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Abstract:
This study distinguishes between announcements that precipitate federal class action securities fraud litigation, such as earnings surprises and restatements, and the later announcement that an issuer has been named as a defendant in such a lawsuit. The study documents a statistically significant negative short-term price response to the litigation announcement as well as a negative response that persists for several weeks subsequent to the litigation announcement.

The response over shorter and longer horizons is more pronounced for smaller firms and for firms with less analyst coverage. Also, passage of the Private Securities Litigation Reform Act of 1995 reduced the cost of obtaining information about the initiation of these lawsuits and is correlated with a more rapid price response, particularly among smaller issuers and those with less analyst coverage.

Although these findings are hardly dispositive of the debate, they present a case study of a price pattern that is far more consistent with a costly-information explanation of stock market price formation than with any behavioral model of which we are aware. These findings also suggest that careful examination of market microstructure and information cost considerations can usefully explain patterns that might otherwise seem inconsistent with the efficient market hypothesis.

Securities class action litigation, stock market response, economic impact, Securities Law Reform, efficient market hypothesis

Abstract:
The evolution of information technology will determine the future structure of the world's financial markets. A nuanced appreciation of technology and its implications for financial markets is therefore essential to the design of a successful, modern securities regulation regime. Although the SEC currently ranks as among the most successful federal agencies in responding to changes in information technology, its ability to stay abreast of new developments is open to question. The agency appears to lack an adequate number of staff that are adept in more advanced implications of information technology. It also has no articulated technology strategy.

This paper expands on the need to develop a technology strategy and provides five distinct examples of initiatives that could emerge from a more affirmative approach to information technology. These examples suggest: (1) a software-based open architecture redesign of EDGAR; (2) a more aggressive role for the SEC in the definition of financial XML and its integration into the disclosure regime; (3) the use of an open API structure to resolve market fragmentation issues generated by the emergence of ECNs and other novel marketplaces; (4) the application of Internet technology to provide individualized trading risk measures that could be responsive to the agency's concerns regarding suitability; and (5) the application of on-line authentication techniques to reduce the risk of "counterfeit" disclosures, such as those which adversely affected Emulex's and Pairgain's stock prices.

Abstract:
In this article suggest that litigation can be analyzed as though it is a competitive research and development project. Developing this analogy, we present a two stage real option model of the litigation process that involves sequential information revelation and bargaining over the surplus generated by early settlement. Litigants are risk neutral and have no private information. The model generates results that, we believe, have analytic and normative significance for the economic analysis of litigation.

From an analytic perspective, we demonstrate that negative expected value (NEV) lawsuits are analogous to out of the money call options held by plaintiffs and that every NEV lawsuit is credible if the variance of the information revealed during the course of the litigation is sufficiently large. This finding helps explain the prevalence of a class of lawsuits that has proved puzzling to traditional, expected value-based modes of litigation analysis. The model also suggests that risk neutral defendants can act as though they are risk averse and that risk neutral plaintiffs can act as though they are risk seeking because increases in variance can increase a lawsuit's settlement option value just as it increases a call option's value without regard to the holder's degree of risk aversion. Models that presume defendants' relative risk aversion may therefore rely on an unnecessary assumption. Our model also suggests that a lawsuit's option settlement value is not a monotonically increasing function of the variance of the information revealed during the litigation. In particular, at low levels of variance a lawsuit's option settlement value may equal its traditional expected value, but as variance increases its option settlement value can display a discontinuity after which its option settlement value becomes a monotonically increasing function of variance. NEV lawsuits can also display dead zones - regions of variance over which the claim is not credible even though it is credible over higher or lower levels of variance. Comparative statics analysis also quantifies the extent to which a lawsuit's settlement value increases as plaintiff's litigation expenses occur later in the litigation process, as the ratio of defendant to plaintiff litigation expense increases, and as plaintiff bargaining power increases.

