Securities Mosaic® Blogwatch
October 23, 2014
Opacity in Financial Markets
by R. Christopher Small

Editor's Note: The following post comes to us from Yuki Sato of the Department of Finance at the University of Lausanne and the Swiss Finance Institute.

In my paper, Opacity in Financial Markets, forthcoming in the Review of Financial Studies, I study the implications of opacity in financial markets for investor behavior, asset prices, and welfare. In the model, transparent funds (e.g., mutual funds) and opaque funds (e.g., hedge funds) trade transparent assets (e.g., plain-vanilla products) and opaque assets (e.g., structured products). Investors observe neither opaque funds' portfolios nor opaque assets' payoffs. Consistent with empirical observations, the model predicts an "opacity price premium": opaque assets trade at a premium over transparent ones despite identical payoffs. This premium arises because fund managers bid up opaque assets' prices, as opacity potentially allows them to collect higher fees by manipulating investor assessments of their funds' future prospects. The premium accompanies endogenous market segmentation: transparent funds trade only transparent assets, and opaque funds trade only opaque assets. A novel insight is that opacity is self-feeding in financial markets: given the opacity price premium, financial engineers exploit it by supplying opaque assets (that is, they render transparent assets opaque deliberately), which in turn are a source of agency problems in portfolio delegation, resulting in the opacity price premium.

This paper is motivated by the rising opacity in modern finance. Opaque investment companies, such as hedge funds - typically with secretive investment strategies and undisclosed holdings - have rapidly grown in size and seem to have played a major role in the markets. Moreover, the importance of opaque and complex financial assets, such as sophisticated structured products - whose payoff information is incomprehensible and/or inaccessible to most retail investors - was highlighted during the 2007-2009 financial crisis. How does opacity affect investor behavior, asset prices, and welfare? In terms of asset prices, an intriguing empirical fact is that opaque and complex assets have been traded at a premium, rather than at a discount. This is puzzling: it appears to be inconsistent with standard asset-pricing models with rational agents. Such models might predict that investors unable to comprehend the nature of an asset would require a discount on the price, rather than pay a premium. Why do opaque assets trade at a premium? More fundamentally, why do opaque assets emerge in the first place?

To answer these questions, I develop a fully rational, dynamic asset-market equilibrium model with portfolio delegation. Its baseline version has one risky asset and one riskless asset. To invest in the risky asset, investors need to give capital to a fund manager, who forms a portfolio consisting of the risky and riskless assets. The manager earns a management fee proportional to the assets under management. The model features two types of opacity in financial markets. First, the funds are opaque in that investors cannot observe the funds' portfolios and the fund managers cannot commit to their portfolio choices. An example is a hedge fund adopting a flexible trading strategy that is not communicated to investors. Second, the risky asset is opaque in that investors cannot observe its payoffs. An example is a sophisticated derivative whose payoff information is, for nonprofessional investors, unavailable or prohibitively costly. Another manifestation of opacity is the complex nature of an asset that makes it difficult to comprehend its payoffs. For instance, understanding the payoff of a structured product may require wading through its prospectus and disclosure documents, which are hundreds of pages long and filled with technical jargon. The volume of information and extent of technical difficulty make the asset's payoffs effectively unobservable to investors (the information overload problem).

An important consequence of these two layers of opacity is that, although investors can (obviously) observe the total return from a fund, they cannot see the composition of that return. This is the source of an agency problem. Investors try to infer (i.e., back out) the opaque asset's unobservable payoff from the observed fund return, estimate the asset's future returns, and allocate capital on that basis. Yet, because the fund manager controls the portfolio that determines the fund return, that manager can potentially manipulate investors' estimations through his portfolio choice. More specifically, the manager can boost the expected fund return by (secretly) levering up and overinvesting in the opaque asset, in an attempt to inflate investors' estimates of the asset's future returns and hence their assessments of the fund's future prospects. So, potentially, investors can be led to allocate excessive capital to the fund and thus pay excessive fees.

