(Editor’s Note: This post comes from Gary Gorton of Yale University, Matthias Kahl of the University of North Carolina at Chapel Hill, and Richard J. Rosen from the Federal Reserve Bank of Chicago.)

In our forthcoming Journal of Finance article Eat or Be Eaten: A Theory of Mergers and Firm Size we propose a theory of mergers that combines managerial merger motives with an industry-level regime shift that may lead to value-increasing merger opportunities. Two of the most important stylized facts about mergers are the following: First, the stock price of the acquirer in a merger decreases on average when the merger is announced. Second, mergers concentrate in industries that have experienced regime shifts in technology or regulation. The view that mergers are an efficient response to regime shifts by value-maximizing managers, the so-called neoclassical merger theory, can explain this second stylized fact. However, it has difficulties explaining negative abnormal returns to acquirers. Theories based on managerial self-interest such as a desire for larger firm size and diversification can explain negative acquirer returns. However, they cannot explain why mergers are concentrated in industries undergoing a regime shift. Our theory of mergers is able to reconcile both of these stylized facts.

The basic elements of our theory are as follows: First, we assume that managers derive private benefits from operating a firm in addition to the value of any ownership share of the firm they have. Second, we assume that there is a regime shift that creates potential synergies. The regime shift makes it more likely that some future mergers will create value, with larger targets being more attractive merger partners due to economies of scale. Third, we assume that a firm can only acquire a smaller firm, which is consistent with the majority of actual market acquisitions.

In our models, the anticipation of potential mergers after the regime shift creates incentives to engage in additional mergers. We show that a race to increase firm size through mergers can ensue for either defensive or “positioning” reasons. Defensive mergers occur because when managers care sufficiently about staying in control, they may want to acquire other firms to avoid being acquired themselves. By growing larger through acquisition, a firm is less likely to be acquired as it becomes bigger than some rivals. This defensive merger motive is self-reinforcing and hence gives rise to merger waves: one firm’s defensive acquisition makes other firms more vulnerable as takeover targets, which induces them to make defensive acquisitions themselves. This leads to an “eat-or-be-eaten” scenario, whereby unprofitable defensive acquisitions preempt some or all profitable acquisitions. We show that in industries in which many firms are of similar size to the largest firm, defensive mergers are likely to occur.

A central implication of our models is that the firm size distribution in an industry matters for merger dynamics. In particular, our models predict that acquisition profitability is positively correlated with the ratio of the size of the largest firm in an industry to the size of other firms in the industry. Additionally, it predicts that firms in industries with more medium-sized firms have a higher probability of making acquisitions. We use data on U.S. mergers during the period from 1982 to 2000 to test these hypotheses and find support for them.

The full paper is available for download here.

(This post is based on client memoranda by Randall Guynn, Annette Nazareth, and Margaret Tahyar of Davis Polk & Wardwell.)

It has been obvious for some time that the outdated US system of financial regulation is badly in need of reform. There have, however, been limited opportunities to unblock the political obstacles to reform, despite valiant attempts by the Paulson Treasury to spur debate with its Blueprint for a Modernized Financial Regulatory Structure and also by many other groups, private, public and academic. The silver lining in the financial crisis may be that at least some elements of reform can now be achieved. Secretary Geithner’s carefully calibrated announcements last week—timed to become public just in advance of the G-20 meetings scheduled in London this week—are an attempt to stage regulatory reform in such a way that those elements where there is the deepest consensus are treated first before more divisive proposals. The need for increased systemic risk regulation and the need for resolution authority for a wide range of systemically important financial institutions are among those priority proposals.

In announcing his new “rules of the road,” Secretary Geithner identified four major axes of reform: addressing systemic risk, protecting consumers and investors, eliminating gaps in the regulatory structure and fostering international coordination. The most detailed elements of the reform package involved systemic risk, including proposed legislation for the resolution of systemically important financial institutions. More detailed frameworks for the other three areas are promised in the coming weeks.

Our recent memorandum, entitled “Treasury’s Rules of the Road for Regulatory Reform,” describes Treasury’s framework for regulatory reform, focusing on the comparatively more detailed proposals for addressing systemic risk, and sets forth some of the issues the government and the private sector may consider as the details are hammered out. A companion memorandum by Randall Guynn, entitled “Treasury’s Proposed Resolution Authority for Systemically Significant Financial Companies” discusses Treasury’s proposed legislation for resolution authority.

The memorandum entitled “Treasury’s Rules of the Road for Regulatory Reform” is available here, and the memorandum entitled “Treasury’s Proposed Resolution Authority for Systemically Significant Financial Companies” is available here.

(Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published in today’s print edition of the Washington Post. Professor Bebchuk’s September 2008 Harvard Discussion Paper and WSJ op-ed piece in which he put forward the idea of buying troubled assets through private managed and competing funds are available here and here. His February 2009 Harvard Discussion Paper proposing a detailed design for such a program is available here, and his Forum post summarizing the analysis of this paper is available here.)

With the world’s attention shifting to London and the upcoming Group of 20 summit, it’s possible that the Treasury’s proposal for dealing with banks’ “troubled assets” will become old news. It shouldn’t. The administration plans to provide as much as $1 trillion to privately managed funds that will buy troubled assets, which is indeed the best way for jump-starting this market. But it is important to add to the program a mechanism that would prevent excessive subsidies to private parties and keep costs to taxpayers at a minimum.

The first government plan to purchase banks’ toxic assets, put forward by then-Treasury Secretary Henry Paulson, was withdrawn after objections that Treasury wouldn’t be able to value the assets. In a white paper issued last September, “A Plan for Addressing the Financial Crisis,” I proposed using privately managed and competing funds as an alternative and argued that such funds would better set prices for these sorts of assets.

The program that Treasury Secretary Timothy Geithner announced last week will lead to the creation of such competing funds. It is structured to produce a market with a significant number of potential sellers facing a significant number of potential buyers.

But while the program is intended to partner public and private capital, the partnership it sets up is quite unequal. As things stand, the private side — the private manager and investors possibly affiliated with it — would capture 50 percent of the upside but would bear a disproportionately small share of the downside, contributing as little as 8 percent of the fund’s capital.

Treasury officials believe that because private parties have not thus far established funds dedicated to buying troubled assets, favorable terms are needed to induce their participation. This logic is reasonable, but it is important to keep the government subsidy at a minimum. Without any market check, the terms set by the government could substantially overshoot what is necessary to induce private participation and end up imposing large and unnecessary costs on taxpayers.

A program of public-private funds should be designed to minimize costs to taxpayers. To attain this objective, the government should base the terms of participation on a process in which private managers compete to be in the program.

If the private side were to contribute only 8 percent of the capital, the government should seek to keep the highest fraction of the upside that would be consistent with inducing such participation. To this end, potential private managers would submit bids indicating the minimum share of the fund’s upside that each manager would be willing to accept for an 8 percent investment, as well as the size of the fund that the manager would establish if accepted into the program. Treasury officials should then set the share of the upside going to the private side in each of the funds under the program at the lowest level consistent with establishing funds that collectively have the aggregate target capital.

Alternatively, assuming that the private side’s share of the upside is fixed at 50 percent, the government should seek to get the largest possible contribution of private capital. Under this scenario, managers would submit bids indicating both the size of the fund each manager would establish and the maximum fraction of the fund’s capital that the manager would commit to raising privately in return for 50 percent of the upside. Based on the bids, the government would set the fraction of capital provided by the private side at the highest level consistent with establishing funds that have the target amount of aggregate capital.

This second scenario would not only keep the government’s subsidy at a minimum but would also induce the largest amount of private capital, thus conserving some of the government gunpowder that the program’s current design would use. Because many banks might well remain undercapitalized even when their assets are valued fairly, restarting the market for troubled assets won’t make these banks healthy; rather, it will make clear the need to recapitalize them and might require the government to inject substantial sums of additional capital.

Establishing privately managed funds that are financed with both private and public capital offers the best approach to restarting the market for troubled assets. Adding a market mechanism for setting the level of government subsidy is necessary to reduce the program’s cost to taxpayers and would leave the government with the most ammunition for the tasks that still lie ahead.

(Editor’s Note: This post is based on an op-ed piece by Mr. Heineman that appeared today in the Washington Post online.)

The just deposed GM leadership team has been in control for nearly a decade. During this period, market share, profitability and stock price have declined precipitously, while debt has risen dramatically. One of the fundamental issues raised by the economic crisis, primarily in the financial sector but also in failing industries like automobile industry, is: Where was the board of directors to set meaningful performance goals (not simply stock price) and hold business leaders accountable? This question, in turn, has raised even more fundamental issues about whether, despite endless governance writing, conferences and academic centers, corporations are capable of governing themselves when hard decisions need to be made.

One important perspective on the Obama administration’s decision about transforming the GM leadership and Board is a demand for accountability. While the failures of the past decade form the critical backdrop, the administration’s “Determination of Viability Summary” holds GM accountable for the failures of the “Restructuring Plan Report” submitted on February 17, 2009, pursuant to the US-GM loan agreement signed at the end of last year. Simply stated, that government summary finds the GM report unrealistic in assumptions about market share, price, brands, dealers, Europe, product mix and legacy costs—and far too slow in its actions. That Ford’s new management team is not seeking bail-out funds is the strongest argument that the time for accountability has arrived. This is not change for
change’s sake.

Of course, from a different perspective, this is all about negotiations (or, when the government is involved, politics). It is a negotiation with the GM stakeholders (especially the unions, bondholders and dealers) to make faster, bigger voluntary moves in 30 days to avoid the more unpredictable and potentially Draconian rigors of formal bankruptcy (even if on an expedited basis). It is a negotiation with the a broad spectrum in Congress to show reluctance to throw more good money after bad and to base the future on realistic plans, while holding out hope that GM can rise again (and get more durable financial assistance from the taxpayers).

