This posting, the February 2012 Davis Polk Dodd-Frank Progress Report, is the eleventh in a series of Davis Polk presentations that illustrate graphically the progress of the rulemaking work that has been done and is yet to occur under the Dodd-Frank Act. The Progress Report has been prepared using data from the Davis Polk Regulatory Tracker™, an online subscription service offered by Davis Polk to help market participants understand the Dodd-Frank Act and follow regulatory developments on a real-time basis.

In this report:

• As of February 1, 2012, a total of 225 Dodd-Frank rulemaking requirement deadlines have passed. Of these 225 passed deadlines, 164 (72.9%) have been missed and 61 (27.1%) have been met with finalized rules.
• Major rulemaking activity this month included CFTC final rules on business conduct standards and registration of swap dealers and major swap participants.
• The GAO published seven studies in January 2012.

Why managers pay dividends remains a puzzle. In our paper, Payout Policy through the Financial Crisis: The Growth of Repurchases and the Resilience of Dividends, which was recently made publicly available on SSRN, we report evidence on the payout policy of US financial and industrial firms over the past 30 years, including through the financial crisis, to shed new light on the why managers pay dividends. There are two specific goals. First, we investigate whether, as would be expected if share repurchases now dominate dividends as a means of paying cash to shareholders, managers used the financial crisis as a convenient excuse to stop paying dividends. Second, we use these data to provide new evidence on whether taxes, and in particular the Tax Relief Act of 2003 (which effectively eliminated the tax disadvantage of dividends) had a first order effect on payout policy.

We find that industrials and financials both increased payouts in the years prior to the crisis, at a pace that was impressive both in absolute terms and relative to earnings. Dividends reach a low point in 2002 but rebound thereafter. Although there is an increase in the fraction of dividend-payers immediately after the Tax Relief Act, we show that this is part of a broader increase in cash payouts that also includes a strong increase in repurchases. In the years after the Tax Relief Act there is no evidence of a shift in the mix of dividends and repurchases towards dividends—if anything, the reverse is true. Nor is there evidence of an increase in dividend payout ratios.

…continue reading: Payout Policy through the Financial Crisis

In our paper, Decoding Inside Information, forthcoming in the Journal of Finance, we employ a simple empirical strategy to decode the information in insider trading. Our analysis rests on the basic premise that insiders, while possessing private information, trade for many reasons, and that by identifying ex-ante those insiders whose trades are “routine” (and hence uninformative), one can better isolate the true information that insiders contain about the future of firms. Using simple definitions of routine traders, we are able to systematically and predictably identify insiders as either opportunistic or routine throughout our sample. We show that stripping away the uninformative signals of routine traders leaves a set of information-rich opportunistic trades that are powerful predictors of future firm returns, news, and events.

We show that while the abnormal returns associated with routine traders are essentially zero, a portfolio strategy that instead focuses solely on opportunistic insider trades yields value-weighted (equal-weighted) abnormal returns of 82 basis points per month (180 basis points per month). Similarly, in a regression context the combined differences in the coefficients between opportunistic trades and routine trades translate into an increase of 158 basis points per month in the predictive ability of opportunistic trades relative to routine trades. Further, this effect increases with the strength of the opportunistic signal (as measured by the number of trades or trade-size intensity), but is unrelated to the strength of the routine signal.

…continue reading: Decoding Inside Information

On Friday, January 6, 2012, the staff of the SEC’s Division of Corporation Finance issued the fourth installment in its new Disclosure Guidance Topic series. Topic No. 4 focuses on the exposures of registrants to the debt of certain European countries. The staff specifically highlighted its concern about “the risks to financial institutions that are SEC registrants from direct and indirect exposures to” European sovereign debt.

Enhanced Disclosures

The goal of this new guidance is to expand and enhance the disclosures that registrants provide related to sovereign debt exposures, to ensure that investors have transparent and comparable information about the uncertainties of these exposures. This information generally is included in registrants’ disclosures about risk factors, qualitative and quantitative market risks, and management’s discussion and analysis. Bank holding companies and other registrants engaging in similar lending and deposit activities also are required to make the disclosures required by the SEC’s Industry Guide 3 (Statistical Disclosure by Banking Holding Companies).

…continue reading: SEC Disclosure Guidance on Exposures to European Sovereign Debt

Key developments in both the litigation and regulatory context are compelling multinational corporations to reassess their global securities litigation and regulatory compliance strategies. In the litigation context, recent U.S. Supreme Court activity has limited the ability of overseas plaintiffs to bring securities class action claims within the United States. As such, plaintiffs have shifted litigation to more flexible jurisdictions in Europe and overseas, thereby forcing global firms listed on multiple exchanges to increasingly defend against securities class action claims and regulatory investigations in numerous jurisdictions. At the same time, governments around the world have responded to the recent financial crisis by bolstering their regulatory capability. Governments have not only adopted more robust legislative regimes with respect to securities regulation, but they have also invested heavily in stronger enforcement protocols.

