Securities Regulation

Question 1

What are the Approaches to Regulating Public Offerings?

Answer 1

• Light-Touch (Fraud Acts), i.e. serious penaliztion of misinformation without mandating disclosure.
• Mandatory Disclosure (Disclosure Acts).
• Blue Sky Laws (Regulatory Acts), i.e. conditioned permissioning of securities Issuing.

Lawcast (Wk. 15, Pt. 1), Approaches to Regulating Public Offerings​.

The approaches are arranged from least to most paternalistic.

Question 2

What sort of Merit Requirements are imposed by Blue Sky Laws?

Answer 2

Requirements may pertain to:

• The Issuer’s nature or identity.
• The securities’ attaching rights.
• Capital adequacy thresholds.
• Treatment and inclusion of Allottees.
• Offering price, which is typically capped at a P/E multiple.

Lawcast (Wk. 15, Pt. 1).

Generally, Merit Regulation is taken to be too costly to be justifiable in a mature market.

Question 3

What are the Regulatory Rationales Underlying Mandatory Disclosure Regimes?

Answer 3

• Investor Protection: Decrease information asymmetries between primary market participants, thus allowing investors to make more well-informed decisions.
• Efficiency: Support efficient pricing mechanisms in the secondary market, and efficient corporate governance generally.

Lawcast (Wk. 15, Pt. 1); Textbook – P. 501.

The need for regulation itself arises from the nature of securities as intangible goods whose qualities cannot be readily inspected by investors and whose value is contingent on unknown future variables, and the inherent conflict between corporate insiders (managers and controlling shareholdres) and outsiders.

Question 4

What are the Arguments for Mandatory Disclosure?

Answer 4

• Greater investor confidence.
• Reduced information asymmetries, achieved by facilitating comparability and reducing adverse selection.
• Reduced moral hazard for in Issuers and Gatekeepers, as exacerbated by oligopolistic market structures that erode competitive pressures.
• Optimized production and distribution of information.
• Supplementation of the EMH’s shortcomings, as evidenced by Behavioral Finance.

Lawcast (Wk. 15, Pt. 1).

The First Point is weak, as there have periods with low disclosure obligations and high confidence, e.g. South Sea Bubble, and vice versa, e.g. the GFC’s aftermath. For the Third Point, see e.g. Enron and Arthur Andersen, and more generally, the threat of deceit. The issue with most of these arguments is that they go towards supporting discolsure per se and not necessarily MD.

Question 5

How may Information Asymmetries increase costs for both Issuers and Investors?

Answer 5

• Issuer: Compensating the Investor for the risk attached to incomplete information by having to offer a lower purchase price.
• Investor: Paying for a potentially overvalued security.

Textbook – P. 501.

Question 6

Why and How does Mandatory Disclosure Optimize the Flow of Information?

Answer 6

Information is a public good, i.e. nonrivalrous, nonexcludable, and thus vulnerable to the Free-Rider Problem. Thus, without mandate, a sub-optimal level of information will be generated.

Lawcast (Wk. 15, Pt. 1).

Here, the Free Rider Problem denotes third-parties benefiting from the information produced by a given firm or investor who suffer the cost of producing the information, but are unable to prevent others from sharing in the resultant gain. Accordingly, their incentive to produce such information to begin with is diminished.

Question 7

What are the Arguments against Mandatory Disclosure?

Answer 7

• Increased cost of funding (Transaction Costs) for Issuers, especially for smaller Issuers.*
• Interest Group Theory, i.e. MDs benefit some at the cost of others, thus creating an unlevel playing field.
• Voluntary disclosure, arising from market demand or Gatekeepers (IIs, Underwriters, etc.), would otherwise prevail.
• Private sector regulation, i.e. Stock Exchanges’ rules.
• EMH, i.e. everything is priced in.

Lawcast (Wk. 15, Pt. 1).

*IPOs of less than €6m are 10-15% more costly, €6-50m 6-10%, €50-100m 5-8%, and €100m+ 3-7.5%.

Question 8

What are the Arguments against Voluntary Disclosure?

Answer 8

• Does not fully address Insider’s moral hazards.
• May lead to underproduction of information relative to MD.
• Information provided thereunder would be idiosyncratic, i.e. non-standardized.

