Over the last few years, Congress and Securities and Exchange Commission (SEC) were put under pressure to seriously consider regulating proxy advisory firms. Financial industry and government leaders have voiced concern that proxy advisory firms exert too much power over corporate governance to operate unregulated. The SEC as well as the Congress have investigated and debated the merits of proxy advisory regulation. The U.S. House of Representatives held a hearing on the matter in June of 2013, and the SEC followed this hearing with a roundtable discussion in December of 2013. On June 30, 2014, the Investment Management and Corporate Finance Divisions of the SEC issued a bulletin outlining the responsibilities of proxy advisors and institutional investors when casting proxy votes. As of yet, no binding regulation has been promulgated, despite repeated calls for it.
Posts Tagged ‘Information asymmetries’
Despite serious concerns about the quality of auditing and financial reporting of U.S.-listed Chinese firms, the SEC and the PCAOB have been unable to provide sufficient or timely information to U.S. investors due to resource constraints, the confidentiality rules underlying the PCAOB disciplinary proceedings, and no access to relevant work papers of Chinese auditors. In the paper, The Informational Role of Internet-Based Short Sellers, which was recently made publicly available on SSRN, I focus on a new breed of information intermediary, i.e. Internet-based short sellers that have emerged in response to such regulatory loopholes and severe information asymmetry. Based on hand-collected Internet reports released during the 2009-2012 period by short sellers that target U.S.-listed Chinese firms, I find that these short sellers provide substantial information both directly and indirectly to investors.
In my paper, Financial Conglomerates and Chinese Walls, which was recently made available on SSRN, I examine the effectiveness of Chinese walls, or information barriers, in preventing financial conglomerates from misusing non-public information in their trading and other activities. In recent years, empirical evidence has shown that financial conglomerates’ Chinese walls fail in important contexts, allowing firms to trade using non-public information they garner from their clients. Nevertheless, Chinese walls continue to have the legal effect of allowing financial conglomerates to discharge the otherwise incompatible client duties they owe under agency law. These incompatible duties arise due to the inflexible application of agency law and to financial conglomerates’ organizational structure, under which firms act for numerous clients across a broad and diverse range of financial activities, accumulating vast quantities of non-public information in doing so. As agents, firms are duty-bound to disclose material information in their possession to clients, and yet to do so is to breach duties of confidence owed to other clients. Chinese walls help financial conglomerates to reconcile their otherwise incompatible duties.
In our paper, The Economics of Solicited and Unsolicited Credit Ratings, forthcoming in the Review of Financial Studies, we develop a dynamic rational expectations model to address the question of why rating agencies issue unsolicited credit ratings and why these ratings are, on average, lower than solicited ratings. We analyze the implications of this practice for credit rating standards, rating fees, and social welfare. Our model incorporates three critical elements of the credit rating industry: (i) the rating agencies’ ability to misreport the issuer’s credit quality, (ii) their ability to issue unsolicited ratings, and (iii) their reputational concerns.
In our paper, The Real Costs of Disclosure, which was recently made publicly available on SSRN, we analyze the effect of a firm’s disclosure policy on real investment. An extensive literature highlights numerous benefits of disclosure. Diamond (1985) shows that disclosing information reduces the need for each individual shareholder to bear the cost of gathering it. In Diamond and Verrecchia (1991), disclosure reduces the cost of capital by lowering the information asymmetry that shareholders suffer if they subsequently need to sell due to a liquidity shock. Kanodia (1980) and Fishman and Hagerty (1989) show that disclosure increases price efficiency and thus the manager’s investment incentives.
However, the costs of disclosure have been more difficult to pin down. Standard models (e.g. Verrecchia (1983)) typically assume an exogenous cost of disclosure, justified by several motivations. First, the actual act of communicating information may be costly. While such costs were likely significant at the time of writing, when information had to be mailed to shareholders, nowadays these costs are likely much smaller due to electronic communication. Second, there may be costs of producing information. However, firms already produce copious information for internal or tax purposes. Third, the information may be proprietary (i.e., business sensitive) and disclosing it will benefit competitors (e.g., Verrecchia (1983) and Dye (1986)). However, while likely important for some types of disclosure (e.g., the stage of a patent application), proprietary considerations are unlikely to be for others (e.g., earnings). Perhaps motivated by the view that, nowadays, the costs of disclosure are small relative to the benefits, recent government policies have increased disclosure requirements, such as Sarbanes-Oxley, Regulation FD, and Dodd-Frank.
Irreconcilable differences among joint owners are all too common in business entities, including closely-held companies such as general partnerships and LLCs. While many joint owners foresee possible deadlocks and include resolution mechanisms in their business agreements, others fail to do so. Judicial involvement may become necessary when a deadlock clause was included in the business agreement but the grounds for dissociation or dissolution are unclear, or when a deadlock clause was not included at all. In both situations, the court may be called upon to determine the appropriate remedy and to design an asset-valuation procedure.
Placing an accurate value on the business assets of a closely-held company can be a daunting task. While publicly-traded companies often have active markets for ownership, closely-held companies may be very difficult for outside investors and/or appraisers to evaluate. By virtue of their experience with the business venture and their expertise, the joint owners may themselves be in the best position to accurately pinpoint the value of the assets. Thus, the court faces the challenge of designing a deadlock resolution mechanism that induces the owners to accurately reveal the value of the business assets.
