Archives For disclosure regulation

The WSJ discusses yesterday’s testimony by SEC chair Mary Schapiro.  Former SEC GC David Becker, you’ll recall, had a family interest in a Madoff account but nevertheless was allowed to work on Madoff issues, including recommending Madoff victim payouts that directly affected the Becker family.

Ms. Schapiro said the incident had taught her to be more thoughtful about ethics matters.

“I have to be looking around the next corner, looking beyond the horizon and thinking above and beyond what may be appropriate advice from ethics counsel to make sure nothing occurs that raises questions about the commission’s mission or process,” she said.

Ms. Schapiro has directed the SEC’s internal watchdog to conduct an investigation of the matter and has ordered a review of the agency’s conflict-of-interest policies. She said the SEC had made significant strides since she took over an agency reeling from enforcement breakdowns.

Many companies will sympathize with Schapiro about “looking around the next corner, looking beyond the horizon” etc. 

Suppose a company or executive civilly or criminally charged with disclosure or internal control violations after a sudden market decline magnifies risks the company ignored tells the SEC or Justice: “we’re making significant strides on disclosure and we’ll do a better job the next time.”  The SEC or Justice will tell the company:  “We understand.  You have to be looking around the next corner or beyond the next horizon, and that’s very hard.  Just do the best you can.” Something like that.

Maybe it’s time to renew my suggestion, triggered by a previous report of SEC internal controls breakdowns , that Congress “shut down the SEC and turn its work over to the private sector, which is subject to SOX.”

Last December Abercrombie filed a preliminary proxy statement announcing a plan to reincorporate from Delaware to Ohio.  Steve Davidoff and I commented on the move. Steve noted that, while Abercrombie had highlighted various reasons for the move, the shareholders had to dig through the disclosures to learn that it was, as I said in December, “essentially a takeover defense.”  I added that “[t]his situation illustrates how jurisdictional choice makes contractual what would otherwise seem to be mandatory takeover rules.”

With respect to the disclosure issue, I asked:

Does it matter if there were enough sophisticated or well-advised institutional shareholders to help ensure an informed vote?

In January, Davidoff commented on Abercrombie’s definitive proxy statement, which he said “was virtually unchanged from the preliminary one”:

This proxy may be technically correct in its disclosure, but a reader can easily fail to put it all together. Moreover, you are left wondering whether the proxy statement truly discloses Abercrombie’s real reason for the reincorporation. * * *The Abercrombie shareholder meeting will be Feb. 28. It will be interesting to see if shareholders have the same questions that I do.

On February 21 Abercrombie told its shareholders:

Although we believe that the definitive proxy statement fully explains the reasons why the reincorporation proposal is in the best interests of our stockholders, there have been a series of articles posted by a “Deal Professor” on The New York Times’ website that question the Company’s reasons for proposing the reincorporation, question the timing of the proposal and imply that the Company has some ulterior motive in proposing the reincorporation. In effect, the articles, which we believe contain a number of factual errors in addition to mischaracterizations of Ohio law and our motivations, appear to demonize not just us and our proposal but Ohio corporate law itself. As a public company, we do not have the same ability to wage a campaign of unsubstantiated words in the public media. However, we would welcome an opportunity to discuss our proposal with you and address the factual errors and mischaracterizations in the blogs. * * *

But yesterday DJ wrote that Abercrombie

facing resistance to its plan to reincorporate in its home state of Ohio, delayed a special meeting of shareholders it had scheduled for Monday, in order to drum up enough investor support for the move.

The teen retailer said in a proxy filing on Monday that it was “convinced” it had strong support for the move after “a succession of positive communications with a number of significant stockholders.” But, general counsel Ronald Robins said, it has “been unable to obtain a strong consensus in favor of reincorporation at this point.” * * *

The company has faced criticism for its plan including from former lawyer and current law professor Steven Davidoff, who writes for the New York Times’s Dealbook Web site under the moniker Deal Professor. He cites provisions in Ohio law that could either make it easier for management to buy the company or make it harder for suitors to acquire the company, both to the potential detriment of stockholders.

Proxy advisory firm ISS had similar criticisms of the move’s effect on shareholder rights. * * *

Robins said that, whether as a result of press criticism or other reasons, some holders that had once supported the reincorporation now oppose it, including one hedge fund he declined to name.

I’ll stick to my original assessment that the market for state corporate law, at least for widely traded public companies, is working efficiently in a rich information environment that includes SEC disclosures, proxy advisor firms and, last but not least, Steve Davidoff.

A couple of weeks ago I noted regarding the “Sachsbook” deal:

So it seems the increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.  Back in the 1980s, you could just call your broker and get rich off of the Microsoft IPO.  Now you have to be a wealthy Goldman client to do it. 

I guess I was a bit optimistic.  Now you have to be a foreign investor to invest in Facebook

I love it:  the US securities laws excluding US investors from investing in a US company in the US. What will they think of next?

What happened to IPOs?

