Archives For securities regulation

Not, as economic theory would predict, because they need the money, according to Bhattacharya and Marshall, Do They Do it for the Money?  Here’s the abstract:

Using a sample of all top management who were indicted for illegal insider trading in the United States for trades during the period 1989-2002, we explore the economic rationality of this white-collar crime. If this crime is an economically rational activity in the sense of Becker (1968), where a crime is committed if its expected benefits exceed its expected costs, “poorer” top management should be doing the most illegal insider trading. This is because the “poor” have less to lose (present value of foregone future compensation if caught is lower for them.) We find in the data, however, that indictments are concentrated in the “richer” strata after we control for firm size, industry, firm growth opportunities, executive age, the opportunity to commit illegal insider trading, and the possibility that regulators target the “richer” strata. We thus rule out the economic motive for this white-collar crime, and leave open the possibility of other motives.

One hypothesis:  the need for more money is not necessarily perfectly correlated with how much you have.  Insider traders are rich because they really want to be rich (some would call this “greed”). The higher demand for money offsets the risks. This doesn’t mean you can “rule out the economic motive” for insider trading. 

There may be broader implications here for executive compensation, executive misconduct generally, and for reconciling this data with evidence of executives’ willingness to trade off insider trading and other compensation.


Larry Ribstein —  17 November 2011

Should you have to do a costly SEC registration and work through a registered broker-dealer just to raise a little money for your start-up? 

Today’s WSJ covers so-called “crowd-funding.” It tells of a guy who raised $41,000 from 17 investors.  The business has done well, but the website it used was ordered to stop doing this because it wasn’t a licensed broker-dealer.  

Supporters of a crowd-funding exemption are rallying near the SEC in Washington today (Occupy the SEC!).

The House has voted an exemption that would allow sales of up to $2 million in equity online to investors whose crowdfunding investments are up to $10,000 year or 10% of their annual income.  A Senate bill would limit these amounts to $1 million and $1,000.

Opponents of crowdfunding exemptions cite the potential for fraud.  But surely there’s a balance between fear of fraud and permitting what could be a significant jobs-generator.

For some academic coverage of crowd-funding see Heminway and Hoffman (arguing that “the offer and sale of crowdfunding interests under certain conditions should not require registration” and suggesting “principles, process, and substantive parameters of a possible solution in the form of a new registration exemption adopted by the SEC under Section 3(b) of the Securities Act”); Steve Bradford (proposing to exempt certain crowdfunding sites from federal regulatory requirements but not antifraud rules); and Hazen (reviewing proposed crowdfunding exemptions and arguing that “the proposals to date do not adequately justify an exemption”).

CBS is all hot and bothered about insider trading by Congress.  Steve Bainbridge is not so sure it’s illegal. Neither am I, and I question whether it should be on policy grounds (see here, first published here).  I suggest more disclosure, and reducing the opportunity for all kinds of corruption by having less law.

Yesterday at the Illinois Corporate Colloquium Steve Choi presented his paper (with Pritchard and Weichman), Scandal Enforcement at the SEC: Salience and the Arc of the Option Backdating Investigations.  Here’s the abstract:

We study the impact of scandal-driven media scrutiny on the SEC’s allocation of enforcement resources. We focus on the SEC’s investigations of option backdating in the wake of numerous media articles on the practice of backdating. We find that as the level of media scrutiny of option backdating increased, the SEC shifted its mix of investigations significantly toward backdating investigations and away from investigations involving other accounting issues. We test the hypothesis that SEC pursued more marginal investigations into backdating as the media frenzy surrounding the practice persisted at the expense of pursuing more egregious accounting issues that did not involve backdating. Our event study of stock market reactions to the initial disclosure of backdating investigations shows that those reactions declined over our sample period. We also find that later backdating investigations are less likely to target individuals and less likely to accompanied by a parallel criminal investigation. Looking at the consequences of the SEC’s backdating investigations, later investigations were more likely to be terminated or produce no monetary penalties. We find that the magnitude of the option backdating accounting errors diminished over time relative to other accounting errors that attracted SEC investigations.

As readers of this blog, and Ideoblog before it, will appreciate, this paper particularly resonated with me.  As I wrote in a large number of posts (e.g.) backdating was a molehill the media blew up into a mountain.  Now come Choi et al with evidence that while the SEC was spending its scarce resources on this overblown molehill it was ignoring real mountains (e.g., Madoff).