From a normative perspective, we offer an impossibility conjecture suggesting that the mere presence of an irreducible degree of uncertainty endemic to the litigation process can be sufficient to prevent private litigation incentives from equating to socially optimal incentives, even if one adopts all other assumptions necessary to equate private and social incentives. It follows that it may be impossible to articulate normative principles of law through substantive standards that ignore the uncertainty inherent in the litigation process and the procedural environment in which the litigation occurs.

litigation, real options, settlement, game-theoretic bargaining model

Abstract:
Plaintiffs in securities fraud class action lawsuits often allege that sales by insiders support a "strong inference" of fraudulent intent. This study examines insider transaction activity for a sample of 842 companies sued in lawsuits alleging a violation of Section 10 (b) of the Securities Exchange Act of 1934 to ascertain whether net insider selling during the litigation class period (the alleged period of misinformation) is unusual in amount and timing relative to net insider selling at other times and at other firms.

We find that class period net insider selling for the litigation sample significantly exceeds net insider selling before and after the class period and exceeds net insider selling around the same dates for a sample matched on industry. The more pronounced differences are for firms with a greater asymmetry of information between insiders and outsiders, namely, smaller firms and firms with lower analyst coverage. We also document a significant, positive association between net insider sales and short interest, particularly for smaller firms and for firms with lower analyst coverage and find that the level of insider transaction activity immediately prior to a corrective disclosure is not elevated to a statistically significant degree once we control for short interest and other information variables.

These results augment the financial literature by providing evidence of information-based selling by insiders around a disclosure event that leads to securities litigation. From a legal perspective, these results are consistent with the view that plaintiffs self select issuers whose patterns of class period insider selling diverge from historical or industry norms. The study is, however, unable to distinguish whether the elevated class period insider selling is the result of insiders' use of material nonpublic information or insiders' (and short traders') legal use of costly public information. The study nonetheless supports a statistically credible, non-fraud alternative explanation for observed elevated levels of insider selling. Accordingly, we suggest that courts should temper the adverse inferences that they might draw from an observed unusual level of insider selling when that level also reflects a heightened level of contemporaneous short interest activity, particularly if the issuer is a smaller company with a lower level of analyst coverage.

Abstract:
There is cause to believe that institutional investors have a comparative advantage in identifying suboptimal governance structures, but that incumbent boards have a comparative advantage in rectifying those shortcomings, provided that the incumbents concur that the shortcomings are material. It follows that a desirable governance mechanism would simultaneously allow shareholders to specialize in the area of their comparative advantage (i.e., the identification of governance problems) and boards to specialize in their area of comparative advantage (i.e., the crafting of solutions to identified problems), while forcing boards to take shareholder criticism seriously. The direct shareholder access proposals under consideration by the SEC lack the significant benefits that can result from such functional specialization.

The "advice and consent" procedure defined by Article II Section 2 of the United States Constitution provides a model of functional specialization within the structure of a representative democracy. This article adapts that "advice and consent" mechanism to the corporate context. Under the proposed mechanism, any director who is elected despite the fact that a majority of shareholders withhold authority for that director's election would suffer a variety of material disabilities imposed under SEC or SRO regulations. For example, the director might not be deemed independent for purposes of listing standards, and might be prohibited from voting on any matter required by SRO or SEC rules. Such directors could also be subject to rules that would call into question a corporation's ability to insure or indemnify them for violations of federal securities laws. Directors are unlikely to be enthusiastic about serving subject to such disabilities. Boards are also unlikely to be enthusiastic about the continued service of such directors. The proposed advice and consent mechanism can thereby create significant incentives for boards and shareholders to reach a compromise regarding acceptable board structures and candidates.

An advice and consent mechanism has several clear advantages over the Commission's proposed shareholder access initiatives. An advice and consent mechanism seeks to promote cooperation between shareholders and incumbent boards rather than to provoke confrontation. It greatly reduces the danger that shareholders will resort to the proxy mechanism as a device for promoting special interest agendas, and also greatly diminishes the dangers of factionalization that can arise from the election of dissident directors to a board. The proposal eliminates the need for the Commission to adopt complex and potentially arbitrary rules defining "trigger conditions" and "qualified shareholders." There is also far less risk that the mechanism could be pre-empted by conflicting state legislation.

