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Abstract:
This paper argues that, contrary to conventional wisdom, conflicts of interest among equities research analysts (i.e., where investment banks would offer positive analyst research in quid pro quos for underwriting business) were beneficial to the capital markets. First, conflicted analyst research credibly signaled positive inside information that is otherwise too costly to communicate under Securities Act liability, correcting informational asymmetries. Second, conflicted analyst research mitigated agency costs between issuer and underwriter by allowing the underwriter to credibly commit to exerting more effort than the underwriter would prefer. Third, analyst research quid pro quos took the form of a competitive bidding market among underwriters, and may have improved competition in the underwriting industry. In light of these conclusions, recent reforms prohibiting analyst conflicts of interest are counterproductive. Preferable modes of regulation include liberalizing Securities Act liability, increasing mandatory disclosure of conflicts, and increasing fraud penalties.

investing, equities, research analysts, capital markets, public offerings, Sarbanes Oxley, underwriting

Abstract:
This paper argues that, contrary to conventional wisdom, conflicts of interest among equities research analysts (i.e., where investment banks would offer positive analyst research in quid pro quos for underwriting business) were beneficial to the capital markets. First, conflicted analyst research credibly signaled positive inside information that is otherwise too costly to communicate under 1933 Act liability, correcting adverse-selection problems. Second, conflicted analyst research mitigated agency costs between issuer and underwriter by allowing the underwriter to credibly commit to seek a higher offering price than the underwriter would prefer. Third, analyst research quid pro quos took the form of a competitive bidding market among underwriters, and may have improved competition in the underwriting industry. In light of these conclusions, recent reforms prohibiting analyst conflicts of interest do more harm than good. Preferable modes of regulation include liberalizing 1933 Act liability, increasing mandatory disclosure of conflicts, and increasing fraud penalties.

investing, equities, research analysts, capital markets

Abstract:
We argue that firms undertake to reduce employee savings in order to avoid final period problems that occur when employees accumulate enough wealth to retire and leave the industry. Normally, reputation constrains employee behavior, since an employee who cheats at one firm will then find herself unable to get a job at another. However, employees who have saved such that they no longer care about continued employment will act opportunistically in the final periods of employment, which can destroy much or all of the surplus otherwise created by the employment relationship. We believe that this sort of final period cheating creates significant problems for employees in positions of delicate trust, particularly those with a large variable compensation component, such as corporate CEOs, securities professionals, and even corporate lawyers.

Payment in-kind (perks), deferred compensation (corporate loans), and the encouragement of employees' conspicuous consumption - either through screening, inculcation, or signaling - are strategies that firms enact to combat this final period problem of employee cheating. Employees who reduce savings are more reliable over the long term than employees who do not, since reduced savings makes employees more dependent upon remaining employed into the future; these employees will invest in their reputations by engaging in less cheating. We make an analogy to drug dependency: the employee who consumes all her resources immediately enjoys large present utility, as does the addict, but is ultimately dependent on the firm to provide her with the same opportunities in the future. Applying the theoretical framework we develop to the real world can help explain much of observable behavior and compensation practice.

Thus, far from being prima facie evidence of corporate fraud - the picture painted by the media, academia, and prosecutors at recent corporate trials - high levels of in-kind compensation, corporate loans, and personal consumption may be evidence of optimal incentivization, where principal and agent have contracted (explicitly or implicitly) for just the amount and type of remuneration that maximizes their joint welfare.

perks, motivation, employe incentives

Abstract:
I formulate a rational expectations signaling model of vicarious liability for securities fraud, particularly the much-criticized "fraud on the market" private class action arising under Rule 10b-5. I show that fraudulent misreporting by managers occurs in the absence of managerial moral hazard - i.e., where managers simply maximize shareholder payoffs - and that vicarious liability can serve as an appropriate deterrent, creating separating equilibrium. I then show that the particular remedy under Rule 10b-5 can perfectly deter fraud and perfectly compensate purchasers, and that, therefore, many of the current criticisms of Rule 10b-5 class actions are ill-founded.

Abstract:
The Supreme Court's recent Dura Pharmaceuticals decision requires a plaintiff to show a market decline (ex post losses), as opposed to price inflation at the time of purchase (ex ante losses), in order to maintain an action for securities fraud. Since fraud is actionable only where a market decline attributable to the fraud occurs under the ex post loss rule, firms that can bundle together disclosures or business projects are under-deterred by the antifraud regime: the success of one project may compensate for the failure of another, the firm can time the release of good and bad news to mask fraud's effect on price, and other factors that would have caused a loss of investment value even without the fraud can disallow a claim for damages. Strategically, firms may bundle to minimize exposure to liability. On the other hand, firms that value transparency may wish to unbundle. In this sense, the credibility of disclosure under an ex post loss rule depends on the extent to which firms can and do unbundle, whereas an ex ante regime is theoretically perfect in any case. This analysis also reveals two additional problems with an ex post rule: market tests for ex post damages awards (a chief purported benefit) are generally not available for bundled firms, and awarding ex post damages may over-punish small frauds but reward big ones.

