Securities Mosaic® Blogwatch
October 17, 2016
Challenging the Myth of Financial Intermediation
by Robert C. Hockett and Saule Omarova

Many contemporary discussions of finance or of subjects that implicate finance – for example, federal budgetary or finance-regulatory policy – seem to be systematically colored by a seldom-examined presumption. We call this presumption the "intermediated scarce private capital myth."

Like many a myth, this one assumes or amounts to a picture. In the picture, financial institutions intermediate between private suppliers of scarce finance capital on the one hand, and various public and private end-users of this capital on the other. Unstated but always assumed in this picture is also a causal direction: the funds that intermediaries intermediate originate with the (again, always private) suppliers thereof, flow to (distinct public and private) end users, and are merely managed, in the course of those flows, by the intermediaries.

As managers of funds, financial intermediaries simply help optimize the volumes, directions, and productivity of privately originating financial flows in the intermediated scarce private capital picture. This they do by performing such familiar financial functions as what the orthodox view highlights as maturity-transformation (converting short-term loans from private investors into longer-term investments in distinct public and private end-users of funds), risk-allocation (among private investors with varying risk-bearing capacities), risk-monitoring (on behalf of the private investors), and the like.

Perhaps unsurprisingly, the canonical taxonomy of "intermediary" functions assumes the same causal direction of financial flows as the word "intermediation" itself tends to connote. For characterizing maturity-transformation, risk-allocation, and risk-monitoring as the principal functions of financial institutions makes sense only if one views private suppliers of scarce finance capital as the primal initiators of financial flows. If some financial flows commence with bank lending in the form of bank-opened or bank-credited borrower deposit accounts, for example, then banks generate the maturity structures of both sides of their balance sheets, rather than "transforming" those of an antecedently given set of liabilities into those of a subsequently assembled set of assets. So a particular view of where finance "comes from" and a corresponding view of what "intermediation" consists in fully mesh together in the intermediated scarce private capital myth.

Now of course, to label a particular way of thinking or picturing things as "mythic" is not in itself to label it "false." Some myths are true, at least in part, and others project noble ideals that persons, societies, or cultures are more or less dedicated to making true through their actions over time. There is, however, very little truth, and even less to recommend as an action-guiding ideal, in the intermediated scarce private capital picture. Indeed, this view of finance is both pernicious and profoundly misleading, whether it be deployed as an ideal or as a picture purporting to capture the structure and operation of our financial system.

In a new article available here, we show how the intermediated scarce private capital orthodoxy falsely depicts modern financial systems, explain why its falsity works mischief, and offer a new model of modern finance that more fully and accurately captures its characteristic dynamics. We call our alternative the "franchise model" of finance.

Our franchise model places center-stage that actor which stands at the core of all modern financial systems, yet somehow drops out of view in the intermediated scarce private capital picture. That is the sovereign public, whose monetized full faith and credit constitutes the principal resource that circulates throughout the financial system. We show in detail how modern financial systems in effect constitute public-private partnerships. In each such partnership, the sovereign public licenses private franchisee institutions to distribute its monetized full faith and credit throughout the broader economy so as to fuel inclusive and sustainable growth.

We begin our analysis by first mapping three possible pictures of financial flows – what we call the "one-to-one" credit-intermediation, the "one-to-many" credit-multiplication, and the "none-to-many" credit-generation models of finance. The intermediated scarce private capital myth, we show, simply assumes the first model. Yet if this model were an accurate depiction of modern finance, then all financial intermediaries would be mutual funds. And yet even die-hard proponents of the intermediated scarce private capital orthodoxy admit that banks, for example, are not mutual funds. So proponents of contemporary orthodoxy actually are committed, apparently without quite realizing it, to orthodoxy’s falsehood. Such is the power of unexamined myth.

After laying out the three possible models of finance and highlighting banking’s incompatibility with the first, we turn to showing that contemporary financial systems in their entireties, not just their banking sectors, conform to the none-to-many credit-generation model. What makes this possible, in turn, we show to be the role played by all modern jurisdictions’ central banks and central governments in what we call "accommodating" and "monetizing" credit-extension decisions made by privately operated financial institutions.

To substantiate our claims, we first carefully map the mechanics of commercial bank lending transactions – transactions which, ironically, orthodoxy takes to be paradigmatic of financial intermediation. The mechanics of bank lending, we show, are not dependent upon antecedent depositing activity on the part of private suppliers of putatively scarce finance capital. (Deposits do not make loans so much as loans make deposits.) Rather, what determines bank lending activity is the combination of (a) banks’ assessments of the likely profitability of lending under prevailing economic conditions, (b) central bank recognition of payments made out of bank-opened or bank-credited demand deposit accounts, and thus (c) bank deposits’ – including deposits opened or credited in the name of borrowers by lending banks – counting as spendable money within the national payments system.

Factor (a) is primarily a function of regulation and broader economic conditions, as the abundance even of "liar loans" in the poorly regulated, capital-glutted mortgage markets during the housing bubble years demonstrated. Factors (b) and (c) are what we have just called public accommodation and monetization of bank-created private liabilities.

From the banking sector, we proceed to the capital markets and "shadow banking" systems that functionally link capital markets to ordinary banks. Here too we show the critical role played by endogenous credit-generation, performed against the backdrop of central bank accommodation and monetization, in driving and indeed constituting financial flows in the capital markets and shadow banking system. We trace the operation of these fundamentally bank-reminiscent dynamics in the non-bank financial markets both functionally and institutionally. That is, we map the structures both of the principal kinds of shadow bank loan transactions and of the institutional affiliations that have enabled such transactions – and have themselves been enabled by legal and regulatory changes over the past decade and a half.

After demonstrating the conformity of the financial system as we presently find it to our franchise view of finance, we look to new developments now shaping the future of finance. We examine the disruptive growth of the brave new world of fintech, covering both marketplace lending platforms and cryptocurrency ecosystems (including but not limiting ourselves to Bitcoin). Perhaps not surprisingly, here as with shadow banking we find a pattern whereby what starts seemingly outside of (and even in self-professed opposition to) the franchise arrangement quickly finds itself commandeered by established institutions – and thereby brought into the franchise arrangement. Access to the sovereign public’s full faith and credit, in other words, turns out to be just as critical in the young and exciting world of fintech as it is in the "boring" old world of traditional banking.

From the frontiers of fintech and its emerging place in the franchise arrangement, we turn to the normative implications of that "paradigm shift" which our new model of finance represents. Developing a new picture of the architecture and dynamics of modern finance as a public-private franchise for the generation and distribution of publicly-accommodated and -monetized credit turns out to yield potentially transformative implications. Among other things, our more realistic depiction of modern finance allows for a fresh, more systemic approach to diagnosing and remedying that dysfunction which has come to be called the "financialization" of the real economy.

In our account, financialization results from and reflects a systemic breakdown in the operation of the franchise arrangement. In effect, it stems from an acute case of franchisor absent-mindedness and consequent absenteeism, whereby the public franchisor effectively abdicates its key functions of modulating and overseeing the allocation of credit flows generated by its private franchisees. Insufficiently mindful of our constitutive role at the center of our financial system, we the sovereign public have come mistakenly to believe that rentiers and franchisee-institutions are the sole originators and drivers of finance, who will withhold "loanable funds" and thereby starve our economy of capital in the event that the policies we adopt fail to meet with their approval. Twenty years of capital glut and associated serial asset price bubbles and busts should have sufficed to undercut that fear; our franchise model of finance shows precisely why it’s unsound.

Of course, if the problem of financialization is rooted in such misconceptions, then the solution begins with correcting our understanding of the proper roles of the public and private in our financial system. Recognizing the true nature of that system and the central role played by the sovereign public therein is the crucial first step to full recognition that the sovereign whose resource the financial system distributes must take a more active role in the related tasks of both modulating and allocating that resource.

This means more, in our account, than the adoption of long-overdue macroprudential finance-regulatory policy. It also means identifying the many recursive collective action problems and other market failures that plague the process of capital allocation when it is left solely to private parties acting in their individual capacities. And it means counteracting those dysfunctions through concerted collective action – including action along the lines we have proposed in associated work.

Like any fundamental change of Gestalt, the franchise view of finance and its far-reaching implications will take some getting used to. Virtually by definition in a world still dominated by a contrary myth, our "countermyth" will at first ring counterintuitive. We are confident, however, that once open-minded readers have worked through our painstaking mapping and tracing exercise, they will see for themselves the descriptive power of the finance franchise view, as well as it’s prescriptively liberating potential.

This post comes to us from professors Robert Hockett and Saule Omarova of Cornell Law School. It is based on their recent article, "The Finance Franchise," available here.

October 17, 2016
Shearman & Sterling discusses Brexit: a Financial Free Zone Within the City
by Barnabas W.B. Reynolds, Thomas Donegan and James Comyn

The UK Government recently indicated that it intends to negotiate a unique EU-UK relationship post-Brexit. It is hoped that the arrangements will be appropriate for the UK and London’s position as a leading international financial centre. A number of existing models have been discussed and will no doubt be analysed, with variations, by the Government. This client note sets out a framework for new opportunities which could be developed in the UK post-Brexit, by establishing a "financial free zone" in London. This would enable the UK to take a bifurcated approach to financial services post-Brexit. The UK as a whole could take an equivalence-based approach or other route to financial services regulation enabling single market access such that financial institutions could continue to provide services cross-border into the EU in a similar way to the present. Separately, the financial free zone could adopt a far more free-market approach to regulation within the zone, subject to tight controls on systemic risk. This would provide optionality to market participants as to whether they wish to do business cross-border at all. We discuss the characteristics and purpose of financial free zones and a proposed framework for the establishment of a London zone.

A Financial Free Zone

Free zones have a number of characteristics in common, namely they are limited to a geographic region, have a single administration, offer benefits to participants, such as tax or investment incentives, and have separate streamlined procedures. Free zones have traditionally had a policy and infrastructure role in developing countries, as they can be used as a tool for economic growth and to attract foreign direct investment. Free zones have been in place in Gibraltar and Singapore from 1704 and 1819, respectively, with the first modern industrial free zone being established in Shannon, Ireland in 1959.