Abstract:
Article II Section 2 of the United States Constitution requires that a majority of the Senate confirm Presidential nominees. It forces the President to negotiate with the Senate in order to obtain the necessary Senatorial approvals. A similar advice and consent mechanism can be replicated in corporate America. Shareholders can be cast in the role of the Senate. The incumbent board can be cast in the role of the Executive. The board can be required to obtain approval of a majority of the shareholder base before a director is allowed to serve. Indeed, there are at least eight substantial reasons to prefer such a system of advice and consent to the variety of proxy access proposals currently advocated by many shareholder rights organizations.

Significantly, at least 63 percent of the S&P 500 have already adopted bylaws or board guidelines that either implement or come reasonably close to implementing just such a regime. The SEC can, if it desires, and consistent with the D.C. Circuit's decision in Business Roundtable v. SEC, adopt regulations that impose additional disclosure requirements and filing liabilities on corporations that fail to implement effective advice and consent regimes. These regulations would provide an incentive for all publicly traded corporations to adopt irrevocable advice and consent mechanisms that conform to minimal SEC requirements. These regulations could also serve as an effective substitute for the two controversial proxy access proposals that the Commission now recognizes as ineffective solutions to the battle over proxy access.

Corporate governance, advice and consent, directors, boards, shareholders, shareholder rights, shareholder voting, shareholder franchise, corporate elections, corporate ballot, proxy fights, access to the ballot

Abstract:
Any person who knowingly provides substantial assistance, whether through participation in a scheme or by any other means, to another who violates the federal securities laws also violates the federal securities laws. The Securities and Exchange Commission can sue these "aiders and abettors" and force them to make payments for the benefit of shareholders harmed by the fraud. They can also be criminally prosecuted by the Department of Justice. But are they additionally liable in private civil actions filed under Section 10(b) of the Exchange Act?

The United States Supreme Court will, in Stoneridge, decide whether the implied private right of action under Section 10(b) supports claims of "scheme liability" against counterparties who properly account for transactions, make no public statements regarding those transactions, and do not transact in any securities affected by the fraud.

Established Supreme Court doctrine and clear statutory text preclude the imposition of such "scheme liability" in a private action. Whether the scope of the implied private right should be expanded to encompass "scheme liability" is a question properly put to Congress not to the Courts.

Stoneridge is therefore important for reasons that transcend the narrow question of "scheme liability." Petitioners can prevail only if the Supreme Court repudiates its own precedent, jettisons its well-established technique for interpreting Section 10(b), ignores clearly relevant statutory text, and disregards two Congressional decisions not to expand the private right under Section 10(b) to encompass "scheme liability." The court will, in other words, have to establish an entirely new jurisprudence of statutory construction.

This new jurisprudence will inevitably re-open a plethora of doctrinal issues regarding the interpretation of the federal securities laws that are today clearly resolved. Where this new and unanticipated jurisprudence would lead - other than to more litigation over the contours of the implied private right of action - is impossible to predict. Stoneridge is truly one of the "most important securities cases" to come before the court "in many years" because, if Petitioners prevail, far more than "scheme liability" is at stake for the future evolution of our nation's securities markets.

Abstract:
We briefly describe a proposed reform of the SEC's disclosure process that would replace the great majority of disclosure forms with an on-line questionnaire driven disclosure regime subject to mandatory updating according to a schedule defined by the Commission. This approach allows the Commission to elicit all the information currently generated by its forms-based filing system at, we believe, a dramatically lower cost to filers. It would also facilitate rapid, low-cost construction of databases that promote ready comparison of disclosures across registrants and over time. The system promises to eliminate the filing of duplicative information and can automatically focus attention on changes from prior disclosures. It thereby facilitates Commission review while simultaneously calling the market's attention to matters most likely to influence price formation. This new regime would also allow the Commission to achieve the significant potential benefits of a company-based disclosure system without seeking legislative authority, and without running the risk of changes to the liability structure provided under the current offerings-based disclosure regime.