It is, ultimately, a negotiation with the American people to see if combining hard actions now with the prospect of more support under specific conditions later can, in the midst of the economic maelstrom and now too-numerous-to-count government anti-recession programs, create political support down the road for longer-term federal involvement in GM. (On the subject of negotiation: it would be enjoyable to be in Fiat’s position when Chrysler comes to negotiate a joint venture with the alternative that the government will cut off support if no deal is done.)

In his announcement, President Obama gave the expected disclaimers: “The United States government has no interest in running GM. We have no intention of running GM.” His auto and financial analysts have found GM’s restructuring plan wanting. So a new plan will be developed. But they also found GM’s execution too slow. The unanswered question today, with removal GM’s leader, is who will take the GM helm, and join the GM Board, actually to “operate” the new GM for the longer term—and under what kind of “super-board” operational oversight from Uncle in Washington. A new age of GM accountability is dawning, but how will it work is in execution, not just in planning.

(Editor’s Note: This post comes from Wallace P. Mullin of George Washington University and Christopher M. Snyder of Dartmouth College.)

Our chapter, “Corporate Crime,” (to appear in the handbook Criminal Law and Economics, edited by Nuno Garoupa, Edward Elgar, 2009) provides a new survey of the law and economics literature on corporate crime. We focus primarily on the relevant theoretical research but also touch on empirical research and policy issues.

We set the stage by updating some stylized facts about prosecuted firms. The data come from various tables in the U.S. Sentencing Commission’s Sourcebook of Federal Sentencing Statistics. Our descriptive analysis is similar to earlier studies using this data source, but we update these earlier studies with the most recent data. The most up-to-date of these earlier studies (Cohen 1996) used data for the 1984-90 period, while our analysis covers the period 2002-06. We also focus on facts that relate to the theory which we go on to survey.

We find that around a third of the cases involved fraud, 20 percent involved environmental violations, around 7 percent involved antitrust, and about an equal fraction involved a general “product” category which includes food, drugs, other consumer products, and agriculture. Around a third of the cases (40 percent in 2006) involved managerial tolerance of behavior of lower-level employees. This figure sheds some light on the theoretical and empirical controversy over whether criminal agents are acting in the interest or against the interest of principals higher up in the organization (firm owners or managers). The figure suggests that different models of corporate crime may apply to different cases. While there are some cases in which the criminal employee may have been acting as a maverick against the interests of the firm’s owners and upper-level management, in a substantial minority of cases the other cases the criminal agent may have been benefitted his principals (at least in the absence of sanctions).

We then proceed to a survey of the theoretical literature, organizing the discussion within a unified framework provided by the principal-agent model. Our model follows closely on Garoupa (2000), since his comprehensive analysis nests much of the previous work.

…continue reading: Corporate Crime

The Private Equity Group at my firm has recently issued its third annual survey of sponsor-backed going private transactions. The survey analyzes and summarizes the material transaction terms of going private transactions involving a private equity sponsor in the United States, Europe and Asia-Pacific.

We surveyed 39 sponsor-backed public-to-private transactions announced from January 1, 2008 through December 31, 2008 with a transaction value (i.e., enterprise value) of at least $100 million (excluding target companies that were real estate investment trusts). Fifteen of this year’s surveyed transactions involved a target company in the United States, 13 involved a target company in Europe and 11 involved a target company in Asia-Pacific.

The survey’s key conclusions for the United States transactions include the following:

• 2008 witnessed a 97% collapse in aggregate transaction value for sponsor-backed going private transactions when compared to 2007. The largest transaction announced in 2008 had a transaction value of approximately $2.1 billion, a 95% decline from the largest transaction announced in 2007. There was also a 76% decline in transaction volume when compared to 2007.

• The percentage of club deals involving two or more private equity sponsors declined significantly in all transaction sizes in 2008. Only 7% of the 2008 transactions constituted a club deal whereas 37% of the 2007 transactions did so.

• The tender offer again made an appearance in 2008, continuing a trend that started in 2006. The same cannot be said for stub equity. There was no transaction in 2008 in which the sponsor offered stub equity to the target’s public shareholders.

• Not surprisingly, the credit crisis continued to adversely impact the debt-to-equity ratios of sponsor-backed going private transactions. Equity accounted for an average of 64% of acquiror capitalization for transactions between $100 million and $1 billion in value and 51% of acquiror capitalization for transactions greater than $1 billion in value.

• The credit crisis has forced sponsors to tap alternative financing sources, including traditional mezzanine lenders and hedge funds.

• The go-shop provision continued to be a common feature of going private transactions in 2008 with 53% of surveyed transactions including this form of post-signing market check. Interestingly, sponsors were more resistant this year to giving a significantly reduced go-shop break-up fee (only one transaction had a go-shop break-up fee of less than 50% of the normal break-up fee).

• Although far from the norm, there was an increase in 2008 in sponsor-backed going private transactions with a financing out (20% in 2008 compared to 3% in 2007).

• When compared to pre-credit crunch transactions, the 2008 transactions reveal a material decrease in the number of MAE exceptions.

• Reverse break-up fees were again the norm in 2008, appearing in 87% of all surveyed transactions (a slight increase from 84% in 2007). In an effort to limit the optionality built-in to the reverse break-up fee structure and incentivize sponsors to consummate the transaction, target boards in a significant minority of surveyed transactions negotiated for a higher second-tier reverse break-up fee or a higher cap on monetary damages.

• Interestingly, specific performance provisions enforceable against the buyer were very rare in 2008. Only 7% of the 2008 transactions permitted the seller to seek specific performance against the buyer rather than be limited to a reverse break-up fee or monetary damages (whereas 33% of the surveyed transactions in 2007 allowed the seller to seek specific performance).

The survey is available here.

(Editor’s Note: This post is based on a client memo by Theodore N. Mirvis, Adam O. Emmerich, William Savitt, David E. Shapiro, and Adam M. Gogolak of Wachtell, Lipton, Rosen & Katz.)

Forthrightly addressing the continued proliferation of swaps, options and other equity derivatives, the UK’s Financial Services Authority (“FSA”) has now adopted final rules requiring the disclosure under the UK’s Disclosure and Transparency Rules of swaps, options and other derivative contracts, including those providing for cash settlement. See Policy Statement 09/3. The new rules require disclosure of aggregate equity positions (including derivatives) beginning at the 3% level (with an exemption for the writers of equity derivatives acting as intermediaries).

The FSA noted two important changes from its prior thinking in adopting the final rules.

First, while the FSA’s prior intention was to make the new rules effective in September 2009, it determined, “in light of the changes in market conditions since last summer and the need for increased transparency driven by these changes,” to accelerate the effectiveness of the new rules to June 1, 2009.

Second, the FSA decided that disclosures should be made on a delta-adjusted (rather than nominal) basis, which the FSA believes is a more accurate reflection of the actual extent of economic interest held at any one time. As a transition matter, the FSA will allow reporting on either a nominal or a delta-adjusted basis for a period of seven months following effectiveness of the new rules, provided that firms choosing to report on a nominal basis during the transition period will be required to provide sufficient information – including the strike or exercise price of each financial instrument reported and the total number of voting rights relating to shares referenced by each financial instrument reported – to allow market participants to calculate the underlying adjusted economic interest.

The FSA’s decisive action to require disclosure of accumulations of significant stakes in publicly traded companies through derivative instruments – and its corresponding approach toward disclosure of short positions (see Discussion Paper 09/1) – only further highlights the inadequacy of the current U.S. disclosure and regulatory regime. While there has been piecemeal reform and adjustment in the U.S. – through judicial decisions such as that in CSX, through private and contractual ordering in by-laws, rights plans and other contracts, and through a variety of other mechanisms – the need for comprehensive reform and market transparency has not been met. There continues to be an overwhelming global consensus towards full and fair disclosure of equity derivatives and other synthetic and non-standard ownership and control techniques. We remain strongly of the view that U.S. regulation should be comprehensively reformed to address derivative arrangements in a clear and uniform manner, generally treating all such arrangements that are coupled with direct or indirect ownership of actual shares by counterparties as in all respects equivalent to actual ownership, and requiring appropriate disclosure of all such arrangements involving more than 5% economic equivalent ownership, whether long or short, and whether accompanied by underlying ownership positions or otherwise.

(Editor’s Note: This post comes from Ulrike Malmendier of the University of California, Berkeley and Geoffrey A. Tate of the University of California, Los Angeles.)

Compensation, status, and press coverage of managers in the U.S. follow a highly skewed distribution: a small number of ‘superstars’ enjoy the bulk of the rewards. However, the “tournament” for CEO status and public attention is not designed by shareholders as an incentive device, but is largely conducted by the media. As a result, the value consequences of superstar status are unclear. While increased media exposure may boost profitability, it could also shift power towards the CEO and induce perquisite consumption. In our paper, Superstar CEOs, which was recently accepted for publication in the Quarterly Journal of Economics, we analyze the ex-post value consequences of the managerial superstar system.

We use several empirical methods to identify a credible counterfactual for the winning CEOs. As our main identification strategy, we construct a nearest neighbor matching estimator. We estimate a logit regression to identify observable firm and CEO characteristics that predict CEO awards. We then match each award winner to the non-winning CEO who, at the time of the award, had the closest predicted probability of winning. Lastly, we verify that award winners and the control sample are indistinguishable along most observable dimensions, including firm and CEO characteristics not explicitly included in the match procedure. We exploit shifts in CEO status due to CEO awards conferred by major national media organizations. We link award-induced changes in status to corporate performance and CEO decision-making, using matched non-winning CEOs as a benchmark.