I found the paper overall quite persuasive.  I wasn’t entirely convinced by the evidence that the backdating cases were getting weaker.  In particular, stock price reactions may just indicate the market was learning about the which companies were involved before the investigations were brought, and was gradually figuring out that backdating was not such a big deal.  But I was convinced of the evidence of the opportunity costs of the SEC’s backdating obsession — the otherwise inexplicable decline in investigations of serious non-backdating accounting problems.

As we discussed in the Colloquium, the paper reveals that there are agency costs not just in the backdating companies that were investigated but also in the agency that was doing the investigating.  Although it’s not clear exactly what moved the SEC to follow the media, there is at least some doubt about whether the SEC’s resource allocation decisions were in the public interest.

This calls attention to another set of agents — the ones in the media.  Why did the media love backdating so much?  As discussed in my Public Face of Scholarship, there are “demand” and “supply” explanations:  the public demands stories about cheating executives and/or journalists like to supply these stories.  David Baron, Persistent Media Bias, presents a supply theory emphasizing journalists’ anti-market bias.

Whatever the cause of media bias, when the media is influential its bias can result in bad public policy. SEC enforcement isn’t the only example. As I discuss in my article (at 1210-11, footnotes omitted):

Where interest groups are closely divided, the outcome of political battles may depend on how much voter support each side can enlist. This may depend on how journalists have portrayed the issue to the public. For example, the press is an important influence on corporate governance. One factor in the rapid passage of the Sarbanes-Oxley Act, the strongest federal financial regulation in seventy years, may have been the overwhelmingly negative coverage of business in the first half of 2002: seventy-seven percent of the 613 major network evening news stories on business concerned corporate scandals.

It’s not clear what can be done to better align SEC enforcement policy with the public interest.  Incentive compensation for SEC investigators?  Perhaps the only thing we can do (as with corporate crime) is to try to keep in mind when creating regulation that even if corporate agents may sometimes do the wrong thing, people don’t stop being people when they go to work for the government.

The semester is off to a bang.  I arrived at Stanford Monday to start teaching in the Law School and begin a research fellowship at the Hoover Institution.  Yesterday I hiked in the mountains overlooking the SF Bay.  Today I am flying back to DC (and blogging in flight, how cool is that) to testify Thursday before the House Committee on Financial Services alongside SEC Chairman Schapiro, former Chairman Pitt, and former Commissioner Paul Atkins on proposed legislation from Congressman Scott Garrett and Chairman Spencer Bachus to reform and reshape the SEC.

Part of the hearing, titled “Fixing the Watchdog: Legislative Proposals to Improve and Enhance the Securities and Exchange Commission” will deal with the study on SEC organizational reform mandated by the Dodd-Frank Act and conducted by the Boston Consulting Group.  Frankly, I found it full of quotes from the consultant’s desk manual, with references to “no-regrets implementation,” “business process optimization” and “multi-faceted transformation.”  I believe the technical term is gobbledy-gook.

The remainder of the hearing will involve a discussion of the SEC Organizational Reform Act (or “Bachus Bill”) and the SEC Regulatory Accountability Act (or “Garrett Bill”).  The Bachus Bill proposes a number of organizational reforms, like breaking up the new Division of Risk, Strategy, and Financial Innovation to embed the economists there back in to the various functional divisions.  The Garrett Bill seeks to strengthen the guiding principles originally formulated in the NSMIA amendments by elaborating on how the agency can meet its economic analysis burden in rule-making.

I thought I would give TOTM readers a sneak peak at my testimony.  I aim to make two key points.  First, sincere economic analysis is important.  SEC rules have consistently done a poor job of meeting the mandate of the NSMIA to consider the effect of new rules on efficiency, competition, and capital formation, and they will continue to do a poor job until they hire more economists and give them increased authority in the enforcement and the rule-making process.  Second, the SEC’s mission should include an explicit requirement that it consider the effect of new rules on the state based system of business entity formation.

Here’s a sneak peak at my testimony for TOTM readers:

Chairman Bachus, Ranking Member Frank, and distinguished members of the Committee, it is a privilege to testify today.  My name is J.W. Verret.  I am an Assistant Professor of Law at Stanford Law School where I teach corporate and securities law.  I also serve as a Fellow at the Hoover Institution and as a Senior Scholar at the Mercatus
Center at George Mason University.  I am currently on leave from the George Mason Law School.

My testimony today will focus on two important and necessary reforms.

