No One Told You?

“’We're not sitting around waiting for people to call us,’ says Norm Champ, deputy director of the SEC's compliance office. ‘But one of the problems we have is when people spot things but don't tell us. If people think they have something, they should let us know.’”

The Intelligent Investor, Why Regulators Can’t Keep ‘Safe’ Bond Funds From Sinking, Wall St. J., Jan. 15, 2011, at C1.

Last week the SEC charged Charles Schwab with misleading investors about the safety of a short-term bond portfolio.  The Intelligent Investor used this as a jumping point to highlight the limits of regulation.  As the article points out, the SEC struggles to keep up with individuals in the financial industry for a variety of reasons.  One key reason being that the SEC is understaffed.  The commission has 460 examiners that monitor 7,500 mutual funds, 1,000 exchange-traded funds and 11,000+ investment advisors.

Despite being over matched, the SEC does not seem to be getting any help from outsiders.  Or does it?  Harry Markopolos is one example.  Markopolos is a former securities industry executive best known for blowing the whistle on Bernie Madoff.  He was asked to look into the Madoff Fund to see how his firm could match Madoff’s double-digit returns.  He quickly realized that the fund was a fraud and reported it to the SEC.  As he chronicles in his book, No One Would Listen, the SEC ignored numerous warnings about Madoff for a period of fifteen years.

Back in March, Markopolos was on the Daily Show and, while ranting about the SEC, brought up an interesting point.  He argued that one of the principle problems with the SEC is that it is staffed with lawyers.  While intelligent people, they do not possess the level of financial sophistication required to keep up with constantly evolving financial markets.  While I do not know how the SEC is staffed, I agree: lawyers can not keep up with financial innovators.  Financial innovation is not the specialty of lawyers and it is too complex to understand it at the same level as hedge fund managers.

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For more on the need to better train lawyers in financial matters, see Robert J. Rhee, The Madoff Schandal, Market Regulatory Failure and the Business Education of Lawyers, 35 J. Corp. L. 363 (2010).

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The Sale of Sterling Bancshare: Brought to You By Risk Metrics

“Few banks wanted to mess with Texas during the savings-and-loan crisis of the 1980s and 1990s. Now, a rare auction of one of the state's independent financial institutions is attracting plenty of interest.”

Robin Sidel, Sterling Bancshares Puts Itself Up for Sale, Wall St. J., Jan. 14, 2011, at C1.

Although Sterling Bancshare is a Texas corporation, I want to make a point about this process and Delaware law.  Sterling has placed itself on the auction block and is accepting offers.  A number of banks with a presence in Texas have shown interest and will likely place bids on the company.  Although Texas law applies this situation, Delaware law tends to be standard and the same doctrines may apply here.  In Delaware, when a company puts itself up for sale, there is a fiduciary duty called the Revlon Duty that kicks in.  Essentially when a sale/takeover becomes inevitable, the target company’s board of directors has the duty to maximize shareholder value.  To do this it cannot play favorites.  An open bidding process insures that the company receives the maximum bid.  It may seem silly that I explain this all, but it is something that came up recently in an MBA group project.  It was a strategic exercise where a dairy company wanted to become more like Whole Foods with the hope of being acquired.  I had to bite my tongue for the good of the project, but an acquireree cannot target an acquireror.  Courting your purchaser constitutes playing favorites and it does not welcome an open bidding process that maximizes shareholder value.

Returning to Sterling Bancshare, they are conducting an open bidding process and will probably maximize their purchase price.  The other interesting thing about this sale is the proxy fight Sterling is facing from its largest shareholder.  Proxy contests are generally very straightforward.  Each voting share gets a vote and the most votes wins.  If one individual has 100 shares, he or she gets 100 votes.  The process has become more questionable due to the limited time and resources of institutional investors.  

Typically and institutional investor, like a mutual fund, will own shares in hundreds of different companies.  Because of this large number of investments and limited time and resources, institutional investors are not able to properly research every proxy they can vote on.  In response to this, companies like Risk Metrics (Institutional Shareholder Services) have come along to assist institutional investors in proxy voting.  They do the research and the shares get voted.