Textbook – P. 508.

Question 9

Generally speaking, what is the Consensus on Mandatory Disclosure?

Answer 9

Some measure of MD is beneficial. However, the optimal measure thereof is unclear because of how difficult it is to quantify the intersection bewteen the marginal cost and benefit of disclosure.

Lawcast (Wk. 15, Pt. 1).

Question 10

For the Legislator, in Drafting Mandatory Disclosure Obligations, what are the relevant considerations?

Answer 10

• Differential regulatory treatment based on:
  
  • Type of Issuer (new vs. seasoned).
  • Type of Investor (retail vs. institutional)
  • Size of Offering.
• Standardization of form of information (to facilitate comparability).

Question 11

What is the Regulatory Cost-Benefit Analysis for Soft Information (Forecasts and Projections)?

Answer 11

• Cost: High. Creates potential legal exposure for failing to satisfy the data if the future pans out differently, e.g. misrepresentation.
• Benefit: Low. Little substance can be derived from the data given how contingent, caveated, and open-ended it will likely be.

Lawcast (Wk. 15, Pt. 1).

For US treatment, see: Securities Act 1933 – Rule 175 and In re Donald J. Trump Casino Sec. Litig. - 7 F.3d 357 (3d Cir. 1993). For EU treatment, see: Prospectus Regulation 2017 and Trend Information/Forecasts.

Question 12

What is the Core Claim of the Efficient Market Hypothesis?

Answer 12

In an efficient market, all securities prices fully reflect all available information thereabout, as it pertains to NPV. This begets two corollaries:

• All price movements must be the result of new information.
• It is impossible to use available information to generate α.

Lawcast (Wk. 15, Pt. 1); E.F. Fama – Efficient Capital Markets: A Review of Theory and Empirical Work; Gilson and Kraakman, The Mechanisms of Market Efficiency [554-555].

Question 13

What are the Different Forms of the Efficient Market Hypothesis? (REVISIT UPON FURTHER READING)

Answer 13

• Weak Form: Historical price information is priced in and thus cannot be used to generate α.
• Semi-Strong Form: All public information is priced in and thus cannot be used to generate α.
• Strong Form: All existing, i.e. public and private, information is priced in and thus cannot be used to generate α.

Brealey et al. Principles of Corporate Finance [340]. Gilson and Kraakman, The Mechanisms of Market Efficiency [555].

Question 14

What does the Concept of Full Reflection entail?

Answer 14

“Prices must behave as if everyone knows the relevant information.” Full reflection is therefore achieved when, “the equilibrium that would result if everyone knew the information,” is actually observed.

Gilson and Kraakman, The Mechanisms of Market Efficiency [557-558].

“The [consequent] effect… is to shift our attention away from the operational consequences of efficiency for traders and toward the challenge of describing the market processes of price formation.”

Question 15

What does the Concept of Availability entail?

Answer 15

The extent to which information is distributed, and therefore accessible, to market actors. It is primarily obstructed by, “differentially efficient market responses to information sets.”

Gilson and Kraakman, The Mechanisms of Market Efficiency [558-559].

“Thus, the strength of the claim that prices fully reflect all available information hinges in large part on where one sets the minimum threshold of information distribution… [with the] Strong Form set[ing] the threshold as low as possible… [and the] Weak Form set[ing] the threshold as high as possible.”

Question 16

What does the Concept of Relative Efficiency entail?

Answer 16

“The speed with which new information is reflected in price,” a metric that, “determines the magnitude of arbitrage opportunities,” for those first gain access to said information.

Gilson and Kraakman, The Mechanisms of Market Efficiency [560].

Thus: “The requirement that prices always reflect new information means, in effect, that these mechanisms must function rapidly enough to foreclose any exploitable trading opportunities.”

Question 17

What does the Concept of Information entail?

Answer 17

The hard data of known facts and the soft data of forecasts and estimates, a distinction necessitated by, “securities prices ultimately turn[ing] on expectations about future earnings.”

Gilson and Kraakman, The Mechanisms of Market Efficiency [561].

“Even a trader fully informed about the past would wish to have access to optimal forecasts about future events that seemed likely to affect future cash flows.”

Question 18

In what sense is Information both Static and Dynamic?