In my paper, Insider Trading in the Derivatives Markets, recently made available on SSRN, I argue that the prohibition against insider trading is becoming increasingly anachronistic in markets where derivatives like credit default swaps (CDS) trade. I demonstrate that the emergence of credit derivatives marks a profound development for the prohibition against insider trading, problematizing conventional theory and doctrine like never before. With the workability of current rules subject to question, this paper advocates for a rethinking of the present regulatory framework for one better suited to modern markets.
Lenders use CDS to trade the risk of the loans they make. And, when they engage in such trading, they are usually privy to vast reserves of confidential information on their borrowers. From a doctrinal perspective, CDS appear to subvert insider trading laws by their very design, insofar as lenders rely on what looks like insider information to transfer the risk of a loan to another institution. Fundamentally, insider trading rules prohibit trading based on information procured at an unfair advantage by those in a privileged relationship to a company. And, increasingly, insider trading laws are taking a fairly broad approach in preventing misuse of confidential information by those who acquire this information through their special access or through deception. For example, Rule 10b-5(2) can ground a claim for insider trading where someone trades on information obtained through a relationship of trust and confidence. In the CDS market, lenders usually buy and sell credit protection based, at least in part, on information they obtain in their relationship with the borrower, one ordinarily protected by restrictive confidentiality clauses. From the doctrinal viewpoint then, old laws and new CDS markets appear to exist in a state of serious tension. Put differently, either this thriving market is operating outside or at the margins of existing law—or the law itself has not adapted to the existence of these markets.
In this post, Federal Financial Analytics, Inc. (FedFin) recommends steps the Consumer Financial Protection Bureau (CFPB) and other regulators can and should take to make their rules simpler, clearer, less burdensome and—critically—more enforceable. This paper is not a call for “cutting the red tape,” a mantra that has all too often meant eviscerating critical consumer protections. It is, rather a how-to on ways to cut through the daunting morass of consumer-protection standards that have only grown worse in the wake of the financial crisis.
We note not only ways to restructure rules to meet these goals, but also how to do so without losing the clarity essential to legal integrity and supervisory effectiveness. We also describe recent efforts by U.S. bank regulators to curtail problematic products (e.g., payday lending) by limiting it at banks, leaving wide swaths of the financial sector (sometimes called “shadow banks”) free to engage in predatory practices unless the bank-centric rules choke them off (uncertain), state regulators intervene (problematic) or federal rules across the sector are quickly enacted (so far unseen).
The process of resolving business deadlocks is time consuming and expensive, typically requiring the services of lawyers, financial experts and judges. Prolonged resolution processes, cost-inefficient administration of those processes, and inequitable outcomes impose high monetary and non-monetary costs on the parties themselves and on society as a whole.
Asset valuation, which is required to complete the transfer of assets in a business divorce, can pose particular problems for closely-held businesses. In contrast to publicly-traded companies with active markets for equity ownership, closely-held companies may be very difficult for outsider investors and appraisers to evaluate. The economic value of closely-held businesses is often intertwined with the human capital of the founders, their relationships with business associates (including key suppliers and customers), and their tacit business knowledge. The true economic value of closely-held businesses may not be fully reflected in the official business documents and financial statements; instead, the best wisdom concerning the value of the business may lie in the minds of the business owners themselves.
Our article, Shotguns and Deadlocks, forthcoming in the Yale Journal on Regulation, studies business deadlocks and their resolution. We advance a proposal to reform the way that courts resolve business deadlocks and value business assets. Specifically, we argue that Shotgun mechanisms, where the courts mandates one owner to name a single buy-sell price and compels the other owner to either buy or sell shares at the named price, should play a larger role in the judicial management of business divorce. Since the party proposing the offer may end up either buying or selling shares, the party has an incentive to identify and name a fair price. In addition, inefficient delays and administration cost associated with external appraisers and public auctions will be avoided. Our proposal is aligned with current statutory rules and case law. General partnerships and limited liability companies (LLCs), the most commonly chosen legal entities, are the focus of this study.
In our paper, Informed Trading through the Accounts of Children, forthcoming in the Journal of Finance, we introduce a novel measure of the probability of information-based trading in a stock, namely, BABYPIN, the proportion of total trading through the accounts of underaged investors. We begin by empirically validating this measure by showing that underaged accountholders are extremely successful at picking stocks, especially when they trade just before large price changes, major earnings announcements, and takeover announcements. We next show that BABYPIN is priced in the cross section of stock returns, consistent with Easley and O’Hara (2004).
There are two reasons to expect a high proportion of informed trading through underaged investor accounts. First, guardians who open accounts and trade on behalf of young children are likely to be above-average investors. We expect these individuals to have more wealth (to bestow on offspring) and to be more successful at investing, possibly due to superior cognitive skills or comparative advantages in obtaining value-relevant information. These attributes, combined with a basic parental instinct to share the benefits of any information advantage with one’s offspring, could lead to a disproportionate number of underaged accounts that bear the fruits of informed trading.