Regulating the Development of Driverless Finance

Before permitting driverless cars to operate on the open road without a licensed driver, lawmakers and innovators are working to ensure the safety not only of the passengers in those cars, but also of third parties – particularly other drivers and pedestrians.  Safety concerns figure much less prominently, however, in discussions about fintech and the increasing algorithmic automation of finance.  While the use of algorithms in finance is nothing new, the ubiquity, sophistication, and autonomy of financial algorithms has increased significantly in recent years with advances in computing power and data usage techniques.  Increasingly automated financial decision-making (a phenomenon that … Read more

The Myth of Risk Free Markets

Economies and markets operate on the assumption that U.S. debt securities (“Treasuries”) are risk-free. This means that the United States is expected to pay its debts. Also, Treasuries are supposed to trade easily and efficiently in secondary markets. Unsurprisingly, the rate at which the U.S. borrows represents a risk-free rate against which any number of financial contracts (e.g. corporate loans, derivative securities) are priced. After the 2008 financial crisis, regulation requires financial firms to deepen their reserves of Treasuries as protection against another collapse. Perhaps most importantly, this risk-free status has enabled the U.S. to confidently rely on global capital … Read more

Initial Crypto-asset Offerings, Tokenization, and Corporate Governance

Blockchain and other types of distributed ledger technology pose various new legal and economic questions for companies. Are crypto-asset holders a new kind of corporate stakeholder? If so, are they like shareholders or bondholders, and how can they participate in the governance of a company? Are smart contracts useful tools for corporate governance? How can free-rider problems in initial crypto-asset offerings (ICOs) be solved? What is the governance of a decentralized autonomous organization (DAO)? And is there such a thing as algorithmic or distributed governance for firms?

In a new article, “Initial Crypto-asset Offerings (ICOs), tokenization and corporate governance”, … Read more

Debevoise Discusses Federal Reserve Proposal to Clarify and Revise Control Framework

On April 23, the Federal Reserve Board (the “FRB”) proposed a new, comprehensive framework for determining “control” under the Bank Holding Company Act (“BHC Act”) and Home Owners’ Loan Act (“HOLA”). We provide a high-level overview of the proposal below. Comments on the proposal will be due 60 days after its publication in the Federal Register.

The proposal is intended to simplify and clarify the FRB’s standards for determining whether a company exercises a controlling influence over the management or policies of another company and, therefore, “controls” the other company under the BHC Act or HOLA. The proposal would codify … Read more

Davis Polk Discusses France’s New Legal Framework for Digital Assets

After becoming one of the first countries to authorize the registration and transfer of unlisted securities using blockchain technology, France has adopted an innovative legal framework governing initial coin offerings (“ICOs”) and digital assets services providers (“DASPs”) with the aim of being at the forefront of the blockchain revolution in Europe.

After allowing the representation and transmission of unlisted securities through the use of blockchain technology in 2017, the draft “PACTE”[1] bill (the “PACTE Act”) was adopted by the French Parliament on April 11, 2019[2], constituting a new step in France’s economic transformation.

This PACTE … Read more

Cleary Gottlieb Discusses Fed’s Proposed Resolution-Planning Rules Overhaul

On April 8, 2019, the Federal Reserve proposed a broad overhaul of the 2011 regulations governing resolution planning (the “Proposal”)[1], which would significantly reduce the frequency of submissions and simplify requirements for many resolution plans.  The Proposal would modify the existing rule to incorporate the experience gained since the first plans were filed in 2013 to target planning efforts on key resolvability issues, while codifying the focus on the eight U.S. global systemically important banks (“U.S. G‑SIBs”).  Most significantly, the U.S. G-SIBs would only file resolution plans every two years alternating between full resolution … Read more

Opening the Black Box of Companies’ Capital Investment Process

In spite of intensive academic research on capital expenditure efficiency, how firms make investment decisions remains largely a black box. We analyze that process by dividing it into two stages: budgeting of capital expenditures (CapEx) and execution of the budget. We find that these two stages have different effects on investment efficiency, and are in turn affected differently by accounting quality and governance. Further, while opportunistic managers massively exceed investment budgets, managers with high ability strategically find a level of execution errors that optimizes their compensation while remaining undetected by boards. These strategic execution deviations entail significant costs for their … Read more