Answer 18

Information is static in that it is either true or false, and is dynamic in that new information may either refute, fine-tune, or further validate old information.

Gilson and Kraakman, The Mechanisms of Market Efficiency [563].

“[This distinction] portrays a constant movement toward certainty.”

Question 19

How do Uninformed Investors go about Informing themselves, and thereby, increasing their Certainty?

Answer 19

The Uninformed Investor may either:

• Act to acquire new information;
• Derive new insights from information already possessed; or
• Analyze the accuracy of information received from others, as most trading data is acquired second-hand and without full appraisal.

Gilson and Kraakman, The Mechanisms of Market Efficiency [564].

An Uninformed Investor is one who does not possess full and perfect information.

Question 20

Functionally, what is a Mechansim of Market Efficiency?

Answer 20

A trading process that, with relative efficiency, “forces prices to a new, fully informed equilibrium.”

Gilson and Kraakman, The Mechanisms of Market Efficiency [565].

Question 21

What are the Obstacles faced by Mechansim of Market Efficiency?

Answer 21

• Extreme variety in the ways in which new information can be initially distributed to markets; and
• Differentially efficient market responses to new information; both of which give rise to the
• Need for several different mechanisms that properly address the diverse instances of information distribution and the responses thereto.

Gilson and Kraakman, The Mechanisms of Market Efficiency [566].

Question 22

What are the Four General Types of Mechanisms of Market Efficiency?

Answer 22

In order of most-to-least relatively efficient:

• Universally-Informed Trading (UIT).
• Professionally-Informed Trading (PIT).
• Derivatively-Informed Trading (DIT).
• Uninformed Trading (UT).

Gilson and Kraakman, The Mechanisms of Market Efficiency [566].

“All four shape the formation of prices in the same securities markets… in a fashion that can account for the reflection of information in price over the entire range of informational availability…. [which is very pertinent] from the perspective of policy formulation.”

Question 23

What are the Critical Features regarding how Mechanisms of Market Efficiency operate?

Answer 23

• Only one Mechanism at a given time can operate to price-in a particular piece of new information.
• Which Mechanism will prevail, “depends on how widely the particular information is distributed in the market.”
• Each Mechanism has a characteristic level of relative efficiency that is influenced by, “how widely information must be distributed in order to trigger it.”
  
  • The wider the initial distribution required to trigger, the more rapidly the Mechanism operates.

Gilson and Kraakman, The Mechanisms of Market Efficiency [567].

“Although all four mechanisms can ultimately lead to efficient equilibrium prices, the dynamics of equilibration will take longer as one moves from wide to narrow distribution mechanisms.” Thus, less available information takes longer to price in and arbitrage results.

Question 24

What is Mechanism, Universally-Informed Trading?

Answer 24

Universal dissemination of information, “in which all traders are, in fact, costlessly and simultaneously informed.” Historical prices and news items are prime examples.

Gilson and Kraakman, The Mechanisms of Market Efficiency [568].

UIT is the only Mechanism that achieves full efficiency, and is the ultimate endpoint of its peers. “[It] lumps together traditional “Weak-Form” [data] about price histories with [data] about current events into a single [data] set that [rapidly spurs reflection] and with near perfect dynamic efficiency.”

Question 25

What is Mechanism, Professionally-Informed Trading?

Answer 25

Dissemination of information to, “a minority of knowledgeable traders who control a critical volume of trading activity,” thus achieving, “that rapid price equilibration.”

Gilson and Kraakman, The Mechanisms of Market Efficiency [570].

Complex technical data, documents filed with government agencies, and insider information are all prime examples. Market professionals comprise the relevant minority. Relative efficiency is hindered to the extent that arbitrage’s costs outweight its returns.

Question 26

What is Mechanism, Derivatively-Informed Trading?

Answer 26

Dissemination of information through, “the information leagkage that is associated with trading itself.” It is therefor a two-stage process of Informational Monopolists trading and Decoders reacting thereto.

Gilson and Kraakman, The Mechanisms of Market Efficiency [572-573].

An Informational Monopolist one who enjoys, “easy access to information that would be prohibitively costly for anyone else to obtain.” He possesses insufficient resources to induce speedy price equilibration. Therefore, “[DIT] enhances relative efficiency… by capitalizing on information leakage.”