Securities and Exchange Commission, securities disclosure, registration, periodic filing, periodic reports, EDGAR, XBRL, internet, on-line questionnaire

Abstract:
In Scheme Liability: A Reply to Grundfest, Professor Robert A. Prentice asserts that the United States Supreme Court was simply and abysmally wrong in Central Bank v. First Interstate Bank. He also claims that the majority of lower courts have been dead wrong in interpreting Central Bank. He further states that the Section 10(b) private right of action is express and not implied, that Congress in 1934 intended to create that private right of action, and that the Securities and Exchange Commission also intended to create a private right when it adopted Rule 10b-5 in 1942. From these premises, Professor Prentice urges that Section 10(b) and Rule 10b-5 be interpreted to sustain a private right of action for scheme liability.

Professor Prentice's analysis rests on revisionist history. The record is clear that the private right of action under Section 10(b) is implied: it is not and has never been express. Congress in 1934 did not intend to create a private right of action under Section 10(b), much less one that would encompass scheme liability. Nor did the Commission intend to create a private right of action in 1942 when it adopted Rule 10b-5. Professor Prentice's conclusions based on these false premises fail of their own weight.

Professor Prentice's analysis is also strategically selective. He ignores 1934-era common law rejecting scheme liability. He nowhere discusses the Court's admonitions that implied rights be narrowly construed. He also fails to appreciate the implications of his historically revisionist analysis. If Professor Prentice is correct that the Section 10(b) private right is express, and intended by Congress and the Commission, then the entire corpus of federal securities law must be rewritten. Central Bank is then far from the only decision in which the Supreme Court is simply and abysmally wrong.

aiding and abetting, scheme liability, implied private right, 10b-5, legislative intent

Abstract:
The Securities and Exchange Commission has proposed proxy rules mandating shareholder access under conditions that can be modified by a shareholder majority to make proxy access easier, but not more difficult. The Proposing Release, however, contradicts the Proposed Rules in two distinct respects that render the Proposed Rules arbitrary and capricious in violation of the Administrative Procedure Act.

The first contradiction relates to core principles of shareholder self determination. A fundamental premise of every proxy access proposal is that the majority of shareholders are sufficiently intelligent and responsible to nominate and elect directors. But the Proposed Rules prohibit the identical shareholder majority from establishing a proxy access regime, or from amending the Proposed Rules to establish more stringent access standards. The Commission offers no rationale as to why an identical majority of shareholders is so selectively intelligent and responsible that it can be relied upon to elect directors nominated pursuant to the Commission’s imposed access standards, but cannot be relied upon to set its own access standards.

The second contradiction relates to the Commission’s assertion that the Proposed Rules replicate the physical shareholder meeting as governed by state law. Nothing in state law sets a minimum proxy access standard, defines the contours of any access proposal to be considered by shareholders, or prohibits a majority of shareholders from amending an access standard to make it more stringent while allowing the same majority to relax the standard. The Proposed Rules thus fail to achieve the Commission’s stated objective, and instead erect barriers to shareholder action that exist nowhere in state law.

Both contradictions are potentially cured by a fully-enabling approach in which proxy rules are modified to allow shareholders to propose, and a majority of shareholders to adopt, access rules that are appropriately suited to the individual circumstances of individual corporations. Only this fully-enabling approach is consistent with core principles of shareholder self-determination, and with the operation of state law governing by-law amendments.

Proxy access, Securities and Exchange Commission, corporate governance, directors, boards, shareholder rights, shareholder voting,, corporate elections, administrative law, arbitrary and capricious

Abstract:
The Securities and Exchange Commission has proposed proxy rules mandating shareholder access under conditions that can be modified by a shareholder majority to make proxy access easier, but not more difficult. From a legal perspective, this Mandatory Minimum Access Regime is so riddled with internal contradictions that it is unlikely to withstand review under the arbitrary and capricious standard of the Administrative Procedures Act A fully-enabling opt-in proxy access rule is, in contrast, entirely consistent with the administrative record developed to date by the agency and is easily implemented without delay.