We find that firms with award-winning CEOs subsequently underperform, both in terms of stock and operating performance. At the same time, CEO compensation increases, CEOs spend more time on activities outside the company like writing books and sitting on outside boards, and they are more likely to engage in earnings management. The ex-post effects are strongest in firms with poor corporate governance, compared to a matched sample of non-winners with no ex ante differences in governance. Our findings suggest that the superstar system has negative ex-post value consequences for shareholders. The net effect of the superstar system, after accounting for ex-ante incentives created by the tournament for status, is hard to assess. However, the ex post value destruction we measure is large and it appears to be avoidable. Firms with strong shareholder rights do not experience a decline in performance when their CEOs win awards, suggesting that it is optimal to increase monitoring after CEOs win awards.

The full paper is available for download here.

(Editor’s Note: This post is based on a client memo by Theodore N. Mirvis, Paul K. Rowe and David A. Katz of Wachtell, Lipton, Rosen & Katz.)

In an important decision, the Delaware Supreme Court has firmly rejected post-merger stockholder claims that directors failed to act in good faith in selling the company, even if it were assumed that they did nothing to prepare for an impending offer and did not even consider conducting a market check before entering into a merger agreement (at a substantial premium to market) containing a no-shop provision and a 3.2% break-up fee. Lyondell Chemical Corp. v. Ryan, C.A. 3176 (Del. Mar. 25, 2009). The en banc decision, authored by Justice Berger, is a sweeping rejection of attempts to impose personal liability on directors for their actions in responding to acquisition proposals, and reaffirms the board’s wide discretion in managing a sale process.

The Court of Chancery had refused to grant summary judgment on claims that the directors of Lyondell had breached their duty of loyalty by failing to act in good faith in conducting the sale process. Lyondell’s certificate of incorporation included an exculpatory provision, as permitted by Section 102(b)(7) of the Delaware General Corporation Law, that shielded the directors from personal monetary liability for any alleged duty of care violations but not for duty of loyalty violations. The Court of Chancery found the board to be independent and disinterested, but held that the directors’ “unexplained inaction” when it appeared that the company would be put “in play” by a Schedule 13D filing created an inference that the directors may have consciously disregarded their fiduciary duties and failed to act in good faith in violation of the duty of loyalty.

In considering the claim under the Revlon standard requiring that the board seek to get the best price available in selling the company, the Supreme Court found that the lower court had misapplied the law in three respects: first, it imposed Revlon duties before the board had decided to sell the company or a sale had become inevitable; second, it misread Revlon as creating a set of specific requirements to be satisfied during the sale process; and third, it treated an arguably imperfect effort to sell the company as equivalent to “a knowing disregard of one’s duties that constitutes bad faith.”

The Supreme Court rejected the view that Revlon duties arise simply because a company is “in play,” holding: “The duty to seek the best available price applies only when a company embarks on a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change in control.” The Court found that the board had appropriately exercised its business judgment by taking a “wait and see” approach in response to a Schedule 13D filing indicating that a party was interested in acquiring the company. The Court ruled that Revlon duties only arose when the directors chose to begin negotiating the sale of the company. The decision thus again makes clear that a board has no duties under Revlon to seek the “best price” in a sale or other transaction simply because a stockholder or other potential bidder tries to put the company “in play.”

…continue reading: Supreme Court rejects post-merger stockholder claims

(Editor’s Note: The post below by Commissioner Troy Paredes is a transcript of remarks by him at the 2009 Southeastern Securities Conference on March 19, 2009 in Atlanta, Georgia.)

It is an honor to be speaking here today at the 2009 Southeastern Securities Conference. Before I begin, I must say the standard disclaimer: The views that I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or of my fellow Commissioners.

Many in the audience are SEC enforcement lawyers and examiners. So let me emphasize at the start the tremendous respect and appreciation I have for you and your hard work. Your dedication and professionalism are inspiring models of committed public service.

* * *

Some outside the agency may not realize the Herculean task that the Division of Enforcement admirably shoulders. Let me offer some context.

Over 12,000 companies have securities registered with the Commission under Section 12 of the Exchange Act. Publicly-traded securities trade on eleven exchanges in the United States, as well as in the over-the-counter market. In addition, there is a huge private placement market. Although private offerings are not registered with the Commission under the Securities Act, they are nonetheless subject to our antifraud authority.

Individual investors often do not hold securities directly, but frequently prefer to invest through mutual funds. The mutual fund industry is large and critically important, particularly as a means of diversification for retail investors — itself a form of investor protection. This translates into additional responsibilities for the Commission, as investors can now choose from among 4,600 registered funds that the SEC oversees. The Enforcement Division’s responsibilities don’t stop there. Rather, there are over 11,000 investment advisers, along with approximately 5,500 broker-dealers. Even this understates the reach of the SEC’s jurisdiction. For example, according to a recent count, the 5,500 broker-dealers have a total of over 170,000 branch offices and 665,000 registered representatives.

In short, the Division of Enforcement’s jurisdiction is incredibly large, diverse, and complex. There is often an international component to securities enforcement, bringing still additional challenges for the staff. It is a vast amount of turf to cover for a Division that houses 1,100 employees.

Just keeping on top of tips and referrals can be daunting. The Commission receives an estimated 700,000 or more leads each year. Notably, the Commission recently announced that it is undertaking efforts to ensure that we have the right systems, processes, and expertise for responding to whistleblowers and tips and referrals from numerous other sources.[1] This kind of scrutiny and adaptation is important if the SEC is to have the state-of-the-art capabilities we need to fulfill our mission.

* * *

While our markets are enormous and the public’s expectations of the Commission are high, the SEC’s resources are limited. We have to ask a very basic question: How does the SEC efficiently and effectively advance our mission given our resource constraints?

When deciding how best to allocate the agency’s efforts, the Commission has to make difficult choices. Enforcement is no exception. As much as we would like to, we simply cannot pursue to the fullest extent each and every possible violation of the securities laws. Even with more money and more staff, we will have to make strategic tradeoffs — rooted in informed policy choices that the Commission makes — in light of the relevant costs and benefits that attend the options in front of us.[2]

…continue reading: Efficient and Effective Enforcement by the SEC

Last night, the Supreme Court of Delaware handed down its much anticipated decision in Lyondell Chemical Company v. Ryan, a case concerning whether the independent directors of a target company’s board were entitled to summary judgment on claims that they failed to act in good faith in conducting the sale of their company. In its decision, available here, the Court of Chancery had denied summary judgmnent in order to obtain a more complete record before determining whether the directors had acted in bad faith. The Supreme Court reversed that decision and remanded the matter for entry of judgment in favor of the Lyondell directors. In doing so, the Supreme Court emphasized the disinterested and independent nature of the directors, their awareness of the company’s value and prospects, and their consideration of the offer with assistance of financial and legal advisers. At most, the Court explained, “[the] record creates a triable issue of fact on the question of whether the directors exercised due care.” But there was no evidence, the Court said, “from which to infer that the directors knowingly ignored their responsibilities, thereby breaching their fiduciary duty of loyalty.”

The case is available here.

(Editor’s Note: This post is by Kelley D. Parker, Terry E. Schimek, Stephen W. Stites, Robert M. Hirsh, Marco V. Masotti, and Jennifer A. Spiegel of Paul, Weiss, Rifkind, Wharton & Garrison LLP.)

(Editor’s UPDATE: We have received another memo, by Davis Polk & Wardwell, on the public-private investment program. Available here, the memo describes the framework of the public-private funds and analyzes key concerns and unresolved questions about the program from the perspectives of troubled asset sellers, fund and asset managers and private investors.)

On 23 March the Treasury released highly anticipated details regarding the Public-Private Investment Fund (“PPIF”) portion of the Financial Stability Plan. The PPIF plan is intended to address the “legacy” assets at the center of the global financial crisis. These assets include both residential and commercial real estate loans held directly on the balance sheets of banks (“legacy loans”) and securities backed by real estate loan portfolios held by financial institutions (“legacy securities”). The announcement covered the creation of both a Legacy Loans Program and a Legacy Securities Program, the latter of which includes an expansion of the Term Asset-Backed Securities Loan Facility (“TALF”) program to include both residential and commercial backed mortgage securities.

We summarize below the various programs announced today and then discuss several open issues to consider in connection with the programs. We note that the details of these programs are still preliminary and the specific requirements and structure of the programs will be subject to further clarifications from the government, including a specific notice and comment rulemaking process for the Legacy Loans Program.

Legacy Loans Program:

FDIC to Oversee Formation of Multiple Funds. Under this program the Federal Deposit Insurance Corporation (“FDIC”) will oversee the formation and operation of multiple PPIFs to purchase legacy loans from insured banks and thrifts.

Auction Process to be Utilized. Private investors will bid for the opportunity to invest through an auction program run by the FDIC. Once asset pools are identified by eligible banks and their regulators, the FDIC will conduct diligence, prepare marketing materials and engage a third party firm to advise on appropriate leverage for the PPIF (not to exceed 6:1 debt to equity ratio) and to represent the government in structuring the auction.

…continue reading: Public-Private Investment Funds

(Editor’s Note: This post comes from Sanjeev Bhojraj of Cornell University, Paul Hribar of the University of Iowa, Marc Picconi of Indiana University, and John McInnis of the University of Texas at Austin.)

In our recently accepted Journal of Finance paper Making Sense of Cents: An Examination of Firms That Marginally Miss or Beat Analyst Forecasts, we provide evidence on the short and long-term price and profitability performance associated with managers undertaking myopic actions to meet short term earnings benchmarks, either through real operating decisions or management of accrual earnings. We also examine whether managers behave in a manner consistent with being aware of the short-term and long-term implications of their myopic choices. Our research design focuses primarily on two particular groups of firms: firms that just beat consensus forecasts (by one cent) but have large income increasing accruals and cuts in discretionary spending, and firms that just miss consensus forecasts (by one cent) but have large income decreasing accruals and increases in discretionary expenditures. We use these two sub-samples to yield the best possible contrasting settings of managerial myopia, where myopic actions are most likely and least likely to have been taken.

