The University of Chicago Law School Faculty Blog

Disclosure of insider trading plans – a puzzle

I’m working on a paper with a professor at Stanford about firms’ decisions to adopt and disclose the existence of corporate insiders’ 10b5-1(c) trading plans.  In theory, these plans can decrease expected litigation risk for firms and executives, either through reducing the ability to trade on material, non-public information or providing an affirmative defense even for trades that might be of questionable legality.  The litigation prophylactic only works, however, if firms disclose the existence of these plans.  Based on data that we have collected, many firms that have adopted these plans made no disclosures about this fact.  This seems puzzling.

Corporate Prediction Markets

Many people are familiar with the predictive success of small, low-stakes “prediction markets” run by the University of Iowa (predicting political elections better than the pollsters) and firms such as Tradesports.com (predicting everything from whether Hamas will recognize Israel to whether Scooter Libby will be convicted) and the Chicago Board of Trade (predicting U.S. unemployment and other key economic indicators).  As colleagues Saul Levmore and Cass Sunstein have pointed out, these markets are routinely better at forecasting what is going to happen than any other available means.  The insight here is a Hayekian one: markets, when they work, are the best available mechanism for gathering, aggregating, and processing information.

Those familiar with this literature may also be familiar with the use of these markets by firms such as Hewlett-Packard and Google, which have made increasing use of prediction markets to help make business decisions.   Initial studies suggest that these markets provide relatively reliable predictions and are not easily manipulated by those who have a stake in decision making.  For example, HP’s market estimated sales of a particular product better than traditional forecasting methods.  Other results suggesting the usefulness of simple prediction markets have been seen at Google, Siemens, Intel, and many other firms. More promising still, David Pennock’s patent-pending dynamic pari-mutuel market and Robin Hanson’s market scoring rule make it possible to generate sound predictions even in very thin markets.

In a forthcoming paper, Michael Abramowicz, a law professor at George Washington, and I explore how these markets may help solve a number of corporate law problems.

A link between options timing and taxes?

The Wall Street Journal recently reported on the growing scandal involving the "back-dating" of stock options issued as compensation to corporate executives. The scheme here, according to the news reports and some academic studies, is to issue the options as of a certain past date when the stock was at a lower level. In other words, if the stock is trading at $50 today but $20 dollars two months ago, the firm could issue the options (with a strike price equal to the market price) as of two months ago, allowing the executive to cash out $30 per share immediately. There is nothing illegal about this. So long as the appropriate corporate procedures (e.g., shareholder and board approval) were followed, a firm can issue any options, including back-dated options, it wants.

So why the big fuss?

The new corporate raiders?

For those hoping for a return of a vibrant market for corporate control (last seen in the 1980s) and the discipline it brings to corporate governance, hope may be on the way.  First, some background:

The fact pattern for my exam in Corporations last year was Oliver Stone’s fabulous movie “Wall Street.”  This isn’t as cute as it seems.  The movie, despite being sloppy with the law and largely mixing up the villains and the heroes, is a perfect snapshot of the market for corporate control that prevailed in the 1980s.  From 1982 until the collapse of the high-yield (“junk”) bond market in 1989, approximately 60% of large U.S. firms were either takeover targets or restructured on their own.  While all LBOs, MBOs, and corporate takeovers did not succeed, the threat of a hostile raider was so real and so scary for management, that it provided unprecedented discipline on managerial behavior.  Executives no longer sought to build empires, like the synergy-free conglomerates slapped together in the 1970s, and executive compensation, instead of being based on firm size, became linked to shareholder value through the use of options and other equity compensation.  A related outgrowth of this takeover activity was the creation of shareholder activist organizations and movements, such as Council of Institutional Investors and Institutional Shareholder Services.  Very often, the public motives of these “good guy” activist groups and the “bad guy” raiders were aligned.  Just take one example from the movie that mimics reality: Gordon Gekko’s speech to the board and management of Teldar Paper at its annual stockholders’ meeting.  Gekko—the supposed villain—rips the executives for wasting the shareholders’ money on country club memberships, hundreds of do-nothing vice presidents, excessive compensation, and “golden parachutes.”  One can imagine CII or ISS making these same arguments then and now.

Why are hedge funds so successful?

With all the talk about hedge funds – the dramatic successes (about 20 hedge fund managers earned in excess of $100 million in compensation last year), and the rising number of flameouts (from the Bayou Group to the Eifuku Master Fund in Japan that lost its $300 million portfolio in seven trading days) – few have focused on the question of how hedge funds are able, so far, to earn higher returns than other investment vehicles. (The largest hedge fund index beat the S&P by about 3% last year, and many of the largest funds earned returns in excess of 30%.)

A couple of hypotheses, some benign and some potentially troubling:

Is sunlight always the best disinfectant?

Ever since Brandeis turned the neat phrase “sunlight is the best disinfectant; electric light the best policeman” in praise of transparency, it has been virtually accepted wisdom in legal and policy making circles.  But the efficiency and efficacy of “sunlight” is not always so obvious.

Consider two examples raised by new SEC Chair Christopher Cox.  Cox said that two of the SEC’s priorities during his tenure will be requiring better disclosure of executive compensation and enforcing the new SEC registration rule for hedge funds, which is intended to help investors get more disclosure from funds.  Both of these are, at best, a misallocation of the SEC’s scarce resources, and, at worst, flatly wrongheaded.

Katrina and Sarbanes-Oxley

Dean Levmore asserts that post-Katrina (and, for the most part, post-9/11), "states are neither here nor there." On the issue of natural and human-caused disasters, one might start from John Adams's assertion that "government turns every contingency into an excuse for enhancing power in itself," and then ask why, if true, the locus of power accumulation is primarily federal and not state. Aren’t the state (and local) governments captured by Adams's postulate? At one level, one might think that state (and local) governments would be more likely to aggrandize power in the wake of these events since they are closer to the situation and thus the citizenry, and are more likely to reap long-term benefits from an increased profile. After all, it is unlikely that Iowa congressional elections in 3 years will focus on Katrina, but we can be sure that the Louisiana local races will. Corporate law is another area that might help us think through the puzzle.

One can think of the recent spate of corporate bankruptcies and frauds as a similarly disruptive event for corporate America. Crudely, Enron = Katrina. Here too we see primarily a federal response. Within months of the Enron bankruptcy, Congress passed the Sarbanes-Oxley Act of 2002, which federalized many important corporate law issues that had heretofore been governed by the states. For example, section 404 of the Act mandates comprehensive (read: expensive and not sure to work) internal controls requirements without regard to differences in size and scope across firms and without regard to the substantial case law in states such as Delaware on the subject. (On the former part, one might have expected a state-law solution to internal controls to be more flexible to the needs of various firms through an enabling default rule approach as opposed to the federal, command and control approach.) A similar intrusion into state law can be seen on a range of issues from board composition to executive liability for financial reports.