Securities Mosaic® Blogwatch
March 28, 2018
Antitrust as Corporate Governance: Why a Firm’s Mission Is to Earn No Profit
by Ramsi Woodcock

BlackRock, the vast asset manager, has been feted for demanding that the boards of its portfolio firms pursue a social purpose, which likely entails spreading corporate profits beyond shareholders to include labor and victims of environmental harm.[1] But despite being a shareholder in numerous firms, BlackRock should not actually have a say over what happens to corporate profits, because the law already requires that profits go to one group only, and not the group you might expect.

The consumer welfare standard in antitrust law requires that firms maximize the margin between price and product quality, a quantity called consumer welfare by economists.[2] This standard, adopted in the 1970s, resolves the long-running debate about which corporate constituency has a right to the profits of the firm, because profits and consumer welfare are a zero-sum game: Profits can be generated only by reducing the margin between price and quality, in effect redistributing wealth from consumers to firms.[3] The rule that consumer welfare must be maximized therefore means that profits must be minimized. The consumer welfare standard requires that firms pay their profits out in full to the one constituency that has hardly figured in debates over corporate mission: the consumer, by charging consumers the lowest possible prices in exchange for products of the highest possible quality.

Rules once thought to determine the distribution of corporate wealth, from the voting rights of shareholders, to the fiduciary duties of boards, to charitable contribution statutes, are all of no relevance, because federal antitrust law requires that firms earn no profits at all but work instead for the exclusive benefit of their customers. I argue in a recent paper that these other rules are preempted by federal antitrust laws that are supreme over all conflicting behavior authorized by state laws.[4] The only exception to supremacy is for behavior that is directly supervised by state regulators.[5] But state regulators do not directly supervise boards’ exercise of their state-corporate-law-granted authority to maximize profits. The states do not even require, as they do of many rate regulated firms, that corporations notify regulators of the prices they charge to consumers, let alone meaningfully regulate those prices.

The notion that firms should generate no profits can inspire panic, because of confusion between the accounting and economic definitions of cost. The consumer welfare standard requires that firms charge prices equal to the cost of production, understood to include every last payment required to make the firm maximize the value that the firm creates, including not only payments to labor and management, but also sufficient payments to shareholders to make them willing to contribute capital to the firm. By contrast, the accounting definition of cost excludes payments required to compensate shareholders, which is why in the popular imagination profits are necessary for businesses to exist.

The wealth of the firm, in the economic sense, is what is left over after costs, including sufficient payment to shareholders to secure their participation, have been paid, a froth that can be ladled out to one group or another without crippling the ability of the firm to perform. Advocates of shareholder primacy have long argued that this froth should go to shareholders in the form of the profits generated by high prices; advocates of corporate social responsibility have said that boards should spread this froth fairly among all constituents of the firm, including workers and victims. Antitrust requires that it be paid out in full to consumers in the form of low prices. And antitrust controls.

The fundamental independence of the division of the froth from the problem of creating it – of distribution from efficiency – has long been obscured by the mistaken notion that the firm will perform well only if the party that gets the firm’s wealth, sometimes called the residual claimant, also controls the management of the firm.[6] The shareholder rights movement has long argued, for example, that because shareholders have, at least by some accounts, the right to the residual, shareholders ought also have control over the board of directors.[7]

This misguided reading of agency theory, the science of bringing the incentives of managers into alignment with those of owners, establishes no connection between distribution and efficiency. Any share of firm wealth that must be paid to management to align incentives is not profit, but cost, a payment necessary for performance, making the agency problem a pure question of efficiency, not distribution. Moreover, the whole point of agency theory is that the entire wealth of the firm need not be paid out to shareholders, managers, the board, or whoever has control over the firm, in order to ensure performance. Otherwise, managers could never act as reliable agents.

So long as a constant fraction of the firm’s wealth is paid out to the controller of the firm, the controller’s wealth will grow in proportion to the wealth of the firm, and the right incentives will be created.[8] It is for precisely this reason that firms grant stock options, but not 100 percent ownership, to managers as a performance incentive: Whether a manager owns a share or the entire firm, the incentive to maximize wealth is the same.[9]

Who gets the wealth that remains once that the necessary share has been paid to managers is quite independent of performance, whether the remaining wealth goes to shareholders or consumers. Under the consumer welfare standard, the entire apparatus of agency theory, which has been devoted to determining the proper way to align incentives, but always under the assumption that shareholders are the principal, ultimately getting the firm’s wealth, remains unchanged. But the consumer becomes the principal.

Recognizing that antitrust preempts state corporate law rules regarding the distribution of corporate wealth resolves a contradiction in the structure of our economic system: the assumption that the invisible hand visits corporate law, but not antitrust law. Corporate law has long assumed that profit maximization should be the goal of the firm, because private self-interested behavior ultimately benefits society as a whole, competition ensuring that the best firms rise to the top and earn rewards consistent with the value they deliver to consumers.[10]

Antitrust once embraced the invisible hand too, seeing its role as promoting the competition that is an essential requirement for the invisible hand to do its work.[11] Antitrust later embraced the consumer welfare standard, however, because antitrust came to believe that competition is not always good for consumers, eroding the production scales sometimes needed to minimize costs or fund research on improving products.[12] Under the consumer welfare standard, antitrust now tolerates monopoly whenever it appears best for consumers. The assumption in corporate law that beyond the walls of the firm there is always a perfectly competitive market turning greed into good is now dated, abandoned long ago, at any rate, by antitrust.

If monopoly’s Cerberus has abandoned its post, then firms must no longer be allowed to maximize profit, because often no market discipline will prevent them from using that authority to raise prices. The corporation must instead internalize the goals that the market once imposed upon the corporation from without. Reading the consumer welfare standard to require firms to minimize profit accomplishes that task.