Our results show that in horizons of one year or less, firms using accruals or cuts in discretionary expenditures (i.e., low quality earnings) to beat a forecast have stock returns that are equal to or marginally better than firms who miss their forecast but maintain high quality earnings. Moreover, both these groups significantly outperform firms that manage earnings upwards but still miss expectations. This finding suggests a short-term benefit to beating expectations. In the long run, however, we find that firms that beat with low quality earnings under-perform the firms that miss with high quality earnings, which is consistent with the myopic behavior of the managers manifesting in the long-term. In addition, we find that future operating performance improves more for firms that miss with high quality earnings relative to firms that beat with low quality earnings, but this finding is limited to the subset of firms that are profitable. Among profitable firms, return on assets (ROA) increases for missers with high quality earnings relative to beaters with low quality earnings. Similarly, increases in capital expenditures are significantly higher and the market-to-book ratio increases more for firms that miss with high quality earnings. Lastly, we show firms that beat forecasts with low quality earnings are significantly more likely to issue equity in the following year and have significantly greater insider selling. These results hold regardless of whether the firms are compared with those that miss forecasts with high quality earnings or with those that beat forecasts with high quality earnings.

Our results suggest that while managers’ intuition regarding stock price benefits is correct in the short-term, the long-term rationale of this strategy is harmful because the quality of earnings manifests itself in performance over the long-run. We also provide empirical evidence that managers of these firms appear to understand these patterns, as they are significantly more likely to capitalize on the short term price benefits associated with beating the benchmark.

The full paper is available for download here.

(Editor’s Note: This comes to us from Karthik Ramanna of Harvard Business School.)

The International Accounting Standards Board (IASB) was established in 2001 to develop International Financial Reporting Standards (IFRS). Since then, nearly 70 countries have mandated IFRS for all listed companies. Further, about 23 countries have either mandated IFRS for some listed companies or allow listed companies to voluntarily adopt IFRS. However, as of 2007, at least 40 countries continued to require domestically developed accounting standards over IFRS, and this list included some large economies like Brazil, Canada, China, Japan, India, and the US. In joint work with Ewa Sletten of MIT, I investigate why some countries adopt IFRS while others do not. Understanding countries’ adoption decisions can provide insights into the benefits and costs of IFRS adoption.

We focus our analysis on a sample of 102 non-EU countries and examine IFRS adoption over the period 2002 through 2007. We exclude the EU member states from our analysis because their decision to adopt IFRS was closely tied to the establishment of the IASB itself.

In our sample of 102 countries, there is evidence that more powerful countries are less likely to adopt IFRS, consistent with more powerful countries being less willing to surrender standard-setting authority to an international body. There is also evidence that the likelihood of IFRS adoption at first increases and then decreases in the quality of countries’ domestic governance institutions, consistent with IFRS being adopted when governments are capable of timely decision making and when the opportunity and switching costs of domestic standards are relatively low. We do not find evidence that levels of and expected changes in foreign trade and investment flows in a country affect its adoption decision: thus, we cannot confirm that IFRS lowers information costs in more globalized economies.

Finally, we find evidence of the likelihood of IFRS adoption for a given country increasing with the number of IFRS adopters in its geographical region (network benefits). This result is significant because it suggests that as the network benefits from IFRS get large, countries may adopt the international standards even if the direct economic benefits from such standards are inferior to those from locally developed standards. The full paper is available for download here.

(Editor’s Note: This comes to us from Barry R. Goldsmith, Daniel H. Ahn, and Brian D. Boone of Gibson, Dunn & Crutcher LLP. The article is reproduced with permission from Alternative Investment Law Report, 2 AIR 347 (Mar. 11, 2009). Copyright 2009 by The Bureau of National Affairs, Inc. (800-372-1033).)

By virtually any measure, 2008 was a watershed year on the hedge fund enforcement front. Driven by the turmoil that has reshaped our capital and credit markets, enforcement efforts soared to new heights. Regulators and prosecutors redefined their enforcement priorities, commenced an unprecedented number of investigations and enforcement actions, and, according to a senior SEC insider, reached out to and cooperated with domestic and foreign agencies in a manner that has not been seen in at least 30 years. Explaining the unusually intense scrutiny that regulators placed upon hedge funds in 2008, Bruce Karpati, who coordinates the SEC’s Hedge Fund Working Group out of the New York Regional Office, suggested that, given the economic climate, ”half to two-thirds of hedge funds might go out of business”- and, as the aphorism goes, desperate times may lead hedge funds to take desperate measures. And these measures will continue to draw the SEC’s attention under the Obama administration.

Since 2000, the SEC has reportedly brought 145 actions involving hedge funds; and since 2003, the number of actions involving hedge funds each year has been in the teens or twenties. In 2008, that trend continued with the filing of 22 hedge-fund-related enforcement matters. In addition, the Department of Justice brought five hedge-fund-related criminal actions. While these numbers may seem unexceptional given the unprecedented scrutiny that hedge funds faced, the figures should be considered in light of the fact that 2008 saw: (a) the filing of a significant number of large, complex, or novel cases; (b) the culmination of similarly large, complex, or novel previously filed actions; and (c) the commencement of several broad industry-wide sweep investigations focusing on the activities of hedge funds and other market participants- all of which likely required the deployment of significant regulatory and prosecutorial resources. One need look no further than the highly publicized civil and criminal actions brought against Bernard L. Madoff for allegedly defrauding his advisory clients (hedge funds and others) out of billions of dollars in what might be the largest financial fraud in history. Investor losses from the fraud could reach $50 billion.

The take-away is clear: hedge funds were under extraordinary regulatory scrutiny in 2008 - particularly so once the economic crisis came to dominate the daily news-and that level of scrutiny is expected to continue, if not intensify, in 2009. In our article [link to article] , we review those enforcement priorities that dominated the headlines in 2008 and look to remain at the forefront throughout 2009. Along the way, we also offer advice to hedge funds and their advisers about how to navigate the increasingly hostile regulatory landscape. Much of the information presented is based on our review of cases filed and public sources describing enforcement initiatives and investigations. In addition, we have incorporated salient comments and observations made by senior regulators and prosecutors at a Nov. 24, 2008 Practising Law Institute Conference in New York on Hedge Fund Enforcement and Regulatory Concerns.

The article, which was recently published in the Alternative Investment Law Report, is available here.

(Editor’s Note: This post is based on an op-ed post by the author appearing in The Washington Post.)

Finding a new balance between public regulation and private decision-making is a paramount issue of the time. The crisis in capitalism stems from the systemic failures of business judgment in the financial sector which have caused the credit and solvency crises and led the world to the brink of depression. It is now a commonplace that 30 years of financial deregulation has come to an end.

There is a new consensus on the need for sensible public policy to deal with the causes of private excess and to ensure the safety and soundness of the financial sector going forward — to reconstruct the basic foundation of the world economy by finding a proper new balance between public and private decision-making. Numerous reports have been published both in Europe and the U.S. on regulatory visions of the way forward. This week the Obama administration will unveil its financial re-regulation proposals (as well as new ideas on how to deal with the “effects” of the melt-down — the toxic assets which pollute banks’ balance sheets).

But, lurking behind the consensus, along all points on the political spectrum, is the concern that regulation has problems too. High among those is recognition that decisions in the public sector can often be driven by irrational politics rather than sensible policy — by passions expressing the feelings of the moment, unmoored from sound judgment, which mirror the passions like greed and corruption that have hobbled the private sector.

The AIG bonuses are a microcosm of the problem. The Financial Products Group made terrible mistakes that had enormous, adverse multiplier effects. As financial conditions worsened, any incentive pay should have been carefully tied to positive results. Once those conditions turned into financial disaster and virtual government takeover, AIG and the administration should never have let the bonus money out the door — their justifications of legality and retention were not credible in the narrow case of the senior employees at the Group. Predictably, the actual payments have fanned flames of public outrage.

But the House bill, imposing a 90 percent tax on all 2009 bonuses for all TARP companies receiving government funds of more than $5 billion is nonsensical as a matter of policy (putting aside questions about constitutionality).

Leadership is about defining problems correctly. If they measure real contribution to an enterprise over time — real performance with integrity and sound risk management — phased bonuses are an important incentive, not bad per se. This can be especially important going forward as we seek to repair financial institutions. The blunderbuss House bill has any number of bad impacts: failing to recognize the value of good bonuses; driving people out of financial services; driving companies out of government programs.

Most importantly, the House bill undermines the credibility of public regulation and the importance of sound policy responses to the crisis. It is pitchfork populism — exactly what thoughtful people fear.

I believe deeply that terrible executive compensation systems were the rocket fuel that drove the financial sector to disastrous excess. And the public is rightly outraged about past pay practices and amounts. But finding the right future balance between government regulation of executive pay to ensure safety and soundness and private sector incentives for sensible innovation and wealth creation is one of the hardest problems at the core of the new reregulation consensus. Driving talented, blameless people away from regulated entities cannot be the right result.

President Obama (and the Senate) must reject the House bill and go back to the more thoughtful executive compensation proposals he announced a month ago, which invites a sensible, future dialogue between government regulators and affected corporations. Past failures should be handled and explained sensibly case-by-case for individuals responsible for failure, not mishandled as with AIG Financial Products Group leaders. (And, when passions abate, a Dodd amendment to the stimulus bill that arbitrarily limits bonuses also needs to be modified.)

Nothing less than the credibility of public regulation is at stake, with implications far beyond current anger over executive pay as the watershed re-regulation debate begins in earnest.

(Editor’s Note: This post comes from Patrick Bolton of Columbia Business School.)