Question 27

What are the Different Types of Information Leakage?

Answer 27

• Pure Leakage:“Inadvertent, direct communication of trading information to outsiders,” whether by accident or theft.
• Trade Decoding: The gleaning of trading information through direct observation of trading activity.
  
  • Limited by the ability of the Uninformed to identify the Informed and directly observe their trading activities.
• Price Decoding: The gleaning of trading information through observation and interpretation of, “anonymous data on price and trading volume against the backdrop of other [data] or expectations [the Uninformed] may possess.”

Gilson and Kraakman, The Mechanisms of Market Efficiency [573-575].

Question 28

What is Mechanism, Uninformed Trading?

Answer 28

Trading pursuant to aggregate forecasts,“that are more nearly optimal over the long-run than those of any individual trader,” thus marginally increasing relative efficiency. At best, a fine-tuning tool.

Gilson and Kraakman, The Mechanisms of Market Efficiency [580].

Theoretically, one trader’s biases will be off-set by another’s and vice versa, which ultimately leads to a single best-informed aggregate forecast. Practically, however, traders’ systematic biases structurally undermine this Mechanism, and so once traders incorporate price, so will price noise. Still, “the formulation of expectations in response to uncertainty will always constitute a major portion of the task of valuing securities. Over much of this domain, the uninformed trading mechanism will bear the burden of reflecting these expectations in price.”

Question 29

What are the Assumptions upon which the EMH is built?

Answer 29

• Rationality: Investors are rational. They only react proportionately to data regarding fundamentals, and do not speculate.
• Lack of Correlation: To the extent that some investors are irrational, their irrational traders cancel one another out. However, this requires a lack of correlation exist between said irrational trades.
• Arbitrage: To the extent that irrational trades are correlated, arbitrageurs will exploit them, and thereby, provide an equalizing counterbalance.

Lawcast (Wk. 15, Pt. 2).

Question 30

What Criticisms may directed at the EMH’s Underlying Assumptions?

Answer 30

• On Rationality: Investors often behave irrationally when making investment decisions pursuant to their biases.
• On Lack of Correlation: Deviations from economically rational behavior tend to be pervasive and systematic, often underlaid by the same reasons, e.g. psychological biases.
• On Arbitrage’s Efficacy: Aribtrage is subject to practical limitations that impede its ability to optimize efficiency.

Lawcast (Wk. 15, Pt. 2).

Question 31

What is the Random Walk?

Answer 31

The fact that the day-to-day movements of share prices are random, i.e. the changes therein are independent of one another.

Brealey et al. Principles of Corporate Finance [340].

Question 32

Why must Share Prices follow a Random Walk?

Answer 32

“In competitive markets, there are no such free lunches. As investors try to take advantage of any information in past prices, prices adjust immediately until the superior profits from studying price movements disappear.

Brealey et al. Principles of Corporate Finance [341-342].

This is why, “all the information in past prices will be reflected in today’s stock price, not tomorrow’s.”

Question 33

To what extent does the Empirical Evidence support the Weak Form of the EMH and the notion of the Random Walk?

Answer 33

Strongly. The only notable exception is momentum, i.e. the notion that strong past performance (3-12 months) may increase the probability of strong future returns and vice versa.

Lawcast (Wk. 15, Pt. 2). Brealey et al. Principles of Corporate Finance [342].

It is critical to emphasize that momentum is a statistical tendency, not an investment strategy.

Question 34

To what extent does the Empirical Evidence support the Semi-Strong Form of the EMH?

Answer 34

Somewhat:

• Once a Takeover is annouced, the Target’s share price quickly increases accordingly and sustains its new level. However, there is also a notable price increase before announcement, which says that non-public information is also relevant.
• Divergences in the share price of Siamese Twin stocks, e.g. Royal Dutch, is further counter-evidence.

Brealey et al., Principles of Corporate Finance [345].

Share price increases are a result of the market knowing the Bidder will have to a pay a Takeover Premium.

Question 35

To what extent does the Empirical Evidence support the Strong Form of the EMH?

Answer 35

Weakly. Active managers often fail to consistently outperform the market (accounting for management fees), a shortcoming made rather prominent when compared to passive strategies’ strong performance.

Brealey et al., Principles of Corporate Finance [347].