It seems like a simple idea where everybody wins, but it does create an agency problem.  Under traditional agency theory, directors and manages run the company.  The agency relationship between them and shareholders governs their actions and keeps them inline with shareholder interests.  Naturally, when shareholders are asked to vote on more substantial issues, like the sale of the company, self-interest directs the vote.  Introducing Risk Metrics and other proxy advisors into the process complicates this issue.  Institutional investors tend to blindly follow risk Metrics’ recommendations.  This gives the proxy advisor significant influence over decisions in which it has no stake.  It will be interesting to see where Risk Metrics and other proxy advisors come down on this the Sterling Bancshare sale.  Regardless of it they comes down, its vote will most likely drive the outcome.

For more on the proxy advisory industry and agency theory, see Tamara C. Belinfanti, The Proxy Advisory and Corporate Governance Industry: The Case For Increased Oversight and Control, 14  Stan. J.L. Bus. & Fin. 384 (2009).

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Floating the Yuan In Hong Kong

“Hong Kong's stock exchange is working on a way to help investors buy stocks listed in yuan, even if they don't own any of the Chinese money, and will toughen measures to reduce market-wide risks.”

-Shai Oster, Hong Kong Plans for Yuan-Denominated Stocks, Wall St. J. Jan.12, 2011, at C2

China’s place in the world economy is under constant scrutiny because of its fixed exchange rates.  The fixed rates frustrate trade partners because they keep China’s currency artificially undervalued.  As a result, China is at unfair trading advantage and its economy is booming.  Under the Mundell-Fleming economic model, fixed exchange rates will also artificially increase production.  While officials “are still determining whether the margin will float in line with volatility or be fixed,” opening yuan-dominated stocks to other currencies may be another step towards floating the exchange rate.

For more on the consequences of revaluing the yuan, see Surplus ça change:

What would happen if China revalued the yuan? The past offers some clues, The Economist, Apr. 24, 2010.

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When Bangladesh No Longer Has That “Emerging” Feeling, Head to Laos

“Tired of fusty old outposts such as Bangladesh, Nigeria or Mongolia? Try the world's newest—and possibly smallest—stock market, the Laos Securities Exchange.”

-James Hookway, Laos Launches Stock Exchange, Wall St. J., Jan. 11, 2011, at C1

The opening of the Laos Securities Exchange is interesting for a few reasons.  First, as the article points out, Laos is best known for being the most heavily bombed country per capita and an exotic vacation destination.  Second, and more importantly, Laos is a Communist country.  China may have a few exchanges of its own, but its population is also much higher than six million.  It will be interesting to see the extent to which Laos’ Marxist leaders are willing to relinquish control of state-controlled business to the open market.

The addition of this exchange will hopefully bring new capital to Laos, which will in turn increase productivity and the standard of living.  This is, however, contingent the country’s ability to effectively deploy this newly acquired capital.  This is one source of risk, which is true in most emerging markets.  The efficacy of capital deployment is simply unknown.  This risk is one factor that contributes to the higher rate of returns in emerging markets.

Another factor attributing to high risk of emerging markets is their legal frameworks.  In the United States we tend to take for granted the protections investors enjoy.  The Securities Act of 1933 and the Securities Exchange Act of 1934 have established an legal essential framework that provides investors will a high level of transparency.  In addition to this, there are legal frameworks that address corporate governance.  The Delaware Court of Chancery’s well-developed body of case law provides investors and management with clearly defined legal parameters for the corporation.  These two legal frameworks offer investors protections that lesson risk.  Emerging markets are just that, emerging.  These types of legal frameworks have yet to be developed in markets like Laos.  The returns may be higher, but there is a reason.

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Strike Suits on the Rise

One of the many side effects of the financial crisis was a decrease in the mergers-and-acquisitions market.  As the economy begins to rebound, so does M&A activity and, along with it, strike suits.  In the WSJ today there was an article on how the number of investor lawsuits has increase dramatically since 2008.  The article goes on to suggest that strike suits have caused this increase and that they are playing a costly role in M&A activity.

Strike suits are typically frivolous claims that investors bring, not necessarily because they have suffered a loss, but because of a settlement’s potential value.  In the case of an M&A transaction, management will announce a deal.  Investors will then file a suit alleging that management did not fulfill its fiduciary duty of care in arranging the transaction.  Due to litigation costs and the chance that a lawsuit would kill the deal, the company will settle with the plaintiff investors, regardless of the merits of the case.  Often the settlements correspond more to the company’s insurance coverage than to any potential damages plaintiffs may have suffered.