There is much work to be done. For one thing, the phenomenon of the firm that has more cash than it knows how to invest must come to an end. Apple must rebate the $268 billion that it currently carries on its books to consumers.[13] Firms receiving tax windfalls must pass them on as well.[14]

Of potentially greater long-term importance, firms must cease a whole range of technology-driven pricing practices that are oriented toward extracting maximum value from consumers, rather than merely covering costs. These practices, known as yield management in the airline industry, revenue management in the hospitality industry, dynamic, personalized, or surge pricing to consumers, and price discrimination to economists, seek to maximize profits by charging different groups prices that are different but always targeted at extracting the greatest possible wealth.[15] Airlines must stop charging last minute travelers more; Uber must stop pricing the surge; and “Hamilton” tickets must sell for one low price, not because antitrust has created competition in the market – what show can compete with “Hamilton?” – but because corporate boards have a duty, at pain of law, to charge the lowest possible prices consistent with covering costs.[16]

Corporate law has ignored the arrival of the consumer welfare standard for decades, perhaps because the standard is a meta rule, governing which rules antitrust may apply, rather than speaking directly to defendants about what they should or should not do. Courts have used the standard, for example, to limit the longstanding antitrust ban on collusive behavior.[17] But meta does not mean any less the law. If the consumer welfare standard could be used to limit the scope of the antitrust laws, it can be used to limit the scope of state corporate laws.

In the 1960s, when the Chicago School embarked on a program of restoring laissez faire to American business life, the movement sought two things. First, it sought to replace the prevailing socially-oriented managerialist view of corporate law, which saw the board as responsible for spreading the firm’s wealth, with the doctrine of shareholder primacy, which gave pride of place to narrow pecuniary interests.[18] Second, the movement sought to use the consumer welfare standard, which allowed firms to undermine competition in the name of helping consumers, to roll back antitrust.[19] The Chicago Schoolers did not realize that these are fundamentally inconsistent ends. It is time for the law to reconcile them.

Allocating the wealth of the firm to consumers leaves the longstanding problem of oppression of non-controlling constituencies unresolved, because it perpetuates the practice of centralizing corporate wealth in the hands of a single group, now consumers instead of shareholders.[20] Whether management does the bidding of shareholders or consumers, the favored group has an incentive to pressure the board to drive a hard bargain with workers, the supply chain, environmental victims, and other constituencies in order to minimize costs. After all, bargaining determines the size of the payments that are necessary for production to take place, and therefore the size of costs.

Of course, the oppression is tempered if other legal regimes, such as labor law for workers, allows non-controlling constituencies to bring power of their own to the bargaining table.[21] But it is precisely in the uncompetitive markets allowed by antitrust enforcers applying the consumer welfare standard that the bargaining power of these other groups is at its lowest. When the firm is a monopoly, the firm dictates terms. A federal corporate law mandating a more equal division of corporate wealth, or a more progressive tax system, may be needed to address this problem more fully.[22]

In the meantime, throwing off corporate wealth to consumers will surely spread wealth more broadly than it is spread today. The only economic group to which all Americans belong is that of the consumer. Only some Americans own, and many do not work, but all consume, if nothing else than the occasional bite of food. When firms pay their wealth to consumers, they do not pay it all to the poor, but they do pay it to all.


[1] See Larry Fink’s letter to CEOs, BlackRock,

[2] See Steven C. Salop, Question: What is the Real and Proper Antitrust Welfare Standard? Answer: The True Consumer Welfare Standard, 22 Loy. Consumer L. Rev. 336, 336 (2010); John B. Kirkwood & Robert H. Lande, The Fundamental Goal of Antitrust: Protecting Consumers, Not Increasing Efficiency, 84 Notre Dame L. Rev. 191, 198 (2008).

[3] For the history of the consumer welfare standard, see Sandeep Vaheesan, The Evolving Populisms of Antitrust, 93 Neb. L. Rev. 370, 395–403 (2014).

[4] Ramsi A. Woodcock, Antitrust as Corporate Governance (2018),

[5] For antitrust preemption and the state action doctrine, see California Retail Liquor Dealers Assn. v. Midcal Aluminum, Inc., 445 U.S. 97, 102–5 (1980).

[6] See, e.g., Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305, 312 (1976).

[7] See Lucian Arye Bebchuk, The Case for Increasing Shareholder Power, 118 Harv. L. Rev. 833, 850 (2005).

[8] Things get more complicated when risk is taken into account, but the principle is the same.

[9] The share must of course be large enough to make the manager better off than the manager would be doing some other job.

[10] See Michael C. Jensen, Value Maximization, Stakeholder Theory, and the Corporate Objective Function, 22 J. Applied Corp. Fin. 32, 11–12 (2001).

[11] See Northern Pacific R.R. Co. v. United States, 356 U.S. 1, 4 (1958).

[12] See Verizon Communications Inc. v. Law Offices of Curtis V. Trinko, LLP, 540 U.S. 398, 407–8 (2004).

[13] See Apple Inc., Annual Report (Form 10-K) 21 (Sept. 30, 2017).

[14] See What Companies Are Really Doing With Their Tax Windfall (So Far), Bloomberg, Jan. 415, 2018,

[15] For a history of these practices, see Robert G. Cross et al., Milestones in the Application of Analytical Pricing and Revenue Management, 10 J. Revenue & Pricing Mgmt. 8 (2011).

[16] See Christopher Elliott, Why Can’t Airline Tickets Be Transferable?, USA Today, Dec. 23, 2013,; Ben Popper, Uber Surge Pricing: Sound Economic Theory, Bad Business Practice, The Verge, Dec. 18, 2013,; Gordon Cox, ‘Hamilton’ Ticket Prices Hit New High With $1,150 Premium, Variety, Dec. 26, 2017, Supply is obviously fixed in the case of Broadway and airline seats, and not nearly so variable as price in the case of ride-share seats, making these pricing practices largely about distribution, not efficiency.