Having said that, an efficient market requires that some active managers participate if there are to be any incentives to gather information whatsoever. Therefore, “prices cannot reflect all information,” and the financial markets are forever limited to being, “close to perfectly efficient.”

Question 36

It is Extremely Difficult to Value a Security. For our purposes, what are the Implications of this fact?

Answer 36

• Valuation is performed relative to a stock’s historical prices or a similar stock’s price. If confidence is lost in these benchmarks, price volatility will ensue.
• Due to valuation’s relativity, it is almost impossible to examine whether a stock, and by extension a market, is objectively correctly valued.

Brealey et al., Principles of Corporate Finance [348].

Bubbles are the occasional exception, but an arguably rather weak one.

Question 37

How do Bubbles arise?

Answer 37

When prices rise rapidly, and increasing numbers of investors join in on the assumption that said prices will continue to rise. The mere existence of Bubbles is strong evidence against the EMH.

Brealey et al., Principles of Corporate Finance [348].

Getting in on a Bubble may be rational if you are relatively certain that there will be a Greater Fool that you can sell out to.

Question 38

How does Behavioral Finance undermine the EMH?

Answer 38

It proves that Investors often behave irrationally when making investment decisions.

Lawcast (Wk. 15, Pt. 2).

Question 39

What Findings of Behavioral Economics are Relevant to the EMH, and more specifically, its Underlying Assumptions?

Answer 39

Investors have numerous predispositions, weak and strong, to act irrationaly, thus undermining the assumption of investor rationality. Prices therefore reflect both investor sentiment and available information.

Lawcast (Wk. 15, Pt. 2); Brealey et al., Principles of Corporate Finance [349]. See Fig. 13.6, 351 for useful graph.

Investors’ decision-making is undermined by various biases and heuristics, including: Anchoring, Availability, Cognitive and Confirmation Biases, Extension Neglect, Framing, Overconfidence, Prospect Theory, Probability and Game Theory.

Question 40

What is Arbitrage?

Answer 40

The exploitation of market inefficiencies to generate α, a return which is realized when prices once again reflect the fundamentals. In theory, this strategy is without risk, but practically, this is untrue.

Brealey et al., Principles of Corporate Finance [351].

If a security is underpriced or overpriced, the Arbitrageur will buy or sell it, respectively, thus generating α and exerting upwards or downards pressure until the price converges with its true value. This strategy is otherwise known as Convergence Trading.

Question 41

To what extent, if any, is Arbitrage limited in practice?

Answer 41

• Trading costs may be onerous, e.g. buying Options to gain exposure to a stock one does not own.
• Illiquidity may prove obstructive.
• Exposure to market risk (depending on strategy), e.g. Options.

Brealey et al., Principles of Corporate Finance [352].

Question 42

What is the Consequence of Arbitrage being Practically Limited?

Answer 42

“Prices can get out of line and stay out [for quite some time] if the risks of an arbitrage strategy outweigh the expected returns.”

Brealey et al., Principles of Corporate Finance [352].

Question 43

How can Incentive Structures undermine the Efficient Market Hypothesis?

Answer 43

Where incentives compel financial actors to ease their adherence to the fundamentals, e.g. the GFC and the ‘originate-to-distribute’ strategy, inefficiences may arise.

Brealey et al., Principles of Corporate Finance [353].

Question 44

What are Bearley et al.’s Five Lessons to be Learned from Market Efficiency?

Answer 44

• Markets Have No Memory: Past performance is no guarantee of future results.
• Trust Market Prices: As a starting point, assume that a security is correctly priced. To think otherwise would be to believe that one knows more than literally everyone else.
• Read the Entrails: If information is ubiquitous, how one goes about interpreting shall determine his success.
• The DIY Alternative: Before acting, determine whether the beneficiaries are being advantaged in a way that they cannot themselves replicate more cheaply or conveniently.
• Seen One Stock, Seen Them All: Stocks are almost perfectly substitutable in that they offer a fair return for their risk, and therefore, exhibit high demand elasticity.

Brealey et al., Principles of Corporate Finance [354-356].

These Lessons depend on markets behaving (mostly) efficiently.

Question 45

What is the Relevance of the Information Market?

Answer 45

It determines the initial distribution of information in the capital markets.

