Recoupment Under Dodd-Frank: Punishing Financial Executives and Perpetuating Too Big to Fail

In July 2011, the Federal Deposit Insurance Corporation (FDIC) promulgated new rules implementing Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules define a cause of action to recoup compensation paid to senior executives and directors of failed nonbank financial institutions placed into the FDIC\u27s orderly liquidation authority receivership. An action for recoupment is based on a negligence theory of liability, but it does not require establishing that an executive\u27s conduct caused the financial institution any harm. The rules presume liability merely for having held executive responsibility prior to the firm entering receivership. The executive may rebut the presumption of negligent conduct, but not causation. Put simply, a senior executive or director can lose two years of pay even if he or she could conclusively establish the total absence of any link between his or her conduct and the firm\u27s failure. This Comment argues that disconnecting recoupment from causation leads to overdeterrence and perpetuates the dangerous phenomenon of too big to fail. In particular, executives may abstain from taking optimal risks that may be mischaracterized later as negligent should other factors cause the firm\u27s failure. Such overdeterrence is likely to cause talented executives to gravitate toward financial institutions that have the lowest risk of failure. Recoupment thus imposes a cost concomitant with a firm\u27s perceived risk of failure, giving large, interconnected institutions an advantage when competing for managerial talent. Indeed, the liquidation of firms perceived as too big to fail may be so improbable that they can credibly offer executive compensation with little to no risk of recoupment. The remedy for this deficient rule is to make causation a rebuttable presumption. Because executives can cheaply show that other factors were responsible for the firm\u27s failure, they would discount potential recoupment liability chiefly by the likelihood of causing actual harm. This probability would not vary between firms, promoting healthy competition among financial institutions and reversing the arbitrary advantages conferred by the current regime on too big to fail firms. Retaining a presumption of causation would still ease the evidentiary burden of holding financial executives accountable for reckless behavior

Short and Distort

Pseudonymous attacks on public companies are followed by stock price declines and sharp reversals. These patterns are likely driven by manipulative stock options trading by pseudonymous authors. Among 1,720 pseudonymous attacks on mid- and large-cap firms from 2010 to 2017, I identify over $20.1 billion in mispricing. Reputation theory suggests these reversals persist because pseudonymity allows manipulators to switch identities without accountability

A Private Ordering Solution to Blockholder Disclosure

The recent debate over reforming the Securities Exchange Act section 13(d) ten-day filing window demonstrates the importance of balancing the costs and benefits of delayed blockholder disclosure in both consequentialist and deontological terms. While hedge fund activism may create shareholder value, short-termism is a very real problem for firms today. Rather than a rigid mandatory rule, the duration of the blockholder disclosure window should be set through a shareholder amendment to the corporate bylaws that empowers shareholders to set an optimal maximum length for each firm. To internalize the economic and moral costs to society of permitting trading on asymmetric information, the SEC should impose a filing fee on blockholders utilizing the delayed disclosure window and use the proceeds to compensate investors who sold shares while a blockholder engaged in a stealth accumulation

Recoupment Under Dodd-Frank: Punishing Financial Executives and Perpetuating Too Big To Fail