Whilst free zones have traditionally been set up to encourage trade exports and foreign direct investment, a more contemporary approach is the creation of a multi-sectoral zone. For example, the Chinese government is creating a special economic zone at Qianhai bay, Shenzhen, which specializes in financial services, logistics, technology and startups. Within the zone, firms will be given help to raise Yuan offshore, and banks established in Hong Kong will be able to enter the zone more easily than under the current set-up. These measures are designed to reduce the severity of China’s capital controls[1] and encourage financial cooperation with Hong Kong. Financial free zones are a similar concept. The zone is located in an area demarcated for financial activity to be conducted and is set up with its own legal and regulatory system. The United Arab Emirates ("UAE") has several free zones, used for sectors as diverse as duty-free, shipping and financial services. Most recently, it established the Abu Dhabi Global Market ("ADGM"), a broad-based international financial centre for local, regional and international institutions, with the aim of it being a catalyst for the growth of a dynamic financial services sector in the UAE.[2] The Dubai International Finance Centre ("DIFC") was established in 2004 to encourage businesses and financial institutions to tap into the emerging markets of the Middle East, Africa and South Asia and has also proven to be highly successful.

A London International Financial Centre

A London International Financial Centre ("LIFC") could see the creation of a new, small territorial area within London demarcated for London-based financial institutions wishing to operate on an even more free-market based model than the rest of the market. The LIFC would have its own laws and regulations, based on the common law and UK statutes, but tailored for a high-growth, highly dynamic market subject to the main constraint that the laws must nevertheless (as with all modern financial services laws) minimize systemic risk and ensure clean markets. The LIFC could also create streamlined work visa processes, to ensure continuing ready access to a worldwide talent pool.

This LIFC would not seek equivalence, as a matter of course, with the EU except on topics it wished to or even, potentially, substituted compliance recognition with the US. It would have a stand-alone regime where institutions could operate in a highly deregulated environment but in the EU time zone.

Own Territory

The LIFC would need its own territory. Historically, the City of London housed the main financial businesses in the UK but the financial sector has spread as it has grown and a lot of the business is also located in Canary Wharf. A clearly demarcated area would be needed to bring certainty as to where certain activities could be undertaken within the free zone framework. We do not propose that London, the City or Canary Wharf be designated. Rather, such a proposal would work best in a significant area of new-build or regeneration-build real estate, such that those using the free zone freely choose to participate in it.

Separate Regulatory Framework

It is likely that separate regulators will be needed for the LIFC from the rest of the UK. For example, the Financial Services Regulatory Authority ("FSRA") is the independent regulator for financial services in ADGM and the Dubai Financial Services Authority ("DFSA") is the independent regulator for financial services in the DIFC, with the Central Bank of the UAE, the Securities & Commodities Authority and the Insurance Authority regulating financial services in the rest of the UAE. In establishing the LIFC, the current regulatory architecture could be maintained so that the Bank of England, the Financial Conduct Authority ("FCA") and the Prudential Regulation Authority ("PRA") would continue to regulate financial services in the UK more generally. The Bank of England would continue to be responsible for macro-prudential regulation of the UK economy as a whole. Due to the EU compliant infrastructure and rules that are already administered by the Bank, the FCA and PRA, as well as the existence of good working relationships with the EU authorities such as the European Central Bank and the European Supervisory Authorities ("ESAs"),[3] these relationships should be continued separately from the LIFC.

Independent Judicial System

Characteristically, financial free zones have independent judicial systems. Both ADGM and the DIFC, for example, have an independent judicial system and the special economic zone in Qianhai will also have its own separate legal system with a Shenzhen Court of International Arbitration and a Qianhai Tribunal.[4] The LIFC could establish either a separate judicial system or a designated court within the current judicial framework, to deal specifically with financial services issues arising within the LIFC regime.

Free Movement of People

An additional possible benefit of establishing an LIFC could be the introduction of preferential immigration laws, enabling foreign nationals to work in professional services within the LIFC and reside there. For example, the special economic zone being established in Qianhai has implemented a regime under which foreign nationals working within designated professional services can apply for permanent residence to live and work in the zone. A separate immigration regime for an LIFC could enable the UK to continue to benefit most easily from the international talent pool whilst implementing more stringent immigration controls for the rest of the UK.[5]

The Likely UK-EU Relationship: EU Equivalence Regimes

The introduction of the LIFC could allow the UK to develop within the LIFC financial services laws that differ more radically from those of the EU, giving London-based financial institutions a choice as to which regime best suits their business, whilst retaining the advantages of being based in London.

As set out in our previous client note,[6] the likely outcome for the UK as a whole is an equivalence-based relationship with the EU for financial services where financial market participants established in the UK can do business that is cross-border in law with counterparties and customers in the EU under UK laws that are equivalent to those in the relevant sector in the EU – and vice versa. A summary of the equivalence regimes is set out in our previous note. There are some holes in those regimes, many of which (if not all of them) we believe are likely to be plugged.


Whilst the future relationship between the UK and the EU remains to be negotiated, an LIFC is an exciting prospect for the UK’s future financial sector. It could serve to boost further the UK’s unparalleled position as a major financial centre and offer new opportunities to the UK, the EU economies and other markets around the world.


[1] China Offshore, "Qianhai Bay Special Economic Zone to act as bridge between Hong Kong and the mainland," available here.

[2] You may like to see our client note, "Abu Dhabi Global Market: Financial Services Regulations and Rules," available here.

[3] The ESAs comprise the European Securities and Markets Authority, the European Banking Authority and the European Insurance and Occupational Pensions Authority.

[4] Qianhai Website, "Legal Environment," available here.

[5] You may like to see our client note, "Brexit: Free Movement of Persons," available here.

[6] "Brexit and Equivalence: Review of the Financial Services Framework Across All Sectors," available here.

This post comes to us from Shearman & Sterling LLP. It is based on the firm’s memorandum, "Brexit: a Financial Free Zone Within the City," dated September 19, 2016, and available here.

October 17, 2016
Corporate Governance Indices and Construct Validity
by Antonio Gledson de Carvalho, Bernard Black, Burcin Yurtoglu, Vikramaditya Khanna, Woochan Kim
Editor's Note: Bernard Black is Nicholas D. Chabraja Professor at Northwestern University Pritzker Law School and Kellogg School of Management; and B. Burcin Yurtoglu is Professor and Chair of Corporate Finance at WHU—Otto Beisheim School of Management. This post is based on a recent paper by Professor Black; Professor Yurtoglu; Antonio Gledson de Carvalho, Assistant Professor at Fundação Getúlio Vargas School of Business at Sao Paulo; Vikramaditya Khanna, the William W. Cook Professor of Law at the University of Michigan Law School; and Woochan Kim is Associate Professor of Finance at Korea University Business School (KUBS). Related research from the Program on Corporate Governance includes Related research from the Program on Corporate Governance includes What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen and Allen Ferrell (discussed on the Forum here)

A common strategy in corporate governance research is to build a corporate governance index and then see whether the index predicts firm value or performance. These indices are imperfect, but their use is widespread because researchers lack good alternatives. A major concern with governance indices is what they actually measure. The concept of governance is abstract and latent rather than concrete and observable, and we are not sure how to proxy for this vague concept using observable measures. This raises concerns about the degree to which the proxy (a governance index) measures what it claims to be measuring. The fit between the observable proxy or “construct” (the governance index) and the underlying concept (governance) is known as construct validity. This core issue is rarely addressed in corporate governance research. Larcker, Richardson and Tuna (2007) and Dey (2008) are exceptions.

In our paper we discuss what can usefully be said about which of the many possible governance indices are sensible constructs. We conduct an exploratory analysis of how to tackle this question, using tools drawn from the causal inference, education and psychology literatures.

The often-used Gompers, Ishii and Metrick (2003) “G” index illustrates the central role that governance indices play in corporate governance research and how central unaddressed issues of construct validity are to index construction. They create a governance index with 24 equally weighted elements that measure takeover defenses and provide evidence that this construct predicts firm value and performance. Bebchuk, Cohen, and Ferrell (2009) criticize this index and argue that only six elements, which they use to build their own “E” index, predict firm value and performance; the remainder are noise. Straska and Waller (2014) beg to differ, and report evidence that the 18 measures that Bebchuk, Cohen and Ferrell want to drop from the G index, treated as an “O” (for other) index, predict takeover likelihood. Karpoff, Schonlau and Wehrly (2016) build yet a different subset of the G-index elements, which they call the “D” index, that also predicts takeover likelihood. The confusion would be compounded if one considered takeover defense elements not in the original G index, or sought to build a broader governance index not limited to takeover defenses.

As the basis for our own analysis, we begin with our own prior work (Black et al. 2014 and 2016), in which we build governance indices in four major emerging markets (Brazil, India, Korea, and Turkey). In those studies, we argue that using a “common index” that relies on the same set of governance “elements” in each country—as massively multicountry studies typically do—is likely to yield poor constructs. As an example, consider board independence, often seen as a central component of corporate governance. Typical levels of board independence vary greatly across countries. Many Brazilian and Turkish firms have no independent directors at all. Korean firms are required to have a minimum of 25% independent directors, and Indian firms must have either a majority of independent directors or else at least one-third independent directors plus a non-executive board chair. Thus, a board structure element that asks whether a firm has one independent director is useful in Brazil and Turkey, but meaningless in India and Korea. Conversely, an element that asks whether a firm has a majority of independent directors is useful in India and Korea, but of limited value in Brazil and Turkey, where very few firms have a majority of independent directors. To use the fraction of independent directors as a governance element would also be misleading. The effect in Brazil and Turkey of firms moving from zero to one independent director may be very different from the effect in India or Korea firms moving from three to four independent directors (in these countries, a minimum percentage is required by law; Turkey added a minimum independence requirement during our sample period); or the effect from moving from a minority to a majority of independent directors.