Gilson and Kraakman, The Mechanisms of Market Efficiency [593].

Question 46

In the Information Market, what is Information ultimately a Function of?

Answer 46

Cost. The lower the cost of ascertaining information, the wider it will be distributed, the more effectively the Mechanisms will operate, and the more efficiently the market will operate with respect to it.

Gilson and Kraakman, The Mechanisms of Market Efficiency [593].

Question 47

What are the Types of Information Costs?

Answer 47

• Acquisition Costs.
  
  • For Originators, this is costs of creating data, and for Recipients, it is costs of gaining access thereto.
• Processing Costs.
• Verification Costs.
  
  • For Originators, this is the cost of verifying their data, but for Recipients, this also includes the cost of verifying the Originator.

Gilson and Kraakman, The Mechanisms of Market Efficiency [594].

Question 48

How do the Capital Markets go about decreasing Acquisition Costs?

Answer 48

In increasing and decreasing order of costliness and relative efficiency:

• The Financial Press and first-hand information from the Originator. [Weak][UIT]
• Information intermediaries (e.g. CRAs). [Semi-Strong][PIT]
• Collectivization, both public (e.g. securities legislation)[PIT] and private (e.g. analyst trade associations)[DIT]. [Semi-Strong]
• Espionage, surveillance, and investigative analysis (due diligence). [Strong][UT]

Gilson and Kraakman, The Mechanisms of Market Efficiency [599-609].

Question 49

How do the Capital Markets go about decreasing Processing Costs?

Answer 49

In increasing and decreasing order of costliness and relative efficiency:

• The Financial Press. [Weak][UIT]
• Information intermediaries (e.g. CRAs). [Semi-Strong][PIT/DIT]
• Investment in human capital and internal support facilities. [Strong][UT]

Gilson and Kraakman, The Mechanisms of Market Efficiency [599-609].

Question 50

How do the Capital Markets go about decreasing Verification Costs?

Answer 50

In increasing and decreasing order of costliness and relative efficiency:

• Reputation (of Originators). [Weak][UIT]
• Collective signalling, i.e. civil and criminal penalties. [Semi-Strong][PIT]
• Seller signalling, e.g. warranties, bonding mechanisms, or insider buying. [Semi-Strong][PIT/DIT]
• Information and financial intermediaries. [Semi-Strong][DIT]
• Buyer verification. [Strong][UT]

Gilson and Kraakman, The Mechanisms of Market Efficiency [599-609].

Question 51

What is the Relationship between Relative Efficiency and Information Costs?

Answer 51

Relative efficiency is a function of information costs. “The information available to be reflected in price by the capital market is determined by cost conditions in the information market.”

Gilson and Kraakman, The Mechanisms of Market Efficiency [609].

This is likewise true for Mechanisms, with capacity for reflection being correlated with low information costs. Information costs are therefore determinative of the viability of Efficiency Mechnaisms.

Question 52

What are the Roles of the Investment Banker (IB) in Facilitating an Efficient Market?

Answer 52

IBs function as:

• Distributors (for Issuers).
• Underwriters (for Issuers).
• Informational (and Reputational) Intermediaries.

Gilson and Kraakman, The Mechanisms of Market Efficiency [618].

Question 53

How do Investment Bankers function as Informational (and Reputational) Intermediaries?

Answer 53

The IB, “rents the Issuer its reputation,” by representing, “to the market… that it has evaluated the Issuer’s product in good faith and that it is prepared to stake its reputation on the value [thereof].” The IB’s status as a repeat player further strengthens its signalling.

Gilson and Kraakman, The Mechanisms of Market Efficiency [619-].

The effect is to decrease processing and verification costs for buyers, thus decreasing total information costs, increasing the distribution of information, and therewith, market efficiency. They are able to do this because of collectivization and the economies of scale and scope that they enjoy.

Question 54

What is the Efficiency Paradox?

Answer 54

The state of vacillating disequilibrium that arises from full market efficiency regarding particular information, namely in that it decreases incentives to acquire further information and thereby causes market inefficiency.

Gilson and Kraakman, The Mechanisms of Market Efficiency [622-623].

Grossman, its creator, resolved it by introducing the concept of noise, i.e. because prices do not fully disclose all information, full efficiency can never be achieved, rendering the Paradox an impossibility.