In July 2011, the Federal Deposit Insurance Corporation (FDIC) promulgated new rules implementing Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules define a cause of action to recoup compensation paid to senior executives and directors of failed nonbank financial institutions placed into the FDIC\u27s orderly liquidation authority receivership. An action for recoupment is based on a negligence theory of liability, but it does not require establishing that an executive\u27s conduct caused the financial institution any harm. The rules presume liability merely for having held executive responsibility prior to the firm entering receivership. The executive may rebut the presumption of negligent conduct, but not causation. Put simply, a senior executive or director can lose two years of pay even if he or she could conclusively establish the total absence of any link between his or her conduct and the firm\u27s failure. This Comment argues that disconnecting recoupment from causation leads to overdeterrence and perpetuates the dangerous phenomenon of too big to fail. In particular, executives may abstain from taking optimal risks that may be mischaracterized later as negligent should other factors cause the firm\u27s failure. Such overdeterrence is likely to cause talented executives to gravitate toward financial institutions that have the lowest risk of failure. Recoupment thus imposes a cost concomitant with a firm\u27s perceived risk of failure, giving large, interconnected institutions an advantage when competing for managerial talent. Indeed, the liquidation of firms perceived as too big to fail may be so improbable that they can credibly offer executive compensation with little to no risk of recoupment. The remedy for this deficient rule is to make causation a rebuttable presumption. Because executives can cheaply show that other factors were responsible for the firm\u27s failure, they would discount potential recoupment liability chiefly by the likelihood of causing actual harm. This probability would not vary between firms, promoting healthy competition among financial institutions and reversing the arbitrary advantages conferred by the current regime on too big to fail firms. Retaining a presumption of causation would still ease the evidentiary burden of holding financial executives accountable for reckless behavior

Passive Exit

In recent years, securities lending — making shares available for borrowing by short sellers who “sell first and buy later” — has been an object of increasing regulatory attention. Securities lending is linked to the growth of passive investing because large, buy-and-hold passive investors are among the largest lenders of portfolio securities. But relatively little is understood about the relationship between securities lending and passive investing. In this Article, I show how securities lending allows passive investors to generate revenue from a decline in the value of their investment portfolios in addition to borrowing fees determined by demand from the market. I find that when an active mutual fund exits a portfolio firm, passive index funds belonging to the same fund family raise the cost of borrowing the firm’s shares for short selling. To identify these supply-side shifts, I exploit changes in the identity of active managers which are likely to be uncorrelated with information that would otherwise drive within-portfolio variation in share lending costs. I find that the exercise of market power is pronounced in value lending programs targeting hard-to-borrow securities. Share lenders with market power capture most of the surplus arising from price declines

Asking the Right Question: The Statutory Right of Appraisal and Efficient Markets

In this article, we make several contributions to the literature on appraisal rights and cases in which courts assign values to a company\u27s shares in the litigation context. First, we applaud the recent trend in Delaware cases to consider the market prices of the stock of the company being valued if that stock trades in an efficient market, and we defend this market-oriented methodology against claims that recent discoveries in behavioral finance indicate that share prices are unreliable due to various cognitive biases. Next, we propose that the framework and methodology for utilizing market prices be clarified. We maintain that courts should look at the market price of the securities of a target company whose shares are being valued, unadjusted for the mews of the merger, rather than at the deal price that was reached by the parties in the transaction. In our view, unadjusted market price has two distinct advantages over deal price. First, the unadjusted market price automatically subtracts the target firm\u27s share of the synergy gains and agency cost reductions impounded in the deal price. This is appropriate to do because dissenting shareholders in appraisal proceedings are not entitled to these increments of value that are supplied by the bidder and it is difficult to accurately ascertain the proportion of the deal price that is attributable to these increments of value. Second, the unadjusted market price is unaffected by any flaws in the deal process that led to the ultimate merger agreement. Recently, commentators have contended that deal prices in merger transactions should be ignored in appraisal cases where there are flaws in the process that led to the sale. However, flaws in the sales process are not reflected in the unadjusted market price, so such prices are valid indicators of value, regardless of whether there were flaws in the deal process. Further, no deal process is perfect, and ignoring market prices when a deal process is flawed succumbs to what economists call the Nirvana fallacy, which posits that an analytical approach (such as relying on market prices) should not be ignored or abandoned even if using that approach does not produce perfect results. Rather, an analytical approach should be used if it is better than the available alternatives and provides useful information to a tribunal or policymaker. Finally, we extend our analysis of market efficiency to a new domain. We point out that market prices can be used even when shares of non-publicly traded target companies are being evaluated to determine whether the acquirer paid a fair price in certain cases by examining the share price performance of the acquirer\u27s shares. In cases where a bidder has paid an unfairly low price for the target\u27s shares due to self-dealing, incompetence, or inattention on the part of the seller, the acquirer\u27s stock should react positively to the announcement of the transaction if the transaction is significant. In the absence of such a positive share price reaction on the part of the acquirer, the price should be deemed presumptively fair. This analysis seems particularly apt in situations where there is a dc line in the value of the bidder\u27s stock upon announcement of an acquisition