Instead of assuming that the same elements have the same meaning in different countries, we accept that the meaning of the same element will often differ across countries. We attempt to build different constructs in each country, that are likely to proxy for similar underlying governance aspects. More specifically, we first identify a limited number of general aspects of governance, using a combination of our own judgment, the available empirical evidence and such corporate governance theory as exists: board structure, disclosure, shareholders rights, related party transactions and ownership structure. Next, for each country, we identify elements (observable variables) that are “meaningfully” related to each of the general aspects. The elements used in each country reflect a combination of local norms, local institutions and local data availability. We use these elements to build proxies for the general aspects of governance. We call these proxies “subindices.” We then build each overall country governance index (CGI) as an equally weighted average of the subindices.

How well does a particular construct (a board structure subindex in a particular country, say) represent the corresponding general aspect of governance (board structure)? We cannot assess the validity of board structure subindex, seen as a construct, simply by asking whether this subindex empirically predicts an outcome of interest (we focus on Tobin’s q). If board structure subindex predicts the outcome, it could still be a poor construct, which is measuring something else—perhaps about “governance,” perhaps not—or is simply correlated with an omitted variable which is the “true” predictor of the outcome. Board structure index could also be a useful construct, yet fail to predict the outcome because the underlying theory that posits a relationship between the general aspect (board structure) and the outcome is wrong. Therefore, predictive power is neither necessary nor sufficient, as a test for construct validity.

We pursue two approaches for assessing construct validity. First, we measure Cronbach’s α scores, both for subindices (comprised of elements) and overall indices (comprised of subindices). Cronbach’s α measures the inter-item correlation among the elements of an index. If the elements of a subindex collectively contribute to measuring the same general aspect of governance, one would expect those elements to be positively correlated and to yield a reasonably high Cronbach’s α. At the same time, overly high inter-element correlations suggest that two elements are not sufficiently distinct and are capturing the same concept. Furthermore, if subindices in fact capture distinct aspects of governance, Cronbach’s α across subindices cannot be extremely high.

Our second approach uses principal component analysis (PCA) as an alternative procedure to compute subindices. PCA consists of finding clusters (principal components) of related elements. Each component consists of a group of elements that correlate more among themselves than with other elements not belonging to that component. In this fashion, elements are aggregated according to their statistical properties rather than by prior leads from theory or previous empirical evidence. If our subindices (based on prior knowledge) are good constructs, one would expect that components will be loaded mostly or entirely of elements from a single subindex. We also perform regression analysis with firm fixed effects and extensive covariates to test the predictive power of subindices vis-à-vis components.

We find in all four countries that overall indices that are calculated as the average of subindices present reasonable construct validity. The mean correlations across subindices are moderate, suggesting that the subindices in fact capture different aspects of governance. Conversely, these correlations suggest that inference from a narrow index, a single subindex, or, even worse, a single element, likely suffers from omitted variable bias, because of the omission of important aspects of governance.

At the subindex level construct validity in often reasonable, but we find exceptions, where one has less confidence that a subindex is measuring a coherent underlying governance aspect. One can also use the construct validity analysis as a guide to how to build indices and subindices. We rely on that analysis to guide an effort to divide Board Structure Subindex into sub-subindices for Board Independence and Board Committees.

We find that regressions of Tobin’s q on principal components, while informative, are not a substitute for regressions on carefully built subindices. Instead the subindices often have greater statistical power in predicting Tobin’s q.

The full paper is available for download here.

October 17, 2016
Responding to Concerns Regarding the Protection of the Interests of Long-Term Shareholders in Activist Engagements
by Abe Friedman, Derek Zaba, Pete Michelsen, Sharo Atmeh, CamberView
Editor's Note: Abe Friedman is Managing Partner at CamberView Partners. This post is based on a CamberView publication by Mr. Friedman, Pete Michelsen, Derek Zaba, and Sharo Atmeh and is a reply to a publication from State Street Global Advisors, discussed on the Forum here.

On October 10, 2016, State Street Global Advisors (SSGA) issued a press release and published an article (discussed on the Forum here) expressing wariness about rapid settlements with activists without the input of long-term shareholders, a view shared by other large institutional investors. To address this concern, SSGA CEO Ron O’Hanley requested that “corporate boards develop principles for engaging with activist investors to promote long-term value creation.” Specifically, SSGA calls for companies to:

  • Engage with long-term investors prior to entering into a settlement agreement with an activist
  • Consider the benefits (in addition to the costs) of not rushing into a settlement and instead proceed down the initial path toward a proxy fight, which offers “long-term investors and other market participants an opportunity to provide their views”
  • Include provisions in settlement agreements to help align activist nominees with long-term investors, such as longer duration standstills, post-settlement stock-holding requirements, minimum ownership thresholds and a prohibition on pledging company shares

In addition, SSGA is creating a probationary period for one year after the settlement in which it will scrutinize any “unplanned financial engineering … to better understand the reasoning behind the strategic change.”

SSGA is not alone in voicing these concerns. Over the past two years, other large institutional investors have been pushing back against short-termism and the risk of activism including through letters from Larry Fink at BlackRock and Bill McNabb of Vanguard. Norges Bank, Norway’s $872 billion sovereign wealth fund, also expressed concern that quick settlements with activists could jeopardize long-term strategy. These investors’ public positions are further supported by the formation of groups like Focusing Capital on the Long Term, and the publication of Commonsense Corporate Governance Principles, which encourage long-term thinking and are skeptical of certain forms of shareholder activism.

The SSGA release and other investor pronouncements make it clear that institutional investors—both passively and actively managed—are demanding to be consulted when their portfolio companies undertake key strategic decisions. Companies must engage or risk the ire of their long-term investors.

The Prevalence of Activist Settlements

The increasing prevalence of settlements with activist investors has created concerns among many long-term institutional investors. Citing ISS and Lazard research, SSGA notes that “as of August 2016, 49 companies had conceded 104 board seats to activists, almost on par with the 106 seats conceded by 54 companies in all of 2015.” Settlements continue to gain traction, with SSGA noting that less than 10% of board seats conceded in an activist campaign in 2015 and 2016 resulted from a proxy contest, versus 34% in 2014.

The timeframe to settlement is decreasing too. The average time it takes companies to reach a settlement with activists threatening a proxy contest is currently 56 days from the time of disclosure of the activist’s position, down from 83 days in 2010, according to research firm Activist Insight. SSGA’s release raises the flag explicitly that “settlements are being reached too quickly and without any input from other shareholders,” with the net effect of 13% of new board seats conceded via settlement so far in 2016.

The quick rush to settlement means that a significant number of companies facing an activist threat have made strategic board changes with limited input from the investors affected most by the director appointment or change in strategy.

How Should Companies Respond?

In light of this new institutional investor engagement environment, in the context of potential settlement agreements with activists, we recommend that companies take the following steps:

  • Prior to the Arrival of an Activist, Develop a Proactive Engagement Program. Now more than ever, companies must maintain a comprehensive shareholder engagement program with both portfolio managers and governance teams. The engagement should include a discussion of long-term strategy and how it relates to board composition, governance and compensation practices. SSGA and other institutional investors seek the ability to provide input into these matters, and companies should not wait until an activist arrives to begin these discussions.
  • If an Activist Arrives, Solicit Feedback from Your Top Investors. SSGA and other institutional investors want to ensure that their viewpoints are being considered before any major strategic, financial or board decision is determined. Additional engagement with investors will reveal perspectives on key items of the activist agenda and will help identify positions of strength from which the company can engage with the activist. Investors will also provide companies with context for which of the activists’ arguments resonate with them and in which cases they would not support change. A failure to engage, on the other hand, will leave institutional investors frustrated at their inability to have a say in one of the most critical decisions a portfolio company can make. This frustration may be expressed through votes on future director nominees, Say on Pay proposals, or in future contested situations, especially if the activist makes incremental demands in the coming years. Settlements will only “keep the peace” to the extent that new issues aren’t created because the opinions of some investors are not solicited.
  • If Long-Term Investors Have Viewpoints that Differ from the Activist, Consider Delaying Settlement or Letting the First Stages of a Proxy Contest “Play Out”. SSGA notes that while proxy contests “are distracting and costly (and can pose reputational risks), [they] give long-term investors and other market participants an opportunity to provide their views.” SSGA’s concerns about settlements are in line with our observations of the viewpoints of governance teams at many other major institutional investors—the teams that represent either influential or decisive votes in a proxy contest. Too often, companies view the nomination deadline as a “point of no return,” which forces rapid settlement. Forcing the activist to put its slate and its strategy into the public market, with the company providing a measured response to the activist’s agenda and an openness to a constructive resolution, may be the optimal way to engage in “vote discovery” with the broader investor base. Moreover, this path does not need to be costly, contentious, or distracting if it is approached in a constructive manner. The feedback generated in the market by gaining insight on both positions can provide leverage to obtain a settlement that narrows the gap between the activist position and that of long-term shareholders.
  • If Settlement with an Activist Has Occurred, Conduct Post-Settlement Engagement Outreach. Pre-settlement engagement remains the exception rather than the norm. Companies that have already settled with an activist without input from the full range of institutional investors must conduct that engagement with their broader investor base to explain their decision and why it was in the best interests of shareholders. Moreover, even post-settlement, the company will benefit from gaining investor perspectives before making any significant strategic, financial or governance decision, especially if these decisions are viewed to be a deviation from the company’s pre-settlement path.
October 17, 2016
Tandy Reps: No Longer Required for Acceleration Requests Too!
by Broc Romanek

As John blogged recently, Corp Fin recently announced that it would no longer require companies to include "Tandy letter" representations in their responses to Staff comments. The question that I got from some members was: "I presume Tandy reps are still required for acceleration requests?" The answer is "no, the Staff no longer seeks Tandy language in acceleration requests." This is consistent with the rationale for no longer requiring the language in comment response letters...

Here’s a blog by Keith Bishop highlighting that he had questioned whether Tandy reps were enforceable several months ago. By the way, these were called "Tandy" representations because of a position that the SEC Staff took in the mid-’70s against the Tandy Corporation…

Tomorrow’s Webcast: "Virtual-Only Annual Meetings – Nuts & Bolts"

Tune in tomorrow for the webcast – "Virtual-Only Annual Meetings: Nuts & Bolts" – to hear HP’s Katie Colendich, Broadridge’s Cathy Conlon, Ciber’s Tara Dunn, GoPro’s Eve Saltman and the Veaco Group’s Kris Veaco as they describe the recent trend towards virtual-only annual meetings, including numerous first-hand accounts of the processes necessary to pull them off.