Question 55

From the Dual Market Perspective, is the Efficiency Paradox’s Assertion that a Market can never be Fully Efficient true?

Answer 55

No. Even where the ubiquity of certain inforamtion, e.g. past price data, renders the further acquisition thereof uprofitable, if it forms a part of an investment strategy that has the potential to generate α, then further acquisition becomes a joint cost.

Gilson and Kraakman, The Mechanisms of Market Efficiency [624].

“The information about past prices behaves as if it were costless to the extent that the expenditure necessary to acquire and process this information is made for another purpose. The market becomes completely efficient with respect to one form of information as a result of efforts to exploit inefficiency with respect to another.”

Question 56

How does the Dual Market Perspective’s Joint Costs Analysis impact the Efficiency Paradox?

Answer 56

Joint costs render maintenance of equilibrium effectively costless, thus banishing the Paradox. Maintenance costs do not reflect discovery costs, “but the costs of continuing to reflect a prior discovery in price.”

Gilson and Kraakman, The Mechanisms of Market Efficiency [625].

“The [cost-benefit] necessary to induce the initial acquisition of new [data is] very different from the [cost-benefit] necessary to maintain an efficient equilibrium with respect to [data that has] become widely distributed. It is the incentive to acquire new [data] and to develop new innovations that encourages the behavior necessary to maintain an efficient equilibrium with respect to prior [data] and innovations.”

Question 57

To what extent does Insider Trading increase Market Efficiency?

Answer 57

“The increase in the correctly specified supply caused by an insider’s sell order is simply too small to have any but a transitory, and probably insignificant, impact on the price of the security.”

Gilson and Kraakman, The Mechanisms of Market Efficiency [630].

Insider Trading is a form of DIT, which is a comparatively inefficient Mechanism that, “functions slowly and sometimes only sporadically.” Thus, even though it can push prices in the right direction, “encouraging it is unlikely to have much effect on the efficiency of securities prices.”

Question 58

In light of the Shortcomings of Insider Trading from an Efficiency Standpoint, can Derivatively-Informed Trading be made to Function more Efficiently?

Answer 58

Insiders ought be required to disclose their identities, trades, and other relevant data well before their trades to more widely distribute this data to uninformed traders, and thereby, increase efficiency.

Gilson and Kraakman, The Mechanisms of Market Efficiency [632].

“Making the derivatively informed trading mechanism more effective requires wider distribution of the information on which the critical deductions are based.”

Question 59

From the Dual Market Perspective, what are the Merits of a Mandatory Disclosure regime?

Answer 59

“[MD may] have created substantial savings for informed traders by collectivizing some of the costs of acquiring, processing, and verifying [data] that traders had independently expended [beforehand].”

Gilson and Kraakman, The Mechanisms of Market Efficiency [638].

They reject the argument that MD is unfruitful merely because it does not effect price behavior, namely because unless the material data to be MD’d was, “either very costly or wholly unavailable to the market [beforehand],” one would not expect MD to immediately effect prices. In other words, MD may increase net returns rather than gross returns.

For further reading, see Textbook – P. 507, Footnote 134.

Question 60

Regarding Mandatory Disclosure, on what grounds can a Distinction between Public and Private Companies be made?

Answer 60

• Private firms investors generally have some connection with the company, and thus suffer from less severe information asymmetries.
• Frauds in public firms may impact the prices of similar firms in the market.
• Private firms share purchases are generally the subject of negotiations, which means that purchasers can contract for their own protection and bargain for disclosures.
• MD would be too costly for most private firms (given their small size).

Textbook – P. 503.

Question 61

What Merit Regulations are in place with respect to Public Offers?

Answer 61

Draft Prospectuses must be vetted by the FCA,* and Listing applications may be rejected if the FCA believes they would be detrimental to investors.**

Textbook – P. 503 (also 10.4.3.2 for more); *FSMA 2000 – §87A; **FSMA 2000 – §75(5).

The purpose of these requirements is to ensure compliance with the Prospectus Regulation, FSMA, and the FCA Handbook, not to verify correctness. The FCA can, however, be expect to spot glaring warnigs, but it cannot guarantee completeness or accuracy.