In equilibrium, such an agency problem results in overpricing of the opaque asset, excessively high fund leverage, and lower social welfare. A key mechanism for these results is "signal jamming." Opaque funds' managers are inclined to lever up secretly in an effort to inflate investor expectations about their funds' future performance, thereby attracting more capital and thus more fees. Investors understand the managers' desire to fool them and hence are not fooled in equilibrium; nevertheless, the managers still lever up because otherwise their funds' future prospects would be underestimated by the investors who believe that the managers do lever up secretly. Overinvestment drives up the asset's price, resulting in lower expected returns for both the asset and the funds. In terms of utility, investors are unaffected, but managers are worse off: they attract less capital and thus earn lower fees as they fail to commit to not fool investors using opacity. In contrast, if funds are transparent and portfolios are observable (e.g., mutual funds), then the equilibrium does not depend on whether or not the risky asset is opaque. Indeed, regardless of managers' actions, investors always correctly back out the asset's payoff from the funds' observed portfolios and returns, and therefore there is no scope for the managers to manipulate investors' estimations.

To study a more realistic setting, I extend the model to accommodate both transparent and opaque funds, as well as transparent and opaque assets with identical payoffs. Each fund can choose one of the two risky assets to which to invest. In equilibrium, the opaque asset trades at a premium over the transparent asset, consistent with empirical observations. The result holds even though it is common knowledge that these assets yield identical payoffs and all funds can purchase whichever asset they wish. This price gap - the opacity price premium - is accompanied by endogenous market segmentation: transparent (opaque) funds trade only transparent (opaque) assets. This result is consistent with the real-world observation that mutual funds tend to focus on traditional asset classes, whereas hedge funds often trade opaque, complex financial instruments. The reason behind this segmentation is as follows. Because opaque fund managers cannot commit to their portfolio choices, a moral hazard problem prevents them from buying the transparent asset credibly; however, they can purchase the opaque asset credibly, being motivated by their desire to inflate the investors' expected fund assessment. In contrast, transparent fund managers simply buy the cheaper transparent asset because the asset's opacity is irrelevant for them.

Last, I address the fundamental question of why opaque assets emerge in the first place. In this model, they arise naturally from the demand of opaque fund managers. To study the supply of opaque assets, I introduce "financial engineers" - that is, agents who can make a transparent asset opaque and vice versa. In effect, the engineers act as arbitrageurs who exploit the opacity price premium: as long as the premium is positive, they buy transparent assets, make them opaque, and sell them at a profit. In equilibrium then the engineers serve to eliminate the premium. In that sense, opacity is self-feeding: engineers exploit the opacity price premium by supplying opaque assets, which in turn are the source of agency problems (in portfolio delegation) that result in a premium for opacity.

The full paper is available for download here.

October 23, 2014
Cleary Gottlieb discusses Restitution for Internal Investigations
by Lewis Liman

Few crises are worse for a public corporation than to lose one of its top officers to a federal criminal investigation, particularly one resulting in a conviction. Yet, the loss of such an officer to an investigation is not unheard-of, particularly in a change-of-control transaction. In past decisions, the Second Circuit has provided a silver lining. At least, the corporate employer can recover as restitution the costs of an internal investigation that assisted in an employee's subsequent conviction.[1] In United States v. Cuti,[2] the Second Circuit recently established and reiterated guidelines for such restitution. The decision is a reminder for corporations (which can see their costs of investigation covered by their culpable employees) as well as for putative defendants (who will face the risk not only of conviction but of funding the investigation that leads to it). It also sets forth rules that will be important for corporations seeking restitution, or contemplating the pursuit of restitution, to follow.

The facts of Cuti are easily stated and fall within a recognizable pattern. Anthony Cuti was the Chief Executive Officer ("CEO") and board chairman of Duane Reade. In 2005, a private equity firm, Oak Hill, acquired Duane Reade. Cuti's employment was terminated thereafter and he sued. Duane Reade hired outside counsel to defend against Cuti's employment lawsuit. In the course of defending against that employment-related claim brought by Cuti, outside counsel uncovered what it asserted was evidence that Cuti had perpetrated numerous acts of fraud during his time at Duane Reade. Duane Reade then retained separate counsel and a forensic accounting firm to conduct an internal investigation. The costs of the investigation were shared by Oak Hill and Duane Reade under a cost-sharing agreement. Eventually, outside investigation counsel presented its findings to the United States Attorney's Office ("USAO") and a prosecution soon followed. Ultimately, Cuti was convicted of conspiracy, securities fraud and making false statements in SEC filings.