Larry Ribstein —  4 January 2011

So Facebook finally had its public offering.  But it didn’t look like your father’s IPO.  Instead, Facebook sold $500 million in stock to one person. The stock will be held by a single special purpose vehicle so Facebook avoids going over the 500-investor-limit for avoiding the disclosure obligations of a public company.  Wealthy investors get to trade interests in that interest.  Facebook gets that cash (plus an expectation of another $1.5 billion in stock sales) for growth, a $50 billion market valuation (of which 14 billion belongs to Zuckerberg), stock it can use for acquisitions and hiring — many of the goodies post-IPO companies get. 

According to Steve Davidoff, this won’t work if Facebook is deliberately circumventing the securities laws, and “Goldman’s planned special purpose vehicle and any other vehicles formed certainly appear to be cutting it close.” Facebook therefore may have to start reporting anyway, but not until May 2012, by which time it may be ready to go public, which it may want to do anyway.  The tactic at least enables Facebook to delay an IPO for as long as possible.

Per the VC partner Ben Horowitz, quoted in the WSJ,

the incentive for going public has lowered and the penalty for going public has increased. . . [T]he regulatory environment and the rise of hedge funds has made it “dangerous” for start-ups go to public without a large cushion of cash. In general, we recommend that our companies be very careful about going public.

Meanwhile, Dealbook reports the establishment of another trading system for private firms.

Another Dealbook story adds that “[l]ots of people would stand in line to buy shares in Facebook, but for now, only an exclusive few — wealthy clients of Goldman Sachs — will be able to.”

 “This is a topsy-turvy world,” said Scott Dettmer, a founding partner of Gunderson Dettmer, a law firm that has advised venture capitalists, start-ups and entrepreneurs since the 1980s. He added that even a few years ago, “there were all sorts of business reasons to go public, but for entrepreneurs it was also a badge of honor.”

But now, private market alternatives

have become more attractive for companies, in part because of the increased regulations imposed on public companies but also because of the rise in short-term trading, which leaves some executives feeling they have lost control of their companies. * * *

Ben Horowitz, a partner with Andreessen Horowitz, a venture capital firm, said the cost of being a public company had risen to about $5 million a year, from about $1 million a year. Mr. Horowitz, an early employee of Netscape, said that such costs would have eaten into the meager profits of the pioneering Internet company when it went public in 1995. Additionally, accounting and legal requirements have become distractions for many start-ups, said Mr. Horowitz, whose firm is an investor in Facebook.

So it seems the increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.  Back in the 1980s, you could just call your broker and get rich off of the Microsoft IPO.  Now you have to be a wealthy Goldman client to do it.  Of course you also got to get poor off of a company that turned out to be a dog.  Now both options are reserved for wealthy people in the name of increasingly onerous disclosure regulation and federal governance requirements such as board structure, proxy access, and whistleblowing rules.

Each of these rules was thought to have some benefit at the time they were enacted.  Nobody really considered how private markets would react (e.g., by establishing alternatives to public markets) or the long-run effects of substituting quasi-private for public markets.  So rules designed to make the markets safe for ordinary investors have ended by excluding them.

Maybe it’s time to start considering whether we got what we wanted.

I have been writing for some time about the First Amendment and the securities laws.  In a nutshell, the formerly inviolate notion that the securities laws are a First-Amendment-free zone has always been constitutionally questionable.  The questions multiply with the expansion of the securities laws.  The Supreme Court’s recent broad endorsement of the application of the First Amendment to corporate speech in Citizens United signals that we may finally get some answers. 

The bottom line is that securities regulation that burdens the publication of truthful speech is subject to the First Amendment.

For a little history:  I first wrote on this issue 16 years ago in my article with Henry Butler, Corporate Governance Speech and the First Amendment, 43 U. Kans. L. Rev. 163 (1994).  This was the basis of a chapter in Butler & Ribstein, The Corporation and the Constitution,  excerpted here.

I’ve written on this subject from time to time since the 90s: 

  • On the unconstitutionality of Regulation FD (which requires firms that disclose material nonpublic information to securities market professionals to disclose the same information simultaneously or promptly to the public, thereby effectively restricting truthful statements to analysts)
  • On the SEC’s recent mandatory disclosures on global warming.
  • Most recently, on the SEC’s proxy access rule (14a-11), where I noted that “the ramifications of Citizens United may be even broader than were initially supposed.  Speech about capitalism finally may get the same protection as, say, pornography.  And one of the first casualties of this approach may be ill-considered and unnecessary SEC restrictions on truthful speech.”

And now:  Bulldog Investors’ challenge of Massachusetts securities laws forbidding it from disseminating truthful information about its investment products. Here’s the complaint against Bulldog and a lower court opinion from last summer on a suit filed by Leonard Bloness, a non-investor who is simply seeking information about Bulldog.

The trial court opinion notes that from about June 9, 2005, to January 5, 2007, Bulldog Investors maintained a website that made certain information about its products available to any visitor, subject to getting the visitor’s agreement to a disclaimer providing, in part, “[t]he information is available for information purposes only and does not constitute solicitation as to any investment service or product and is not an invitation to subscribe for shares or units in any fund herein.”  The visitor could get more information by registering with certain information. 