[17] See Broadcast Music, Inc. v. Columbia Broadcasting System, Inc., 441 U.S. 1, 19–20 (1979).

[18] See Milton Friedman, The Social Responsibility of Business is to Increase Its Profits, The New York Times Magazine, Sept. 13, 1970.

[19] See George L. Priest, Bork’s Strategy and the Influence of the Chicago School on Modern Antitrust Law, 57 J. L. & Econ. S1 (2014).

[20] See Lynn A. Stout, The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public (2013).

[21] Henry Hansmann & Reinier Kraakman, The End of History for Corporate Law, 89 Geo. L.J. 439, 442 (2000).

[22] See Thomas Piketty, Capital in the Twenty-First Century (Arthur Goldhammer trans., 2017).

This post comes to us from Professor Ramsi Woodcock at Georgia State University. It is based on his recent article, “Antitrust as Corporate Governance,” available here.

March 28, 2018
Simpson Thacher Discusses Supreme Court Ruling on State Court Jurisdiction Over Securities Class Actions
by Jim Kreissman, Alexis Coll-Very, Stephen Blake and Pete Kazanoff

On March 20, 2018, the Supreme Court in Cyan, Inc. v. Beaver County Employees Retirement Fund, No. 15-1439, unanimously held that state courts have jurisdiction over class actions alleging only violations of the Securities Act of 1933.[1]  The Court rejected the issuer’s argument that the Securities Litigation Uniform Standards Act passed in 1998 eliminated the jurisdiction of state courts to hear such class actions.  In resolving a split among state and federal courts, the Court likewise rejected a middle-of-the-road position advanced by the Solicitor General that such actions should be removable from state to federal court.

Statutory Framework

The Securities Act of 1933 (“the ’33 Act”) allows persons who acquire a registered security to bring suit against an issuer, underwriter, and numerous others for materially false or misleading statements or omissions made in a registration statement or offering document.  As originally passed, the ’33 Act provided for concurrent jurisdiction, meaning that a plaintiff could bring such a claim in either state or federal court.

In 1995, Congress passed the Private Securities Litigation Reform Act (the “PSLRA” or “the Reform Act”) to combat the “nuisance filings, targeting of deep-pocket defendants, vexatious discovery requests, and ‘manipulation by class action lawyers of the clients whom they purportedly represent’” that had become a known feature of private securities litigation.  Merrill Lynch, Pierce, Fenner, & Smith Inc. v. Dabit, 547 U.S. 71, 81 (2006).  The PSLRA instituted significant changes to class actions brought under federal securities statutes, including the ’33 Act.  Because these class action reforms generally applied only to cases brought in federal court, however, the PSLRA had an unintended consequence:  plaintiffs bringing securities fraud class actions could avoid the PSLRA’s new restrictions by bringing their claims in state court, asserting claims under state law or under the ’33 Act.

Concerned that the intent of the PSLRA was not being fully effectuated, Congress passed the Securities Litigation Uniform Standards Act (“SLUSA”) in 1998.  SLUSA’s “core provision” is § 77p, in which SLUSA divested state courts of the ability to hear class actions bringing state law claims involving “covered securities.”  Merrill Lynch, 547 U.S. at 82.  Generally, a security is a “covered security” if it was listed on a national stock exchange at the time the alleged misrepresentation, omission, or deceptive conduct occurred.  The question the Court decided on Tuesday was “whether § 77p limits state-court jurisdiction over class actions brought under” the ’33 Act.

Case Background

In 2014, three pension funds and one individual sued Cyan, Inc. (“Cyan” or “Petitioners”), a network support provider, and several of its officers and directors in California Superior Court alleging violations of the ’33 Act.  The plaintiffs (Respondents in the U.S. Supreme Court) had purchased shares in Cyan’s 2013 Initial Public Offering, whereupon the company’s stock began to trade on the New York Stock Exchange.  After Cyan’s stock price dropped in 2014, the plaintiff shareholders sued Cyan in California state court on behalf of a putative class, alleging that Cyan violated the ’33 Act by misrepresenting the company’s reliance on certain projects and the impact of those projects on future sales in its offering documents.  Cyan moved for judgment on the pleadings, arguing that the California state court did not have jurisdiction over class actions that assert claims exclusively under the ’33 Act.  The court denied the motion, pointing to California precedent holding that SLUSA did not prohibit ’33 Act claims from being heard in state court.  After appeals through the California state court system were denied, Cyan petitioned the U.S. Supreme Court for a writ of certiorari, which was granted on June 27, 2017.

Summary of the Court’s Opinion

Justice Kagan, writing for a unanimous Court, found that the provision of SLUSA in dispute does not deprive state courts of their concurrent jurisdiction over class actions alleging violations of the ’33 Act.  That provision provides that federal district courts “shall have jurisdiction[,] concurrent with State and Territorial courts, except as provided in section 77p of this title with respect to covered class actions, of all suits in equity and actions at law brought to enforce any liability or duty created by” the ’33 Act.  15 U.S.C. § 77v(a) (2012) (emphasis added).  The Court termed the italicized language of this provision the “except clause,” and the central dispute in the case was whether the clause’s reference to “covered class actions” pointed to the definition of that term in § 77p(f)(2).  If it did, Petitioners argued, state courts would not have jurisdiction over such class actions brought under the ’33 Act.

The Court rejected Petitioners’ argument for two reasons.  First, if Congress had wanted to refer to § 77p(f)(2)—instead of more broadly to § 77p, as it did in the except clause—it would have done so, “just by adding a letter, a number, and a few parentheticals.”  Indeed, elsewhere in SLUSA Congress did use a pinpoint reference to a subsection of § 77p, Justice Kagan noted.  Second, § 77p(f)(2) provides a definition (of “covered class action”) not an exception to concurrent jurisdiction, and Congress is well aware of the difference between those two functions.