Political Contributions: Senator Warren Still Red Hot

As noted in this WSJ article, Senator Elizabeth Warren recently wrote this scathing letter to SEC Chair White over the lack of political contribution disclosure rulemaking. I have blogged about this saga before...

Here’s a blog by Kevin LaCroix about Warren’s letter, noting it came on the heels of the SEC announcing record Enforcement activity...

Broc Romanek

October 16, 2016
Bridging the Week: October 10 to 14 and October 17, 2016 (Coming to the US; Cross-Border; Liquidity Management; Insider Trading Supervision)
by Gary DeWaal

Navinder Sarao will likely soon be headed to the United States to stand trial in connection with criminal charges against him for his alleged role in the May 201o “Flash Crash” after losing his last effort to avoid extradition from his home in the United Kingdom. In addition, non-US consolidated subsidiaries of US entities might more readily have to register as swap dealers under proposed new cross-border rules by the Commodity Futures Trading Commission, while the Securities and Exchange Commission issued final rules to purportedly strengthen the liquidity risk management of open-end investment funds. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Alleged Flash Crasher Navinder Sarao Loses Final Effort to Avoid US Extradition (includes Legal Weeds);
  • CFTC Requires All Non-US Consolidated Subsidiaries of US Parents to Count All Swaps in De Minimis Threshold in Proposed Cross-Border Rules (includes My View and Legal Weeds);
  • SEC Imposes Tougher Liquidity Requirements on Mutual Funds; Defers Decision on Derivatives;
  • Just Calling Sam Is Inadequate Substitute for Robust AML Procedures Even at Small Broker-Dealer Rules FINRA Adjudicatory Council (includes Compliance Weeds and Culture and Ethics);
  • Investment Adviser and Supervisor Resolve SEC Charges They Failed to Supervise Employee Who Engaged in Insider Trading;
  • COMEX and NYMEX Should Increase Testing of Position Limits Exemptions Says CFTC in Rule Review (includes My View);
  • Federal Court Finds No Possible Manipulation of US Treasury Markets Where No Allegation of Intent (includes Legal Weeds); and more.


  • Alleged Flash Crasher Navinder Sarao Loses Final Effort to Avoid US Extradition: Navinder Sarao, the London-based futures trader who in April 2015 was criminally charged with contributing to the May 2010 “Flash Crash,” is now less than 28 days away from likely being extradited from his home abroad to the United States to stand trial. This is the result of a decision last Friday by two justices of the UK’s High Court denying Mr. Sarao permission to challenge a prior extradition order. Previously, another UK court found that the offenses for which Mr. Sarao was indicted in the United States – spoofing and engaging in manipulative conduct – would be prosecutable in the United Kingdom, albeit under different laws and thus his involuntary transfer to the United States was warranted. (Click here for background on Mr. Sarao’s prior UK court hearing in the article, “Alleged Spoofer, Blamed for Partly Causing Flash Crash, Loses UK Extradition Hearing” in the March 27, 2016 edition of Bridging the Week.) In April 2o15, Mr. Sarao was also subject to civil charges brought by the Commodity Futures Trading Commission. The CFTC charged Mr. Sarao and his trading company, Nav Sarao Futures Limited PLC, with engaging in spoofing involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange for the purpose of disrupting the market in order to facilitate related trading that netted him profits in excess of US $40 million. The alleged wrongful trading occurred between April 2010 and April 2015. In addition, the two defendants were charged by the CFTC with manipulation, attempted manipulation and employing manipulative or deceptive devices or contrivances. (Click here for details regarding the criminal and CFTC civil allegations against Mr. Sarao in the article, “London-Based Futures Trader Arrested, Sued by CFTC and Criminally Charged With Contributing to the May 2010 Flash Crash Through Spoofing” in the April 22, 2015 edition of Between Bridges.) The “Flash Crash” refers to events on May 6, 2010, when major US-equities indices in the futures and securities markets suddenly declined 5-6 percent in the afternoon in a few minutes before recovering within a similarly short time period.

Legal Weeds: Earlier this year Michael Coscia was sentenced to three years’ imprisonment for illicit futures trading he engaged in during three months in 2011. Like Mr. Sarao currently, Mr. Coscia had been criminally charged for violating the law prohibiting spoofing that was enacted after the 2007-2008 financial crisis. (Click here to access Commodity Exchange Act Section 4c(a)(5)(C), 7 US Code § 6c(a)(5)(C).) Previously, Mr. Coscia had settled civil actions related to the same conduct with the CFTC, the Financial Conduct Authority and the CME Group by payments of aggregate fines of approximately US $3.1 million; disgorgement of profits; and a one-year trading suspension. (Click here for details in the article, “CFTC, UK FCA and CME File Charges and Settle with Proprietary Trading Company and Principal for Spoofing” in the July 22, 2013 edition of Between Bridges.) Mr. Coscia was convicted of six counts of commodities fraud and six counts of spoofing for his prohibited trading activities in November 2015. (Click here for details of Mr. Coscia's conviction in the article, “Jury Convicts Michael Coscia of Commodities Fraud and Spoofing” in the November 8, 2015 edition of Bridging the Week.)

  • CFTC Requires All Non-US Consolidated Subsidiaries of US Parents to Count All Swaps in De Minimis Threshold in Proposed Cross-Border Rules: The Commodity Futures Trading Commission proposed rules regarding the application of certain of its swaps requirements, including registration, in connection with cross-border transactions. Among other provisions, the CFTC proposed that all non-US persons that are consolidated for accounting purposes with a US entity (Foreign Consolidated Subsidiary or FCS) be required to count all swaps opposite US persons and non-US persons in determining whether they exceed the so-called de minimis threshold that would trigger their registration as a swap dealer. However, the CFTC also proposed that only non-natural persons organized or incorporated in the United States or that have their principal places of business in the United States (including any branch) would constitute US persons under its new proposal. The CFTC expressly noted that its proposed definition would “not include a commodity pooled account, pooled account, investment fund or other collective investment vehicle that is majority-owned by one or more US persons” unless the investment vehicle met the new proposed territorial requirements. The CFTC also proposed that when a non-US swap dealer uses US persons to arrange, negotiate or execute a swap (ANE Transaction) that, if executed, would be booked outside the United States, such transactions would be subject to the CFTC’s anti-fraud and anti-manipulation rules as well as obligations to communicate in a fair and reasonable manner. ANE Transactions, opined the CFTC, will include activities “normally associated with sales and trading, as opposed to internal back-office activities, such as ministerial or clerical tasks performed by personnel not involved in the actual sale or trading of the relevant swap.” The CFTC will accept comments for 60 after publication of its proposed rules in the Federal Register. (Click here for additional details regarding the CFTC proposal in the article, “CFTC Proposes New Rules for Cross-Border Swaps” in the October 14, 2016 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)

My View: The CFTC’s proposed cross-border rules regarding application of certain of its swap requirements contains at least one potentially deleterious expansion and one potential improvement over its 2013 Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations. (Click here for details of the CFTC’s 2013 guidance in the article, “CFTC Enacts Interpretive Guidance and Passes Exemptive Order regarding Cross Border Swaps Transactions” in the July 16, 2013 edition of Between Bridges.) The bad provision is the proposal that all FCSs – even if non-guaranteed or bankruptcy remote from their ultimate parent company – must count all swaps with US and non-US persons in determining their potential registration requirement as a swap dealer. Moreover, a non-US person would have to include a bilateral swap opposite an FCS in its own threshold calculation to assess its own potential registration requirement. This could dissuade non-US persons from engaging in swaps with FCSs. On the other hand, by defining a bright light territorial test to assess whether an investment vehicle is a US person, non-US persons might be inclined to engage in more swaps with non-US-based investment vehicles since they will not have to worry about such swaps causing them potential US swap dealer registration headaches.

Legal Weeds: In September 2014, a US federal court mostly tossed out all legal challenges brought by three industry groups to the CFTC’s 2013 Interpretive Guidance. In ruling generally against the plaintiffs, the court adopted the CFTC’s principal argument, that the Dodd-Frank Wall Street Reform and Consumer Protection Act’s swaps requirements applied extraterritorially when swaps activity outside the United States had a “direct and significant connection” with US commerce without the need for any implementing regulations. As a result, the court said, “[t]he CFTC was not required to issue any guidance (let alone binding rule) regarding its intended enforcement policies. … Indeed, the CFTC’s decision to provide such a non-binding policy statement benefits market participants and cannot now, all other things being equal, be turned against it.” Notwithstanding, the court ordered the CFTC to conduct a cost-benefit analysis regarding the extraterritorial application of many of the CFTC’s rules addressed in the cross-border guidance. In response, the CFTC sought comment on its cross-border guidance in March 2015. (Click here for details in the article, “CFTC Formally Responds to Court Judgment on International Guidance; Calls for Public Comments” in the March 15, 2015 edition of Bridging the Week.) The current proposed rules incorporate the CFTC’s response to that input.