…continue reading: A New Playbook for Global Securities Litigation and Regulation

It has probably not escaped the attention of the reader that European banks, and their ability to meet their continuing funding needs, have been some of the principal victims of the continuing uncertainty surrounding the future of the Eurozone, due to their exposures to Eurozone sovereign debt. As part of its general efforts to increase market confidence in European banks, the European Banking Authority (EBA) published a Recommendation [1] on 8 December 2011 as to the creation and maintenance of temporary capital buffers by European banks.

The EBA recommends that European banks should have created, by 30 June 2012, a temporary capital buffer by attaining a Core Tier 1 capital ratio of at least 9 percent.

The Core Tier 1 capital ratio is to be calculated by comparing a bank’s Core Tier 1 capital to its risk-weighted assets. “Core Tier 1 capital” is defined to include ordinary shares or similar instruments, but also newly-issued contingent convertible instruments if their terms comply with a new common term sheet for such instruments (“Buffer Convertible Capital Securities” or “BCCS”) set out by the EBA in Annex III to the Recommendation. This represents the first time that a European banking authority has laid down in such detail the core terms that such an instrument should possess in order to count as Tier 1 capital. Existing convertible capital instruments of European banks will not be counted towards the 9 percent ratio, unless they convert into Core Tier 1 capital by the end of October 2012.

…continue reading: A Blueprint for Contingent Convertible Securities?

The CFTC has adopted two final rules — a Swap Data Reporting Rule and a Real-Time Reporting Rule — that, in less than a fully coordinated manner, establish the new Dodd-Frank Act reporting regime for swaps. [1] The rules require market participants to report a host of swap information upon execution or shortly thereafter to a swap data repository (“SDR”), which is then responsible for disseminating a portion of that information to the public. Updated information for a given swap must be reported to the same SDR throughout the life of the swap.

The methods by which the swap information is reported to the SDR and the time allotted for such reporting depend on the counterparties to the swap, the type of swap and whether the swap is large enough to qualify as a block trade or large notional off-facility swap. The rules also require market participants to maintain records concerning swaps and to ensure the timely retrievability of records. The rules will go into effect in stages based on the type of market participant and asset class, beginning no earlier than July 7, 2012.

…continue reading: CFTC Swap Reporting Regime Rules

In our paper Why Do CEOs Survive Corporate Storms? Collusive Directors, Costly Replacement, and Legal Jeopardy, which was recently made publicly available on SSRN, we consider new explanations for the puzzling result that a majority of misreporting CEOs retain their jobs.  We extend the literature by investigating the role of directors’ both personal and reputational incentives in the CEO retention decision.  Overall, our analysis improves our understanding of the CEO retention decision by 30 to 40% relative to a benchmark model based on the severity of the misreporting, the firm’s performance and risk characteristics, and traditional measures of the strength of corporate governance.

We show that two types of personal benefits make conventionally independent directors less likely to remove CEOs: loss avoidance on equity-contingent wealth and increased compensation. First, we find that in firms where independent directors emulate CEOs’ trading behavior and also engage in abnormal insider selling over the misreporting period, CEOs are 13.6% more likely to be retained.  We view independent directors’ trading as suggestive of collusion because, like CEOs and other executive directors, they personally benefit by selling their equity at inflated prices during the period over which earnings are misreported.  To the extent that the misreporting sustains the firm’s overvaluation, the fact that directors engage in abnormal selling suggests they have access to negative information about the firm that they do not reveal to shareholders.  We posit that independent directors prefer not to attract attention to their own abnormal selling.  Thus, even though dismissing the CEO could enhance shareholder value by restoring credibility, directors whose trading actions align with those of CEOs have weaker incentives to replace the CEO.

…continue reading: Why Do CEOs Survive Corporate Storms?

The past year has been one of change and challenge for public companies and their boards, as companies have moved to implement “say-on-pay” and other provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). With the 2012 proxy season on the horizon, public companies and their directors will continue to feel the impact of Dodd-Frank as the Securities and Exchange Commission (“SEC”) proceeds with its ongoing efforts to implement the law. At the same time, public companies and their boards are operating in an environment where the balance of power between boards and shareholders continues to shift. The traditional, board-centric model of corporate governance continues to gravitate toward a paradigm that includes an increased role for shareholders. Activist shareholders are seeking greater participation in companies’ governance and operations, and they are exerting increased pressure on companies to adopt so-called corporate governance “best practices.”

…continue reading: Considerations for Public Company Directors in the 2012 Proxy Season

According to a reform applicable as of January 1, 2012, the right to deduct interest due with respect to the purchase of shares in French target companies will be denied, unless the French acquiring company demonstrates — by any means — that (i) the decisions relating to such shares and (ii) the control over the target companies are effectively made by it or by a related party established in France.

For the purpose of this reform, a related party can be a controlling company or an entity controlled by or under common control with the acquiring company.

This new rule targets the purchase of shareholdings that are eligible for the French long-term participation exemption regime, i.e. mainly shares that represent at least 5% of the financial and voting rights of companies (other than certain real estate property companies).

…continue reading: French Thin Cap Reform