ProfessorBainbridge.com

Rethinking director compensation plans

My friend and colleague Jim Barrall has a new blog post on the need for companies to reconsider their director compensation plans. Recommended reading.

The Southern Agrarians' Opposition to Corporate Personhood

You could hardly call the Southern Agrarians leftists. Yet, as I recently learned while researching a project on populism and corporate governance, the Southern Agrarians shared with modern left-wing Occupy-style populists a disdain for the idea of corporate personhood. For example, in an essay entitled The Foundations of Democracy, Frank Owsley complained that the Supreme Court had erected the 5th and 14th Amendments "into bulwarks of human freedom, but into impregnable fortresses of corporate wealth."

The usual arguments in favor of corporate personhood apply, of course. One might also note that the New Deal, during which Owsley was writing, proved that corporations were, shall we say, pregnable. 

Anyway, I toss this out there for the benefit of anybody who wants to do a project of how both right of center and left of center populists both get corporate personhood wrong.

We are seminal, early, and classic

Merritt B. Fox, Lawrence R. Glosten, Gabriel V. Rauterberg, Informed Trading and Its Regulation, 43 J. Corp. L. 817 (2018):

² For just a sampling of seminal early work in this area, see Henry Manne, Insider Trading and the Stock Market 131-45 (1966) [hereinafter Manne, Insider Trading] (arguing that insider trading is efficient because it promotes pricing accuracy and entrepreneurialism); Stephen M. Bainbridge, Insider Trading Under the Restatement of the Law Governing Lawyers, 19 J. Corp. L. 1, 21 (1993) (arguing that the prohibition on insider trading is best justified as a property right protection for information); Victor Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws, 93 Harv. L. Rev. 322, 343, 347-48 (1979) (analyzing the proper scope of the disclose-or-abstain rule); Dennis W. Carlton & Daniel R. Fischel, The Regulation of Insider Trading, 35 Stan. L. Rev. 857, 862 (1982) (arguing that permitting insider trading may be an efficient way to compensate corporate managers); Zohar Goshen & Gideon Parchomovsky, On Insider Trading, Markets, and “Negative” Property Rights in Information, 87 Va. L. Rev. 1229, 1238-43 (2001) (arguing that widespread insider trading would drive market analysts out of business with deleterious consequences for the informational quality of securities prices); Roy A. Schotland, Unsafe at Any Price: A Reply to Manne, Insider Trading and the Stock Market, 53 Va. L. Rev. 1425 (1967) (arguing that insider trading may be injurious because it deters investors who perceive it as unfair from trading in securities).

¹⁰⁹ ... The negative effects of insider trading on liquidity, and to a lesser extent price accuracy, have already been noted by a vast and rich legal literature, often arguing in favor of existing legal bans. For just a sampling of classic papers, see Bainbridge, supra note 2, at 11-12; Mark J. Loewenstein & William K.S. Wang, The Corporation as Insider Trader, 30 DEL. J. CORP. L. 45, 74-77 (2005); William K.S. Wang, Stock Market Insider Trading: Victims, Violators and Remedies - Including an Analogy to Fraud in the Sale of a Used Car with a Generic Defect, 45 VILL. L. REV. 27, 38 (2000); H. Nejat Seyhun, Insiders' Profits, Costs of Trading, and Market Efficiency, 16 J. FIN. ECON. 189, 190-92 (1986); Jonathan R. Macey & Maureen O'Hara, From Markets to Venues: Securities Regulation in an Evolving World, 58 STAN. L. REV. 563, 589 (2005). Others have come to more ambivalent conclusions based on the finance literature. See Donald C. Langevoort, Rereading Cady, Roberts: The Ideology and Practice of Insider Trading Regulation, 99 COLUM. L. REV. 1319, 1324 (1999) (stating that the alleged injury to investors from insider trading is yet unidentified).

No brag. Just fact.

Is Interference with Corporate Plans a Valid Reason for Regulating Insider Trading? (Not really.)

In an earlier post, I mentioned that James Cox has a new paper on the famous Texas Gulf Sulphur decision, in which he explores various rationales for regulating insider trading that can be discerned from the factual background of the opinion (as opposed to the legal analysis in the opinion, which I have demonstrated elsewhere is completely bogus, as the court hopelessly misrepresented the precedents on which it relied). One concerned delayed disclosure, which I discussed in a prior post. The other one he advances is potential interference with corporate plans:

The employee defendants in TGS did not reveal to Timmins landowners their secret knowledge of K-55-1. Nonetheless, their trading and tipping posed the same risks to TGS’s ability to exploit its discovery. It is reasonable to fear that trading, certainly as massive as was carried out by the TGS defendants, could have alerted markets and TGS competitors of on-going material, secret developments at the firm. If this surmise is plausible, then ... proscription of the agent’s threatening conduct would be a reasonable prophylaxis.