At sentencing, Duane Reade sought to recover from Cuti both the costs of counsel who handled the employment-related claim and outside investigation counsel under the Victim and Witness Protection Act of 1982 ("VWPA"), claiming that both investigations were necessary expenses, since the misconduct was initially identified in the course of defending the employment claim. After initially denying the restitution request, the district court ultimately agreed with Duane Reade and held that restitution was available under the VWPA for the fees paid to both sets of lawyers. It awarded over $7 million in restitution to Oak Hill and Duane Reade for expenses incurred in connection with the investigation of Cuti's fraudulent conduct. The restitution included expenses related to the internal investigation, the employment dispute, as well as the payment of legal fees to retain counsel for current and former employees who were interviewed by the USAO.[3]

Cuti appealed, arguing that Oak Hill was not a victim of the offense and that costs incurred in connection with the reimbursement of legal fees for employee-witnesses were not recoverable, and that the costs expended on counsel who handled the employment-related claim did not qualify as "necessary... expenses related to participation in the investigation or prosecution... related to the offense" and therefore, were improperly included in the restitution award by the district court.

On appeal, the Second Circuit affirmed the restitution award in part and vacated and remanded the restitution award in part. The Court held that because Oak Hill paid expenses on Duane Reade's behalf, it was entitled to restitution as a non-victim and that the legal fees for Duane Reade's employees were properly included in the restitution order. Those rulings appear to be unexceptional.

The Second Circuit, however, vacated the award of restitution for the fees of the counsel who handled the employment-related litigation. Previously, in United States v. Maynard, the Court held that under the MVRA, "necessary... expenses related to participation in [an] investigation" include "expenses the victim was required to incur to advance the investigation or prosecution of the offense."[4] In that case, the Second Circuit vacated the award of restitution for investigative expenses that were not necessary. Recognizing that the statutory language regarding the scope of restitution is "nearly identical" in the MVRA and VWPA, the Cuti Court held that the definition of "necessary... expenses" under the MVRA also applied to cases under the VWPA. Using the language of discretion, the VWPA provides with respect to restitution that the court may order the defendant to "reimburse the victim for... necessary... expenses related to participation in the investigation or prosecution of the offense."[5] The Court thus held that the Government had not established that the costs of counsel who handled the employment-related claim were subject to restitution because it had not established that the purpose of their internal investigation was to "uncover or investigate fraud 'when faced with evidence, indicia, or a grounded suspicion of internal misconduct.'" The Court ruled that if the investigation was commenced, and its corresponding expenses were incurred, for another reason than to aid in a government's investigation, the victim is not entitled to restitution, because "that particular investigation cannot be 'a means calculated to achieve the protection' of a corporation's 'ongoing operations and reputation'" as required in Maynard.

The Court additionally found that because two sets of law firms both conducted parallel and independent investigations into Cuti's misconduct, it could not find that the costs incurred by Duane Reade for legal services from counsel who handled the employment-related claim were "necessary" to advance the government's claims under the VWPA. The Court concluded that "to be 'necessary' for restitution, it is not enough that the expenses incurred 'helped the investigation.'"

The decision has several important implications:

  • In order to collect restitution for costs incurred in connection with an internal investigation, a corporation must show that the purpose of the investigation was to aid the government in its investigation of the matter.
  • Corporations will likely not receive restitution for costs incurred in connection with a civil litigation or arbitration proceeding, if the investigation conducted in these proceedings is redundant or duplicative of a similar investigation that is being conducted in conjunction with a government agency.
  • If the above requirements are met, the Second Circuit takes a liberal view regarding the scope of what expenses are "necessary" to the advancement of the government's investigation. Thus, in addition to facing criminal and civil liability, white collar defendants may also be liable for paying millions of dollars in restitution damages to corporations that conducted internal investigations into their wrongdoing.

[1] See United States v. Amato, 540 F.3d 153 (2d Cir. 2008) (holding victim's costs of an investigation are recoverable as restitution under the Mandatory Victims Restitution Act of 1996 ("MVRA")); United States v. Battista, 575 F.3d 226 (2d Cir. 2009) (holding victim's costs of an investigation are likewise recoverable under the Victim and Witness Protection Act of 1982 ("VWPA")).

[2] See United States v. Cuti, No. 13-2042-cr, 2014 WL 4452976 (2d Cir. Sept. 11, 2014).

[3] See United States v. Cuti, No. 08-CR-972 (DAB), 2013 WL 1953741 (S.D.N.Y. May 13, 2013).