In my working paper Satisficing Contracts which I recently presented at the Law, Economics and Organizations Workshop here at Harvard Law School, my co-author Antoine Faure-Grimaud and I analyze a contracting model with two agents, each facing thinking costs, in which equilibrium incomplete contracts arise endogenously. The basic situation we model is an investment in a partnership or an ongoing new venture. The contract the agents write specifies in a more or less complete manner what action-plan they agree to undertake initially, and how the proceeds from the venture are to be shared. In any given state of nature both agents face costs in thinking through optimal decisions in that state. Therefore an optimal contract that maximizes gains from trade net of thinking costs is generally incomplete in the sense that it is not based on all the information potentially available to agents in all states of nature. By introducing positive thinking or deliberation costs into an otherwise standard contracting framework, it is thus possible to formulate a theory of endogenously incomplete contracts.

The main results from our analysis are as follows: First, incomplete contracts specifying control rights may emerge in equilibrium (when such contracts are not strictly dominated by a complete contract with the same equilibrium information acquisition). The rationale for control rights in our model—defined as rights to decide between different transactions in contingencies left out of the initial contract—is that the holder of these rights benefits by having the option to defer thinking about future decisions. Second, control rights tend to be allocated to the more cautious party. Indeed, the more cautious party is then more willing to close the deal quickly, even though it has not had the time to think through all contingencies, in the knowledge that thanks to its control rights it can impose its most favored decision in the unexplored contingencies. Third, the sharp distinction between a first contract negotiation phase followed by a phase of execution of the contract usually made in the contract theory literature is no longer justified in our setup. In particular, the contracting agents may choose to begin negotiations by writing a preliminary contract specifying the broad outlines of a deal and committing the agents to the deal. Fourth, when agents’ objectives conflict more, equilibrium contracts are more complete. The main reason is that each agent may be concerned about the detrimental exercise of control by the other agent, so that abuse of power cannot be limited by just allocating control to the agent that is least likely to abuse power. In such situations the exercise of control may have to be circumscribed contractually by writing more complete contracts. Another reason is that when agents have conflicting goals they are less willing to truthfully share their thoughts, so that the net benefit of leaving transactions to be fine-tuned later is reduced.

Our analysis thus provides new foundations for incomplete contracts and the role of control rights. In particular, our framework allows for contractual innovation by the contracting agents independently of any changes in legal enforcement. In addition, changes in legal enforcement may have no effect on equilibrium contracts if enforcement constraints were not binding in the first place. The full paper is available for download here.

This post is by my colleagues Phillip R. Mills and Justine Lee.

The SEC recently published for public comment the NYSE’s proposal to eliminate broker discretionary voting in uncontested director elections, signaling that the Commission’s new leadership is prepared to move forward on an issue that has been on hold at the SEC since it was originally proposed in 2006. The rule change—which would not become effective until 2010 at the earliest—could make it more difficult for companies that have adopted a majority voting standard to elect management’s slate of nominees, as discussed below.

The NYSE has long classified uncontested director elections under Rule 452 as a “routine matter,” giving brokers the discretion to vote shares held in investors’ accounts when they do not receive voting instructions from the beneficial owner within ten days of a company’s meeting. Such uninstructed votes can make up a meaningful percent of the vote and have routinely been cast with management in the past. Several close elections have attracted scrutiny in recent years as activists contended that the outcomes would have been different if broker discretionary votes were excluded. In the absence of SEC action on this issue, a number of brokers have recently moved to voluntary policies of proportional voting, under which they vote uninstructed shares in proportion to how their voting clients cast their ballots. While the proportional voting policy was likely chosen over abstention (which would be closer to the NYSE proposal) in order to address quorum and other concerns, it can also skew voting results by disproportionately magnifying the vote of those retail investors that provide instructions to their brokers—a particular concern in the current climate for embattled companies that may have a dissatisfied retail shareholder base. It can also make outcomes less predictable since, unlike instructed shares, which are cast ten days prior to the meeting, shares voted proportionally are not cast until 72 hours before the meeting.

The NYSE proposal would re-classify director elections as a non-routine matter on which NYSE member organizations are not permitted to vote—regardless of which exchange the company is listed on—without instructions from the beneficial owner. If the SEC adopts the NYSE proposal, brokers would no longer be able to vote uninstructed shares, effectively reducing the number of votes in favor of board-nominated directors. This could make it difficult for directors to attain the requisite majority vote at companies with majority vote standards, particularly if there is a large retail investor base or if directors are facing a “withhold vote” campaign.

The proposed amendment is available here.

(Editor’s Note: This post comes from Yael V. Hochberg, Paola Sapienza and Annette Vissing-Jørgensen of Northwestern University.)

In our forthcoming Journal of Accounting Research paper entitled A Lobbying Approach to Evaluating the Sarbanes-Oxley Act of 2002, we evaluate the impact of the Sarbanes-Oxley Act (SOX) on shareholders by studying the lobbying behavior of investors and corporate insiders in order to affect the final implemented rules under the Act.

Following the passage of SOX in 2002, Congress delegated the drafting and implementation of the principles outlined by SOX to the Securities and Exchange Commission (SEC). The various sections of SOX were divided into separate rules by the SEC, which then solicited public comments regarding the proposed rules, prior to adopting the final releases. Letters to the SEC commenting on the proposed rules were publicly available on the SEC website or through its public reference office. Following the main compliance-related titles of SOX, we classify the rules on which the SEC solicited comments into groups. We focus on three major sets of rules: provisions related to enhanced financial disclosure (including the much-discussed Section 404 assessment of internal controls), provisions related to corporate responsibility, and provisions related to auditor independence.

Our review of these comment letters revealed that Investors lobbied overwhelmingly in favor of strict implementation of SOX, while corporate insiders and business groups lobbied against strict implementation. In addition, we find that the firms most likely to lobby were firms in mature industries, with relatively low forecasted earnings growth, high profitability and poor governance. These are precisely the types of firms that Jensen’s [1986] theory of free cash flow would predict are likely to provide more opportunities to management for expropriation, perquisite consumption or mismanagement of firm resources. In contrast, our analysis of audit fees indicates that lobbying firms are unlikely to be those that expect a large relative increase in compliance costs. Rather, lobbyers on average had lower audit fees relative to initial market value pre-SOX, and their audit fees relative to size increased by less, post-SOX, than those of non-lobbying firms.

Our portfolio analysis of returns reveals that during the period leading up to passage of SOX (February to July of 2002), cumulative returns were approximately 7 percentage points higher for corporations whose insiders lobbied against one or more of the SOX ‘Enhanced Disclosure’ provisions than for non-lobbying firms of similar size, book-to-market and industry characteristics. In contrast, we find no significant evidence of higher cumulative returns for those corporations whose insiders lobbied against one or more of the SOX ‘Corporate Responsibility’ provisions or for those corporations whose insiders lobbied against one or more of the SOX ‘Auditor Independence’ provisions than for comparable non-lobbying firms. Our analysis of returns in the post-passage implementation period suggests that investors’ positive expectations with regards to the effects of the ‘Enhanced Disclosure’ provisions were warranted.

The full paper is available for download here.

(Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published in today’s Wall Street Journal.)

The AIG bailout—at $170 billion and rising—may end up as the costliest rescue of a single firm in history. There is much debate about bonuses paid to AIG’s executives. But there is far too little debate on the government’s willingness to back all of AIG’s obligations.

The company claims any failure by the government to do so would have catastrophic consequences. This claim is exaggerated. Serious consideration should be given to forcing AIG’s partners in derivative transactions—which are mainly buyers of credit default swaps from the company—to take a substantial haircut.

AIG is a holding company, conducting most of its business through insurance subsidiaries organized as separate legal entities. The financial products subsidiary, which has produced the huge losses from derivative transactions that brought AIG down, is also a separate legal entity—but AIG has guaranteed the subsidiary’s obligations.

While AIG has thus far been able to cover derivative losses using government funds, the possibility of large additional losses must be recognized. AIG recently stated that it still has about $1.6 trillion in “notional derivatives exposure.” Suppose, for example, that AIG ends up with losses equal to, say, 20% of this exposure—that is, $320 billion. Suppose also that the value of AIG’s current assets, including the shares in its insurance subsidiaries, is $160 billion. In this scenario, the government’s fully backing AIG’s obligations would produce an additional loss of $160 billion for taxpayers. Should the government be prepared to do so?

The alternative would be to put AIG into Chapter 11. In this case, AIG’s creditors, including its derivative counterparties, would obtain the company’s assets. They would end up with a 50% recovery on their claims, bearing those $160 billion of losses themselves.

AIG recently stated that failure to meet all of the company’s obligations could lead to a “run on the bank” by customers seeking to surrender insurance policies and “would have sweeping impacts across the economy.” But insurance policy holders wouldn’t be at risk if AIG failed to meet its obligations. The insurance subsidiaries are not responsible for the debts of their parent AIG, and insurance policy claims are backed both by the subsidiaries’ required reserves and state insurance funds.

Still, what about the concern that losses to derivative counterparties—which are now known to include major U.S. and foreign banks—would substantially deplete the capital of some of them? That concern would be best addressed by the U.S. government (or foreign governments in the case of their banks) infusing capital directly—in return for shares—into the banks that need it. There is no reason to back AIG’s obligations as an instrument for infusing capital (with taxpayers getting nothing in return) into, say, Goldman Sachs or Spain’s Banco Santander.

It is true that the collapse of Lehman Brothers last September led to a crisis of confidence among depositors in banks and money market funds, which had a dramatic effect on markets. Letting AIG’s derivative counterparties take a significant haircut, however, should not lead to such a crisis. AIG’s obligations are to derivative counterparties, not to depositors. Moreover, governments world-wide are now committed to backing fully the claims of depositors in financial institutions.

It is important to understand that the government can also employ intermediate approaches between fully backing AIG’s derivative obligations and no backing. For example, the government could place AIG in Chapter 11, but commit to provide supplemental coverage that would make up any difference between the value that creditors would get from AIG’S reorganization and, say, an 80% recovery. Such an approach could allow setting different haircuts for different classes of creditors. The government, for example, might elect not to provide such supplemental coverage to executives owed money by AIG.