I agree that interference with corporate plans is a legitimate concern, as I explained in my insider trading text. But I don't think it is a particularly strong argument for a federal prohibition of insider trading under the securities laws.

Trading during the planning stage of an acquisition is a classic example of how insider trading might adversely interfere with corporate plans. If managers charged with overseeing an acquisition buy shares in the target, and their trading has a significant up-ward effect on the price of the target’s stock, the takeover will be more expensive. If their trading causes significant price and volume changes, that also might tip off others to the secret, interfering with the bidder’s plans, as by alerting the target to the need for defensive measures.

The risk of premature disclosure poses an even more serious threat to corporate plans. The issuer often has just as much interest in when information becomes public as it does in whether the information becomes public. Suppose Target, Inc., enters into merger negotiations with a potential acquirer. Target managers who inside trade on the basis of that information will rarely need to delay corporate action in order to effect their purchases. Having made their purchases, however, the managers now have an incentive to cause disclosure of Target’s plans as soon as possible. Absent leaks or other forms of derivatively informed trading, the merger will have no price effect until it is disclosed to the market, at which time there usually is a strong positive effect. Once the information is disclosed, the trading managers will be able to reap substantial profits, but until disclosure takes place, they bear a variety of firm-specific and market risks. The deal, the stock market, or both may collapse at any time. Early disclosure enables the managers to minimize those risks by selling out as soon as the price jumps in response to the announcement.

If disclosure is made too early, a variety of adverse consequences may result. If disclosure triggers competing bids, the initial bidder may withdraw from the bidding or demand protection in the form of costly lock-ups and other exclusivity provisions. Alternatively, if disclosure does not trigger competing bids, the initial bidder may conclude that it overbid and lower its offer accordingly. In addition, early disclosure brings the deal to the attention of regulators and plaintiffs’ lawyers earlier than necessary.

An even worse case scenario is suggested by SEC v. Texas Gulf Sulphur Co. Recall that insiders who knew of the ore discovery traded over an extended period of time. During that period the corporation was attempting to buy up the mineral rights to the affected land. If the news had leaked prematurely, the issuer at least would have had to pay much higher fees for the mineral rights, and may well have lost some land to competitors. Given the magnitude of the strike, which eventually resulted in a 300–plus percent increase in the firm’s market price, the harm that would have resulted from premature disclosure was immense.

Although insider trading probably only rarely causes the firm to lose opportunities, it may create incentives for management to alter firm plans in less drastic ways to increase the likelihood and magnitude of trading profits. For example, trading managers can accelerate receipt of revenue, change depreciation strategy, or alter dividend payments in an attempt to affect share prices and insider returns. Alternatively, the insiders might structure corporate transactions to increase the opportunity for secret keeping. Both types of decisions may adversely affect the firm and its shareholders. Moreover, this incentive may result in allocative inefficiency by encouraging overinvestment in those industries or activities that generate opportunities for insider trading.

Judge Frank Easterbrook has identified a related perverse incentive created by insider trading. Managers may elect to follow policies that increase fluctuations in the price of the firm’s stock. They may select riskier projects than the shareholders would prefer, because, if the risks pay off, they can capture a portion of the gains in insider trading and, if the project flops, the shareholders bear the loss. In contrast, Professors Carlton and Fischel assert that Easterbrook overstates the incentive to choose high-risk projects. Because managers must work in teams, the ability of one or a few managers to select high-risk projects is severely constrained through monitoring by colleagues. Cooperation by enough managers to pursue such projects to the firm’s detriment is unlikely because a lone whistle-blower is likely to gain more by exposing others than he will by colluding with them. Further, Carlton and Fischel argue managers have strong incentives to maximize the value of their services to the firm. Therefore, they are unlikely to risk lowering that value for short-term gain by adopting policies detrimental to long-term firm profitability. Finally, Carlton and Fischel alternatively argue that even if insider trading creates incentives for management to choose high-risk projects, these incentives are not necessarily harmful. Such incentives would act as a counterweight to the inherent risk aversion that otherwise encourages managers to select lower risk projects than shareholders would prefer. Allowing insider trading may encourage management to select negative net present value investments, however, not only because shareholders bear the full risk of failure, but also because failure presents management with an opportunity for profit through short-selling. As a result, shareholders might prefer other incentive schemes.