Abstract:
This paper explores how legal liability in the IPO context can impact an entrepreneur's decision of whether and how to take a firm public. Liability under the Securities Act of 1933 effectively embeds a put option in an IPO security, where the entrepreneur must insure the shareholder against poor firm performance, which inflates the price of the security and exposes the entrepreneur to risk. This may cause IPO firms to appear to underperform relative to non-IPO firms as the option value decays, and may lead the entrepreneur to undertake strategic (but destructive) responses to minimize the put value and his exposure to risk. Because of the value-destroying characteristics of these responses - which include initial underpricing, entrenchment, lower NPV projects, asset partitioning, and reduced disclosure - this state of affairs is inefficient compared to a system where the entrepreneur can simply allocate the risk to shareholders. While the Securities Act's risk-allocation regime may provide some benefits in the form of more accurate disclosure, the availability of substitute responses by the entrepreneur makes any such benefit uncertain.

Abstract:
The literature on private equity ignores the impact of the securities laws. This is an oversight: key facets of private-equity structure (in particular, the limited control, liquidity, and information rights that are typical of limited partner investors) can be explained as an attempt to escape the reach of securities antifraud rules. The benefit of circumventing these rules is that doing so prevents the unwinding of optimal risk allocation between general and limited partners that would otherwise occur. This does, however, come at a significant cost, which is the exacerbation of agency costs between limited partner investors and the general partner manager; this necessitates the massive performance-based compensation that general partners receive, which is inefficient from a first-best perspective. Hence, reforming the securities laws would benefit not just public companies, but also private equity.

Abstract:
Using a unique data set, I find that U.S. IPO prospectus disclosure dramatically affects the degree of first day underpricing of the new issue, consistent with theories of underpricing as caused by informational asymmetry. In particular, a 1 standard deviation increase in positive prospectus disclosure is associated with almost a third reduction in first day underpricing. More disclosure also has a significant positive relation with measures of informational completeness. Further, I show that the amount of disclosure may derive from litigation risk. Controlling for measures of litigation risk, more disclosure exhibits a significant and positive relation with IPO litigation, while absent controls the relation is negative – suggesting that the amount of disclosure responds to ex ante perceived risk of litigation.

Abstract:
In the aftermath of the accounting scandals and stock collapses of Enron, WorldCom, et al., much was made of "conflicted" securities analysts - so much, in fact, that the Sarbanes-Oxley Act prohibits a conflicted analyst from issuing reports on securities that the analyst's firm is underwriting. But the analyst research report, and the promise to issue the report prior to the time of the offering, allowed the underwriter and issuer a means to communicate an underlying degree of confidence to the marketplace. The underwriter was putting its money on the line by committing ahead of time, on the basis of what it knew before the offering, to a positive recommendation. The threat of fraud liability under the Exchange Act, and damage to the underwriter's reputation, provided a check upon untruthful disclosures in those communications. Disclosure of the nature of the conflicts of interest - which were required by National Association of Securities Dealers rules well before the recent analyst scandals - provided the market with the information it needed to evaluate and discount the analyst reports accordingly.

Accounting, accounting scandal, stocks, stock collapse, Enron, WorldCom, security analyst, Sarbanes-Oxley, underwriter, fraud, Exchange Act

Abstract:
I model a firm where shareholders choose the manager's compensation in light of the manager's dual roles of exerting effort and making disclosures regarding the firm's value. Because of limited contracting ability and the divergence of short-term interest between shareholder and manager, shareholders may be unable to obtain their first-best choices of effort and disclosure policy; where agency costs are too large, shareholders will be unwilling to award performance-based compensation, which induces both effort and fraudulent reporting. The principal findings are (1) fraud and effort are positively correlated, and given a poor outcome fraud is more likely to obtain when effort is exerted in equilibrium, (2) the incidence of fraud-inducing compensation increases as agency costs decrease, and (3) reductions in agency costs actually increase the incidence of fraud when agency costs are high.

Abstract:
The Securities Act of 1933 was once considered a great benefit for investors because of the strict liability it places on firms to truthfully disclose information to investors. But the strict liability provisions are now dissuading firms from communicating useful information for fear that it may inadvertently contain errors or inaccuracies. The resulting silence is no benefit to investors. Strict liability simply makes no sense in today's sophisticated and deep capital markets.

securities act, mandatory disclosure rules, hidden costs, SEC, securities and exchange commission, liability, equity-based compensation, performance-based compensation, shareholders, public firms, investors, capital markets, james spindler