The Massachusetts regulatory action began when an employee of a law firm that was representing a client in litigation with Bulldog registered on the Bulldog website and received an email with additional information about Bulldog funds. The administrative complaint alleged that Bulldog had offered unregistered/nonexempt securities for sale in the Commonwealth through the website. Bulldog denied the allegations and raised a First Amendment defense.  While this action was pending, the Bloness complaint was filed seeking relief pursuant to 42 U.S.C. § 1983 from the alleged violation of their First amendment Rights.

The basic problem here is that Bulldog lost its exemption when it generally advertised its fund through its website and followup email.  As a result, it is broadly barred from distributing information about its funds, however truthful, including to people who are accredited investors like Bloness.  Nor does it matter, as with Bloness, whether the people seeking access to the site are even would-be investors, as distinguished from scholars and journalists who want information on the industry.

The administrative action concluded with a cease and desist order and fine of $25,000.  The court later denied plaintiffs’ mostion for preliminary injunction on the 1983 complaint.

At the July 31, 2009, trial of that case, the court received the expert testimony of Suffolk law professor Joseph Franco of Suffolk University Law School that, according to the court’s summary, ” the regulatory scheme directly serves the identified governmental interest, and that none of the alternatives would do so as effectively.”

The court denied relief, concluding:

Capital formation is, of course, an important goal, which is to some degree in tension with investor protection and market integrity. Regulatory constraints that protect market integrity impose burdens on issuers and sellers of securities. In that respect, they may tend to impede capital formation. It follows that relaxation of such regulatory restraints might ease capital formation. The state regulatory scheme in issue here, and the corresponding federal scheme, reflect a regulatory choice to emphasize market integrity over capital formation. This Court has no authority to second-guess that choice. Rather, once it has been established (as it has been here by stipulation), that the interest the regulator seeks to serve is a substantial one, the Court’s role is to determine whether the means the Secretary has chosen to effectuate that choice is proportional to that interest, as measured by the criteria articulated in Central Hudson. Neither the Advisory Committee’s report nor the New York City Bar’s letter purports to address that issue, and neither sheds any light on it.

The Court concludes, based on the stipulated facts and the evidence presented at trial, that the statute and regulations in issue, and the Secretary’s enforcement action against Bulldog Investors, meet the test of Central Hudson, and do not violate the First Amendment rights either of Bulldog or of Mr. Bloness. A declaration will enter to that effect.

The case is now on appeal.  Here’s a website with the briefs.  The court will hear oral argument  to be posted here, on January 6.  I understand via an email from Bulldog’s Phil Goldstein (also reported here) that Harvard Professor Laurence Tribe will argue the case for Bulldog.

Tribe’s participation suggests the constitutionality of the securities laws may finally get the attention the issue has long deserved.  And, as I noted above, Citizens United suggests this attention may not be favorable to those laws (I expect to have another post on that later this week).  The Massachusetts case threatens the entire scheme for new issues under the Securities Act of 1933, while the 14a-11 case threatens significant chunks of federal proxy regulation. The reasoning in these cases could affect some mandatory disclosure rules, particularly including Regulation FD.

Stay tuned.

Lynn Stout, writing in the Harvard Business Review’s blog, claims that hedge funds are uniquely “criminogenic” environments.  (Not surprisingly, Frank Pasquale seems reflexively to approve):

My research, shows that people’s circumstances affect whether they are likely to act prosocially. And some hedge funds provided the circumstances for encouraging an antisocial behavior like not obeying the laws against insider trading, according to these investigations.

* * *

Recognizing that some hedge funds present social environments that encourage unethical behavior allows us to identify new and better ways to address the perennial problem of insider trading. For example, because traders listen to instructions from their managers and investors, insider trading would be less of a problem if those managers and investors could be given greater incentive to urge their own traders to comply with the law, perhaps by holding the managers and investors — not just the individual traders — accountable for insider trading. Similarly, because traders mimic the behavior of other traders, devoting the enforcement resources necessary to discover and remove any “bad apples” before they spoil the rest of the barrel is essential; if the current round of investigations leads to convictions, it is likely to have a substantial impact on trader behavior, at least for a while. Finally, insider trading will be easier to deter if we combat the common but mistaken perception that it is a “victimless” crime.

Rather than re-post the whole article, I’ll direct you there to see why she thinks hedge funds are so uniquely anti-social.  Then I urge you to ask yourself whether she has actually demonstrated anything of the sort.  Really what she demonstrates, if anything, is that agency costs exist.  Oh, and people learn from their peers.  Remarkable!  And this is different than . . . the rest of the world, how?  There are Jewish people in the world, a lot of them work on Wall Street, and many of them attend synagogue.  No doubt Jews mimic the behavior of other Jews.  Bernie Madoff was Jewish.  The SEC should be raiding temples all across New York, New Jersey and Connecticut!