Justice Kagan reasoned that, by its terms, § 77p only prevents certain class actions based on state law from being heard in state courts (the statute requires that they be removed to federal court and dismissed), and that nothing in the text prevents a state court from hearing class actions based exclusively on federal law.

Turning from the statutory language, the Court concluded that even if arguments about SLUSA’s legislative purpose and history could overcome a plain reading of the statutory text, Cyan failed to account for other ways in which SLUSA furthers Congress’s objectives.  SLUSA’s preamble sets out the statute’s goal of “limit[ing] the conduct of securities class actions under State law.”  In barring class actions brought under state law, SLUSA guarantees that the substantive protections of the federal Reform Act will apply to class actions, regardless of whether they proceed in state or federal court.  This objective does not depend on stripping state courts of jurisdiction over ’33 Act class actions.

Moreover, Justice Kagan wrote, SLUSA’s revisions to the Securities Exchange Act of 1934 (“the ’34 Act”) served Congress’s goal of moving the majority of securities class actions to federal court.  As with the ’33 Act, SLUSA also amended the ’34 Act to bar class actions based on state law, forcing plaintiffs to bring claims under the ’34 Act.  Because federal courts are vested with exclusive jurisdiction over ’34 Act claims, those plaintiffs end up in federal, not state, court.  And far more suits are brought under the ’34 Act, which regulates all trading of securities, than the ’33 Act, which regulates only securities offerings.

Finally, the Court rejected the Solicitor General’s “halfway-house position,” holding that SLUSA does not permit the removal of class actions alleging only ’33 Act claims from state to federal court.  Under that interpretation, another provision of § 77p in subsection (c) would permit the removal of ’33 Act class actions to federal court if they allege false statements or deceptive devices in connection with the purchase of a covered security, as listed in § 77p(b).  But § 77p(b) refers to state-law class actions, which are removable to federal court (after which they are to be dismissed), not federal-law class actions asserting ’33 Act claims.  The Court explained that the government’s construction distorted SLUSA’s text, and statutory language cannot be ignored “based on an intuition that Congress must have intended something broader.”


Plaintiffs have often found greater success litigating ’33 Act claims in state court rather than federal court, and the Court’s holding that such suits are permissible presumably will result in more ’33 Act cases being filed in state courts.  The Court has left it to Congress to place any further restrictions on the proper venue for federal securities class action litigation.  Proposals to limit the ability of state courts to hear cases involving ’33 Act claims may now gain traction in Congress.


[1] Simpson Thacher filed a brief in this case on behalf of amici curiae in support of Petitioners.

This post comes to us from Simpson Thacher & Bartlett. It was originally published as a client memorandum on March 26, 2018, titled “Supreme Court Unanimously Upholds State Court Jurisdiction Over Class Actions Alleging Only Claims Under the Securities Act of 1933” and available here.

March 28, 2018
Blackrock Investment Stewardship’s Approach to Engagement on Human Capital Management
by Michelle Edkins, BlackRock

BlackRock has an industry leading global investment stewardship program that promotes corporate governance best practices at the companies in which we invest. This program is part of the investment function at BlackRock, fulfilling our fiduciary duty to protect and enhance the value of our clients’ assets.

As Larry Fink recently wrote in his 2018 annual letter to CEOs:


Companies must ask themselves: What role do we play in the community? Are we working to create a diverse workforce? Are we adapting to technological change? Are we providing the retraining and opportunities that our employees and our business will need to adjust to an increasingly automated world?

For several years, the BlackRock Investment Stewardship (BIS) team has been engaging companies on the topic of human capital which we also identify as one of our 2018 engagement priorities. [1] The BIS team has been in discussions with companies about their management of employees as an investment issue.

This post sets out in some detail our thinking on human capital management (HCM) and explains how we approach engagement on the topic.

Why Human Capital Management is an Investment Issue

Most companies BlackRock invests in on behalf of clients have, to varying degrees, articulated in their public disclosures that they are operating in a talent constrained environment, or put differently, are in a war for talent. It is therefore important to investors that companies explain as part of their corporate strategy how they establish themselves as the employer of choice for the workers on whom they depend. A company’s approach to HCM—employee development, diversity and a commitment to equal employment opportunity, health and safety, labor relations, and supply chain labor standards, amongst other things—will vary across sectors but is a factor in business continuity and success. In light of evolving market trends like shortages of skilled labor, uneven wage growth, and technology that is transforming the labor market, many companies and investors consider robust HCM a competitive advantage.

Research has consistently shown the importance of human capital to company performance. Companies included in Fortune magazine’s “100 Best Companies to Work For” lists earned, over the long-term, excess risk-adjusted returns of 3.5%. [2] Another report surveyed a multitude of studies on human capital and found that there is a positive correlation between human resource initiatives and investment outcomes such as total shareholder return, return on assets, return on earnings, return on investment and return on capital employed. [3] A survey concluded that companies that had a workforce that was not engaged had an average one-year operating margin below 10%; however, those that consistently promoted workers’ well-being had an average one-year operating margin of 27%.

BlackRock’s Engagement On Human Capital Management

HCM is both a board and a management issue. We would expect a company’s board to be deeply engaged in the oversight of a company’s strategy and the defining of a company’s purpose—to help ensure the effective strategic implementation of HCM throughout their organization. Companies that can better articulate their purpose are more likely to build strong relationships with their employees (and customers), and have a clear sense of their strategic objectives. These are essential components of long-term growth. Employees who do not feel valued by their organization are generally less productive or more likely to leave. Product quality and reputation can suffer when employees are not fully engaged and supportive of the company, its business and goals. When present, these dynamics make it much more difficult for a company to meet its strategic objectives. For management, it is an issue that is central to their everyday duties. We also expect that boards, acting as fiduciaries on behalf of investors and as those who help set the tone at the top, to be focused on the opportunities and risks associated with HCM.