The big issue with strike suits is that shareholders other than those bringing the suit bear their costs.  Often the shareholders bringing the suit are no longer current shareholders.  When the settlement is made, the costs are passed along to current shareholders through the corporate system.  

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Verizon’s Big News: A Case For Efficient Markets

On Tuesday Verizon will make big announcement and everyone is on pins and needles about what it could be. Not really. This should not be breaking news, but the iPhone is coming to Verizon. Link. While the major players this announcement affects may see some movement in their stock prices, fortunes will not be made on Tuesday. The market has already accounted for the impact of this partnership.

The iPhone’s presence at Verizon is a huge deal. Any competitive advantage AT&T had is quickly vanishing. Despite being the most unreliable major cell phone carrier, AT&T always had the iPhone. Not only does the iPhone strengthen Verizon’s market position in relation to AT&T, it leaves Sprint, T-Mobile and other carriers at a significant disadvantage. The deal’s impact even stretches to Silicon Valley. Google’s Droid and Android’s competitive positions had been based in large part on AT&T’s exclusive hold on the iPhone. Those dynamics are gone.

While all these changes are coming, the market has already accounted for most of them. It has been anticipated for some time that Verizon would get the iPhone. As time passed and the likelihood of the partnership increased, the market slowly absorbed its impact. The announcement of the Tuesday’s press conference finally established a definite timetable and may have been the last big splash. Apple stands to benefit the most and saw a 0.72% jump on Friday. It may not seem very impressive, but with a market cap over $300 billion that is a jump of $2.19 billion. AT&T has the most to lose and saw a 1.03% drop, or $1.78 billion hit to its $170+ billion market cap. All this movement and Verizon has yet to make the official announcement.

In terms of the efficient market hypothesis, what does this mean? Can we actually say that the iPhone/Verizon partnership is public information? If so, the semi-strong form applies. However, the announcement has not yet been made. While the market strongly expects the iPhone's arrival at Verizon, Verizon has yet to make it official. Although this seems to support strong-form efficiency where all information, public or private, is incorporated into a company’s stock price, the nature of this information seems to reside in a gray area between public and private.

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Facebook Private Offering: Are Some Filing Exemptions Antiquated?

For the past few days Facebook’s private offering through Goldman Sachs has dominated the Wall Street Journal. A lot has been made about the 500-shareholder mark and Facebook’s filing exemption. It now appears that Facebook will have more than 500 investors and will begin disclosing its financials or go public by next spring. Regardless of the course of action taken, the company’s financials will finally be available to the public. This raises an interesting question. In an environment focused on systemic risk, why is the number of investors the trigger point for disclosing the financial information of a $1.5 billion investment?

In the wake of the financial crisis systemic risk has become a major issue. The Dodd-Frank Bill places significant emphasis on it. However, systemic risk is ignored in registration exemptions like the one Facebook had been operating under. Facebook’s exemption allowed it to refrain from registering with the SEC so long as it had fewer than 500 investors. This and other exemptions have been put in place for a number of reasons, chief among them being that registration is not necessary. It is assumed that when securities are offered to such a small pool of investors, the investors are either close enough to the company to perceive the risk or sophisticated enough to perceive the risk. As such, federal filing requirements are not needed to protect these investors. They are able to "fend for themselves." While this may be true, it does not mean that these investors will actually perceive the risks accurately and respond appropriately.

Because Goldman’s offering of the Facebook equity is private, many of the investors are likely hedge funds and other financial institutions. If the financial crisis teaches us anything, it is that the composition of the institutions’ balance sheets is extremely important. Supposing that Facebook’s investor count had not reached 500, the financial information of a $1.5 billion capital investment would have been undisclosed. Granted, $1.5 billion may only be a drop in the bucket when spread amongst a handful of financial institutions; however, it does raise the question of whether a private offering can be so large that the resulting systemic risk requires enhanced regulation.

For more on the need to regulate systemic risk, see Anita I. Anand, Is Systemic Rick Relevant to Securities Regulation?, 60 U. Toronto L.J. 941 (2010). SSRN Link.

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