At a minimum, the government should conduct “stress tests,” estimating potential losses in alternative scenarios, and formulate a policy on the magnitude and fraction of derivative losses it would be willing to cover. A policy that doesn’t fully back AIG’s obligations should be seriously considered.

This post is by my partners Laurie B. Smilan and Howard A. Sobel.

With the increase in private securities, derivative and bankruptcy-related litigation against portfolio companies, private equity firms need to maximize the protections for the private equity firm, the funds they organize and the individuals who agree to serve as their representatives on portfolio company boards. Ironically, however, a private equity firm’s effort to provide “more” protection to its director-representatives may be far more expensive than the firm expects or intends.

Typically, private equity firms and the funds they organize grant their representatives serving on portfolio company boards broad indemnification rights—“to the fullest extent permitted by law.” Typically, too, private equity firms and their funds require that their portfolio companies provide “fullest extent of the law” protections to these same directors. Each of the firm, the fund and the portfolio company likely will have separate insurance policies to satisfy their respective indemnification obligations. Optimally, the firm and the fund will be entitled to indemnification rights from the portfolio company pursuant to the terms of a management services agreement.

Absent thoughtful drafting, however, the broader the indemnification rights provided by the private equity firm or its fund to the individual director, the more likely it is that the firm or its fund will be liable for a disproportionate share of defense and settlement costs incurred by the director in litigation involving the portfolio company and the less likely that such costs can be fully recovered from the portfolio company or its insurer. Moreover, the broader the terms of the insurance provided by the private equity firm, the greater the chances that the portfolio company’s insurers will resist paying out the full proceeds of the portfolio company’s policy before other sources of insurance are tapped.

Often times, the allocation of responsibility for indemnification and advancement obligations as between the portfolio company and the private equity firm and the fund that holds the investment in the portfolio company are not considered until after litigation has been filed. The same holds true with respect to the terms and amount of available insurance, especially at the portfolio company level.

As the foregoing suggests, there are a number of issues that every private equity firm that designates directors on its portfolio companies’ boards must consider to maximize protection against liability to plaintiff shareholders (or trustees in bankruptcy) and minimize the risk of paying the cost of defending against such claims.

…continue reading: Indemnification of Director-representatives by PE Firms

The Harvard Program on Corporate Governance has issued a new discussion paper entitled “Loyalty’s Core Demand: The Defining Role of Good Faith in Corporation Law.” Co-authored by Leo E. Strine, Jr., who is Vice Chancellor of the Delaware Court of Chancery and Senior Fellow of the Program of Corporate Governance, and by Lawrence A. Hamermesh, R. Franklin Balotti and Jeffrey M. Gorris, the paper examines the role of good faith in corporate law, and its use as the key element in defining the state of mind that must motivate a loyal fiduciary. Employing an historical, etymological, and policy-oriented analysis, the authors address the particular question of whether the obligation of directors to act in good faith is a separate, free-standing fiduciary duty, or a core aspect of the duty of loyalty.

In the paper, the authors outline their views as follows:

We conclude, consistent with the Delaware Supreme Court’s recent decision in Stone v. Ritter, that in the American corporate law tradition, the basic definition of the duty of loyalty is the obligation to act in good faith to advance the best interests of the corporation. What this article also shows is that the duty of loyalty has traditionally been conceived of as being much broader than the duty to avoid acting for personal financial advantage. The duty of loyalty also precludes acting for unlawful purposes, and affirmatively requires directors to make a good faith effort to monitor the corporation’s affairs and compliance with law.

The authors analyze arguments in favor of a free-standing duty of good faith separate from the duty of loyalty. While conceding the importance and enduring relevance of the duty of good faith, the authors see no basis to conclude that the traditional place of good faith — as the definition of a loyal state of mind — should be altered. Doing so to make room for such a separate duty would add confusion not clarity, the authors argue. In so stating, the authors acknowledge and discuss circumstances when the duty of loyalty remains most difficult to apply.

The paper also emphasizes a critical policy implication resulting from Stone v. Ritter - “that an independent director who is accused of having failed in her monitoring duties may only be held liable if a court finds that she breached her duty of loyalty by consciously failing to make a good faith effort to comply with her duty of care.” The authors explain that “by requiring a finding of bad faith before imposing liability on an independent director, the corporate law, as explicated by Stone, protects the policy interests underlying the business judgment role from erosion.”

The paper is available here.

(Editor’s Note: This post comes from Marc Weingarten and Erin Magnor of Schulte Roth & Zabel LLP.)

Many companies have enacted special bylaw provisions regulating the ability of shareholders to nominate directors or place items on the agenda for consideration at a company’s annual or special meeting or by consent, typically referred to as advance notification bylaws (“ANBs”). Historically, most ANBs have been straightforward, and typically advanced the date by which a shareholder was obligated to notify the company to 60 or 90 days prior to the expected meeting date. These ANBs, or First Generation ANBs, also typically required the proponent shareholder to include in the notification the same basic information about the shareholder, and if applicable the nominees, as required by the proxy rules.

More recently, however, many companies, at the urging of counsel “defending” against activist investors, have adopted new forms of ANBs, or Second Generation ANBs, that demand far more extensive disclosure from, and in some cases purport to establish eligibility qualifications for, proponent shareholders. This article describes these new provisions, which include not only longer advance notice requirements, but also requirements for the completion of company-drafted director nominee questionnaires, submission of broad undertakings by nominees to comply with company “policies,” minimum size and/or duration of holding requirements, continuous disclosure of derivative positions, disclosure of otherwise confidential compensation information, and even information regarding shareholders with whom the proponent has merely had conversations regarding the company.

First Generation ANBs were upheld by the courts because they simply provided an orderly procedure for shareholder action that helped to give the company and the other shareholders adequate time to evaluate proposals. This article analyzes the new Second Generation ANB provisions, many of which we believe are designed not to elicit the relevant information a company reasonably needs to know months in advance of a proxy contest to ensure an orderly process, but rather to erect barriers in the path of shareholders seeking to exercise their rights in an attempt to disqualify them. We believe such provisions should, and will, be declared invalid when their legitimacy is challenged. Unfortunately, shareholders will be forced to bear the expense of challenging the validity of these provisions—which no doubt was part of the calculus when companies adopted them in the first place.

Advance Notice Periods
In a 2005 article addressing First Generation ANBs, [1] we noted that courts had determined that 90-day advance-notice requirements had become commonplace. [2] Since then, some companies have adopted ANBs requiring notice of 150, or even 180, days prior to the annual meeting (in some cases keyed off the mailing date of the prior year’s proxy statement).

…continue reading: Second Generation Advance Notification Bylaws

(Editor’s Note: This post comes from John Bizjak of Portland State University, Michael Lemmon of the University of Utah and Hong Kong University of Science and Technology, and Ryan Whitby of Texas Tech University)

In our forthcoming Review of Financial Studies paper Option Backdating and Board Interlocks, we examine the role of board connections in explaining how the controversial practice of backdating employee stock options spread to a large number of firms across a wide range of industries. Given that the practice was not publicly disclosed, it is unlikely that it originated independently in each firm. We focus on the role that director interlocks played in contributing to the spread of backdating since the board of directors has primary authority over the level and structure of executive compensation, including determination of the amount and timing of option grants.

We find strong evidence that board interlocks are related to the spread of backdating. We find that a firm is more likely to begin backdating option grants if the firm has a director who is a board member of another firm that previously backdated its stock options. Our results are both statistically and economically significant. The increase in the likelihood that a firm begins to backdate stock options that can be explained by having a board member who is interlocked to a previously identified backdating firm is approximately one-third of the unconditional probability of backdating in our sample. We also find that a firm is more likely to begin to backdate option awards if directors concurrently receive a stock option grant.

In addition, we identify several other firm and governance characteristics that are associated with the adoption of option backdating. Firms with higher stock-price volatility are more likely to start to backdate options, which is consistent with the fact that higher stock-price variation provides more opportunities to backdate options. A firm is also more likely to begin to backdate, the greater the stock and option holdings of the CEO and when the CEO is younger. Finally, we find that commonalities in firms’ auditors and geographic location also help to explain the initiation of backdating. The fact that commonality in auditor choice and geographic location is associated with the initiation of backdating suggests that other linkages between firms beyond those created through board interlocks may also play a role in facilitating the spread of this practice. In contrast to some earlier research, we find little evidence that other measures of the quality of corporate governance, such as institutional ownership, board size, board independence, and whether the CEO is also the chair of the board, are systematically related to the incidence of backdating.

The full paper is available for download here.

In my briefing memo, The U.S. Government as Control Shareholder of the Financial and Automotive Sector: Implications and Analysis, I offer an analysis of the implications of the U.S. Treasury holding equity control over private industry. This was also the subject for recent briefings to members and staff of the U.S. Congress and the Securities and Exchange Commission, organized through my work at the Mercatus Center Financial Markets Working Group, and a forthcoming op-ed in Forbes, Why the Bailout is Self-Defeating, which is available here. My work in this area is ongoing, with a fuller article expected this submission season, and I welcome any comments.

The Treasury Department has converted its preferred shares in Citigroup into common equity, giving it a position of up to 36% of Citi’s outstanding voting equity. This means that as defined under Delaware corporate law, the securities laws, and even the CFIUS process for reviewing foreign investments in U.S. Companies, the U.S. Treasury is a control shareholder in Citigroup. Further, the remaining unconverted preferred shares in other banks, issued to the Treasury by TARP participants, give the government substantial leverage over corporate policy decisions at those banks.