The Future of Data Driven Finance: Financial Regulation, Data Regulation, and RegTech

Fifty years ago, banking was a relationship business. Bank managers collected information about depositors and borrowers from all sorts of sources, formal and informal. In recent decades, credit decisions have become far more data-driven, with companies like Amazon and the Alibaba-affiliate, Ant Financial, taking the lead in the U.S. and China. This paradigm shift in finance, however, is only just beginning. We are entering a period in which the leaders in finance will have to focus intensely on data and its analysis. Banks and traditional financial institutions around the world are in the process of building ever-more sophisticated IT systems … Read more

Arnold & Porter Discusses Bill on Banking Services for Marijuana-Related Firms

Depository institutions have been understandably reluctant to provide banking services to cannabis-related businesses in light of the significant (and costly) regulatory and compliance expectations that apply under the Bank Secrecy Act (BSA) and other anti-money laundering (AML) laws and regulations.[1] Legislative relief, however, may be on the way. On March 27, 2019, with approval of the Secure and Fair Enforcement Banking Act of 2019, H.R. 1595 (SAFE Banking Act), the US House Financial Services Committee (HFSC) is now seeking to increase access to banking services for cannabis-related businesses and their service providers.[2] The SAFE Banking Act, which was … Read more

The Social Functions of the Stock Market: A Primer

A stock market is a key feature found in any economy with a substantial private sector.  For example, in the United States, we see the New York Stock Exchange and Nasdaq, in the U.K, the London Stock Exchange, and in Brazil, B3.  While some commentators suggest that a stock market is primarily simply a place for useless speculation, a well-functioning stock market does in fact serve a number of important social purposes.  It facilitates firms selling shares to raise funds for new investment by assuring potential purchasers that they can easily resell their shares when they wish to.  The shares … Read more

Debt Overhang, Rollover Risk, and Corporate Investment: Evidence from the European Crisis

Investment expenditure in Europe collapsed in the aftermath of the 2008 global financial crisis. This collapse followed a boom during which the corporate sector borrowed heavily (Gopinath, Kalemli-Ozcan, Karabarbounis, Villegas-Sanchez, 2017). Figures 1 and 2 illustrate the extent of the increase in leverage and the collapse of investment  in Europe as compared with the United States. These developments were particularly pronounced in peripheral European economies.

In a new paper (Kalemli-Özcan, Laeven, Moreno, 2018), we investigate whether the corporate debt accumulated during the boom years held back investment by non-financial corporations after the crisis. Specifically, we consider whether high levels of … Read more

How U.S. Tax Inversions Affect Shareholder Wealth

The United States had one of the world’s highest tax rates – around 35 percent – prior to the Tax Cuts and Jobs Act of 2017 (TCJA 2017, and especially the Global Intangible Low-Taxed Income (GILTI) rules in new tax code Section 951A). It also uses the country-of-residency basis for corporate taxation that subjects, at least in theory, all worldwide income earned by a corporation to U.S. tax. Corporations that receive a significant proportion of foreign income can employ corporate inversions, which lead to the U.S. parent company being treated as a foreign entity.  Those firms relocate their legal domicile … Read more

What Do Mutual Fund Investors Really Care About?

Do investors behave rationally? Many researchers examine actively managed mutual funds to answer this question. The advantage of doing so setting is that we can observe the past performance of fund managers as well as the capital allocation decisions of investors, both at relatively high frequency.