[4] United States v. Maynard, 743 F.3d 374, 381 (2d Cir. 2014). The MVRA requires restitution when a defendant is convicted of specified offenses, including crimes of violence, offenses against property (including any offense committed by fraud or deceit) and offenses related to theft of medical products, "in which an identifiable victim or victims has suffered a physical injury or pecuniary loss." See Mandatory Victims Restitution Act, 18 U.S.C. § 3663A (2012). It does not apply to all federal offenses. The Victim and Witness Protection Act of 1982, by contrast, applies to any offense listed under Title 18 or 49 of the U.S. Code, as well as certain offenses under the Controlled Substances Act. See Victim and Witness Protection Act of 1982, Pub. L. No. 97 - 291, 96 Stat. 1248 (1982) (codified as amended in scattered sections of 18 U.S.C., with the restitution provision at 18 U.S.C. § 3663 (2012)).

[5] See 18 U.S.C. § 3663.

The full and original memorandum was published by Cleary Gottlieb Steen & Hamilton LLP and is available here.

October 23, 2014
Many Companies' Most Significant Regulatory Risks Are Not in Their Home Country
by Kevin LaCroix

When Chinese regulators hit GlaxoSmithKline with a $489 million penalty last month - the largest corporate penalty ever in China - it set off alarm bells around the world. Among other things it sent out a "wake-up call for global companies that assumed that their main regulatory risk is in their home countries," according to a commentator quoted in an October 21, 2014 Bloomberg article entitled "Hong Kong is Hot Spot for U.S. Lawyers as Probes Rise" (here). The GSK penalty is just one of several developments that have triggered fears of increased regulatory enforcement action in China and elsewhere, that, according to the Bloomberg, has led to increased concerns in corporate executive offices and increased opportunities for lawyers and law firms in Hong Kong and elsewhere.


A critical aspect of the GSK bribery action in China is that it has triggered investigations in both the U.S. and the U.K. as regulators in those countries look into whether the company broke their anti-bribery laws. These circumstances provide just one example of how regulatory and enforcement actions in one country increasingly can lead to regulatory actions in multiple countries. Another example of this phenomenon is the investigation whether Wall Street's hiring practices in China and Hong Kong violated anti-bribery laws. The issues are also being investigated in the U.S. as well. The ongoing investigations into Libor benchmark rate manipulation and foreign exchange rate manipulations are other examples where regulatory investigations quickly crossed borders and became multi-jurisdictional.


The upshot of al this is that a regulatory investigation in one country can lead to what one commentator in the Bloomberg article called "industrial strength investigations," involving agencies in the U.S., Europe and Asia. These trends are only likely to accelerate as additional countries - including, for example, India, Indonesia and Thailand - step up efforts on anticorruption, antitrust and sanctions.


The point of the Bloomberg article is that this regulatory enforcement trend has fueled a boom for lawyers, as the cross-border investigations require the involvement of lawyers and law firms that can coordinate responses the investigations in the various jurisdictions. In addition, companies interested in trying to head off problems before they arise have been willing to enlist the services of lawyers to provide compliance and training services.


There are a number of interesting points in the Bloomberg article, particularly the point that increasingly companies' greatest regulatory risks may not be in their home country. Even if the risks outside the home country are not greater, it is certainly true for many companies that their regulatory risks are not limited to those in their home country. As regulators everywhere become more active on anti-bribery and other issues, the risk of regulatory action is now widespread and dispersed, and includes not only the risk of a regulatory action outside a company's home country, but also includes the risk of a cross-border, multi-jurisdictional regulatory action.


In many instances the onset of a regulatory action will not trigger a company's D&O insurance policy, although it usually will trigger a claims notice from the company to its insurer. But as a regulatory action progresses into an enforcement proceeding, the D&O insurance may become a factor, at least for defense costs - particularly if individuals are targeted in the investigation or named as defendants in an enforcement action. So even though the D&O policy will not in most instances provide insurance for regulatory fines and penalties, it could nevertheless prove to be important even if just on a defense cost basis.


An additional factor be kept in mind as well is that regulator and investigative action can, as is noted in the Bloomberg article, be followed by a follow-on civil action against company management, which likely would trigger the D&O policy, or even possibly insolvency proceedings, which again could lead to actions that might trigger the D&O policy.