The point is that she has no point, and directing her pointless observations toward hedge funds in particular is just silly (and/or politically expedient).  There are bad apples everywhere.  There are agency costs everywhere.  A police state could probably reduce the consequences of these problems (but don’t forget corruption (i.e., bad apples) in the government!).  The question is whether it’s worth it, and that requires a far more subtle analysis than Stout provides here.

And all of this is because insider trading really needs to be eradicated, according to Stout:

Of course, insider trading isn’t really victimless: for every trader who reaps a gain using insider information, some investor on the other side of the trade must lose. But because the losing investor is distant and anonymous, it’s easy to mistakenly feel that insider trading isn’t really doing harm.

Actually, the reason most people feel that insider trading isn’t really doing harm is because it isn’t.

I’ll leave the synopsis of the argument to Steve Bainbridge.  On the adverse selection argument, see Stanislav Dolgopolov.  Sure, there is debate.  Empirics are hard to come by.  But the weight of the evidence and theory, especially accounting for enforcement costs (one study even seems to suggest that making insider trading illegal actually induces more insider trading to occur (and impedes M&A activity)), is decidedly against Stout’s naked assertion.  The follow on claim that, in essence, agency costs justify stepped up dawn raids at hedge funds is even more baseless.

Stephen Bainbridge is the William D. Warren Professor of Law at UCLA School of Law.

Mandatory disclosure is a—maybe the—defining characteristic of U.S. securities regulation. Issuers selling securities in a public offering must file a registration statement with the SEC containing detailed disclosures, and thereafter comply with the periodic disclosure regime. Although the New Deal-era Congresses that adopted the securities laws thought mandated disclosure was an essential element of securities reform, the mandatory disclosure regime has proven highly controversial among legal academics—especially among law and economics-minded scholars. Some scholars argue market forces will produce optimal levels of disclosure in a regime of voluntary disclosure, while others argue that various market failures necessitate mandatory disclosure.

Both sides in this longstanding debate assume that market actors rationally pursue wealth maximization goals. In contrast, my work in this area draws on the emergent behavioral economics literature to ask whether systematic departures from rationality might result in a capital market failure necessitating government regulation. I conclude that behavioral economics is a very useful tool, but that it in this instance it cannot fairly be used to justify the system of mandatory disclosure.

Continue Reading…

Intel’s rebates are apparently given rise to a potentially whole new class of suits based on the notion recipients of the rebates at the center of the Commission’s antitrust action should have been disclosed.   The WSJ reports:

Dell said last week that it and Mr. Dell were in talks with the Securities and Exchange Commission to settle civil allegations that they violated securities laws in connection with Dell’s dealings with Intel, a longtime supplier of microprocessor chips. At issue, people familiar with the situation say, is whether Dell should have disclosed rebates it received from Intel to investors. …

The settlements also won’t affect Mr. Dell’s position as the company’s chairman and chief executive, the company said. But they may come with sizable monetary penalties—the company has set a $100 million reserve for its own potential liability. The settlements could also shed new light on what effect Intel’s subsidies had on Dell’s finances over the years.

The story mentions that competitively-sensitive information like prices and rebates are typically treated confidentially.  And for good reason.  Intel’s rebates are competitive activity.  Competition for distribution from Intel and AMD to secure business from OEMs like Dell are a normal part of the competitive process, and like other forms of competition, generate benefits for consumers.  Requiring disclosure of competitively-sensitive information to the public, and competitors, runs the same risks that one would presume present if one substituted the word “rebates” with “prices.”

The disclosure issue here brings to mind another example of a potentially misguided disclosure regime that was the subject of one of my first blog posts back from when TOTM was hanging out at Ideoblog.   Back in 2005, California was considering a bill that would require retailers to disclose shelf space payments (aka “slotting fees“) to rival manufacturers.  Senator Figeuroa introduced Senate Bill No. 582, which would have mandated that:

A retailer shall, upon the request of a qualified supplier or manufacturer, disclose the placement fees or arrangements that the retailer assesses other suppliers or manufacturers for placement of similar products.”

Violations would allow competing manufacturers to recover a $10,000 civil penalty and attorney’s fees from a retailer who fails to comply.  Luckily for California consumers, SB 582 went away.  SB 582 was embarassingly misguided policy, and obviously bad for California consumers, who are the ultimate beneficiary of payments to retailers for valuable shelf space.   Taking action to facilitate an agreement to collude on slotting fees would be obviously unwise policy with little or no offsetting benefits.

Disclosure regulation regimes are frequently given a pass when it comes to cost-benefit analysis.  Legal scholars and economists are often guilty presuming without analysis that disclosure presumptively satisfies the “do no harm” principle.  (Geoff Manne’s Hydraulic Theory paper offering a systematic analysis of the costs of disclosure in the securities context is a must read.)  While economists generally appear to agree with the notion that more information is better than less in many settings, and many disclosure proposals are offer some potential net benefits, policy proposals like SB 582 (and potentially required disclosure of rebates for OEMs) are grounded in a failure to understand the competitive process and specifically, the role of competitive payments for distribution in that process.   If the economics of these payments are not understood, an SEC settlement which requires Dell and recipients of these rebates to disclose them to rivals and the public may impose significant costs on consumers.   Regulators charged with protecting the public interest ought to be mindful of the competitive implications of these payments when thinking about disclosures.

