauses in customer agreements. Missing from the debate has been empirical research of perceptions of fairness by the participants, especially investors. To fill that gap, we mailed 25,000 surveys to participants in recent securities arbitrations involving customers to learn their views of the process. The article first details the survey's background, explains the importance of surveying perceptions of fairness, and describes our methodologies, procedures, and survey error structure. We then present our findings, including our primary conclusions that (1) investors have a far more negative perception of securities arbitration than all other participants, (2) investors have a strong negative perception of the bias of arbitrators, and (3) investors lack knowledge of the securities arbitration process. We also offer several explanations for these negative perceptions. We conclude that customers' negative perceptions transform the reality faced by policy-makers and mandate reform of the process, including the elimination of the industry arbitrator requirement and further public deliberation on the value of the explained award.

Ahdieh on Rule 14a-8

The Dialectical Regulation of Rule 14a-8: Intersystemic Governance in Corporate Law, by ROBERT B. AHDIEH, Emory University School of Law; Program in Law and Public Affairs, was recently posted on SSRN.  Here is the abstract:

In recent years, Rule 14a-8 of the Securities Exchange Act - first adopted more than sixty years ago to increase shareholder participation in corporate governance - has been the subject of a flurry of litigation, scholarly analysis, and SEC rulemaking. Most recently, following several years of debate, the SEC issued a significant clarification of the rule, reversing the Second Circuit's hotly contested interpretation of it in AFSCME v. AIG. For the most part, the debates surrounding Rule 14a-8 - including in the latter case - have focused on the scope of the rule's exceptions. This paper, selected for reprinting in the Securities Law Review's forthcoming volume of the year's top securities law articles, attempts to go beyond those exceptions, to suggest a fundamental rethinking of the nature and operation of the rule.

Specifically, the paper explores Rule 14a-8 as an occasion for what I have termed "intersystemic governance" - an embrace of cross-jurisdictional overlap and engagement in regulatory design and function. In its very structure, thus, Rule 14a-8 calls on the SEC to interpret and apply state law. Properly utilized, this scheme offers an opportunity for the development of regulatory norms that meaningfully integrate both federal and state values of corporate governance and shareholder participation. To this end, among other reforms, I propose a shift in the SEC presumptions applicable to no-action letters, praise Delaware's recent constitutional amendment to permit SEC certification of questions to the Delaware courts, and highlight various opportunities for heightened discourse. By means such as these, a more integrated - and ultimately more efficient - regime of shareholder participation may begin to emerge.

Schwarcz on Principles-Based Regulation

The 'Principles' Paradox, by STEVEN L. SCHWARCZ, Duke University - School of Law, was recently posted on SSRN.  Here is the abstract:

Although principles-based regulation is thought to more closely achieve normative goals than rules, the extent to which that occurs can depend on the enforcement regime. A person who is subject to unpredictable liability is likely to hew to the most conservative interpretation of the principle, especially where that person would be a potential deep pocket in litigation. This creates a paradox: Unless protected by a regime enabling one in good faith to exercise judgment without fear of liability, such a person will effectively act as if subject to a rule and, even worse, an unintended rule.

Miller on Tellabs

Pleading After Tellabs, by GEOFFREY P. MILLER, New York University - School of Law, was recently posted on SSRN.  Here is the abstract:

In Tellabs, Inc. v. Makor Issues & Rights, Ltd., the Supreme Court held that a securities fraud complaint will survive a motion to dismiss only if a reasonable person would deem the inference of [culpable state of mind] cogent and at least as compelling as any opposing inference one could draw from the facts alleged. This paper analyzes how the Tellabs test may be applied, identifies questions left open under the decision, and discusses broader implications of the opinion and the PSLRA. Among other things, the paper suggests that the PSLRA's heightened pleading rules have deformed the motion to dismiss to the point where it now operates in securities fraud cases as a hybrid falling somewhere in between the traditional Rule 12(b)(6) and Rule 56 summary judgment procedures.

Fox on Mandatory Disclosure

Civil Liability and Mandatory Disclosure, by MERRITT B. FOX, Columbia University - Columbia Law School, was recently posted on SSRN.  Here is the abstract:

This paper explores the appropriate system of civil liability for mandatory securities disclosure violations by established, publicly traded issuers. The U.S. system's design has become outmoded as the underlying mandatory disclosure regime that has moved from an emphasis on disclosure at the time that an issuer makes a public offering, to an emphasis on the issuer's ongoing periodic disclosures. An efficiency analysis shows that, unlike U.S. law today, the relevant actors should have equally great civil liability incentives to comply with the disclosure rules whether or not the issuer is offering securities at the time.