The risk of the follow-on civil action coming in the wake of a regulatory investigation is a phenomenon I have noted frequently on this blog - including in particular the risk of follow in civil actions in the U.S. following regulatory actions and investigations outside the U.S, as discussed here.


I happen to think that the increasing global regulatory enforcement activity is one of the important emerging trends in the corporate liability arena. These developments have very important liability implications both for non-U.S. companies in their home countries and operating abroad, and for U.S. companies operating overseas. For D&O underwriters, these developments have important underwriting implications. And for policyholders and their advisors, these developments raise important and challenging questions about the availability and effectiveness of their insurance to respond to these emerging regulatory claims in all of the jurisdictions in which the claims might arise.


More About Dark Pool Trading: If you have not yet read the article entitled "The Empire of Edge" in October 13, 2014 issue of The New Yorker (here) about the insider trading investigation of S.A.C. Capital and the conviction of former S.A.C. trader Mathew Martoma, you will want to set aside some time and read it carefully. It is absolutely fascinating, particularly on the questions surrounding Martoma's motivations.


Among many other very interesting details in the article is its account of how S.A.C. Capital took advantage of trading on a private "dark pool" trading platform to unwind its massive positions in the securities of Elan and Wyeth - just ahead of public disclosures of clinical trial setbacks in a promising Alzheimer's therapy the companies were pursuing - without attracting attention to its trades:


When the market opened on Monday, Cohen and Martoma instructed Phil Villhauer, Cohen's head trader at S.A.C., to begin quietly selling Elan and Wyeth shares. Villhauer unloaded them using "dark pools" - an anonymous electronic exchange for stocks - and other techniques that made the trades difficult to detect. Over the next several days, S.A.C. sold off its entire position in Elan and Wyeth so discreetly that only a few people at the firm were aware it was happening. On July 21st, Villhauer wrote to Martoma, "No one knows except me you and Steve."

[T]he next evening, word of the ambiguous results hit the news wires. Tim Jandovitz, a young trader who worked for Martoma, watched in dismay as the news appeared on his Bloomberg terminal in Stamford. He checked Panorama [an S.A.C. portfolio monitor], which showed that S.A.C. still held huge positions in Elan and Wyeth. Jandovitz believed that both he and Martoma had just lost more than a hundred million dollars of Steven Cohen's money - and, along with it, their jobs. The next morning, he braced himself and went to the office. But when he consulted Panorama he saw that the Elan and Wyeth shares had vanished. Some time later, Martoma informed Jandovitz that S.A.C. no longer owned the stock.

October 23, 2014
Turkish Banking Law Is All About Image
by David Zaring

Turkey's largest Islamic bank believes that it has been targeted for destruction by the Turkish government, and, given the way things seem to go in that country, the level of conspiratorial innuendo is high. But also high is the discretion of the government to act against banks and observers of same. Banks generally did well in the financial crisis of 2008, if not so well before then. Usually, supervision is done for safety and soundness. But here's Euromoney's quote of one of the principles of Turkish banking law:

The 'protection of reputation' article of Turkey's banking law, introduced after the country's devastating banking crisis of 2001, states "no real or legal person shall intentionally damage the reputation, prestige or assets of a bank or disseminate inaccurate news either using any means of communication". Convicted violators of the code face up to three years in prison.

That seems like almost untrammeled regulatory discretion to me, joined with severe penalties. You could go after shorts, any sort of speaker, and probably the banks themselves, for soiling their own reputation. Via Matt Levine.

October 23, 2014
Adviser, Co-founder, Settle SEC Breach of Duty Proceeding
by Tom Gorman

The Commission filed settled administrative proceedings against an investment adviser and its co-founder based on a claimed breach of fiduciary duty. The Order alleged violations based on negligence, citing Securities Act Section 17(a)(2) and Advisers Act Section 206(2) and, in addition, Advisers Act Section 207. In the Matter of Clean Energy Capital, LLC, Adm. Proc. File No. 3-15766 (October 17, 2014).

Clean Energy Capital, or CEC, was a registered investment adviser until 2012 when the firm determined it was no longer eligible to register with the Commission because of the amount of assets under management. Respondent Scott Brittenham is the co-founder of the adviser and holds an 89% ownership interest but only has a 50% voting interest. He managed the business.

CEC marketed 19 separate private equity funds to investors using Ethanol Capital Partners, L.P. Each fund was marketed as a separate series, labeled by a letter such as Fund A. Respondent also marketed the Tennessee Ethanol Partners, L.P. Collectively the 20 CEP Funds raised $64 million from hundreds of investors.

