The Catholic University of America

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Table of Contents
William K. Sjostrom, University of Arizona - James E. Rogers College of Law
Claire A. Hill, University of Minnesota, Twin Cities - School of Law
Lee Harris, University of Memphis - Cecil C. Humphreys School of Law
Shimon Kogan, University of Texas at Austin
Bryan Routledge, Carnegie Mellon University - David A. Tepper School of Business
Jacob S. Sagi, Vanderbilt University - Owen Graduate School of Management
Noah A. Smith, Carnegie Mellon University - School of Computer Science

WILLIAM K. SJOSTROM, University of Arizona - James E. Rogers College of Law
The Article examines the regulation of underwriting compensation by the Financial Industry Regulation Authority. Although the regulation dates back almost 50 years and impacts virtually every U.S. public offering of securities, its propriety has received zero attention from legal scholars. The Article fills the gap in the literature. In that regard, it provides a history and overview of the regulation and critiques its policy justifications. The Article finds the justifications deficient and the regulation’s costs conceivably quite large. Consequently, it contends that the regulation should be abolished.
CLAIRE A. HILL, University of Minnesota, Twin Cities - School of Law
Why did rating agencies do such a bad job rating subprime securities? The conventional answer draws heavily on the fact that ratings are paid for by the issuers: Issuers could, and do, “buy” high ratings from willing sellers, the rating agencies.

The conventional answer cannot be wholly correct or even nearly so. Issuers also pay rating agencies to rate their corporate bond issues, yet very few corporate bond issues are rated AAA. If the rating agencies were selling high ratings, why weren’t high ratings sold for corporate bonds? Moreover, for some types of subprime securities, a particular rating agency’s rating was considered necessary. Where a Standard & Poor’s rating was deemed necessary by the market, why would Standard & Poor’s risk its reputation by giving a rating higher (indeed, much higher) than it knew was warranted?

Finally, and perhaps most importantly, giving AAA ratings to securities of much lower quality is something that can’t be done for long. A rating agency that becomes known for selling its high ratings will soon find that nobody will be paying anything for its ratings, high or low.

In my view, that issuers pay for ratings may have been necessary for the rating agencies to have done as bad a job as they did rating subprime securities, but it was not sufficient. Many other factors contributed, including, importantly, that rating agencies “drank the Kool-Aid.” They convinced themselves that the transaction structures could do what they were touted as being able to do: with only a thin cushion of support, produce a great quantity of high-quality securities. Rating agencies could take comfort, too, or so they thought, in the past - the successful, albeit short, recent history of subprime securitizations, and the longer history of successful mortgage securitizations.

“Issuer pays” did not so much make the rating agencies give higher ratings than they thought were warranted as it gave the agencies a “can do” mindset regarding the task at hand - to achieve the rating the issuers desired, working with them to modify the deal structures as needed. That the issuers were paying motivated the agencies to drink the Kool-Aid; having drunk the Kool-Aid, the agencies gave the ratings they did. My account casts doubt on the efficacy of many of the solutions presently being proposed and suggests some features that more efficacious solutions should have.
LEE HARRIS, University of Memphis - Cecil C. Humphreys School of Law
In the vivid imagination of Delaware courts, the shareholder franchise is “the ideological underpinning” upon which corporate power rests. A corporate election to choose who should lead the firm is “corporate democracy” at work, since such elections give shareholders the power “to turn the board out.” However, in reality, the vast majority of corporate elections are ho-hum affairs. The current board members are re-elected without contest. Annual corporate meetings to hold the elections are dull - held in front of tame audiences in quiet auditoriums. Election outcomes are predictable. Rarely is there a contested corporate election, in which the incumbent directors face a challenge for their board seats. Even these affairs, while more interesting, are still as predictable. The incumbents always have the upper hand. The corporate election system is, as a consequence, broken, anti-competitive and in need of significant reform.

Yet, as will be shown in this Article, previous proposals have overlooked the “genius” of the public sector. In particular, in political elections campaign reformers have already offered a good answer for how to create competitive elections, even though the costs of campaigning to contestants is high, voters are apathetic and dispersed widely, and incumbents have a natural, built-in advantage: Make campaign subsidies available to challengers. Most notably, for instance, in federal elections the system of public subsidies for eligible presidential campaigns, the Presidential Campaign Fund, provides a remarkably sturdy roadmap for how to reform corporate elections and create a subsidy system for shareholder challenges to the board of directors.
SHIMON KOGAN, University of Texas at Austin
Carnegie Mellon University - David A. Tepper School of Business
Vanderbilt University - Owen Graduate School of Management
Carnegie Mellon University - School of Computer Science
We find evidence that public firm disclosure, in the form of Management Discussion and Analysis (Sections 7 and 7a of annual reports), is more informative about the firm's future risk following the passage of the Sarbanes-Oxley Act of 2002. Employing a novel text regression, we are able to predict, out of sample, firm return volatility using the Management Discussion and Analysis section from annual 10-K reports (which contains forward-looking views of the management). Using the relative performance of the text model as a proxy for the informativeness of reports, we show that the MD&A sections are significantly more informative after the passage of SOX. We further show that this additional information is associated with a reduction in share illiquidity, suggesting that the information divulged was new to investors. Finally, we find that the increase in informativeness of MD&A reports is most pronounced for firms with higher costs of adverse selection.

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