The BIS team is aware that disclosure of information on HCM is still evolving and that the way HCM risks manifest themselves may vary by industry and market. We are members of the Investor Advisory Group of the Sustainability Accounting Standards Board (SASB), which provides industry-specific HCM metrics. We encourage companies to aim over time to go beyond commentaries and provide more transparency on their practices. Investors recognize that most companies are already in possession of HCM data on their workforce, but are cautious of disclosing this information. We believe that both qualitative and quantifiable indicators can help effectively distinguish companies that are managing this important driver of value in their business.

Our engagements seek to be constructive, aiming to build mutual understanding while asking probing questions. Where we believe a company’s practices fall short relative to market or peer practice, we will share our insights and perspectives.

When engaging boards on HCM we are likely to discuss:

  • Oversight of policies meant to protect employees (e.g., whistleblowing, codes of conduct, EEO policies) and the level of reporting the board receives from management to assess their implementation
  • Process to oversee that the many components of a company’s HCM strategy align themselves to create a healthy culture and prevent unwanted behaviors
  • Reporting to the board on the integration of HCM risks into risk management processes
  • Current board and employee composition as it relates to diversity
  • Consideration of linking HCM performance to executive compensation to promote board accountability
  • Board member visits to establishments or factories to independently assess the culture and operations of the company

When engaging management teams, the topics we may cover include:

  • Policies to encourage employee engagement outcomes and key drivers (e.g., wellness programs, support of employee networks, training and development programs, and stock participation programs)
  • Process for ensuring employee health and safety and complying with occupational health and safety policies
  • Voluntary and involuntary turnover on various dimensions (e.g., seniority of roles, tenure, gender, and ethnicity)
  • Statistics on gender and other diversity characteristics as well as promotion rates for and compensation gaps across different employee demographics
  • Programs to engage organized labor and their representatives, where relevant
  • Systems to oversee matters related to the supply chain (including contingent workers, contractors and subcontractors)
March 28, 2018
Do Proxies for Informed Trading Measure Informed Trading? Evidence from Illegal Insider Trades
by Kenneth Ahern

Trading by investors who have material, non-public information is of first-order importance to liquidity providers, stock market operators, and securities market regulators. Liquidity providers, such as market makers and institutional investors, worry that an informed trader will take advantage of their lack of information. Operators of stock markets worry that the presence of informed investors will drive uninformed investors out of the market. Regulators worry that an unfair advantage by some investors will impair equal access to equity markets.

Though many market participants worry about the presence of informed trading, there is little credible evidence on the validity of existing empirical proxies to identify periods of informed trading, such as bid-ask spreads, Kyle’s lambda, and trade order imbalances. Though these proxies are theoretically grounded, they remain largely untested. This is because validating the proxies requires the rare opportunity to directly observe informed trading.


In a new paper entitled, Do Proxies for Informed Trading Measure Informed Trading? Evidence from Illegal Insider Trades, I exploit detailed data on illegal insider trading to provide new evidence on the validity of a host of proxies for informed trading. Though illegal insider trading does not represent all informed trading, these data help to overcome a number of empirical obstacles. First, the legal documents in insider trading cases provide direct observations of the timing of information flows and trades. Second, the trades documented in illegal insider trading cases are, by definition, based on material non-public information, not speculation or public information. Third, the data include observations of informed trading in a wide range of firms and events. Finally, the longevity of information varies in the data, allowing a comparison of short-lived versus long-lasting information.

The observations of insider trading are hand-collected from all insider trading cases filed by the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) between 2009 and 2013. The sample includes 312 different firms in 410 different insider trading events over the period 1996 to 2013. Mergers and acquisitions are the most common event in the sample (52%), followed by earnings announcements (28%), news about drug regulation (9%), and other announcements about operations, security issuance, and financial distress. Firms range from recently public firms to the largest firms in the economy, including Microsoft, Procter & Gamble, and Berkshire Hathaway, and the median sample firm is comparable to the median firm on the NYSE.

Using direct observations of insider trading, I compare the power of widely used measures of illiquidity to predict informed trading. Specifically, using intraday data of trades and quotes, I calculate quoted, effective, and realized spreads, price impact, absolute order imbalance, Kyle’s lambda, and parameters from the decomposition of the bid-ask spread. Using daily data, I also calculate the Amihud illiquidity.

First, I show that informed traders strategically time their trades to avoid detection. In particular, without controlling for strategic timing, I find that none of the standard proxies of informed trading are significantly related to illegal insider trading. Instead, sophisticated insiders wait to trade on days when liquidity is high and their trades are harder to identify by market participants and regulators. This causes proxies of informed trading to be low exactly when insiders are trading.

Second, when I control for strategic timing, the results are strikingly different. When information is short-lived, and informed investors do not have the luxury to wait for days with high liquidity, nearly all of the proxies of informed trading are correlated with illegal insider trading, consistent with theoretical predictions.

However, these results are subject to the concern that the data on illegal insider trading is limited to the cases that were detected by the regulators. In particular, if regulators use standard proxies of informed trading to detect illegal insider trading, the results might just reflect bias in the way in which the data were sampled from the population by the regulators

To test for sampling bias, I run tests to separate cases in which regulators are more likely to have used proxies of informed trading to detect illegal insider trading, compared to cases detected by traditional investigations. To separate cases driven by empirical proxies, I identify SEC insider trading cases that were investigated with assistance of FINRA. FINRA is the financial sector’s self-regulatory agency and has the responsibility to monitor markets for suspicious trading behavior. If FINRA detects abnormal behavior using its proprietary algorithms, it refers the case to the SEC. In contrast, the SEC also brings cases that were detected by tips submitted by the public and other non-market investigation techniques.