The reason for the conversion is that it will artificially increase the bank’s common equity, which will give it a good tangible common equity number when the Treasury begins its promised stress testing regime for unhealthy banks. This is however an entirely artificial construct. Tangible common equity serves as a good proxy for a banks health when it reflects the market’s interest in becoming the residual beneficiary of fees from the bank’s loan portfolio, but here it merely reflects the federal government’s willingness to bail out a bank without concern for future price appreciation in its shares. If Treasury’s bank stress tests are a final exam, the teacher has given a favorite student the answers in advance.

The consequences of a government agency holding voting equity in a private bank can also be costly. Comparisons to the different forms of government ownership in Europe, Asia and South America teach that government owned banks are unequivocally used to advance political agendas to the detriment of a bank’s financial health. Advancing a political agenda may actually be easier through controlling common equity stakes, an effective semi-nationalization, than outright nationalization. A government agency using shareholder power over private companies has two unique freedoms:

i) the ability to bypass the administrative law process, the separation of powers and judicial review that constrain regulatory discretion, and instead simply require the board to initiate corporate policy changes favored by the Treasury, and

ii) the ability to bypass the federal budget process and transparency to the voters that work to constrain transfers to political interest groups, and instead require the bank to make those transfers in the form of increased lending and artificial interest rate caps entirely off the federal budget.

…continue reading: Problems Hidden Under The TARP

(Editors Note: This post comes to us from David M. Geffen of Dechert LLP.)

My recent article, “A Shaky Future for Securities Act Claims Against Mutual Funds“, considers the liability of mutual fund issuers under §§ 11(a) and 12(a)(2) the Securities Act.

In a Securities Act § 11(a) or § 12(a)(2) action, a plaintiff complains of a materially misleading statement (misstatement) in an issuer’s registration statement (prospectus). In the article, I explain why a mutual fund issuer, by establishing a loss causation defense, should prevail in defending these actions. For a mutual fund, establishing a loss causation defense is straightforward, and a mutual fund can defeat § 11(a) and § 12(a)(2) claims at the pleading stage of a lawsuit.

Courts have described an issuer’s liability under § 11(a) and § 12(a)(2) as “strict” or “near-strict.” Therefore, the regular and successful deployment of loss causation defenses by mutual funds marks a significant change. In effect, mutual funds are largely and, perhaps, wholly insulated from Securities Act § 11(a) and § 12(a)(2) claims.

In Parts I and II of the article, I describe the elements of claims under § 11(a) and § 12(a)(2) in the context of mutual funds, including the price-depreciation measure of damages in both statutes.

The article’s core analysis is contained within its Part III, where I explain why, for a mutual fund, establishing a loss causation defense is straightforward. Unlike a security traded on an exchange, the price of a mutual fund share is calculated each day according to a statutory formula that relies on the market value of the portfolio securities owned by the fund. Shares are offered for sale by the fund continuously at each day’s calculated price and redeemed by the fund, when a fund shareholder chooses, at that day’s calculated price. There is no secondary market for a mutual fund’s shares.

Accordingly, there is no mechanism for a misstatement in a mutual fund’s prospectus to affect a fund share’s price and, therefore, there is no mechanism for a misstatement or its revelation to cause a plaintiff’s losses. Because changes in a fund share’s price cannot be caused by a prospectus misstatement, a mutual fund defendant can prevail by establishing the loss causation defense permitted by § 11(e) or § 12(b). The defense simply is that any misstatement identified by the plaintiff could not cause the fund share’s price to depreciate and, therefore, did not cause the plaintiff’s losses.

If that outcome seems harsh, consider that the justification for liability without reliance under § 11(a) and § 12(a)(2) is that a misstatement causes the market to overestimate the value of a security. A purchaser is harmed by the misstatement, even if he did not rely on it, because the market price is inflated by the misstatement. However, Congress did not consider how § 11(a) and § 12(a)(2) should apply to mutual funds. This includes considering that neither price inflation nor overpayment occurs when an investor purchases shares of a mutual fund while the fund’s prospectus contains a misstatement. Thus, price inflation and overpayment, which justify liability without reliance for non-fund issuers, do not justify similar liability for mutual funds.

Part IV presents the practical implications if plaintiffs cannot succeed against a mutual fund under § 11(a) and § 12(a)(2). A plaintiff’s inability to make out a claim under § 11(a) and § 12(a)(2) should deter plaintiffs from instigating lawsuits under the Securities Act against mutual funds based on prospectus misstatements. Plaintiffs may be relegated to claims under Rule 10b-5, the Investment Company Act and state law.

…continue reading: The Future of Claims Against Mutual Funds

(Editor’s Note: This post comes to us from Itay Goldstein of the Wharton School at the University of Pennsylvania)

In Activist Arbitrage: A Study of Open-Ending Attempts of Closed-End Funds, which was co-written with Michael Bradley, Alon Brav, and Wei Jiang, and which was recently accepted for publication in the Journal of Financial Economics, we conduct a comprehensive empirical study of the attempts of activist arbitrageurs to open-end closed-end funds in the U.S. Unlike the traditional pure-trading arbitrage, activist arbitrageurs do not simply wait for convergence, but rather take actions to open-end the target fund, knowing that upon open-ending the price of the fund’s shares will be forced to converge to the NAV.

Our analysis is based on a unique hand-collected dataset consisting of all activist arbitrageurs’ activities in U.S. based CEFs between 1988 and 2003. Activist arbitrage in closed end funds was quite rare until the early 1990s. However since the mid-1990s—shortly after the SEC significantly relaxed constraints on communication among shareholders of public corporations—this type of arbitrage has become very common. Several arbitrageurs—hedge funds, endowment funds, banks, and financial arms of corporations—have become quite active in initiating proxy contests and proposals targeted at open-ending discounted CEFs. In the peak years of 1999 and 2002, about 30% of the funds in our sample were targets of such attacks.

We find that activist arbitrage has substantial impact on CEF discounts. While most of the open-ending attempts in our sample were met with resistance from the funds’ managements, quite a few led to successful open-endings despite such resistance. In addition, activists’ activities were sufficiently credible in many instances to induce fund managers to take actions themselves to reduce the size of the discount. We find that a key variable that guides activist arbitrageurs in choosing which fund to target is the fund’s discount from its NAV. Using an instrumental-variables approach and an econometric technique that allows us to estimate a simultaneous system of an endogenous dummy variable and an endogenous continuous variable, we are able to show that a one percentage point increase in the discount leads to a 1.07 percentage point increase in the probability of an open ending attempt in a given year.

To investigate the role of communication, we conduct tests using cross-sectional measures of the costs of communication in different funds. The three proxies we employ are turnover, which measures the frequency at which the shares of the CEF change hands, the average size of trade in the fund’s shares, and the percentage of institutional ownership in the fund. Overall, we find that costs of communication enhance activist arbitrage. Interestingly, the effects of the above proxies are present only after the legal reform of 1992. Our results suggest that before the 1992 Reform, communication among shareholders was so severely restricted by the SEC that cross-sectional differences in the shareholder base did not matter much for activist arbitrageurs.

Lastly, we find the governance of funds also plays an important role in determining the probability of an open-ending attempt. Funds that have pro-manager governance structures (i.e., have staggered board, supermajority voting, and ability of the board to call a special meeting) are more likely to be targets for activism after the legal reform of 1992, but not before. This is likely because communication among shareholders is particularly important when managers have more power. While managerial entrenchment attracts more attacks after 1992, we find that it lengthens the time needed to implement a successful open-ending.

The full paper is available for download here.

(Editor’s Note: For earlier posts on this Forum on the Federal Reserve’s proposed Term Asset-Backed Securities Loan Facility (TALF), including an early reform proposal by Lucian Bebchuk, please see here and here.)

This post is based on a client memo by my colleagues B. Robbins Kiessling, Timothy G. Massad, William V. Fogg, Julie Spellman Sweet, Sarkis Jebejian, Joel F. Herold, and Erik R. Tavzel.

On March 3, 2009, the U.S. Treasury Department and the Federal Reserve announced the formal launch of the Term Asset-Backed Securities Loan Facility (TALF). The TALF provides government financing to private investors for the purchase of certain AAA-rated asset-backed securities (ABS), with the objective of making credit more readily available to consumers and small businesses. The TALF program may be attractive to a broad range of investors because it provides non-recourse financing with favorable interest rates and limited downside risk.

The Federal Reserve first announced the creation of the TALF on November 25, 2008. In connection with the formal launch of the TALF, the Treasury Department and the Federal Reserve have issued updated terms and conditions and frequently asked questions (FAQs) which modify certain of the previously announced rules.

This memo provides a brief overview of the TALF and the key changes announced on March 3 and provides a road map for investors considering participating in the TALF. Appendix A provides an indicative timeline for the April TALF funding.

TALF OVERVIEW
The Federal Reserve has authorized the Federal Reserve Bank of New York (FRBNY) to lend up to $200 billion (subject to an increase to up to $1 trillion as part of the Obama administration’s Financial Stability Plan announced on February 10, 2009) to eligible borrowers (described below) to finance investments in eligible ABS, which currently are certain AAA-rated securities backed by new and recently originated auto loans, student loans, credit card loans or small business loans fully guaranteed by the Small Business Administration (SBA). Under the TALF, the FRBNY will offer to eligible borrowers on a monthly basis three-year, non-recourse loans in an amount equal to the value of the eligible ABS purchased or owned by the borrower, less a collateral haircut of between 5-16% of their value depending on their type and expected life. The TALF loans must be fully secured by the ABS financed by the loan.

The interest rate on TALF loans will equal the three-year LIBOR swap rate plus 100 basis points for fixed-rate ABS and one-month LIBOR plus 100 basis points for floating-rate ABS (in each case, other than loans secured by ABS backed by student loans guaranteed by the Federal government and ABS backed by small business loans guaranteed by the SBA, which will have lower interest rates). Borrowers may request TALF loans in minimum amounts of $10 million and may pledge any combination of eligible ABS as collateral for a single TALF loan (as long as all the pledged ABS for a single loan are either fixed rate or floating rate securities). In addition, borrowers must pay to the FRBNY an administrative fee equal to 5 basis points of the loan amount.