  • SEC Imposes Tougher Liquidity Requirements on Mutual Funds; Defers Decision on Derivatives: The Securities and Exchange Commission approved final rules aimed at enhancing liquidity risk management by open-end investment funds and increasing the reporting and disclosure obligations of registered investment companies. Under the SEC’s new rules, impacted funds will be required to assess, manage and periodically review their liquidity risk based on enumerated factors to minimize the likelihood that they could not meet requests to redeem shares without detrimentally impacting remaining shareholders. In addition, impacted funds would be required to decide a minimum percentage of their net assets that they would have to maintain in highly liquid assets (i.e., cash or investments that could reasonably be expected to be liquidated in three business days or less without significantly deteriorating their market value) and cap its holding of illiquid assets to 15 percent of its overall assets (i.e., investments that could not reasonably be expected to be liquidated in current market conditions within seven calendar dates without significantly deteriorating their market value). Open-end management investment companies would be required to disclose on their registration forms their procedures for redeeming fund shares, the number of days reasonably expected to pay redemption proceeds and the method for meeting redemption requests, and on reporting forms, information regarding the aggregated percentage of their portfolios representing each of four ease of salability classification categories and information on the use of lines of credit and inter-fund borrowing and lending. The SEC also proposed rules permitting funds to pass along costs incurred in meeting redemption requests (i.e., swing pricing). The SEC deferred adopting final rules related to the use of derivatives by funds. (Click here for details regarding the SEC’s proposal to restrict the use of derivatives by registered investment companies in the article, “SEC Considers New Rule to Restrict Use of Derivatives by Investment Companies” in the December 13, 2015 edition of Bridging the Week.) Different final rules have different compliance dates, with the largest funds being required to comply with the liquidity management rules by December 1, 2018.
  • Just Calling Sam Is Inadequate Substitute for Robust AML Procedures Even at Small Broker-Dealer Rules FINRA Adjudicatory Council: A decision by the Financial Industry Regulation Authority to fine Lek Securities Corporation, a registered broker-dealer, US $100,000 for failing to establish and implement adequate anti-money laundering procedures was upheld by the National Adjudicatory Council – a FINRA committee that reviews initial decisions from disciplinary and membership proceedings. A FINRA panel found after a hearing in 2014, that from January 1, 2008, through October 31, 2010, Lek Securities’s AML procedures were inadequate because they “contained little guidance with regard to manipulative trading that might require the filing of a suspicious activity report.” Instead, its AML procedures predominantly focused on money movement issues. Moreover, during one-half of the relevant time, said the NAC in affirming the FINRA panel’s decision, Lek Securities “had no specific automated exception report for potentially manipulative trading.” Instead, noted the NAC, the majority owner of Lek Securities, Samuel Lek, expected that most serious issues would be identified by the firm’s small staff (approximately 20) and brought to his attention. According to Mr. Lek’s testimony, “[t]he written supervisory procedures are not a description of exactly what in a 20-man firm everybody should do other than call Sam. That’s – that’s the general thing, let Sam know.” As a result, the NAC upheld the FINRA panel’s conclusion that Lek Securities’s AML policies were not reasonably designed for their purpose and that the firm improperly delegated some of its AML obligations to an introducing firm. The NAC also assessed Lek Securities approximately $16,500 in costs for the appeal.

Compliance Weeds: Applicable law and rules of the Financial Crimes Enforcement Network of the US Department of Treasury require broker-dealers and other covered financial institutions (banks, Commodity Futures Trading Commission-registered future commission merchants and introducing brokers and SEC-registered mutual funds) to file a suspicious activities report (SAR) with FinCEN in response to transactions or patterns of transactions involving at least US $5,000 which a covered entity “knows, suspects, or has reason to suspect” involve funds derived from illegal activity; have no business or apparent lawful purpose; are designed to evade applicable law; or utilize the institution for criminal activity. In spring 2016, Albert Fried & Company, LLC, a registered broker-dealer, agreed to pay a fine of US $300,000 to resolve charges by the Securities and Exchange Commission that, from August 2010 through October 2015, it failed to file SARs by customers with FinCEN, as required by law. (Click here for details in the article, “Broker-Dealer Sanctioned by SEC for Anti-Money Laundering Breakdowns” in the June 5, 2016 edition of Bridging the Week.) Previously, FINRA fined Brown Brothers Harriman & Co. US $8 million for failing to file SARs in connection with similar activity involving penny stocks. In that matter, FINRA also fined and suspended the firm’s global anti-money laundering compliance officer for his alleged role in the firm’s alleged misconduct. (Click here for details in the article, “FINRA Says Brown Brothers Harriman Had an Unsatisfactory Anti-Money Laundering Program; Sanctions Firm and Former Global AML Compliance Officer,” in the February 10, 2014 edition of Bridging the Week.) Covered entities should continually monitor transactions they effectuate and ensure they maintain written procedures they follow to identify and evaluate red flags of suspicious activities and file required SARs with FinCEN when appropriate. (Click here for a discussion of another FINRA disciplinary action against a member for alleged widespread AML breakdowns in the article, “Two Related Broker-Dealers To Pay US $17 Million for Widespread AML Compliance Failures; Former AML Compliance Officer Also Sanctioned” in the May 22, 2016 edition of Bridging the Week.)

Culture and Ethics: Sam tried to keep it simple. And perhaps, in a former day, his method of supervision might have been more appreciated. Unfortunately, today, it is unlikely that just a few surveillance systems, an astute and observant small staff, and just calling Sam are sufficient to meet minimum regulatory expectations for reasonable supervision particularly, as in the case of Lek Securities, where the client base generated 500 trades/minutes. However, Sam tried to keep it simple, and focusing employees on a few high level objectives in addition to the myriad of rules that likely govern their business, is very important to ensuring that a strong compliance culture is ingrained within the DNA of an organization. These days, however, employees need to abide by both high level objectives and detailed rules (memorialized in robust written procedures and training), and have strong automated surveillance systems tailored to a firm's precise business for a registered entity to satisfy the minimum expectations of regulators. (Click here for a recent presentation I made to students considering careers on Wall Street on applying the "grandma test" to assess whether proposed conduct is right or wrong.)

  • Investment Adviser and Supervisor Resolve SEC Charges They Failed to Supervise Employee Who Engaged in Insider Trading: Artis Capital Management LP, a registered investment adviser, and Michael Harden, a senior analyst at Artis, settled charges brought by the Securities and Exchange Commission that they failed reasonably to supervise Matthew Teeple, an analyst at Artis, who, on at least two occasions in 2008, illicitly obtained insider information regarding Foundry Networks, Inc., a publicly traded company. The SEC charged that Artis relied on this information in making trading decisions for Artis-managed hedge funds. The SEC noted that, unlike an ordinary analyst, Mr. Teeple worked from home, did not use analytic models for his trading recommendations and did not provide written reports regarding his views. As a result, the SEC claimed, Mr. Harden should have been suspicious when Mr. Teeple made recommendations to buy Foundry in July 2008, and five days later Foundry announced it would merge with a third party. According to the SEC, Mr. Harden also failed to question another recommendation regarding Foundry by Mr. Teeple in October 28 followed by predicted corporative activity. Among other things, Mr. Foundry, in response, did not consult with Artis’s chief compliance officer as required by Artis’s policies, charged the SEC. As a result of trading on the alleged insider information forwarded by Mr. Teeple, Artis achieved profits and avoided losses of approximately $25.3 million, and achieved other income of approximately $5.17 million (e.g., through management agreements with the funds). To resolve this matter, Artis agreed to pay a total penalty of almost US $9 million, including almost US $5.17 million in disgorgement, while Mr. Harden agreed to pay a fine of US $130,000. Mr. Teeple previously settled civil and criminal charges related to his conduct.
  • COMEX and NYMEX Should Increase Testing of Position Limits Exemptions Says CFTC in Rule Review: The New York Mercantile Exchange and the Commodity Exchange should consider adopting a formal review process to confirm that market participants are using approved strategies when relying on an exemption from an exchange-granted position limit, said Commodity Futures Trading staff in a rule review of the two exchange’s compliance with certain of the core responsibilities of designated contract markets. In general, staff of the CFTC’s Division of Market Oversight concluded that NYMEX and COMEX maintained an adequate surveillance program for routine surveillance of market trading and expiring contracts; had adequate surveillance tools and staffing; and that the exchanges’ investigative work was “thorough and complete.” The CFTC did not review the exchanges’ handling of exchange for related position transactions as part of its review, but indicated that a separate review on EFRPs was currently underway. DSIO staff indicated that the exchanges’ use of warning letters to resolve certain violations was “appropriate.” In those instances, the exchanges’ market surveillance (MS) staff had concluded that the relevant cases “typically involved simple administrative or clerical errors and very low overages, which MS determined did not disrupt the market or unduly impact settlements of contracts.”

My View: I recently reported on a rule review by the CFTC’s DMO of the CBOE Futures Exchange, LLC. (Click here to access the article, “CFTC’s Division of Market Oversight Highlights Compliance Department Resources Concern in CBOE Futures Rule Enforcement Review” in the July 10, 2016 edition of Bridging the Week.) One recommendation made by staff was that the CBOE Futures Regulation Department “should recommend and the Exchange should promptly take appropriate disciplinary action when it makes a finding that a violation of a substantive trading rule occurred.” This may sound innocuous. However, the recommendation was made in response to the issuance of warning letters by CFE to certain trading permit holders in response to their alleged placement of fictitious orders and trades. According to CFTC staff, “[w]hile a warning letter may be appropriate for certain violations of recordkeeping or audit trail rules, the Division believes that issuing a warning letter for a substantive trading violation is never appropriate.” As I have written previously, this statement appears contrary to the plain language of CFTC Rule 38.711 (click here to access) that does not limit the types of violations for which warning letters may be issued. All this provision does is limit to one time the number of occasions an exchange may issue a warning letter for any type of rule violation during a rolling one-year period. If, based on its own assessment of facts and circumstances, an exchange believes that the appropriate disciplinary action in response to a rule violation is to issue a warning letter, the CFTC should defer to the exchange’s discretion absent extraordinary circumstances. It is encouraging that CFTC staff may have backed away from its harsh and seeming misinterpretation of the relevant CFTC rule in DMO’s NYMEX and COMEX rule review.