First, I will argue that clarifying the SEC’s legislative mandate to conduct economic analysis and a commitment of authority to economists on staff at the SEC are both vital to ensure that new rules work for investors rather than against them.  Second, I will urge that the SEC be required to consider the impact of new rules on the state-based system of business incorporation.

Every President since Ronald Reagan has requested that independent agencies like the SEC commit to sincere economic cost-benefit analysis of new rules.  Further, unlike many other independent agencies the SEC is subject to a legislative mandate that it consider the effect of most new rules on investor protection, efficiency, competition and capital formation.

The latter three principles have been interpreted as requiring a form of cost-benefit economic analysis using empirical evidence, economic theory, and compliance cost data.  These tools help to determine rule impact on stock prices and stock exchange competitiveness and measure compliance costs that are passed on to investors.

Three times in the last ten years private parties have successfully challenged SEC rules for failure to meet these requirements.  Over the three cases, no less than five distinguished jurists on the DC Circuit, appointed during administrations of both Republican and Democratic Presidents, found the SEC’s economic analysis wanting. One
failure might have been an aberation, three failures out of three total challenges is a dangerous pattern.

Many SEC rules have treated the economic analysis requirements as an afterthought. This is in part a consequence of the low priority the Commission places on economic analysis, evidenced by the fact that economists have no significant authority in the rule-making process or the enforcement process.

As an example of the level of analysis typically given to significant rule-making, consider the SEC’s final release of its implementation of Section 404(b) of the Sarbanes-Oxley Act.  The SEC estimated that the rule would impose an annual cost of $91,000 per publicly traded company.  In fact a subsequent SEC study five years later found average implementation costs for 404(b) of $2.87 million per company.

That error in judgment only applies to estimates of direct costs.  The SEC gave no consideration whatsoever to the more important category of indirect costs, like the impact of the rule on the volume of new offerings or IPOs on US exchanges.

In Business Roundtable v. SEC alone the SEC estimates it dedicated over $2.5 million in staff hours to a rule that was struck down.  An honest commitment by the SEC to empower economists in the rule-making process will be a vital first step to ensure the mistakes of the proxy access rule are not replicated in future rules.

I also support the goal in H.R. 2308 to further elaborate on the economic analysis requirements.  I would suggest, in light of the importance and pervasiveness of the state-based system of corporate governance, that the bill include a provision requiring the SEC to consider the impact of new rules on the states when rule-making touches on issues of corporate governance.

The U.S. Supreme Court has noted that “No principle of corporation law and practice is more firmly established than a state’s authority to regulate domestic corporations.”

Delaware is one prominent example, serving as the state of incorporation for half of all publicly traded companies.  Its corporate code is so highly valued among shareholders that the mere fact of Delaware incorporation typically earns a publicly traded company a 2-8% increase in value.  Many other states also compete for incorporations, particularly New York, Massachusetts, California and Texas.

In order to fully appreciate this fundamental characteristic of our system, I would urge adding the following language to H.R. 2308:

“The Commission shall consider the impact of new rules on the traditional role of states in governing the internal affairs of business entities and whether it can achieve its stated objective without preempting state law.”

The SEC can comply by taking into account commentary from state governors and state secretaries of state during the open comment period.  It can minimize the preemptive effect of new rules by including references to state law where appropriate similar to one
already found in Section 14a-8.  It can also commit to a process for seeking guidance on state corporate law by creating a mandatory state court certification procedure similar to that used by the SEC in the AFSCME v. AIG case in 2008.

I thank you again for the opportunity to testify and I look forward to answering your questions.

Last year I suggested that regulators would better fight corporate fraud by letting those in the know trade on the information than through the complex whistleblowing rules like those in Dodd-Frank.

Robert Wagner has similar thoughts.  The article is  Gordon Gekko to the Rescue?: Insider Trading as a Tool to Combat Accounting Fraud.  Here’s the abstract:

This Article puts forward that, counter-intuitively, one way to help avoid future accounting scandals such as WorldCom would be the legalization of “fraud-inhibiting insider trading.” Fraud-inhibiting insider trading is the subcategory of insider trading where: (1) information is present that would have a price-decreasing effect on stock if made public; (2) the traded stock belongs to an individual who will likely suffer financial injury from a subsequent stock price reduction if the trading does not take place; (3) the individual on whose behalf the trading occurs would have the ability to prevent the release of the information or to release distorted information to the public; and (4) the individual in question did not commit any fraudulent activities prior to availing himself of the safe harbor. Arguing that prohibiting all insider trading incentivizes corporate fraud, this Article begins by giving examples from recent cases in which insider trading could have been used to avoid significant harm. Next, the Article briefly discusses both the history of insider trading and the philosophical and policy arguments against it. This Article particularly focuses on the two most prominent arguments raised against insider trading: (1) that it erodes confidence in the market; and (2) that it is similar to theft and should be prosecuted accordingly. Previously unexamined empirical evidence suggests that the confidence argument may be incorrect and does not suffice to justify a prohibition on fraud-inhibiting insider trading. This Article also shows that while the property rights rationale is the strongest position against general insider trading, it is an insufficient basis to outlaw fraud-inhibiting insider trading. The Article concludes with a proposal that the courts, the Securities and Exchange Commission, or Congress enact a safe harbor to legalize fraud-inhibiting insider trading and thus enable the insider trading laws to more effectively achieve their purported goal of protecting the securities market and investors.

Another day, another paper showing evidence of the negative effect on market efficiency of bans on short-selling.  Today it’s Yerkes, Regulatory Trading Restrictions, Overvaluation, and Insider Selling.  Here’s the abstract:

A contentious debate is emerging over the regulatory response to the financial crisis. This paper takes advantage of a rare opportunity to empirically test sweeping short sale constraints. Specifically, I analyze 2008 trading restrictions which prohibited short selling in all U.S. financial stocks. It is not clear whether restrictions keep negative sentiment off the market, sending prices up, or discourage ownership by stock lenders, sending prices down. It is also debatable how coincident events such as TARP affect prices, since avoiding bankruptcy is beneficial, but equity issuance and poor capitalization is not. The findings in this paper have three important implications for market participants. First, positive abnormal return and increased insider selling are consistent with an overvaluation hypothesis. The possibility of overvaluation due to TARP is ruled out since only a small percentage of restricted firms receive TARP funding and prices react negatively when they do. The overvaluation finding is consistent with prior studies of trading restrictions, such as IPO lockups. Second, additional evidence is provided on the documented relationship between institutional ownership and short sale constraints. Firms with low institutional ownership, low short interest, small market cap, and firms traded on the NASDAQ were least affected by the ban. This is relevant since 95% of stocks are not constrained by institutional ownership levels. Finally, short selling is known to facilitate information revelation and I find large declines in short interest result in less market efficiency.

Want more evidence of the efficiency effects of short-selling and the inefficiency of banning it?  Try this, this, and this. Here’s one of many posts on government’s war on the shorts (aka killing the messenger). And Bruce Kobayashi and my broader criticism of regulation of “outsider trading.”

I would like to add to Jay’s praise of departing SEC Commissioner Casey my own appreciation.  I noted a couple of weeks ago the Commissioners Casey and Paredes’ influence on the DC Circuit’s proxy access decision. These Commissioners haven’t just been nay-sayers throwing down a gauntlet against regulation. Rather, they have been consistently thoughtful and articulate advocates of well-reasoned decision-making by our leading financial regulator. The DC Circuit decision is an example of the potential influence of powerful dissents. But even if these Commissioners haven’t yet been able to change the course of this regulatory ocean liner, they may help establish a better direction for future regulation.

Amid yesterday’s market turmoil it’s easy to forget about Rajat Gupta.  He’s the guy whose suit against the SEC led a federal judge to put the agency under judicial supervision.

Now the SEC has dismissed its misbegotten administrative proceeding. They can file a civil insider trading case before the same judge who has cast his skeptical gaze on the agency.

Ten leading corporate and securities law professors have petitioned the SEC to develop rules to require companies to disclose their political spending.

This is the latest iteration of efforts to end-run Citizens United’s restrictions on regulating corporate campaign activities by calling it corporate governance regulation.  See my recent post on the Shareholder Protection Act.  I’ve written on these issues in my recently published The First Amendment and Corporate Governance.

The proposed regulation has a good chance of passing muster under the First Amendment because it would focus on disclosure rather than imposing substantive restrictions on corporate speech. Nevertheless, the First Amendment is still relevant.  I have already noted my view that the SEC’s proxy access rule (which is also basically a disclosure rule) avoided a confrontation with the First Amendment only because the DC Circuit could invalidate it on other grounds. At some point mandatory disclosure can sufficiently burden corporate speech to be unconstitutional.  To give just one example, requiring firms to pre-disclose all of their spending for the coming year, thereby preventing them to respond flexibly to changes in the political environment, could push the line.