The Order alleges a series of violations:

Expenses: Beginning in 2008, and continuing to the present, Respondents misallocated certain CEC expenses to the ECP Funds. Specifically, the ECP Funds, each of which is a separate entity, paid CEC a management fee and a portion of the dividends received by the Funds from portfolio companies and portions of the proceeds from sales of portfolio company stock.

The expenses were divided into three groups: 1) CEC only expenses; 2) ECP Fund only expenses; and 3) expenses split between CEC and the Funds. For the split expenses, typically 70% were allocated to the Funds, divided equally among them. Part of those expenses included Mr. Bittenham's $1.1 million in compensation from 2008 to 2011 and his bonus.

Neither the PPMs nor the LPAs for eight of the funds disclosed the payment of the split expenses. Likewise, CEC's Forms ADV filed in July 2011 and March 2012 did not disclose those expenses. In addition, the allocation of Mr. Brittenham's compensation to the funds constituted an undisclosed conflict of interest. Mr. Brittenham benefitted from these transactions since he received distributions from CEC's profits.

Conflicts/principal transactions: Beginning in September 2012, and continuing for the next four years, CEC issued loans to 17 of the Funds which had insufficient cash reserves to pay the expenses after closing. The LPAs for 14 of the Funds did not permit borrowing money to pay expenses. Promissory notes were issued for the loans and the assets of the funds pledged. Mr. Brittenham unilaterally, and without notice to the investors, amended the documents. The loans represented a conflict of interest. The pledges represented principal transactions between CED and the Funds which require written notice and consent that was not obtained.

Distributions: Beginning in 2011 CEC and Mr. Brittenham altered the manner in which CED calculated distributions. The new methodology was to the detriment of the Funds. The new methodology also adversely affected the dividends received by investors in Series A, B and C. The changes were not adequately disclosed.

Misstatements: During the offering for Series R in 2009, misrepresentations were made to an investor regarding the investment of Mr. Brittenham and the co-founder in the offering. Specifically, the investor was told that each invested $100,000. In reliance on that representation the investor put $250,000 into the fund.

Custodian: From August 2010 through September 2013 CEC kept the Funds' cash assets in a single master bank account that was comingled, failing to segregate the client assets. In addition, CEC did not have a qualified custodian for original stock certificates it held that were owned by the Funds.

Compliances: The compliance procedures for CEC incorrectly described the private offering exception of the custody rule. Specifically, the procedures failed to specify that audited financial statements needed to be prepared and distributed - and they were not.

Prior violations: The PPMs for three series of offerings for the Funds failed to disclose the co-founder's prior disciplinary settlement with the Commission. That 2012 settlement was based on violations of the antifraud provisions of the Securities Act, the Exchange Act and the Advisers Act and included a cease and desist order and a civil penalty.

The Respondents resolved the action and entered into a series of undertakings. Those included the retention of an independent consultant whose recommendations will be adopted. In addition, each Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order, to a censure and to pay disgorgement of $1,918,157.00 along with prejudgment interest. Respondents will also pay a penalty of $225,000. Portions of the disgorgement will be returned to certain Funds.

October 23, 2014
The Latest SEC Enforcement Stats
by Broc Romanek

Last week, the SEC released the stats for the activities of its Enforcement Division for the agency's 2014 fiscal year, noting a "record" number of enforcement actions in 2014 involving a "wide range of misconduct" and including a "number of first-ever cases." As Kevin LaCroix blogs, important lessons can be learned. Here's an excerpt from Kevin's blog:

During FY 2014, the SEC filed 755 enforcement actions, which represented a 10% increase over the 686 enforcement actions filed in FY 2013. In FY 2014, the agency also obtained orders totaling $4.16 billion, compared to $3.4 billion in 2013. By way of comparison to the statistics for FY 2013 and FY 2014, in FY 2012 the agency filed 734 enforcement actions and obtained orders totaling $3.1 billion in disgorgement and penalties.

The agency identified at least two significant factors driving the increase in enforcement actions. The first was the agency's use of "new investigative approaches and the innovative use of data and analytic tools" and the second was the agency's expansion into a number of new areas based on "first time cases."