[Post bumped to the top, and cross-posted at Organizations & Markets, in light of our technical difficulties last week and in the hopes of eliciting a response — Eds]

Dear Gene and Ken:

I must say that I was totally flabbergasted when I read your recent blog posting on insider trading.  I know that your usual posts on investments, which I often cite to friends, are well-informed and empirically-supported; your work over the years on these topics is important and influential—and rightly so.  Unfortunately, in this post, you have deviated from your usual high quality.  Anyone current on the topic of insider trading will recognize that you have been careless in your selection of anti-insider-trading arguments and that you omitted from your brief note the major part of the argument about insider trading: whether and how much it contributes to market efficiency.  To say this is a strange omission coming from Fama and French would be an understatement.

Your first error is to assume that the insider trading debate is about informed trading only by “top management”.  I suspect that this error may flow from my original argument for using insider trading to compensate for entrepreneurial services in a publicly held company, a matter you do not mention and which I will not pursue here except to note that “entrepreneurial services” does not equate to top management.  Strangely no one seems to notice that most of the celebrated cases on the subject have not involved corporate personnel at all (a printer, a financial analyst, a lawyer and Martha Stewart).

I was more surprised, however, to see you repeating the oldest myth in the whole field, one that even the SEC gave up on as wrong many years ago and which frankly is no longer a part of the respectable debate on this topic: that a trade by an insider “disadvantages” the party on the other side.  (I will let pass the peculiar mistake of relating this by inference to a duty owed to existing shareholders when insiders are selling—how about insider sales to perfect strangers to the corporation?  Is there an inchoate fiduciary duty?).  I challenge you to show me any way in which the anonymous buyer or seller in an exchange transaction is harmed because that transaction just happens to involve an insider on the other side.  In fact, you cannot.  The specialist might be assumed to be vulnerable to losses from insiders’ being in the market, but careful research has shown that even they are totally unconcerned about the presence of insiders (other than as usurpers of their rents, and disclosure laws from the ’33 Act to Regulation FD have ensured that the specialists’ sphere of operation is well-protected) and that this so-called “moral hazard” argument is simply insignificant in the real world

Then you repeat another of the old myths surrounding the topic of insider trading:  that allowing it will create a further managerial moral hazard since it will give an incentive to top managers (who I presume are supposed to be able to manage this mischief without anyone else knowing about it—weird) to produce bad news rather than good news.  There is not, in the entire enormous literature on the topic, one iota of evidence for this statement, although some law professors, who are generally better at making arguments for a legal brief than they are at doing rigorous economics, may still mouth it. True, there could indeed be a small end-period problem with trading on bad news.  But, even if there is, it must be of little significance compared to the benefits to shareholders and other investors of allowing insider trading.  There are many forces, including reputation and market competition, operating to induce managers to produce good news, and there is no limit on the amount of this the market will continue to reward them for.  But there are no incentives other than this highly theoretical one encouraging managers to produce bad news.  A bit too much of this and the manager is ruined, while the possibility of making a gigantic killing to justify some once-in-a-lifetime malfeasance with inside information is all but non-existent.  This would be a very foolish bet for any corporate manager to make, and not surprisingly there is no evidence that they do so.

As for the idea that they will delay disclosure (a special form of the bad news/moral hazard argument), as Harold Demsetz pointed out over 40 years ago, the insider will have every incentive not to delay but to speed up disclosure so he can get the highest rate of return on his transaction.  Again there is not one bit of evidence suggesting that this delay ever occurs in the real world and some very strong evidence (the best is by Lisa Meulbroek) that insider trading of the illegal variety quickly moves stock price in the appropriate direction.

On this point, I can’t help but ask what is your theory of how stock market pricing came to be so efficient?  Surely it is not a result of the SEC and disclosure laws—a joke if it were not all so expensive (on which see, among other things, my son’s Hydraulic Theory of Disclosure article).  The studies that have looked have found a mixed result, at best, and the best of these (starting with Stigler’s in 1964 and Benston’s in 1973) find that the market was just as efficient before the SEC and the ’33 and ’34 Acts as it was after.  Gilson and Kraakman certainly did not supply a satisfactory answer to this question that they addressed many years ago, even though they were trying desperately to prove that something besides insider trading was making the market so efficient.

Obviously this is a much larger topic than I can address here, but I must admit to being most dismayed by your implication that the goal of instantaneous communication of new information to all market participants is a worthy ideal that in some way might be aided by disclosure regulation or a ban on insider trading.  We know very well who was pushing all along for a ban on insider trading: the market professionals who stood next in line for new information if they could just get those pesky insiders out of the picture.  They certainly were not interested in universal, equal access to information, nor was the SEC who aided and abetted them in this project.  Given this well-known history, do you really mean to stand with those rent seekers?

I have greatly admired your work for many years, as you know, and I hope I may have missed something in your short blog post.  But precisely because I admire your work—and because many others do, too—I felt an obligation to respond to your problematic comments on this point.  I look forward to your thoughts in response.