  • Federal Court Finds No Possible Manipulation of US Treasury Markets Where No Allegation of Intent: A US federal court in Chicago dismissed a lawsuit against anonymous “John Doe” defendants that claimed the defendants engaged in spoofing-type trading activities of US Treasury markets that constituted manipulation under the anti-fraud provisions of applicable securities laws and relevant regulations promulgated by the Securities and Exchange Commission. (Click here to access Section 10(b) of the Securities Exchange Act of 1934, 15 USC §78j(b) and here to access SEC rules 10b-5(a) and (c).) According to a lawsuit filed by CP Stone Fort Holdings, LLC, the defendants manipulated the US Treasury markets by submitting orders to various trading platforms (i.e., BrokerTech and eSpeed) that they never intended to be executed. The complaint alleged defendants placed orders on one side of the market “to create the false appearance of market demand,” then pulled the order, and placed orders on the opposite side of the market to achieve execution. However, the court held that plaintiff’s complaint was deficient as it failed to state, with respect to each alleged act or omission by defendants, particular facts “giving rise to a strong inference[e]” that the defendants acted with an intent to deceive, manipulate or defraud. Such statement is required for a complaint to go forward under the relevant anti-fraud provisions  said the court. All the plaintiff pleaded, noted the court, was that defendants placed orders that they later cancelled and, “as plaintiff must admit, there is nothing improper or illegitimate about placing passive orders in the order book and then reversing position.” Among other things, the complaint failed to allege "how many orders were executed, how long the ultimately cancelled orders had remained resting and available for execution prior to cancellation, or whether the platform rules required the orders to be exposed further." The court observed that plaintiff’s complaint was “devoid of any allegation” that the defendants refused to execute any submitted order. As a result, concluded the court, because the plaintiff failed to allege illegal manipulation it also failed to allege the “strong inference” of scienter necessary to sustain its complaint.

Legal Weeds: The key phrase of Section 10(b) of the Securities Exchange Act of 1934 “manipulative or deceptive device or contrivance” is also at the heart of the relatively new parallel provision of the Commodities Exchange Act, Section 6(c)(1) enacted after the 2008/2009 financial crisis (click here to access this provision, 7 US Code § 9(1)). Pursuant to this CEA authority, the CFTC adopted Rule 180.1 (click here to access), and has used this law and rule in a wide-ranging host of enforcement actions, from its proceeding against JP Morgan in the so-called “London Whale” incident, to allegations of illegal off-exchange metals transactions, insider trading, claims of more traditional manipulation and attempted manipulation (without endeavoring to show an artificial price) and allegations of spoofing. In adopting Rule 180.1, the CFTC indicated that it would be guided “but not controlled” by the substantial body of judicial precedent applying the comparable language of SEC Rule 10b-5. (Click here to access CFTC insight on its Rule 180.1.; click here for a discussion of the CFTC’s use of its Rule 180.1 in the article, “Ex-Airline Employee Sued by CFTC for Insider Trading of Futures Based on Misappropriated Information” in the October 2, 2016 edition of Bridging the Week.)

And more briefly:

  • CFTC Formally Delays Swap Dealer De Minimis Threshold Decrease: The Commodity Futures Trading Commission formally extended for one year the current US $8 billion de minimis threshold that would trigger a swap dealer registration requirement. Currently, if a person engages in certain swaps with a gross notional amount in excess of $8 billion during the prior 12-month period it must register as an SD; this amount was automatically scheduled to reduce at the end of 2017. The CFTC action delays this reduction until the end of 2018 so the agency can further study the impact of any change in the threshold amount. (Click here for further information on the de minimis threshold in the article, “Just in Time for Football Season, CFTC Chairman Decides to Punt Swap De Minimis Threshold for One Year” in the September 18, 2016 version of Bridging the Week.)
  • Nonmember Fined US $100,000 and Access Ban by CME Group for Prearranged Trading to Transfer Equity: A business conduct committee panel of the Chicago Board of Trade order that Yong Zhang, a nonmember, pay a fine of US $100,000 for engaging in 96 trades of soybean futures contracts from October 8 through November 8, 2012 to transfer equity between two accounts he controlled. One account was the account of Mr. Zhang’s employer, while the other account was that of another nonmember. The panel also ordered Mr. Zhang to pay approximately US $31,000 in restitution and be prohibited from accessing any CME Group exchange for trading or membership.
  • SEC Applauds Itself on Most Ever Enforcement Cases in Fiscal Year 2016: The Securities and Exchange Commission summarized that it had filed 868 enforcement actions in its 2016 fiscal year that just ended on September 30 and obtained aggregate judgments and orders in excess of US $4 billion in fines and disgorgement. This number of actions was a “single year high” said the SEC.
  • Investment Bank Resolves SEC Charges It Failed to Safeguard Nonpublic Research Information: Deutsche Bank Securities Inc., a registered broker-dealer, agreed to pay a fine of US $9.5 million to resolve charges brought by the Securities and Exchange Commission that, from at least January 2012 through December 2014, it failed to have and enforce policies and procedures that were reasonably designed to prevent its equity research analysts for misusing nonpublic information contained in their unpublished views and analyses that later appeared in the firm’s research reports. The SEC said that, as a result, during the relevant time, DBSI, on a few occasions, did not stop its research analysts from sharing their views regarding potentially market sensitive information with customers and DBSI sales personnel in advance of a formal dissemination. The SEC also charged DBSI with a violation of its analyst certification rule (Click here to access the relevant provision of SEC Regulation AC) when, on March 29, 2012, it published a buy recommendation by Charles Grom, one of its analysts, who certified that the recommendation reflected his personal view, when in fact it did not. Mr. Grom previously was sued by the SEC for this alleged violation. (Click here for details in the article, “Research Analyst Fined by SEC for Falsely Rating Client to Keep Relationship” in the February 21, 2016 edition of Bridging the Week.)
  • HK SFC Commences Review of Brokers’ Internet and Mobile Trading Systems: The Hong Kong Securities and Futures Commission announced it began a focused review to assess “the cybersecurity preparedness, compliance and resilience of brokers’ internet/mobile trading systems.” SFC claimed this sweep was initiated by reports that an increasing number of such systems have been compromised. The SFC anticipates using the results of its review to develop its cybersecurity policy.
October 16, 2016
Do Institutional Investors Demand Public Disclosure?
by Andrew Bird, Stephen Karolyi
Editor's Note: Stephen A. Karolyi is Assistant Professor of Finance and Accounting and Andrew Bird is Assistant Professor of Accounting at the Tepper School of Business at Carnegie Mellon University. This post is based on their recent paper.

Do institutional investors demand corporate disclosure? A central question in finance and accounting is whether corporate transparency benefits or hurts investors. This issue is complicated by the fact that information provision could affect groups of investors differentially. Public information may crowd out the private information advantage of some institutional investors; alternatively, investors, particularly those following more passive trading strategies, may not be information sensitive. However, even passive institutional investors may benefit from an increase in monitoring by other stakeholders following improved disclosure. Further, regardless of the preferences of institutional investors, whether or not they are able to affect corporate policy on this margin is unclear. This tradeoff is reflected in mixed empirical evidence on the relationship between institutional ownership and corporate disclosure.

To address this tradeoff faced by institutional investors, we analyze the revealed preference for corporate disclosure by institutional investors and the associated impact on the information content of corporate disclosure. Empirically, identifying a causal effect of institutional ownership on corporate disclosure policy is difficult because experimental settings and direct measures of corporate disclosure quantity and characteristics are scarce. We propose a two-part solution to these problems. First, we utilize exogenous changes in institutional ownership around Russell 2000 index reconstitutions in a regression discontinuity design to identify the effect of institutional ownership on corporate disclosure policy. Second, we directly measure the characteristics of corporate disclosure using a novel data set composed of all 8-K filings between 1996 and 2006.

Russell index membership satisfies the key aspects of a regression discontinuity design because membership is based on the end of May closing-price implied market capitalization rank. While these market capitalization rank cutoffs are public knowledge and consistent through time, the underlying market capitalization cutoffs are time-varying and depend on the cross-sectional distribution of market capitalization at the end of the last trading day in May. Firms in the top 1,000 ranked market capitalization on that day become members of the Russell 1000, and the subsequent 2,000, those ranked between 1,001 and 3,000, compose the Russell 2000. Therefore, especially close to these market capitalization rank thresholds, Russell index reconstitutions are quasi-random with respect to corporate policies. Because the indexes are value-weighted, the largest firms in the Russell 2000 receive weights that are ten to fifteen times larger than do the smallest firms in the Russell 1000, even though they are similar in size. Since these indexes are widely used as performance and portfolio benchmarks by institutional investors, this difference in weights leads to significant differences in institutional ownership between firms at the bottom of the Russell 1000 relative to those at the top of the Russell 2000.

This experimental setting and novel data provide a platform to contribute to our knowledge about institutional investor demand for corporate disclosure along the dimensions of quantity, form, and quality. We find that Russell 2000 inclusion has a positive impact on the quantity of disclosure. Relative to firms just excluded from the Russell 2000 index, firms just included disclose more 8-K filings and more items per 8-K filing. These results suggest that institutional investors demand more corporate disclosure and that this preference is successfully reflected in incremental disclosure by firms.

Not only do corporations disseminate more content per disclosure, but the information content of disclosures, as measured by the absolute market reaction to announcements, increase as well. Furthermore, this increase in market reaction is directly related to the increase in length, embedded graphics, and exhibits per 8-K filing. Indeed, our findings suggest that the increase in the information content of 8-K filings is explained by the change in disclosure characteristics. From these results, we infer that the increase in the information content of 8-K announcements is a result of changes in disclosure quantity and form, rather than index-membership-induced changes in investor attention.

Disclosure is a unique component of governance both because it has important feedback effects on other components of governance, by empowering all shareholders with decision-relevant information, and because it affects allocative efficiency. Our results demonstrate that institutional investors demand and affect the public dissemination of decision-relevant information. That is, we observe both that governance affects disclosure policy, and that disclosure policy then affects investment decisions. Because the investment decisions in response to the disclosure are not likely being made by the same investors that benchmark to the Russell indexes, we can infer that the incremental information has reached its target audience and that the institutional investors that enacted the change in disclosure policy must benefit indirectly from this incremental disclosure.

Trading in response to Russell index reconstitutions is a result of benchmarking behavior, so our inferences about the governance and disclosure preferences of institutional investors necessarily relate to institutional investors that benchmark to the Russell indexes. Because both active and passive investors may use the Russell indexes as portfolio benchmarks, the Russell index reconstitution setting identifies the governance and disclosure preferences of a mix of active and passive investors. However, because investors that are close to the pure indexing extreme of the benchmarking continuum are the most likely to respond to Russell index reconstitutions, we view our results as reflecting the disclosure preferences of relatively passive investors.

The full paper is available for download here.