…continue reading: Key changes to TALF program

The Review of Financial Studies will publish later this year my paper with Zvika Neeman on “Investor Protection and Interest Group Politics.”

The paper models how lobbying by interest groups affects the level of investor protection. In our model, three groups – insiders in existing public companies, institutional investors (financial intermediaries), and entrepreneurs who plan to take companies public in the future – compete for influence over the politicians setting the level of investor protection. We identify conditions under which this lobbying game has an inefficiently low equilibrium level of investor protection. Factors pushing investor protection below its efficient level include the ability of corporate insiders to use the corporate assets they control to influence politicians, and the inability of institutional investors to capture the full value that efficient investor protection would produce for outside investors. The interest that entrepreneurs (and existing public firms) have in raising equity capital in the future, we show, reduces but does not eliminate the distortions arising from insiders’ interest in extracting rents from the capital that public firms already possess. Our analysis generates testable predictions, and can explain existing empirical evidence, regarding the way in which investor protection varies over time and around the world.

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Here is a more detailed outline of the article’s analysis, results, and contributions: The paper seeks to contribute to understanding what determines the level of that protection and the reason such protection might fall short of being optimal. Why do countries vary so much in their level of investor protection? Why do levels of investor protection within any given country change over time? When investor protection is too low, is such suboptimality generally due to lack of knowledge on the part of public officials, which should be expected to disappear as they learn more about which governance arrangements are optimal? Or are there some structural political impediments that may enable excessively lax corporate rules to persist even after they are recognized as inefficient? The paper aims to contribute to answering these questions by developing a model of how interest group politics affects the level of investor protection.

To be sure, a country’s level of investor protection may be influenced by long-standing factors such as the country’s legal origin, its culture and ideology, or the religion of its population, all of which lie outside the realm of current interest group politics. But given that countries do change their investor protection arrangements considerably over time, the level of such protection at any given point in time may also result at least partly from recent decisions by pubic officials. The theory of regulatory capture (Stigler (1971) suggests that the regulatory decisions by public officials might be influenced and distorted by the influence activities of rent-seeking interest groups. In the area of finance, Rajan and Zingales (2003, 2004) and Perotti and Volpin (2008) argue that existing firms seeking to deter entry and retain market power lobby for weak investor protection that would make it difficult for potential entrants to raise capital. Our analysis focuses on another conflict among interest groups – the struggle between public firms’ corporate insiders, who seek to extract rent from the capital under their control, and the outside investors who provided them with capital.

We view lobbying on investor protection as important because, in the ordinary course of events, most corporate issues are intensely followed by the interest group with sufficient stake and expertise but are not sufficiently understood and salient to most citizens. When this is the case, politicians can expect their investor protection decisions to have limited direct effects on voting behavior, which implies that these effects do not significantly influence politicians’ investor protection decisions. In contrast, such decisions may be significantly affected by the activities of organized interest groups.

…continue reading: Investor Protection and Interest Group Politics

(Editor’s Note: This post is based on a client memorandum by Edward D. Herlihy, Craig M. Wasserman, Lawrence S. Makow, Richard K. Kim, Jeannemarie O’Brien, Nicholas G. Demmo, and Matthew M. Guest of Wachtell, Lipton, Rosen & Katz.)

We are at a critical point in working our way through the current financial crisis. The situation initially manifested as a crisis of confidence among depositors, financial institution counterparties and market participants that led to sudden and catastrophic collapses of leading financial institutions. Now the crisis appears to have evolved beyond that stage, with declining housing prices and low consumer confidence slowing the economy and the initial panic being replaced with lingering investor uncertainty about the business model of financial institutions, the direction governmental intervention might take and the risk that the changing rules of the game – on compensation, cramdown or otherwise – will continue to whipsaw investors. Much of this crisis is fed by a 24/7 media cycle that, without actual collapses or bank runs to report, repeats speculation about financial institution balance sheet and capital (further fueling concern about the direction of government policy and actions including the spectre of actual, if not de facto, “nationalization”) and inciting resentment over executive compensation, among other things.

Much of the future direction beyond this critical juncture will depend on the choices made by the new administration and in Congress. Will a clear focus be maintained on prompt, decisive steps necessary to restore confidence to the financial system, and will we let bank regulators and bank management go back to doing their jobs and join together in working our way out of the current situation? Or will the focus remain blurred by measures that (though sometimes well-intentioned) have served to discourage the capital buildup necessary to facilitate repayment of TARP funds, outright political intervention, and unwarranted punitive rhetoric that destroys the public confidence so critical to a recovery?

Getting the recovery on track is likely to involve respect for the following tenets:

• The banking system that has served our nation so well, while currently challenged, is not fundamentally broken and need not be destroyed.

• The long-term health of the economy depends on a robust, trusted banking system.

• Restoring private capital investment in financial institutions must have the highest and clearest priority, and doing so requires not only government action where necessary, but also appropriate restraint, including a renewed commitment to a stable legal framework and ceasing retroactive, game-changing interventions that cause private capital to flee.

• We already have a strong and robust system of financial regulation in place that, while it can be improved, should be allowed to function with a minimum of political interference to do the day-to-day blocking and tackling necessary to restore public confidence in the banking system. For instance, concerns regarding executive compensation could be simply and readily addressed by the existing federal regulatory framework for monitoring compensation at institutions deemed to be in troubled condition. Moreover, recognizing that all bank mergers are already subject by law to a rigorous regulatory review eliminates the need to add layers of additional rules that indiscriminately prohibit potentially useful transactions.

• Bank mergers, key employee compensation and other strategic business decisions are important tools that, when properly used, are essential for bank managers to build the strength of their institutions; these important tools should not be lightly interfered with and will continue to be used by banks, as they have been in the past, only under the watchful eyes of the banking regulators.

First: Job No. 1 is restoring private capital investment in financial institutions. Regulators already have a clear window into banking institutions and they should consider clearly communicating the financial condition of the nation’s banks in advance, and in lieu, of a vaguely defined future “stress test.” Relentless speculation about banks amid plunging common stock prices and indiscriminate talk that “the banking industry is effectively insolvent” has created a mistaken impression of hairtrigger fragility among the nation’s banks. Regulators should play a leading role in promptly fixing this misimpression.

…continue reading: Removing the Overhang Plaguing Bank Equity Valuations

(Editor’s Note: This post comes from Ohad Kadan of Washington University in St. Louis, Leonardo Madureira of Case Western Reserve University, Rong Wang of Singapore Management University; and Tzachi Zach of Ohio State University.)

In our paper Conflicts of Interest and Stock Recommendations: The Effects of the Global Settlement and Related Regulations, which was recently accepted for publication in the Review of Financial Studies, we investigate the impact of regulatory changes, including the Global Settlement, NASD Rule 2711 and the amended NYSE Rule 472, on analysts’ recommendations. We address three main questions. First, have analysts’ recommendations become more informative following the regulations? Second, did the regulations mitigate the effects of conflicts of interest? Lastly, did the regulations affect the response of investors to analysts’ recommendations?

Following the regulations, most leading investment banks moved from the traditional five-tier rating system to a coarser three-tier rating system over a short period of time (typically one day). The adoption of new rating systems was accompanied by banks completely reshuffling their recommendations, obtaining a more balanced distribution. We examine the informativeness of recommendations, as proxied by investors’ reactions, and how it was affected by the regulations. We start by examining conditional informativeness measured as the abnormal price reactions to recommendations, conditional on their type (optimistic, neutral, and pessimistic). The results suggest that investors internalized the change in the distribution of recommendations in the period following the regulations. For instance, the price response to optimistic recommendations is more positive in the Post-Reg period, suggesting that optimistic recommendations are perceived to be more reliable. By contrast, price responses to neutral and pessimistic recommendations are less negative following the regulations, since more recommendations fall under these categories. In additional tests, we find that the overall informativeness of recommendations has significantly decreased following the regulations: The absolute price reactions to stock recommendations are significantly lower in the Post-Reg period. We further show that recommendations issued by brokers who use a three-tier rating system (before or after the regulations) provide less information to investors. Additionally, the decline in informativeness after the regulations is stronger for banks that were sanctioned in the Global Settlement, all of whom have switched to a three-tier system.

We use a difference-in-differences approach to gauge the impact of the regulations on conflicts of interest between investment banking and research. Our main proxy for the presence of conflicts of interest is past underwriting relationship between the brokerage house and the recommended firm (affiliation). We document a significant change in how conflicts of interest influence stock recommendations. We corroborate prior research and the concerns of regulators by showing that conflicts of interest were associated with excess optimism in the Pre-Reg period. We show that in the Post-Reg period, affiliated analysts are as likely to issue optimistic recommendations as unaffiliated analysts. Moreover, the difference-in-differences between affiliated and unaffiliated analysts across the two periods is significant, suggesting that analysts have changed their recommendation practices. In contrast, conflicts of interest might still be influencing pessimistic recommendations. In both the Pre-Reg and Post-Reg periods, affiliated analysts are more reluctant to issue pessimistic recommendations than unaffiliated analysts, and the difference-in-differences is not significant. Alternative measures of conflicts of interest, also suggest significant changes in analysts’ practices. Before the regulations, analysts were overly optimistic regarding firms that have recently issued equity, and with respect to firms that experience financing deficit. We show that after the regulations, this optimism has declined significantly.

Finally, we examine whether investors react differently to recommendations issued by potentially conflicted analysts before and after the regulations. We find that investors discount affiliated neutral recommendations to a lesser extent after the regulations. However, we do not find such evidence for optimistic and pessimistic recommendations.

Collectively, we view our findings as consistent with a limited achievement of the regulations’ objectives. Although the mix of recommendations has become more balanced, the overall informativeness of recommendations has declined in the Post-Reg period.

The full paper is available here.