From a political perspective, and consistent with the agency capture literature, the Proposed Rules are easily explained as an effort to generate megaphone externalities and electoral leverage to benefit constituencies allied with currently dominant political forces, even against the will of the shareholder majority. Viewed from this perspective, the Proposed Rules have nothing to do with shareholder wealth maximization or optimal governance, and reflect a traditional contest for economic rent common to political brawls in Washington D.C.

From an economic perspective, if the Commission nonetheless determines to implement an opt-out approach to proxy access, it will then confront the difficult problem of defining the optimal proxy access default rule that should be subject to a symmetric opt-out by shareholder majority (not the asymmetric opt out imposed by the Mandatory Minimum Access Regime, for which there is no support in the academic literature). The administrative record currently contains no information that would allow the Commission objectively to assess the preferences of the shareholder majority regarding proxy access at any publicly traded corporation. To address this gap in the record, the Commission should, if it determines to follow an opt-out strategy, conduct a properly designed stratified random sample of the shareholder base, and rely on the results of that survey to set appropriate default proxy access rules. The Commission’s powers of introspection are insufficient to divine the value-maximizing will of the different shareholder majorities at each corporation subject to the agency’s authority.

Proxy access, Securities and Exchange Commission, corporate governance, directors, boards, shareholder rights, shareholder voting,, corporate elections, administrative law, arbitrary and capricious

Abstract:
We hypothesize that earnings management causes "quadrophobia," the under-representation of the number four in the first post-decimal digit of EPS data. We demonstrate that quadrophobia is pervasive, persistent, and follows economically rational patterns. Consistent with analyst coverage being a determinant of earnings management, quadrophobia increases (declines) when companies gain (lose) analyst coverage, and is more frequent when earnings are close to analyst forecasts. Persistent quadrophobes are more likely to restate financials and to be sued in SEC proceedings alleging accounting violations. Quadrophobia, even if itself legal, therefore appears to signal a propensity to engage in problematic accounting practices.

earnings management, earnings per share, forensic accounting, analyst coverage, earnings benchmarks, Sarbanes-Oxley Act, accounting restatements, SEC enforcement actions

Abstract:
Rating agencies have been broadly criticized for their failure to anticipate a range of credit market conditions. The dominant critique, voiced by the President of the United States, the Chairman of the SEC, leading members of Congress, and foreign regulators, is that the leading rating agencies are subject to inherent conflicts of interest arising from the “issuer-pays” model that drives their business: Because these rating agencies are paid by the issuers of the securities they rate, the agencies have embedded incentives to please the sources of their essential cash flow and therefore are neither as objective nor as critical as they might be if driven by an alternative business model. Proposals for reform currently under consideration by Congress and the SEC, however, do nothing to alter these basic incentives. They fiddle at the edges of the marketplace and leave untouched the fundamental incentive conflict about which policymakers appear to agree. This article suggests an alternative regulatory strategy. Under existing statutory authority, the SEC could create a new category of rating agencies - - Investor Owned and Controlled Rating Agencies (“IOCRAs”) - - and require that every rating issued by an issuer-paid Nationally Recognized Statistical Rating Organization (“NRSRO”) that is not an IOCRA, such as Moody’s and Standard & Poor’s, be accompanied by at least one rating issued by an IOCRA. Because IOCRAs would be under the control of the sophisticated investor community, and because any one investor’s ownership interest in an IOCRA would be capped, the incentives of IOCRAs should be oriented to generating ratings that accurately reflect the risks of holding specific debt instruments, even though their fees would be also paid by issuers. This regulatory strategy introduces immediate competition into a market that is a strong duopoly and incentivizes innovation that has been lacking. Most significantly, however, IOCRAs would constitute rating agencies with an inherently investor-oriented perspective, and if IOCRAs were to fail in anticipating credit market issues, the investor community would, at the end of the day, have only itself to blame.