October 15, 2016
Key Points from Governor Tarullo's Speech on Stress Testing and the Fed's NPR
by Adam Gilbert, Armen Meyer, Dan Ryan, Mike Alix, PricewaterhouseCoopers
Editor's Note: Dan Ryan is Leader of the Financial Services Advisory Practice at PricewaterhouseCoopers LLP. This post is based on a PwC publication by Mr. Ryan, Mike Alix, Adam Gilbert, and Armen Meyer.

The Federal Reserve (Fed) is tilting the balance of its supervisory stress testing program to drive capital requirements higher for large, systemically important Bank Holding Companies (BHCs),[1] while providing some relief for less complex institutions. In an important speech last Monday, Fed Governor Daniel Tarullo suggested several significant changes to the Fed’s annual Comprehensive Capital Analysis and Review (CCAR), which will more fully align ongoing capital requirements with stress-based capital requirements and generally raise regulatory minimum capital ratios to levels the Fed otherwise expected prudently managed firms to maintain on their own.[2] See the Appendix for a graphic depiction of this point.

Most significantly, Governor Tarullo’s proposals, still subject to rulemaking, will embed the G-SIB capital surcharge[3] into CCAR’S post-stress minimum thresholds and, for ongoing capital requirements, substitute more severe institution-specific stress capital buffers in place of the existing

2.5% capital conservation buffer (CCB). However, Governor Tarullo also discussed several changes to the Fed’s economic scenario assumptions which would mitigate some of the capital impact to the largest BHCs. These increases to BHCs’ capital requirements could be implemented as early as 2018, following a rulemaking proposal and comment process.

Separately, but critically for less-complex BHCs, the Fed also issued a Notice of Proposed Rulemaking (NPR) that provides smaller traditional banking organizations subject to CCAR with relief from intensive CCAR qualitative assessments (including relief from the potential for their capital plans to be publically rejected for qualitative reasons). This beneficial change would take effect in the next CCAR cycle.

BHCs subject to CCAR will have ongoing capital requirements that directly incorporate the Fed’s modelled post-stress capital calculations.

Governor Tarullo’s speech introduced a new Stress Capital Buffer (SCB), which all CCAR BHCs would add to their minimum ongoing capital ratio thresholds. The SCB would be separately defined for each BHC as the BHC’s most recent CCAR result’s maximum projected decline in the common equity tier 1 (CET1) ratio under the severely adverse scenario.[4] This variable, risk-sensitive, Fed-modelled SCB would replace the existing fixed 2.5% capital conservation buffer (CCB).[5] The application of the SCB to BHCs’ ongoing capital thresholds would mean that BHCs would for the first time be forced to manage to their stressed CCAR results throughout the year. To reinforce this point, the Fed would also require each BHC to maintain projected ratios above the new minimums in its baseline economic scenario under CCAR. Because the Fed has long expressed an expectation that BHCs maintain sufficient capital to weather a severe downturn, this new formulation for ongoing requirements should be manageable.

The G-SIB capital surcharge will be incorporated into CCAR’s post-stress requirements.

With the introduction of the SCB closing one gap between ongoing and post-stress capital requirements, the Fed introduced another change to further tighten the link. Governor Tarullo suggested that, as previously signaled, the G-SIB capital surcharge, which is a new core component of ongoing capital requirement for G-SIBs, would also be included in BHCs’ post-stress capital minimums under CCAR. As a result, G-SIBs, especially those with large trading activities, must maintain a higher capital ratio after consideration of the Fed’s projected losses under the severely adverse scenario in order to pass CCAR’s annual quantitative test. (Note that the CCB was never part of CCAR’s post-stress minimum ratios; likewise the SCB will not be part of that calculation for the severely adverse scenario, but it will be included under the baseline scenario.)

To mitigate these challenges, BHCs’ planned capital distributions would not be fully factored-in under CCAR’s severely adverse scenario.

Currently under CCAR, the Fed deducts the full nine quarters of BHCs’ planned dividends and buybacks from the Fed’s projected capital losses to assess whether post-stress capital ratios remain above minimum capital ratio thresholds. However, Governor Tarullo suggested limiting this deduction to only four quarters of dividends (i.e., leaving out all buybacks and the remaining dividends) when applying CCAR’s severely adverse scenario. This would make the incorporation of the G-SIB surcharge into CCAR more manageable because buybacks and the remaining five quarters of dividends often make up the bulk of planned capital distributions. The change also addresses BHCs’ long-standing observation that if severely adverse conditions were to occur, BHCs would be compelled by regulation to curtail distributions so would not maintain planned capital distributions for the entire nine-quarter planning horizon.

Could the baseline economic scenario become BHCs’ new binding constraint?

Governor Tarullo made clear that under CCAR, BHCs would have to maintain regulatory minimum capital ratios under all scenarios. With the SCB included in this minimum threshold for CCAR’s baseline economic scenario, and the inclusion of all planned dividends and buybacks in the baseline scenario (unlike the severely adverse scenario), the Fed’s modelled baseline projections could become BHCs’ new binding constraint.

The Fed’s baseline projections, and the projections’ comparison with the BHCs’ own modelled baseline projections, have been inconsequential to this point, so the Fed has never emphasized or published these results. However, since BHCs will need to be more concerned about how the Fed will project their performance under the baseline scenario, the Fed may have to consider disclosing the baseline results alongside the severely adverse and adverse results which the Fed has published. The Fed has thus far avoided disclosing baseline results in order to avoid the market confusing the Fed’s projections with BHC earnings forecasts.

The Fed will no longer project growth in BHCs’ balance sheets, which provides some additional relief.

Beginning in CCAR 2014, the Fed began making its own projections of BHCs’ balance sheets and risk-weighted assets (RWA) over the stressed time horizon, rather than using BHCs’ projections. The Fed’s projections have predictably proven to be more conservative than the BHCs’, but Governor Tarullo’s speech indicated that the Fed is taking into consideration industry arguments that some business lines could significantly shrink during periods of stress, and therefore reduce expected losses and shrink balance sheets and RWAs (i.e., the capital ratios’ denominators). Therefore, rather than making a projection, the Fed would make a simplifying assumption of constant asset and RWA balances during the stressed time horizon (based on BHCs’ starting assets and RWA). This change would offer BHCs more certainty and make it somewhat easier for BHCs to meet their stressed minimum ratios, because the capital ratios’ denominators would be smaller. The Fed would not need to issue a rulemaking in order to make this change, so it could occur as soon as CCAR 2017 given its simplicity to implement.

Integration of funding and liquidity stress into CCAR?

Governor Tarullo’s remarks indicated that the Fed is considering the introduction of funding and liquidity shocks into future CCAR scenarios. Most notably, Governor Tarullo noted that “direct” funding shocks (i.e., increased funding costs as a result of losses and demands from creditors) could be included in stress testing models in the relatively near future because of their direct ties to BHCs’ capital levels, projected losses, and reliance on short-term wholesale funding. However, the integration of liquidity shocks would prove to be more challenging due to the highly interrelated nature of liquidity shortages. The Fed plans to continue research on the linkages between capital and liquidity stress testing, and in particular may try to use stress testing results as a starting point for its less well-known, non-public, liquidity stress-testing program, called Comprehensive Liquidity Analysis and Review (CLAR), or vice versa. Although Governor Tarullo noted that most of the new features still need further study before they are ready to be incorporated into supervisory models, his comments should highlight to BHCs the importance of integrating capital, funding, and liquidity stress considerations.

The Fed will increase transparency, but stop short of full disclosure.

Governor Tarullo remarked that the Fed plans to continue increasing stress testing transparency, particularly for supervisory modeling updates, pre-provision net revenue (PPNR) projections, and the Fed’s qualitative assessment results. Currently, a high-level summary of changes to supervisory models is released publicly with the results, thus giving BHCs insufficient time to react. Governor Tarullo indicated that the Fed is considering releasing changes to the models “well in advance” of the April 5th submission deadline, and phasing in the most significant changes over two years in order to reduce potential stress testing result volatility. The latter consideration would be particularly important for the stability of the SCB.

Additionally, we expect that the Fed’s PPNR disclosures will include increasing granularity over the next several CCAR cycles, including a breakdown of net interest income, non-interest income, non-interest expense, and operational risk losses. Governor Tarullo’s speech further noted that the Fed is considering ways to increase the information released in relation to the qualitative feedback it delivers to specific BHCs. However, Governor Tarullo rejected industry requests for the Fed to fully disclose its supervisory models due to the potential that it would incentivize firms to simply copy and optimize the characteristics assessed by the Fed.

Scenario design revisions are under consideration.

Governor Tarullo indicated that the Fed is taking another look at some of its core macroeconomic scenario variables, namely the unemployment rate and housing prices. As we pointed out in February,[6] the magnitude of CCAR 2016’s employment shock was larger than prior years because the unemployment rate started at a lower level and grew at a faster rate to still reach prior peaks. Governor Tarullo suggested that the Fed would incorporate less severe shocks to employment in downturns, with the goal of making the severely adverse scenario less pro-cyclical. To further reduce pro-cyclicality, Governor Tarullo remarked that the Fed would connect projected changes in housing prices to changes in disposable personal income.

Smaller BHCs will receive relief from qualitative requirements.

As we predicted,[7] the Fed’s NPR excludes certain smaller and less complex BHCs from the qualitative portion of CCAR. BHCs must meet three measures (averaged over the prior four quarters) to be included in this relief: have (a) less than $250 billion in total assets, (b) less than $10 billion in foreign exposures on their balance sheets, and (c) less than $75 billion in nonbank assets (collectively defined as “large and noncomplex” BHCs). The third criterion related to nonbank assets is different from the Fed’s earlier definition of “large and noncomplex” BHCs [8] and was included to ensure that the Fed provides relief only to BHCs that are primarily engaged in traditional banking activities, as opposed to capital markets activities that could have a greater systemic impact. We expect there are a couple firms considered large and noncomplex under the Fed’s previous definition that remain caught in CCAR’s qualitative review and may want to consider strategies to untie themselves.