Yours cordially,

Henry Manne

Dear Gene and Ken:

I must say that I was totally flabbergasted when I read your recent blog posting on insider trading.  I know that your usual posts on investments, which I often cite to friends, are well-informed and empirically-supported; your work over the years on these topics is important and influential—and rightly so.  Unfortunately, in this post, you have deviated from your usual high quality.  Anyone current on the topic of insider trading will recognize that you have been careless in your selection of anti-insider-trading arguments and that you omitted from your brief note the major part of the argument about insider trading: whether and how much it contributes to market efficiency.  To say this is a strange omission coming from Fama and French would be an understatement.

Your first error is to assume that the insider trading debate is about informed trading only by “top management”.  I suspect that this error may flow from my original argument for using insider trading to compensate for entrepreneurial services in a publicly held company, a matter you do not mention and which I will not pursue here except to note that “entrepreneurial services” does not equate to top management.  Strangely no one seems to notice that most of the celebrated cases on the subject have not involved corporate personnel at all (a printer, a financial analyst, a lawyer and Martha Stewart).

I was more surprised, however, to see you repeating the oldest myth in the whole field, one that even the SEC gave up on as wrong many years ago and which frankly is no longer a part of the respectable debate on this topic: that a trade by an insider “disadvantages” the party on the other side.  (I will let pass the peculiar mistake of relating this by inference to a duty owed to existing shareholders when insiders are selling—how about insider sales to perfect strangers to the corporation?  Is there an inchoate fiduciary duty?).  I challenge you to show me any way in which the anonymous buyer or seller in an exchange transaction is harmed because that transaction just happens to involve an insider on the other side.  In fact, you cannot.  The specialist might be assumed to be vulnerable to losses from insiders’ being in the market, but careful research has shown that even they are totally unconcerned about the presence of insiders (other than as usurpers of their rents, and disclosure laws from the ’33 Act to Regulation FD have ensured that the specialists’ sphere of operation is well-protected) and that this so-called “moral hazard” argument is simply insignificant in the real world

Then you repeat another of the old myths surrounding the topic of insider trading:  that allowing it will create a further managerial moral hazard since it will give an incentive to top managers (who I presume are supposed to be able to manage this mischief without anyone else knowing about it—weird) to produce bad news rather than good news.  There is not, in the entire enormous literature on the topic, one iota of evidence for this statement, although some law professors, who are generally better at making arguments for a legal brief than they are at doing rigorous economics, may still mouth it. True, there could indeed be a small end-period problem with trading on bad news.  But, even if there is, it must be of little significance compared to the benefits to shareholders and other investors of allowing insider trading.  There are many forces, including reputation and market competition, operating to induce managers to produce good news, and there is no limit on the amount of this the market will continue to reward them for.  But there are no incentives other than this highly theoretical one encouraging managers to produce bad news.  A bit too much of this and the manager is ruined, while the possibility of making a gigantic killing to justify some once-in-a-lifetime malfeasance with inside information is all but non-existent.  This would be a very foolish bet for any corporate manager to make, and not surprisingly there is no evidence that they do so.

As for the idea that they will delay disclosure (a special form of the bad news/moral hazard argument), as Harold Demsetz pointed out over 40 years ago, the insider will have every incentive not to delay but to speed up disclosure so he can get the highest rate of return on his transaction.  Again there is not one bit of evidence suggesting that this delay ever occurs in the real world and some very strong evidence (the best is by Lisa Meulbroek) that insider trading of the illegal variety quickly moves stock price in the appropriate direction.

On this point, I can’t help but ask what is your theory of how stock market pricing came to be so efficient?  Surely it is not a result of the SEC and disclosure laws—a joke if it were not all so expensive (on which see, among other things, my son’s Hydraulic Theory of Disclosure article).  The studies that have looked have found a mixed result, at best, and the best of these (starting with Stigler’s in 1964 and Benston’s in 1973) find that the market was just as efficient before the SEC and the ’33 and ’34 Acts as it was after.  Gilson and Kraakman certainly did not supply a satisfactory answer to this question that they addressed many years ago, even though they were trying desperately to prove that something besides insider trading was making the market so efficient.

Obviously this is a much larger topic than I can address here, but I must admit to being most dismayed by your implication that the goal of instantaneous communication of new information to all market participants is a worthy ideal that in some way might be aided by disclosure regulation or a ban on insider trading.  We know very well who was pushing all along for a ban on insider trading: the market professionals who stood next in line for new information if they could just get those pesky insiders out of the picture.  They certainly were not interested in universal, equal access to information, nor was the SEC who aided and abetted them in this project.  Given this well-known history, do you really mean to stand with those rent seekers?

I have greatly admired your work for many years, as you know, and I hope I may have missed something in your short blog post.  But precisely because I admire your work—and because many others do, too—I felt an obligation to respond to your problematic comments on this point.  I look forward to your thoughts in response.