With respect to the use of data and analysis, the press release quotes SEC Chair Mary Jo White as saying that "the innovative use of technology - enhanced use of data and quantitative analysis - was instrumental in detecting misconduct and contributed to the Enforcement Division's success in bringing quality actions."

The kinds of "first-ever cases" identified in the press release included "actions involving the market access rule, the 'pay-to-play' rule for investment advisers, an emergency action to halt a municipal bond offering, and an action for whistleblower retaliation."

The press release also quotes SEC Chair White as saying that "aggressive enforcement" will remain a "top priority" and quotes the head of the SEC Enforcement Division as saying that he expects "another year filled with high-impact enforcement actions." Going forward, the SEC Enforcement head said, the agency will "continue to bring its resources to bear across the entire spectrum of the financial industry." Ominously, for the clients of the readers of this blog, he noted that among other things the agency will focus on bringing "cases against gatekeepers."

SEC Commissioner Piwowar Doesn't Like "Broken Windows" Enforcement Policy

In this speech, SEC Commissioner Piwowar analyzes the agency's enforcement efforts - including noting that he's not in favor of the Commission's recent "broken windows" initiative including this quote: "If every rule is a priority, then no rule is a priority."

Meanwhile, this "Naked Capitalism" blog is entitled "Private Equity as the Latest Example of SEC Enforcement Cowardice?"

– Broc Romanek

October 23, 2014
Commercial Banks, the Securities Markets, and the Need for Glass Steagall: The OIG Report on the Supervision of JP Morgan
by J Robert Brown Jr.

The OIG at the Fed just issued a report on the Fed's oversight of JP Morgan Chase in connection with the London Whale incident in 2012. A summary of the report is here

The report made findings that the Fed's oversight was inadequate. Interestingly, the report noted that the FRB New York was aware of the risks posed by the trading in London but did not share the concerns with the OCC or conduct its own inspections of the London operations. As the report noted: 

  • We acknowledge that FRB New York's competing supervisory priorities and limited resources contributed to the Reserve Bank not conducting these examinations. We believe that these practical limitations should have increased FRB New York's urgency to initiate conversations with the OCC concerning the purpose and rationale for the planned or recommended examinations related to the CIO. Even if FRB New York had either initiated conversations with the OCC to discuss the planned or recommended examinations in accordance with SR Letter 08-9 or conducted the planned or recommended activities, we cannot predict whether completing any of those examinations would have resulted in an examination team detecting the specific control weaknesses that contributed to the CIO losses.

The report also found that the Fed and OCC staff "lacked a common understanding of the Federal Reserve's approach for examining Edge Act corporations" and that "FRB New York staff were not clear about the expected deliverables resulting from continuous monitoring activities." Finally, the report concluded that "FRB New York's JPMC supervisory teams appeared to exhibit key-person dependencies."   

So what were the recommendations? There were 10. Some of them went to better coordination among banking agencies. Mostly, though, the recommendations focused on improvements in the inspection process. These included: the issuance of "guidance detailing expectations for documenting and approving the deliverables of continuous monitoring activities, tracking identified issues, and performing follow-up activities," the mitigation of "key-person dependency," and the hiring of "additional supervisory personnel with market risk and modeling expertise."   

The Report will likely result in more intense inspections of commercial banks (the section on the response to recommendations indicated little patience by the FRB New York with the recommendations),  particularly with respect to activities in the securities markets. That in turn will likely result in banks becoming more risk averse. Risk aversion is good for commercial banking but bad for the securities markets.

Prior to the repeal of Glass Steagall, increased risk aversion among commercial banks would have had little impact on the securities markets. The securities markets were dominated by a class of investment banks that could not engage in commercial banking (and visa versa) and were therefore outside the scope of oversight of bank regulators. With the repeal of Glass Steagall, though, the commercial banks have ousted the independent investment banks, a dynamic that was eminently predictable. See The "Great Fall": The Consequences of Repealing the Glass-Steagall. With the demise of Lehman, the acquisition of Merrill and Bear Stearns by commercial banks, and the conversion of Morgan Stanley and Goldman, there are no more large investment banks that fall outside the oversight of bank regulators.

The securities markets are about risk taking. Limitations on risk taking in turn hurts the securities markets. Regulatory oversight of commercial banks seeks to reduce risk taking. This has the potential to impose long term harm on United States capital markets.   