Once I control for FINRA’s involvement in a case, I find that only two proxies of informed trading still predict illegal insider trading: absolute order flow of stock trades and the autocorrelation of order flow. Traditional measures, such as the bid-ask spread and Kyle’s lambda lose their ability to predict insider trading. Moreover, my results indicate that FINRA’s algorithms rely on unusual changes in bid-ask spreads (quoted by market makers) to detect suspicious activity, but ignore patterns of orders (placed by traders). FINRA’s algorithm might be improved if they rely more heavily on patterns of order flow.

This paper’s results have a number of important implications. First, though standard proxies for informed trading have the power to predict illegal insider trading, they are only effective when information is short-lived and traders cannot strategically time their trades. When information is long-lived, strategic timing nullifies the predictive power of all of the illiquidity measures. Second, the illiquidity measures that are the most reliable predictors are based on order flows, not prices or quotes. This suggests that market makers do not adjust prices and quotes in response to informed trading, contrary to the assumptions of many theoretical models. Finally, the results of this paper help to reveal the conditions under which regulators are more likely to detect insider trading.

The complete paper is available here.

March 28, 2018
Upcoming Volcker Rule Regulatory Changes
by Mark Nuccio, Ropes & Gray

Federal financial regulators responsible for enforcement of the Volcker Rule are about to embark on a process that will culminate in a significant revision to the regulations that went into effect eighteen months ago. In a March 5, 2018 speech at the Institute of International Bankers Annual Washington Conference in Washington, D.C., Randal K. Quarles, Federal Reserve Board Vice Chairman for Supervision, outlined the expected principal areas of focus. He also endorsed legislative efforts to pull community banks out from under the Volcker Rule.


Where the regulators can make adjustments without Congressional approval, Vice Chairman Quarles stated that a serious effort will be made to address areas where the current regulations make life harder than necessary for regulators and the regulated, as follows:

  1. Clarify what is, and what is not, subject to the Volcker Rule, particularly, definitions of key terms like “proprietary trading” and “covered fund.” Interpreting these definitions has required hours of legal analysis of complex banking and securities regulations. Regulatory supervisors have been unable to provide clear and transparent guidance. New regulations will seek to provide greater certainty that would benefit market participants as well as the supervisors at the agencies.
  2. Clarifying certain exemptions will be another area of focus. Vice Chairman Quarles highlighted difficulty in interpreting the exemption for market making-related activities, which is one of the key exemptions from the prohibition on proprietary trading. The statute provides an exemption for the market making-related activities that are designed not to exceed the reasonably expected near-term demands of clients, customers, or counterparties. The regulatory exemption is extraordinarily complex and the regulators will be considering different ways to use a clearer test. Vice Chairman Quarles stated that the Federal Reserve Board also understands that the Volcker rule has had an extraterritorial impact on foreign banking organizations. With respect to foreign banks, he said, there are at least a few places where the Federal Reserve Board would like to revisit the application of the final rule based on concerns raised by market participants and others over the past four years of implementation.
  3. Non-U.S. financial institutions may get a reprieve from the rule. Foreign funds organized outside the United States by foreign banks in foreign jurisdictions and offered solely to foreign investors may be subject to the Volcker Rule due to Bank Holding Company Act control principles. Last summer, the banking agencies, in consultation with the Securities and Exchange Commission and the Commodity Futures Trading Commission, issued guidance that effectively stayed enforcement of the Volcker Rule to these foreign funds in light of the technical and complex issues they raise. Expect that stay to remain in force while the regulators consider revisions.
  4. The regulators also appear ready to re-examine the ease with which non-U.S. banks may qualify for an exemption that permits them to trade outside the U.S. without the Volcker Rule strictures. The revision could provide U.S. banks with the ability to qualify for the non-U.S. trading exemption, an exemption for which they are currently ineligible.
  5. Most importantly, perhaps, is the prospect of revisions to the Volcker Rule compliance regime.

The speech by Vice Chairmen Quarles will be cheered by the industry. Amending regulations will take time, but the speech signals that the process will commence in the near term.

March 28, 2018
SEC Charges of Failure to Supervise by BD Heading For Hearing
by Tom Gorman

Typically broker-dealers and other regulated entities resolve Commission investigations prior to the institution of any proceedings. A west coast broker-dealer alleged to be a recidivist, however, chose not to resolve failure to supervise claims by the agency that are alleged to stem from years of manipulative conduct by one of its registered representatives whose business partner is a part owner of the firm. The case will be set for hearing. In the Matter of Wedbush Securities, Inc., Adm. Proc. File No. 3-18411 (March 27, 2018).

Los Angeles based Wedbush was founded in 1995. It registered with the NASD as a broker-dealer. Later the firm registered with the Commission as a broker-dealer and investment adviser. Twice in recent years the firm has been charged with violations of the federal securities laws. First, in June 2014 the firm was charged by the Commission with violations of Exchange Act Rule 15c-3-5 for providing market access to certain international traders in the absence of appropriate controls. The firm settled, agreeing to take certain remedial steps while Paying a $2.44 million penalty. Second, in February 2018 the firm settled charges that it violated Exchange Act Sections 15(c)(3) and 17(a)(1) by agreeing to retain an independent compliance consultant and pay disgorgement and a $1 million penalty.

This proceeding centers on the firm’s failure to supervise registered representative Timary Delorme (see below). Ms. Delorme has been with the firm for over 30 years and is partners with one of its partial owners. In 2009 Ms. Delorme’s front-line supervisor conducted a review of trading and customer portfolios as part of an overall analysis of those he supervised. Although the supervisor had concerns about the quality of the penny stocks in the customer accounts and limited her trading in the last hour of the day as well as in certain penny stocks, he tried to be “gentle” with her because of her ties to firm ownership.