Anti-Herding Regulation

In some contexts, an individual’s choice to mimic the behavior of others, to join the herd, can increase systemic risk and retard the production of information. Herding can thus produce negative externalities. And in such situations, individuals by definition have insufficient incentives to separate from the herd. But the traditional regulatory response to externality problems is to impose across-the-board mandates. Command-and-control regulation tends to displace one pooling equilibrium by moving behavior to a new, mandated pool. Mortgage regulators, for example, might respond to an unregulated equilibrium where most homeowners start with 2% down by imposing a requirement that causes most homeowners instead to place 10% down. But this Article shows that society can at times be better off if regulation induces separating behaviors by regulated entities. We evaluate a variety of mechanisms including licenses, subsidies, and regulatory variances as well as regulatory menus and heterogeneous altering rules that can incentivize a limited number of regulated entities to take the path less chosen. Anti-herding regulation provides a new means to attend to ways that mimicry can both suppress the production of information and exacerbate systemic risk

Three Proposals for Regulating the Distribution of Home Equity

The Consumer Financial Protection Bureau’s recently-released “qualified mortgage” rules effectively discourage predatory lending but miss an equally important source of systemic risk: low-equity clustering. Specific “volatility-inducing” mortgage terms, when present in a substantial cluster of mortgage contracts, exacerbate macroeconomic risk by increasing the chance that the housing and lending markets will have to absorb a wave of simultaneous defaults after a downturn in housing prices. This Article shows that these terms became prevalent in a substantial proportion of residential mortgages in the years leading up to the home mortgage crisis. In contrast, during the earlier “amortization era” (when mortgagors were more likely to borrow at different times, with more substantial down payments, and more continual rates of amortization, without a need to refinance), an equally-sized negative shock to housing prices would likely produce less negative equity and confine it to a smaller set of borrowers. Instead of prohibiting the volatility-inducing terms, this Article proposes three policies to better assure a greater diversification in the distribution of equity: (a) a modified home-mortgage interest deduction; (b) a modified “qualified residential mortgages” standard; and most importantly, (c) direct macroprudential regulation through a “cap-and-trade” system of leverage licenses and through instituting varying degrees of “conforming mortgages” for Fannie Mae and Freddie Mac. Limiting the simultaneous clustering of negative equity mortgages could reproduce the structural advantages of the amortization era, when inevitable downturns disparately impacted homeowners with different levels of equity and could more easily be absorbed by the market

Informed Trading and Cybersecurity Breaches

Cybersecurity has become a significant concern in corporate and commercial settings, and for good reason: a threatened or realized cybersecurity breach can materially affect firm value for capital investors. This paper explores whether market arbitrageurs appear systematically to exploit advance knowledge of such vulnerabilities. We make use of a novel data set tracking cybersecurity breach announcements among public companies to study trading patterns in the derivatives market preceding the announcement of a breach. Using a matched sample of unaffected control firms, we find significant trading abnormalities for hacked targets, measured in terms of both open interest and volume. Our results are robust to several alternative matching techniques, as well as to both cross-sectional and longitudinal identification strategies. All told, our findings appear strongly consistent with the proposition that arbitrageurs can and do obtain early notice of impending breach disclosures, and that they are able to profit from such information. Normatively, we argue that the efficiency implications of cybersecurity trading are distinct – and generally more concerning – than those posed by garden-variety information trading within securities markets. Notwithstanding these idiosyncratic concerns, however, both securities fraud and computer fraud in their current form appear poorly adapted to address such concerns, and both would require nontrivial re-imagining to meet the challenge (even approximately)