October 22, 2014
Shareholder Scrutiny and Executive Compensation
by R. Christopher Small

Editor's Note: The following post comes to us from Mathias Kronlund of the Department of Finance at the University of Illinois at Urbana-Champaign and Shastri Sandy of the Department of Finance at the University of Missouri at Columbia.

As a result of the Dodd-Frank Act of 2010, public firms must periodically hold advisory shareholder votes on executive compensation ("say on pay"). One of the main goals of the say-on-pay mandate is to increase shareholder scrutiny of executive pay, and thus alleviate perceived governance problems when boards decide on executive compensation. In our paper, Does Shareholder Scrutiny Affect Executive Compensation? Evidence from Say-on-Pay Voting, which was recently made publicly available on SSRN, we examine how firms change the structure and level of executive compensation depending on whether the firm will face a say-on-pay vote or not.

The theoretical impact of having a say-on-pay vote on executive compensation is ambiguous. On the one hand, it is possible that having a vote results in more efficient compensation practices, for example, in the form of stronger alignment between pay and performance, or in the form of lower pay if past pay was excessive. Say-on-pay may also improve compensation practices simply because directors pay more attention to executive compensation when they know that the pay packages they award face increased scrutiny. On the other hand, it is also possible that say-on-pay results in less efficient compensation practices. For example, having a say-on-pay vote may lead firms to excessively conform to the guidelines of proxy advisors, who tend to prefer specific pay practices that may not sufficiently account for each firm's unique circumstances. Finally, it is possible that say-on-pay has no effect at all, either because governance problems are so severe that say-on-pay is an insufficient mechanism to improve firms' pay practices, or conversely, because firms already have optimal pay practices and therefore have no reason to change them in response to increased scrutiny.

To examine the effect of say-on-pay on executive compensation, our identification strategy exploits within-firm variation regarding when (i.e., in which years) firms hold say-on-pay votes based on a pre-determined cyclical schedule. Specifically, many firms have elected to hold votes in cycles of every two or three years rather than every year, resulting in predictable year-to-year variation in whether a vote is held or not. Our empirical strategy then compares executive compensation across years when, according to its voting cycle, a firm is expected to hold a vote, versus the same firm in years when it is expected to not hold a vote.

Our results show that in years when firms are expected to hold a say-on-pay vote, they decrease CEO salaries, and increase stock awards. We also find that firms are significantly less likely to have change-in-control payments ("golden parachutes") for their CEOs in years with a vote. These results are consistent with altering pay practices to better comply with proxy advisors' guidelines. Further, deferred compensation and pension balances are higher in years with a vote, which is consistent with say-on-pay resulting in increased use of less-scrutinized components of pay.

The net effect on total CEO pay from these changes in various pay components is positive. In other words, firms increase total CEO compensation when they face increased scrutiny, mainly as a result of the higher stock awards. Thus, to the extent that the goal of the say-on-pay mandate was to reduce total executive pay, this regulation has had the opposite effect. We generally find much weaker results among non-CEO executives compared with CEOs, which is consistent with CEO pay receiving the most scrutiny around say-on-pay votes.

We also find economically large, but statistically weaker, evidence that executives choose to exercise fewer options in years when they face say-on-pay votes. Executives thus appear to shift realized pay from voting years to non-voting years - which suggests that executives believe that observers of pay (e.g., shareholders, news media) do not distinguish between awarded pay and ex-post realized pay.

One goal of the say-on-pay regulation was to foster more transparent CEO compensation and better alignment of CEO incentives with the interests of shareholders. Overall, our results show that holding a say-on-pay vote does cause firms to change how they pay executives. But despite the law's intention of improving executive pay practices, the say-on-pay mandate has not unambiguously resulted in more efficient CEO compensation. And contrary to the goals of the say-on-pay regulation, the net result of these changes may be higher, not lower, total compensation. The fact that salaries are lower but stock awards higher is consistent with firms being particularly concerned about the optics of pay (Bebchuk and Fried (2004)) in years when compensation will be put to a vote, but is also consistent with models of optimal pay as in Dittmann and Maug (2007). Because CEOs receive more stock awards in voting years, which in turn will make their wealth more closely aligned with that of shareholders going forward, it is possible that pay in these years is more efficient, despite being higher. The fact that firms change pay practices between years with and without votes further is evidence that pay practices are not always perfectly optimal. If they were, whether a vote is held or not should be irrelevant for pay.

The full paper is available for download here.

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