In 2012 the supervisor reviewed an e-mail between Ms. Delorme and a customer. The e-mail outlined deals involving the customer, Zirk Englebrecht and others about the efforts to inflate the price of penny stocks, many of which were held in accounts at Wedbush and by customers of Ms. Delorme. In 2014 Mr. Englebrecht was charged by the Commission with violating the antifraud and registration provisions of the federal securities laws. Mr. Engelbrecht eventually pleaded guilty in the criminal case to one count of conspiracy to commit securities fraud, two counts of securities fraud, and four counts of wire fraud. Mr. Engelbrecht had engaged in pump-and-dump schemes. He is currently serving a sentence of 151 months in prison. Although Ms. Delorme continued to participate in the scheme after the date of the e-mail, the firm did not restrict her activities.

At about the same time as the e-mail, Ms. Delorme and Wedbush were named as respondents in two FINRA customer arbitrations. The first, brought by four customers, alleged that the representative had solicited their investments in certain penny stocks, guaranteed no losses, gifted securities, set up a deal between her customer and an associate of Mr. Engelbrecht, and was involved in manipulative trading to guarantee profits. The complaint was reviewed by a number of firm personnel including the president who initialed it. The second matter, filed latter in 2012, was similar. The actions were settled with Ms. Delorme paying half the settlement amounts. The firm deemed her culpable for her behavior.

By year end 2012 Wedbush had received inquiries from FINRA’s Office of Fraud Detection and Market Intelligence into trading in a specific penny stock by three accounts held by Ms. Delorme and her husband. FINRA also made a number of inquiries about the customer arbitrations noted above. While compliance and legal at Wedbush each conducted an inquiry, both were flawed. Both lacked process and failed to document the scope of the inquiry or its results. It is “unclear what, if anything, was reported from legal or compliance to Wedbush’s management,” according to the Order. Ms. Delorme was placed on heightened supervision for one year in March 2014 but it appears this was instituted in order to resolve the FINRA matter noted above. In fact, Wedbush has no documentation reflecting who decided on Ms. Delorme’s discipline, the reason the heightened supervision was appropriate or the timing of the discipline.

The Order alleges that Wedbush’s “policies and supervisory systems lacked any reasonable coherent structure to provide guidance to supervisors and other staff for investigating possible facilitation of market manipulation by registered representatives . . .” This lack of reasonable policies and procedures resulted in a failure to supervise Ms. Delorme. The Order alleges a failure to supervise with a view to preventing and detecting Ms. Delorme’s violations of Securities Act sections 17(a)(1) and (3) and Exchange Act sections 9(a)(2) and 10(b). The proceedings will be set for hearing. See also In the Matter of Timary Delorme, Adm. Proc. File No. 3-18410 (March 27, 2018)(registered representative consented to entry of a cease and desist order based on Securities Act section 17(a) and Exchange Act sections 9(a)(2) and 10(b) tied to manipulation claim, bar from the securities business and a penny stock bar, and payment of a $50,000 civil penalty).

Program: Insights Into SEC Enforcement, is roundtable discussion of the Former Directors of the SEC’s Division of Enforcement that will be held on April 3, 2018 beginning a 4:30 p.m. at Georgetown University Law School. The program will be followed by a reception. Registration is available here without charge. The program is sponsored by the SEC Historical Society, the Federal Bar Association, and the Association of SEC Alumni.

The post SEC Charges of Failure to Supervise by BD Heading For Hearing appeared first on SEC ACTIONS.

March 28, 2018
Blockchain Technology for Corporate Governance and Shareholder Activism
by Anne Lafarre, Christoph Van der Elst

Although the hype around the buzzword “blockchain” is currently still largely focused on speculation with virtual currencies like bitcoins, blockchain is a state-of-the-art technology that can offer smart solutions for classical inefficiencies in the corporate governance field. In our recent paper, Blockchain Technology for Corporate Governance and Shareholder Activism, we look into the applications of blockchain technology in the field of corporate governance, paying special attention to the restructuring of the old-fashioned and rigid Annual General Meeting of Shareholders (the AGM). We explore the AGM’s (lack of) performance and make a strong plea for blockchain-based AGM.


Agency theory in corporate law aims to optimize the contractual framework that governs the relationship between directors and shareholders. Despite all (scholarly) efforts, following the seminal theory of Jensen and Meckling, agency costs can never be fully excluded, unless the fundamental corporate characteristic of a delegated management structure can be removed. Blockchain technology can mitigate the salient agency problem and its related costs. Nonetheless, The DAO—which was a completely decentralized blockchain based association—shows that the lack of a centralized authority can create a sub-optimal situation, too.

Despite the failure of The DAO, blockchain offers new possibilities to facilitate the agency relationship between corporate actors, thereby creating trust and transparency. In particular, we see possibilities for reducing the agency costs for both shareholders and companies through the optimisation and modernization of the AGM. The AGM plays an important theoretical role in shareholder monitoring and corporate bonding, but in practice, it is considered a dull mandatory ritual, which classical outline remained unchanged for centuries. In contrast, corporate life has moved on and pays only lip service to the old-fashioned legal requirements of AGMs. As we show in the paper, all three theoretical functions of the AGM—the information, forum and decision-making function—are currently at least partially hollowed and strict procedural requirements hinder fast and flexible decision-making. For example, economic theory predicts that, in particular, small shareholders have low incentives to engage in decision-making as their voting costs are generally higher than their voting benefits. Reducing these costs can increase (the willingness of) small shareholders participation, improving participation rates and thus the validity of the AGM’s decision-making function.