Yours cordially,

Henry Manne

Usha Rodrigues and Mike Stegemoller have penned an interesting article, “Placebo Ethics,” assessing the effect of one of SOX’s disclosure provisions: The required immediate disclosure of waivers from a company’s code of ethics, found in Section 406 of the law.  The article is concrete, informative, empirical and well-written.

The article’s abstract summarizes the heart of the paper:

Out of 200 randomly selected firms, we found only one waiver over 4 years disclosed pursuant to Section 406. However, by exploiting an overlap in disclosure regulations [between SOX 406 and Item 404 of Regulation S-K requiring disclosure of related-party transactions in year-end proxy statements], we were able to cross check our sample companies’ waiver disclosure. We find 30 instances where companies appear to be violating the law, and another 74 where companies evade illegality by watering down their codes to an arguably impermissible degree – their codes of ethics do not forbid the same Enron-style conflicts of interest that led to the adoption of Section 406 in the first place. Finally we study all waivers filed by all public companies with the SEC in the four years following SOX’s passage – and find only 36 total. Event studies reveal that the market generally does not react to these transactions, suggesting that companies only use waivers to disclose innocuous, immaterial information.

There’s a lot of interesting stuff here, including the conclusions that 15% of the sample firms are apparently violating the law and that the waivers that are disclosed are viewed by the market as irrelevant.  It is also interesting that 37% of the sample “evade illegality by watering down their codes to an arguably impermissible degree.”  It is this latter claim on which I want to focus.

I talked a bit about this issue in my Hydraulic Theory of Disclosure article.  In the article I said this about the waiver disclosure requirement:

The implicit assumption is that disclosure to shareholders will deter inappropriate waivers, inducing better compliance with the underlying code of ethics.  But that assumption must be animated by a further assumption that some conduct will be relatively static—that codes of ethics will not themselves be re-written and relaxed in response to the rule. In fact, however, the more likely outcome is that codes of ethics will be (and have been) re-written in order to minimize the need for waivers, in the event actually stemming rather than improving the flow of information . . . .  In other words, disclosed waivers are (privately) costly, and it may be less (privately) costly to amend codes of ethics than to seek and publicize waivers. Underlying behavior of the sort requiring waivers may not change, or it may even deteriorate. And either way less of it will be disclosed.

Rodrigues’ and Stegemoller’s (R&S’s) concluision seems to be 1) that immediate disclosure of related-party transactions would be a good thing, 2) that SOX 406 intended this but was poorly-executed to achieve the result, and 3) that companies’ failure to disclose waivers of their codes of ethics for related-party transactions is a violation of SOX 406, even where the code does not explicitly prohibit such transactions.

While the abstract quoted above is somewhat circumspect about the illegality of these “in spirit” violations of SOX 406, the article itself is a bit more hard-nosed:

It may be that, by omitting related-party transactions from their codes of ethics, companies are in violation of Section 406(c)(1), because prohibiting related-party transactions is “reasonably necessary” to promote “ethical handling of actual or apparent conflicts of interest between personal and professional relationships.” At the very least, these codes violate the intention, or “spirit” of Section 406’s disclosure requirements. As discussed in Part III, Section 406’s waiver provision was specifically enacted to address Enron’s related-party transactions with its CFO, Andy Fastow. Yet the majority of our sample companies do not forbid related-party transactions in their codes.

Instead, companies tend to have generic “conflicts of interest” provisions. And even when the provisions address related-party transactions, they use “weasel wording” that makes it hard to find an actual violation.

As R&S note, most ethics codes do not prohibit related-party transactions outright, so neither waivers of these codes, nor, therefore, disclosure of waivers, is required.  While seemingly proving my prediction that the effect of SOX 406 would be watered-down codes of ethics and, thus, less disclosure of information (assuming the watering down came in response to SOX 406), R&S focus instead on the illegality point, with which I have some trouble.

Basically, R&S argue that ethics codes that do not prohibit related party transactions are, in fact, impermissible under SOX, but I find their reasoning to be a stretch, and certainly there is no case law or SEC ruling (that I know of or that they cite) supporting the claim.  The R&S argument goes, in essence: a) a firm has an ethics code, waivers of which must be disclosed immediately; b) the code “should” prohibit related-party transactions but it does not on its face; c) there is a related-party transaction; d) there is no disclosure of a waiver; e) 406 is violated because the code of ethics “should” have prohibited this transaction, thus it “should” have required a waiver, and thus the absence of disclosure of a waiver is a violation of 406.  This seems like a pretty big stretch to me.  It might be that firms are interpreting 406 liberally, but it’s a long way from that to saying they are breaking the law.  Rather, I would say that failure to disclose waivers in this case is not an example of a firm flouting its obligation under SOX, it is instead an example of the predictable (and predicted) hydraulic effect of imperfect regulation.

This would still count as a failure of SOX 406, in my book (whether that’s a bad thing or not is another matter), but not because of non-enforcement, as R&S suggest, but rather because of the perverse incentive created by SOX 406 that induces firms to enact less-restrictive ethics codes.