Even if the SEC rules are constitutional, they would still not necessarily be good policy.  Notably, the law professors’ rulemaking petition, while spending some time discussing the supposed importance to investors of corporate political spending, said nothing about whether an SEC rule was necessary.  The petition highlighted the fact that many corporations already were voluntarily disclosing political spending, sometimes even without shareholder request. Why not continue the experimentation and evolution rather than locking down a one-size-fits-all rule?  Do the benefits of standardization outweigh the costs of experimentation?

The petition cites precedents such as executive compensation disclosure as evidence of the “evolving nature of disclosure requirements.”  But there’s nothing about this evolution that suggests it needs to proceed toward more disclosure about every political hot-button issue.

No doubt the SEC will proceed as the petition requests.  After all, it needs a juicy political issue to deflect attention from the recent questions about the SEC’s soundness and competence as a financial cop. But let’s at least hope that the Commission has learned something from its most recent run-in with the DC Circuit and tries to get some data on exactly who would be helped and hurt by regulation of political disclosures and how much. As with proxy access, would this be all about empowering certain activists at the expense of others, or passive diversified shareholders?  My article discusses some of these tradeoffs. The SEC’s analysis  might benefit from data on exactly what was accomplished by the Commission’s past disclosure enhancements the petitioners highlight.

The danger that the SEC will fall prey to the arbitrariness the DC Circuit criticized is especially intense given the petitioners’ argument that the “symbolic significance of corporate spending on politics suggests setting an appropriately low threshold” on when disclosure is required. I don’t even want to think about the consequences of inviting the SEC to weigh the benefit of “symbolism” against the direct and indirect costs of disclosure.

Anyway, get ready for a contentious debate which, while providing an enjoyable distraction, does nothing to protect investors from the fraud and market dangers that are supposed to be the SEC’s top priority.

I discussed last year the peculiarities of the SEC’s complaint against Goldman arising out of the infamous Abacus transaction. One peculiarity is how John Paulson, whose undisclosed role in structuring the transaction led to the charges against Goldman, has escaped blame.

Today Andrew Ross Sorkin sheds some light on why that might be:  a senior SEC lawyer involved in the case, Adam Glass, had previously worked for Paulson in connection with this transaction.

As Sorkin notes:

[Glass’s] role once again raises questions about the revolving door between Washington and Wall Street at a time when public distrust about the agency and its lack of enforcement action against the culprits of the crisis is running high.

He quotes Jack Coffee: “[I]t is a case that will raise further questions about the S.E.C.”

For more on the revolving door problem at the SEC, see my post yesterday on the FCPA.

Given this, and Madoff, and the SEC’s failure to get its regulatory act together, isn’t it about time somebody started raising some really basic questions about the SEC?  If it’s really true that the financial markets need a cop, it would seem some attention should be paid to whether we have the right cop.

Groupon’s tmi

Larry Ribstein —  28 July 2011

The WSJ reports that the SEC is on Groupon’s case for reporting “adjusted consolidated segment operating income” of $81.6 million while noting that subtracting marketing costs would produce a loss of $98 million.  Groupon recently added that adjusted CSOI “should not be considered as a measure of discretionary cash available to us to invest in the growth of our business or as a valuation metric” and that, according to the WSJ’s paraphrase, “investors should look at standard financial metrics such as cash flow, net loss and others when evaluating its performance.”

Apparently the SEC thinks Groupon shouldn’t disclose CSOI at all because it’s gross revenues rather than “profits.”  But does the SEC really know what investors should rely on?  Might not CSOI be a more realistic measure of future earnings than focusing on the investment the company made to produce that income?  Maybe not, but as long as it’s accurate, why not just give investors all the information with the appropriate qualifiers?

Then, too, Groupon co-founder Eric Lefkofsky committed the sin of “gun-jumping” by saying that “Groupon is going to be wildly profitable.” Sort of reminds me of Google’s famous Playboy interview.  As I asked back then:

[S]houldn’t the First Amendment have something to say about this broad regulation of truthful speech? See my article (with Butler), Corporate Governance Speech and the First Amendment, 43 U. Kans. L. Rev. 163 (1994), a chapter in our Corporation and the Constitution.

I recognize that there’s a point to this regulation:  to protect investors from rushing into horrendous investments like Google in 2004.