An issuer not making a public offering of securities should have no liability because the compensatory justification is weak. Deterrence will be achieved instead by imposing liability on other actors. An issuer's annual filings should be signed by an external certifier - an investment bank or other well capitalized entity with financial expertise. If the filing contains a material misstatement and the certifier fails to do due diligence, the certifier would face measured liability. Officers and directors would be subject to similar liability. Damages would be payable to the issuer. When an issuer is making a public offering, it would be liable to investors for its disclosure violations as an antidote to what otherwise would be an extra incentive not to comply.

This design would address two major complaints concerning the existing U.S. civil liability system: underwriter Section 11 liability for a lack of due diligence concerning disclosures that in modern offerings underwriters have no realistic ability to police, and litigation-expensive issuer class action fraud-on-market liability. The system suggested here would eliminate both sorts of liability. But unlike elimination reforms proposed by underwriters and issuers, it would retain deterrence by substituting in place of these liabilities more effective and efficient civil liability incentives for disclosure compliance.

Rose on Sovereign Shareholders

Sovereigns as Shareholders, by PAUL ROSE, Ohio State University - Michael E. Moritz College of Law, was recently posted on SSRN.  Here is the abstract:

This paper considers the increasing impact of sovereign wealth funds as equity investors. Sovereign investment has been viewed with suspicion because sovereign wealth funds, as tools of sovereign entities, could be used for political rather than investment purposes. While this risk is considerable, much of the discussion surrounding sovereign investment ignores or minimizes the mitigating effect of a number of regulatory, economic and political factors. This paper argues that continued care, but not additional regulation, is necessary to ensure that U.S. interests are not jeopardized by sovereign investment in U.S. enterprises. However, while the U.S. is able to protect its interests within its markets, other countries may not have the regulatory structure or political power to adequately defend their interests. Additionally, U.S. interests could be harmed by politically-motivated sovereign investment in other countries. As a result, this paper argues in support of efforts to establish a code of conduct for sovereign investment.

Ware on Securities Arbitration

What Makes Securities Arbitration Different from Other Consumer and Employment Arbitration?, by STEPHEN J. WARE, University of Kansas - School of Law, was recently posted on SSRN.  Here is the abstract:

This short piece emphasizes what makes consumer and employment arbitration in the securities industry different from consumer and employment arbitration generally. Securities law imposes non-contractual duties to arbitrate on both broker-dealers and securities employees. I believe these laws are bad policy because they restrict contractual freedom. I conclude that securities arbitration should be contractual, like other arbitration.

Cunningham on Gobal Accounting

The SEC's Global Accounting Vision: A Realistic Appraisal of a Quixotic Quest, by LAWRENCE A. CUNNINGHAM, George Washington University Law School, was recently posted on SSRN.  Here is the abstract:

In the most revolutionary securities law development since the New Deal, the SEC is poised to jettison rules requiring companies to apply recognized US accounting standards by inviting use of a new set of international ones created by a private London-based organization. This radical shift follows decades of gradual movement towards international standards that has gained momentum since 2005 when all listed companies in the European Union were required to use them. For the US, the SEC could give companies the option to use either or establish a medium-term plan to move US companies to international standards within a decade.

Analysis of the SEC's vision for this quest reveals that it contains contradictions, paradoxes and ironies that suggest quixotic thinking. A contradiction: the SEC touts its vision as promoting comparability, yet proposes injecting choice and competition into accounting standards that would reduce it. A paradox: the SEC celebrates a single set of global standards while advocating changes that would create a double set within the US and overlooks factors that justify skepticism about the possibility of a single set of written standards translating into uniform application. An irony: the SEC acknowledges that pursuing global standards is "very complex" while its Chairman says the SEC has "declared a war on complexity" in accounting.

A more realistic vision of the quest appreciates that, under either an optional or mandatory route, the shift amounts to a leap of faith posing both large costs for the US and potentially large gains for it and the world. This realistic appraisal lowers expectations about actual comparability; highlights serious risks that competing standards would impair comparability; recognizes needs the SEC has scantly examined to render elaborate infrastructural changes; and, above all, faces the realization that the abrupt shift is less about the SEC's historical mandate to protect investors than about a newly undertaken mission to expand global capitalism.

Mitchell on the Innocent Shareholder in Securities Class Actions

The "Innocent Shareholder": An Essay on Compensation and Deterrence in Securities Class Actions, by LAWRENCE E. MITCHELL, George Washington University - Law School, was recently posted on SSRN.  Here is the abstract:

One of the persistent tropes in the debate over the desirability of private securities class actions is that innocent shareholders pay the damages. The claim that shareholders are indeed innocent has rarely been examined. In this paper, I take the assertion seriously, tracing the use of the concept from its origins as a rhetorical anti-regulatory device from the 1890s through about 1920, its disappearance as the rising New Deal concern with corporate pow