Yet, despite three decades of research on mutual funds, whether investors in mutual funds display rational behavior remains unsettled. The empirical facts are indisputable: While fund managers have a hard time beating their benchmarks and their performance is not consistent over time, investors continue to chase past returns. In a seminal study, Berk and … Read more

How an Issuer’s Multiple Credit Ratings Can Affect Its IPO

While the list of prospective issuers with credit ratings is lengthy, literature is sparse on how ratings from multiple credit rating agencies (CRAs) affect the performance of a company’s initial public offering (IPO). Our research is motivated by the lack of such literature and by Sangiorgi and Spatt (2017), who argue that multiple ratings are socially optimal if the benefit of the additional rating outweighs the cost of information production. This argument aligns with the “shopping hypothesis” and “information production hypothesis” of Bongaerts et al. (2012). Under the former hypothesis, issuers “shop” for an additional rating in hopes of improving … Read more

The New Business Rule and Compensation for Lost Profits

Not so long ago, most American jurisdictions followed the “new business rule.” If a business did not have a history of profitable operations, it would have been denied recovery for lost profits. That has changed. The prevailing wisdom nowadays replaced a per se rule with a rule of evidence—damages must be proven with reasonable certainty, regardless of whether the claimant was a new business.

However, the prevailing wisdom is wrong. The damages for a new business ought not be viewed as merely a matter of whether the evidence is sufficient to surmount the “reasonable certainty” hurdle. The new business rule … Read more

How Banks with Leaders Experienced in Past Crises Fared in Global Financial Crisis

Regulators and policymakers have asserted that the public was “blindsided” by the “perfect storm” that caused the 2007-2009 global financial crisis (GFC, e.g., Financial Crisis Inquiry Commission [FCIC] 2011; Appelbaum 2015). Academic research has similarly found that market participants, including bank CEOs, generally did not recognize the severity of the crisis or respond effectively (e.g., Fahlenbrach and Stulz 2011; Desai, Rajgopal, and Yu 2016). As the FCIC concluded, “[the] greatest tragedy would be to accept the refrain that no one could have seen [the GFC] coming…If we accept this notion, it will happen again” (2011). These concerns are particularly salient … Read more

Corporate Governance and Crowdfunding

In a recent paper, we focus on the expected agency problems in equity crowdfunding markets and the governance mechanisms that might mitigate them.

In equity crowdfunding, there are two pronounced problems that result from significant information asymmetry associated with small firms and their investors. The first involves adverse selection, which posits that the pool of firms seeking to raise capital in equity crowdfunding may not have as high expected (risk-adjusted) returns as does the pool of firms trying to raise capital outside of equity crowdfunding. In the absence of prospectus requirements, it is very hard for a large number … Read more

Cleary Gottlieb Discusses FSOC Proposal to Change SIFI Designation Process

On March 6, 2019, the Financial Stability Oversight Council (“FSOC”) issued new proposed guidance (the “Proposal”) regarding the designation of nonbank financial companies as “systemically important financial institutions” (“SIFIs”).[1] The Proposal makes substantial changes to FSOC’s existing designation approach by shifting its focus away from an “entity‑based” approach towards an “activities‑based” approach. Designation of an individual firm would only occur if FSOC determined that efforts to address the financial stability risks of that firm’s activities by the primary federal and state regulators have been insufficient.

In summary, the Proposal:

  • Requires FSOC to focus

Read more

Debevoise & Plimpton Discusses the Rise of Secured Bonds in M&A Deals

Early 2019 has seen a wave of issuances of secured bonds to finance large acquisitions. The likelihood of slower rate increases by the Fed has led to an uptick in investor demand for secured bonds while making the pricing on such bonds more attractive for issuers. While issuers in recent years generally preferred term loans to bonds, last month, Dun & Bradstreet, TransDigm and CommScope increased the size of their secured bond tranches in response to investor demand. This update reviews some key considerations when issuing secured bonds in lieu of term loans or unsecured bonds.

Key Considerations

Call ProtectionRead more

Disruption and the Credit Markets

In the past 30 years, defaults on corporate bonds have been substantially higher than the historical average. Dividing the years from 1970 to 2016 into two equal periods, the default rate of U.S. corporate bonds rose from 0.12 percent to 0.46 percent, almost quadrupling. The figure below illustrates this development. In a recent working paper with Victoria Ivashina of Harvard, we investigate the role of corporate disruption in this trend.

If disruption is the process whereby new firms appear, using new technology and new business models, why would it affect default rates? Precisely because disruption involves new firms displacing old, … Read more