credit rating agencies, financial regulation, U.S. Securities and Exchange Commission, disclosure, government regulation, risk analysis, capital markets

Abstract:
This study examines investor response to three events that help define a federal class action securities lawsuit, specifically, the announcement that names an issuer as a defendant in the lawsuit (at the class action filing date), the disclosure or accounting restatement that 'corrects' the information deficiency (at the end of the class period), and the date at which the fraud on the market allegedly begins (at the beginning of the class period). We document a significant and predictable stock price response at each of these three events. Our tests also indicate that the market interprets these events not in isolation but as sequential and conditional events. Investor response differs on the basis of the characteristics of the issuer, the allegations in the complaint, and the outcome of the litigation. These results and the fact that we observe no systematic price momentum in investor response beyond the announcement dates imply that the market is reasonably efficient with respect to information about securities fraud litigation. Our results are robust to alternative definitions and procedures, and are based on a proprietary database that includes almost all federal securities class action lawsuits since 1990.

Abstract:
This paper presents a preliminary analysis of the effects of the Private Securities Litigation Reform Act of 1995 on class action securities fraud litigation behavior. The Reform Act appears to have had little effect on the aggregate number of companies sued, but has induced a substitution effect into state court where plaintiff's argue that many of the Act's provisions do not apply. Complaints now allege accounting irregularities and trading by insiders with greater frequency than before, while pure false forecasting cases are now relatively rare. The average stock price decline preceding litigation is now 31%, whereas prior to the Reform Act it was 19%. The Act's "strong inference" pleading requirement is the most likely cause of these shifts. High technology firms continue to be the most frequent targets of litigation, and the appearance ratio of the largest plaintiffs' firm, Milberg Weiss, has increased significantly nationwide and particularly in California. These findings are all consistent with a model that views class action securities fraud litigation as an economic process involving rational profit maximizing agents. The data are, however, too preliminary to support strong conclusions regarding the "success" or "failure" of Reform Act innovations.

Abstract:
This paper suggests that litigation can be profitably modeled as a compound real option with two potential "payoff vectors": a payoff that reflects potential recovery on the merits of a claim and a payoff that reflects defendants' willingness to avoid future litigation costs. Plaintiffs engage in staged investments that can be abandoned at any point, but that require them to incur litigation costs at each stage of the process. Plaintiffs' litigation expenditures impose litigation costs on defendants and simultaneously generate new information about the magnitude of potential verdicts and the magnitude of potential plaintiff and defendant litigation costs. Settlements then reflect the likely outcome on the "merits" (i.e., the verdict), as well as defendants' avoided litigation costs and plaintiffs' prosecution costs. This paper demonstrates that a recent model by Bebchuk is a special case of a compound real option model in which probability distributions are degenerate. The universe of negative expected value lawsuits that can be credibly brought by plaintiffs may be materially larger than Bebchuk suggests, and the size of likely settlements greater. The paper also demonstrates that litigation can be classified into one of three broad categories reflecting the extent to which lawsuits are "meritorious," "vexatious," and/or "exploratory." This taxonomy contributes precision to the current litigation reform debate. It also supports distinctions that differ from traditional characterizations of litigation as "frivolous" or as involving "fishing expeditions." The paper further derives a set of comparative statics results illustrating, among other things, the effect of changed volatility in plaintiffs' and defendants' litigation expenditures. The analysis also suggests a family of cost-shifting rules that are different from the British or American Rules. Under one implementation of the proposed "Stanford Rules," plaintiffs would be taxed for an amount that is a function of the excess, if any, of defendants' reasonable litigation costs over plaintiffs' litigation costs. This payment could be made contingent on the outcome of the lawsuit and could also be made payable to the registry of the court. We demonstrate that this rule has characteristics that may make it preferable to either the British or American Rules.