In the end, I see the article as a vindication of my prediction.  My point was to suggest that SOX 406 would have the opposite effect of the one it intended–less internal prohibition (or policing) by firms of “unethical” conduct and less disclosure of such conduct.  I hasten to note that this study doesn’t say anything about whether SOX had anything to do with the watered-down ethics codes; for all I know they were already watered down (and thus the accuracy of my prediction is unconfirmed by the article).  But that would have been the thing to look at, it seems to me:  The role of SOX in inducing firms to engage in disfavored conduct to avoid new disclosure obligations that they would not otherwise have engaged in.

Despite this critique, I think the article is the best sort of empirical legal scholarship.  My conclusion might diverge from R&S’s (I would not suggest, as they do, a rule simply requiring disclosure of all related-party transactions over a certain size), but the evidence they uncover is important and their presentation of it is straightforward, well-written and informative.

Today the SEC voted 3-2 to approve an interpretive release offering guidance to companies on disclosure obligations as they relate to climate change.  Commissioners Casey and Paredes voted to reject the proposed guidance.

Everyone can agree that companies may have an obligation under Regulation S-K to disclose risks arising from, among other many things, climate change laws and regulations.  But this guidance goes further, urging companies to disclose risks arising from “physical effects of climate change.”  This is nonsense on stilts.  Leave aside the underlying inanity of the larger enterprise built on the premise that rationally-ignorant and rationally-passive individual investors should read, assess and make active investment decisions on the basis of massive amounts of regularly-disclosed information.  Here corporations are asked to disclose “information” about risks to the company posed by future, possible environmental conditions about which the firms know nothing, the science is utterly un-settled and speculative, and the actual physical and economic consequences of which are even less certain.  (I put the word information in scare quotes because nothing so speculative and uncertain can reasonably be called information).  What possible value could there be to investors (assuming there is any value to investors from disclosure of this type of information anyway) from the sorts of disclosures that would reasonably follow?:  “There is somewhere between a 0% and 90% chance that the temperature during either the summer or the winter or maybe-but-not-definitely both will be either warmer or colder by somewhere between 0.01 and 5 degrees sometime within the next 300 years.  This may or may not be bad for our business depending on whether it makes our customers richer or poorer, improves or harms our productivity and helps or harms our competitors by more or less than it helps or harms us.”

At least Troy Paredes isn’t buying it and once again stands nearly alone (Commissioner Casey also voted to reject) for common sense in Washington.  An extended quote from his statement at today’s hearing:

Second, the release states that companies “whose businesses may be vulnerable to severe weather or climate related events should consider disclosing material risks of, or consequences from,” the “physical effects of climate change, such as effects on the severity of weather (for example, floods or hurricanes), sea levels, the arability of farmland, and water availability and quality.”

The prospect that this guidance will in fact foster confusion and uncertainty about a company’s required disclosures troubles me. What triggers a “reputational damage” or “physical effects” disclosure is far from certain, as is the scope of any such disclosure if and when required. More to the point, reputational damage and the impact on a company of the physical effects of climate change can be quite speculative. There is a notable risk that the interpretive release will encourage disclosures that are unlikely to improve investor decision making and may actually distract investors from focusing on more important information. Here, it is worth recalling that, in rejecting the view that a fact is “material” if an investor “might” find it important, Justice Marshall, writing for the Supreme Court in TSC Industries, warned that “management’s fear of exposing itself to substantial liability may cause it simply to bury the shareholders in an avalanche of trivial information — a result that is hardly conducive to informed decisionmaking.

Also problematic are the interpretive release’s introductory and background discussions on climate change and its regulation. To me, the effect of the discussions is to find the Commission joining the ongoing debate over climate change by lending support to a particular view of climate change. Although the release does not expressly take sides, the release emphasizes the “concerns” and potential harms of climate change and discusses a range of regulatory and legislative developments, along with international efforts, aimed at regulating and otherwise remedying causes of climate change. In particular, the release highlights new EPA regulations, proposed “cap-and-trade” legislation, the Kyoto Protocol (which the U.S. has not ratified), the European Union Emissions Trading System, and recent discussions at the United Nations Climate Conference in Copenhagen. While the release stresses the risks of climate change and ongoing efforts to regulate greenhouse gas emissions in the U.S. and abroad, the release fails to recognize that the climate change debate remains unsettled and that many have questioned the appropriateness of the regulatory, legislative, and other initiatives aimed at reducing emissions that the release features. In short, I am troubled that the release does not strike a more neutral and balanced tone when it comes to climate change — an area far outside this agency’s expertise.

Finally, given that there are more pressing priorities before the Commission, now is not the time for this agency to consider climate change disclosure.

For these reasons, I am not able to support the release before us. Nonetheless, I would like to thank the staff for their efforts and professionalism.

On the bright side, maybe this means the SEC is qualified to investigate the fraudulent disclosures in the UN IPCC’s Fourth Assessment Report.  On the other hand, the existence of such . . . misstatements in the authoritative global survey of climate change science suggests that, as Troy suggests, this whole endeavor will have few of the intended–and plenty of unintended–consequences.