The affected large and noncomplex BHCs have largely met or exceeded the Fed’s expectations for capital planning processes, and will no longer be at risk of receiving an objection to their capital plans on qualitative grounds or the associated reputational effects of public criticism. However, they will receive reviews as part of the normal supervisory process and additional horizontal reviews related to specific capital planning topics. Accordingly, we recommend that they stay focused on the Fed’s qualitative expectations in order to avoid critical feedback during annual reviews. Furthermore, other BHCs should note that the shift will allow the Fed to dedicate even more supervisory resources to the larger BHCs remaining in CCAR.

The Global Market Shock will likely have more impact in future CCAR rounds.

In CCAR 2016, the effect of the Global Market Shock (GMS) was limited because the Fed chose an “as-of date” in early January, a time when trading activity is subdued and BHCs tend to have less trading and counterparty risk, so would be less affected by a shock. [9] In order to account for this limitation, the NPR extends the starting point of the Fed’s range of potential GMS as-of dates to October 1st of the prior calendar year, starting in CCAR 2018. This range includes more typical positions for the six G-SIBs affected by the GMS, and raises the likelihood that resulting losses, and thus needed post-stress capital, will be higher. In a related point, Governor Tarullo said that the Fed has yet to determine whether foreign-owned CCAR filers with larger trading operations would be subject the GMS trading and counterparty components. [10]


Each of the below graphics compare current required minimum CET1 levels (once the CCB and G-SIB surcharge fully phase-in) with Governor Tarullo’s proposed minimum levels. Figure 1 does so for ongoing capital requirements and Figure 2 does so for CCAR’s post-stress requirements.

Figure 1 demonstrates that Governor Tarullo’s proposal to replace the CCB with the SCB will increase ongoing CET1 requirements. Figure 2 shows the proposal’s addition of the G-SIB surcharge in the post-stress minimum, partially offset with a severely adverse scenario impact that is somewhat smaller under the proposal because of reductions in distribution and balance sheet growth assumptions.

Therefore, Governor Tarullo’s proposal has the effect of aligning ongoing capital requirements with CCAR post-stress requirements, as depicted by the equal heights of the right-side bars of each Figure.


1 We use “BHC” to refer to all banking organizations that are subject to CCAR, including intermediate holding companies established by July 1, 2016, and any nonbank financial company that becomes subject to CCAR requirements in the future (there are currently none).(go back)

2 Although this post focuses on CCAR, Governor Tarullo’s speech also has implications for Dodd-Frank Act Stress Testing (DFAST). For more information on DFAST, see our post Key Takeaways from the Fed’s 2016 Dodd-Frank Stress Tests (June 2016).(go back)

3 See our post, Fed’s Final G-SIB Surcharge Rule (July 2015).(go back)

4 Governor Tarullo described the SCB using the CET1 ratio as an example. It is unclear whether the SCB would be calculated separately for other risk-based capital ratios or apply to the leverage ratio. The Fed will also need to clarify the impact of dividend payouts on the SCB.(go back)

5 The CCB started to be phased into the Fed’s ongoing capital review this year, and is set to reach 2.5% of CET1 when fully phased-in in 2019. The CCB would remain a floor to the SCB.(go back)

6 See our post, 2016 CCAR Instructions and Supervisory Scenarios (February 2016).(go back)

7 See PwC’s First take, Five key points from the Fed’s Comprehensive Capital Analysis and Review (June 2016).(go back)

8 See PwC’s First take, Fed’s supervisory assessment of capital planning and positions (December 2015).(go back)

9 This limited selection of the GMS as-of date was a side effect of the Fed’s change of the capital plan submission date from January to April, and the associated shift of the potential as-of date range from January to March. See First take cited in note 5 for more detail.(go back)

10 Furthermore, Governor Tarullo mentioned central clearing parties and brought up the topic of second order effects from counterparty default. This could be a sign of a substantial changes in the counterparty default shock.(go back)

October 15, 2016
First Circuit Finds Too Few Brushstrokes to Paint a Portrait of Scienter, in Local No. 8 v. Vertex Pharmaceuticals (October 3, 2016)
by Peter Hawkes

Analogizing a plaintiff’s allegations to "brushstrokes" intended to paint a "portrait" of scienter, the First Circuit found those allegations "cover[ed] too little canvas" to give rise to the strong inference of scienter required under the Private Securities Litigation Reform Act. See Local No. 8 IBEW Ret. Plan & Trust v. Vertex Pharmaceuticals, — F.3d —-, 2016 WL 5682548 (1st Cir. 2016). In doing so, the First Circuit reaffirmed the very high bar that a plaintiff must clear to allege scienter on the basis of recklessness.

The case arose from Vertex’s correction of previously-reported preliminary results from clinical trials for an experimental drug combination treatment for cystic fibrosis. Initially, Vertex reported an "absolute improvement" in lung function of 5 percent or more for 46 percent of patients receiving the combination therapy, and an "absolute improvement" of 10 percent or more for 30 percent of patients receiving the treatment. Vertex was effusive in describing the preliminary results, stating that they "exceeded expectations" and were driving Vertex to accelerate its plans to bring the treatment to market. Immediately thereafter, Vertex’s stock price shot up by more than 55 percent, and by a few weeks later had risen more 73 percent. During that period, several of Vertex’s officers and directors sold over half a million shares of their Vertex stock for a total of almost $32 million.

At that point, however, Vertex reported that the preliminary results had been overstated. Vertex explained that it had "misinterpreted" the results received from a third-party vendor, which reflected a "relative improvement" from the patients’ baseline lung function, rather than an "absolute improvement." Vertex reported that, once the results were recalculated to put them in terms of "absolute improvement," only 35 percent of patients showed an improvement in lung function of 5 percent or more, and only 19 percent showed an improvement of 10 percent or more. Following that disclosure, Vertex’s stock price declined significantly, although it remained over 54 percent higher than it had been before the initial announcement.

Plaintiffs filed a securities class action. The lead plaintiff, Local No. 8 IBEW Ret. Plan & Trust ("Local No. 8"), alleged that, "[w]hen faced with … study results that seemed too good to be true, Defendants, rather than checking the results, turned a blind eye, accepting and promoting unlikely data that offered them a windfall on the sale of their stock." Id. at *3 (quoting complaint). Defendants moved to dismiss, arguing that the facts alleged did not give rise to a "strong inference" of scienter, as required by the Reform Act. The district court granted the motion, and Local No. 8 appealed.

On appeal, the First Circuit explained that, to show scienter through "recklessness" rather than actual intent for purposes of a securities fraud claim, a defendant’s conduct must go beyond "merely simple, or even inexcusable negligence, but [must involve] an extreme departure from the standards of ordinary care." Id. (citation omitted). The court explained that this form of recklessness is "closer to a lesser form of intent" than to ordinary negligence. Id. (citation omitted).

With that background, the First Circuit turned to the facts alleged in the complaint that Local No. 8 argued cumulatively supported an inference of scienter. The court indicated it was "mindful that ‘[e]ach individual fact about scienter may provide only a brushstroke,’ but it is our obligation to consider ‘the resulting portrait.’" Id. at *4 (citation omitted). Thus, the court would evaluate each fact individually, and then assess their cumulative effect. Id.

The First Circuit did not find that any of the facts alleged, considered individually, were particularly indicative of scienter:

  • Local No. 8 alleged that the implausibility of the initial results should have been obvious for a number of reasons, and that some individuals within the company were highly skeptical of them. The court found that, while Defendants admitted the initial results were surprising, Local No. 8 did not allege facts indicating that they were "so obviously suspect" that Defendants should have inquired further. Id. at *4-*6. Nor did Local No. 8 allege that any of the individuals within the company who were "skeptical" of the results reported that skepticism to any of the Defendants. Id. at *5.
  • Local No. 8 argued on appeal that it was "rare" for a company to publish interim results. The First Circuit declined to consider that contention, as it was not made in the complaint and, in any event, there was no legal requirement that Vertex double-check interim results before reporting them. Id. at *6.
  • The First Circuit found that Local No. 8’s allegations of insider trading also did not strongly suggest scienter. The court observed that one of the individual defendants—Vertex’s CEO—did not sell any stock, and one of the others sold only small amounts that were consistent with his trading pattern both before the initial announcement and after the correction. While the other individual defendants had more substantial stock sales, the court found them "perfectly understandable" in light of Vertex’s previously languishing stock price.
  • Finally, Local No. 8 alleged that the sudden retirement of Vertex’s Chief Commercial Officer, Nancy Wysenski, shortly after a U.S. Senator asked the SEC to investigate potential insider trading by Vertex executives suggested consciousness of guilt, at least with respect to her. Id. at *7. The court noted that the allegations "point[ing] the finger" at Wysenski "tend to exculpate the others who did not retire or leave the company." Id. at *8. Moreover, "[a]lternative explanations abound[ed]" for Wysenski’s retirement—her large insider sales could have been embarrassing to the company even in the absence of fraud, or she might have been negligent in preparing the press release announcing the initial results. Id.

The First Circuit concluded that, "[c]umulatively, the brushstrokes here do not paint the required strong inference of scienter." Considered in the context of the allegations as a whole, "the stock sales by some of the individual defendants and the timing of Wysenski’s retirement (which might otherwise look very different) cover too little canvas to evoke inferences of scienter strong enough to equal the alternative inference that Vertex was negligent in viewing very good results as being even better than they in fact were." Id.

View today's posts

10/17/2016 posts

CLS Blue Sky Blog: Challenging the Myth of Financial Intermediation
CLS Blue Sky Blog: Shearman & Sterling discusses Brexit: a Financial Free Zone Within the City
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Corporate Governance Indices and Construct Validity
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Responding to Concerns Regarding the Protection of the Interests of Long-Term Shareholders in Activist Engagements Blog: Tandy Reps: No Longer Required for Acceleration Requests Too!
Bridging the Week: Bridging the Week: October 10 to 14 and October 17, 2016 (Coming to the US; Cross-Border; Liquidity Management; Insider Trading Supervision)
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Do Institutional Investors Demand Public Disclosure?
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Key Points from Governor Tarullo's Speech on Stress Testing and the Fed's NPR
D&O Developments: First Circuit Finds Too Few Brushstrokes to Paint a Portrait of Scienter, in Local No. 8 v. Vertex Pharmaceuticals (October 3, 2016)

Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.