The slow decision-making process can be illustrated with the practice of co-optation that is for example present in Belgium. If a director resigns, her position can directly be taken by another director, co-opted by the board. The next general meeting of shareholders must approve the election of the co-opted director, but practice shows that some co-opted directors already have resigned before the AGM had even approved their election. We claim that the very existence of this corporate law mechanism of co-optation and subsequent AGM’s shareholder approval shows that also legislators recognize that the AGM is too static. Moreover, the general meeting-tool for fast shareholder decision-making is not efficient either, as the premature resignation of the co-opted directors illustrates.

There are other, even more fundamental procedural flaws that undermine the AGM’s functioning in practice. Shares are usually held through complex chains of intermediaries, especially in the case of cross-border voting. These intermediaries not only add transaction costs to shareholder participation per se, there is also high uncertainty that information, including the record of shareholder votes, is correctly channelled between ultimate shareholders and companies in remote participation. Nonetheless, remote voting has proven to be the most common way of shareholder AGM participation to date.

The presence of these substantial practical flaws makes it worthwhile to investigate the possibilities of blockchain technology for AGMs. In a private blockchain, managed by the company only accessible for shareholders for example on the Hyperledger of IBM, the company and shareholders that hold sufficient shares can place proposals. Smart contracting allows for the private ledger to be structured so that all relevant information including majority rules and access rights that are contained in the articles of association and the law are taken into account. Once a certain proposal is placed in the blockchain, shareholders that hold shares in the company are immediately notified and can exercise their voting rights during a short period. The voting results may become instantly available after a cut-off point, and majority requirements, necessary to render the decision binding and verifiable, need to be reached in a specified timeframe. Shareholders can verify their own transactions, but none of the shareholders should be able to determine what voting decision was taken by other shareholders. Since institutional investors in Europe need to publicly disclose information about the implementation of their engagement policy in the near future pursuant to the new Shareholder Rights Directive ((EU) 2017/828), for these shareholders it may actually be beneficial that other shareholders can see their voting decision in the blockchain in a trustworthy and transparent way.

With this blockchain technology shareholder voting transaction costs can be reduced substantially. We claim that it may also offer opportunities for enhancing the AGM’s forum function, in contrast to what opponents of virtual meetings advocate. Moreover, blockchain can also decrease the organisation costs for companies and increase the speed of decision-making, making the AGM a fast and lean corporate organ. The main problems with the current chains of intermediaries and the current remote voting system have to do with transparency, verification and identification—issues that are directly linked to the advantages of blockchain technology.

The recent prototypes of blockchain-based AGMs that we discuss in our paper, of which some are already launched in practice, show that this modernization of the AGM is indeed practically feasible and perhaps just around the corner. Given the large opportunities we expect more initiatives to be launched soon, probably before our contribution’s ink is dry. Nonetheless, it is important to recognize that the blockchain-based AGM would also raise important corporate legal questions, including whether it is desirable to abolish the physical classical AGM. And if it is desirable to organize decentralized blockchain-only AGMs, how much of the forum function would then be incorporated in this technology?

The complete paper is available for download here.

March 28, 2018
10-K/A: 13 Reasons Why
by John Jenkins

This Audit Analytics blog reviews the 13 reasons why (sorry, Netflix – I couldn’t help myself) companies amended their Form 10-Ks last year. Not surprisingly, the most common reason was a need to include Part III information due to an inability to get their definitive proxy materials on file within 120 days of the fiscal year end. In fact, these amendments accounted for 52% of total 10-K/A filings in 2017. Rounding out the top 5 reasons for filing a 10-K/A were the following:

– Signatures & exhibits (8%)
– Auditor’s consent (7%)
– Auditor’s report (7%)
– CEO & CFO Certifications (6%)

Most of these reasons for amending involved pretty technical stuff – but there were some more problematic reasons for amending a 10-K as well. Modifications to disclosure controls & procedures or ICFR disclosures accounted for 5% of amended filings, while restatements accounted for 4%.

Reflecting in part the continuing downward trend in the number of public companies, a total of 340 10-K/As were filed last year – that’s a decline of nearly 20% from the roughly 420 10-K/As filed in 2016.

Lease Accounting: Fear & Loathing on The Implementation Trail

According to this recent Deloitte survey, all is not well on the path to implementation of FASB’s new lease accounting standard. With less than 9 months to implement the new standard, most public companies are still woefully underprepared.  Here’s an excerpt from the press release announcing the survey results:

Just 21.2% of finance, accounting and other professionals say their companies are “extremely” or “very” prepared to comply with the FASB’s and International Accounting Standards Board’s (IASB) respective new lease accounting standards, according to a recent poll from the Deloitte Center for Controllership™. That’s more than double the number expressing confidence from early 2016 (9.8 percent), when the standards were initially issued, but still relatively low as the deadline for adoption (Jan. 1, 2019 for U.S. publicly traded companies) draws closer.

Most survey respondents don’t think that the FASB’s recent efforts to ease the implementation process will make their lives easier as they work toward compliance. In fact, only 10% of respondents anticipate the FASB’s measures will reduce the amount of time and effort needed to implement the new standard.

Transcript: “Activist Profiles & Playbooks”

We have posted the transcript for the recent webcast: “Activist Profiles & Playbooks.”

John Jenkins

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3/28/2018 posts

CLS Blue Sky Blog: Antitrust as Corporate Governance: Why a Firm’s Mission Is to Earn No Profit
CLS Blue Sky Blog: Simpson Thacher Discusses Supreme Court Ruling on State Court Jurisdiction Over Securities Class Actions
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Blackrock Investment Stewardship’s Approach to Engagement on Human Capital Management
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Do Proxies for Informed Trading Measure Informed Trading? Evidence from Illegal Insider Trades
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Upcoming Volcker Rule Regulatory Changes
SEC Actions Blog: SEC Charges of Failure to Supervise by BD Heading For Hearing
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Blockchain Technology for Corporate Governance and Shareholder Activism Blog: 10-K/A: 13 Reasons Why

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