But what does all of this have to do with the policies underlying securities regulation? The risk that insiders may interfere with corporate plans to facilitate their trading is more a matter of state fiduciary duty law than federal securities law.

Is Delayed Disclosure a Valid Basis for Regulating Insider Trading? (No.)

James Cox has a new paper on the famous Texas Gulf Sulphur decision, in which he explores various rationales for regulating insider trading that can be discerned from the factual background of the opinion (as opposed to the legal analysis in the opinion, which I have demonstrated elsewhere is completely bogus, as the court hopelessly misrepresented the precedents on which it relied):

... in TGS, two of the major defendants traded in the interval between the misleading April twelfth press release and the corrective April sixteenth press release. To be sure, each had purchased TGS shares before the misleading press release, but essentially doubled-down after the release. Indeed, the second largest block of shares traded by any of the TGS insiders occurred in the interval between the misleading release and the corrective public release.

Against this record, we can premise an important justification for insider trading: by proscribing insider trading and tipping that yields a personal benefit to the insider, the law removes an incentive that insiders may have to delay the release of inside information. Stated differently, with investors benefitting from the early rather than later release of information, legal rules can better implement that objective by proscribing insiders who delay the release of information to enable them to exploit their secret knowledge of the information by trading on it.

I disagree, as I explained in my insider trading text:

To be sure, insider trading could injure the firm if it creates incentives for managers to delay the transmission of information to superiors. Decision making in any entity requires accurate, timely information. In large, hierarchical organizations, such as publicly traded corporations, information must pass through many levels before reaching senior managers. The more levels, the greater the probability of distortion or delay intrinsic to the system. This inefficiency can be reduced by downward delegation of decision-making authority but not eliminated. Even with only minimal delay in the upward transmission of information at every level, where the information must pass through many levels before reaching a decision-maker, the net delay may be substantial.

If a manager discovers or obtains information (either beneficial or detrimental to the firm), she may delay disclosure of that information to other managers so as to assure herself sufficient time to trade on the basis of that information before the corporation acts upon it. Even if the period of delay by any one manager is brief, the net delay produced by successive trading managers may be substantial. Unnecessary delay of this sort harms the firm in several ways. The firm must monitor the manager’s conduct to ensure timely carrying out of her duties. It becomes more likely that outsiders will become aware of the information through snooping or leaks. Some outsider may even independently discover and utilize the information before the corporation acts upon it.

Although delay is a plausible source of harm to the issuer, its importance is easily exaggerated. I am unaware of any evidence that delay is frequent or lengthy. Given the rapidity with which securities transactions can be conducted in modern secondary trading markets, a manager need at most delay corporate action long enough for a five minute telephone conversation with her stockbroker. Delay (either in transmitting information or taking action) also often will be readily detectable by the employer. Finally, and perhaps most importantly, insider trading may create incentives to release information early just as often as it creates incentives to delay transmission and disclosure of information.

In addition, to the extent (if any) that premature disclosure threatens the firm’s interests, that threat has little to do with the insider trading regime. Instead, it is properly treated as a breach of the insider’s fiduciary duty. 

Finally, concern for ensuring timely disclosure cannot justify a prohibition of the breadth it currently possesses. As we have seen, the prohibition encompasses a host of actors both within and outside the firm. In contrast, only a few actors are likely to have the power to affect the timing of disclosure. A much narrower prohibition thus would suffice if this were the principal rationale for regulating insider trading. Indeed, if this were the main concern, one need not prohibit insider trading at all. Instead, one could strike at the problem much more directly by proscribing failing to disclose material information in the absence of a legitimate corporate reason for doing so.

 

Quoted re Dr Mark McClellan

From Kaiser Health News:

McClellan is director of the Margolis Center for Health Policy at Duke University, the academic position by which he’s commonly identified. But he frequently has not disclosed another position he’s held since late 2013: He earned $285,000 last year on the board of pharmaceutical giant Johnson & Johnson, a company accused of blocking the sale of Pfizer’s Inflectra biosimilar, which competes against J&J’s blockbuster Remicade, a rheumatoid arthritis drug. ...

As a board member to these for-profit health care companies, McClellan has a fiduciary obligation “not to injure them” when writing articles and speaking, said Stephen Bainbridge, law professor at UCLA.

And while there is no legal requirement to disclose board memberships when writing for journals or speaking, Bainbridge and other experts agreed there is an ethical obligation.

“There’s certainly a potential conflict of interest there,” Bainbridge said, adding that while serving on the board of Johnson & Johnson “you are dealing with an enormous company that has fingers in a lot of different pies.”