Question 62

What are the Sources of Firms’ Mandatory Disclosure Obligations?

Answer 62

• EU legislation (Prospectus Regulation and CARD Directive).
• UK legislation (FSMA 2000).
• FCA’s Handbook.
• LSE’s Official List (governed by the FCA) and general applications.

Textbook – P. 509.

Question 63

What is the Main Tool through which Mandatory Disclosure Obligations are imposed on Initial Issuers (Primary Market Participants)?

Answer 63

The Prospectus, as it is a prerequisite to any offering of securities to the public.

Textbook – P. 511.

This, and Secondary Market MD, exist in addition to financial reporting obligations placed on companies by company law, e.g. audited financial statements.

Question 64

When must a Prospectus be Published?

Answer 64

When an Issuer seeks to offer securities to the public or when an Issuer applies to admitted onto a regulated market.

Prospectus Regulation – Art. 3(1).

Question 65

What does it mean to ‘Offer Securities to the Public’?

Answer 65

A communication to anyone in any form or means that presents sufficient information thereto on the terms and securities on offer, so as to enable the recipient to decide to purchase or subscribe.

Prospectus Regulation – Art. 2(d).

This includes offers made through financial intermediaries, i.e. Placement, and seasoned offerings (which enjoy laxer treatment). It also includes the resale of securities, more broadly, that fall under Art. 2(d) and are not exempted therefrom.

Question 66

When will an Offer be taken to have been made ‘To the Public’?

Answer 66

When it is made group of individuals who are not able to fend for themselves, e.g. can ascertain information that would have otherwise been available in a Prospectus or are financially well-experienced.

Lawcast (Wk. 16); SEC v Ralston Purina Co., 346 U.S. 119 (1953).

The case contrasted executive directors and employees as two groups that can and cannot, respectively, fend for themselves as so defined, and stated that the criterion is not quantitative in nature.

Question 67

What are the Exemptions (partial or full) or Alternatives to Art. 3 and the Obligation to Publish a Prospectus?

Answer 67

• Art. 1(3): Offers of securities with a total consideration across the EU of €1m (upto €8m)(upto €75m for debt securities) raised over 12 months.
• Art. 1(4)(a): Offers made to qualified investors.
• Art. 1(4)(b): Offers made to fewer than 150 persons.
• Art. 1(4)(c): Offers of securities in denominations of at least €100,000.
• Art. 1(4)(d): Offers where the investor must pay at least €100,000 to acquire the securities.
• Art. 9: Universal Registration Document (URDs)(effectively a fast track) and its US counterpart, Shelf Registration.
• Art. 14: Secondary Issuances (heavily qualified).
• Art. 15: SMEs and EU Growth Prospectuses (which enjoy otherwise laxer standards).

Textbook – P. 511-513.

The rationale behind these exemptions or alternative is to avoid imposing the cost of MD where it would prove counterproductive or out of proportion, e.g. where no asymmetries exist (M&A), where it would be out of place (bonus shares), where Investors can readily acquire and evalute all the information they need to make an informed decision, or simply where the costs outweight the purported benefits. Firms may yet have to publish a Prospectus if they wish to admit their securities onto a regulated stock exchange.

Question 68

What is the Purpose of the Prospectus?

Answer 68

To provide Investors with the data necessary to make an informed assessment of:

• The Issuer’s (and any Guarantors’) assets, liabilities, profits, losses, financial position, and prospects.
• The rights attaching to the securities; and
• The Issuance’s purpose and purported impact on the Issuer.

Textbook – P. 513; Prospectus Regulation – Arts. 6-8, Annex I.

The information required under Annex I is predominantly historical in nature, namely because of the positive and negaitve cost-benefit analyses of soft and hard data, respectively, and the importance of historical information to Investors’ independent valuations.

Question 69

How must the Information in a Prospectus be communicated?

Answer 69

Whether written or presented, all information must be easily analyzable, concise, and comprehensible.* Further, Issuers must provide a summary of the Prospectus, to be found in the document.**

Prospectus Regulation – *Art. 6(2), **Art. 7.

Question 70

What must the Summary of the Prospectus contain?

Answer 70

”[All] key information on the Issuer, the securities, and the IPO (or admission to list)…. When read… it must be an aid to investors [in their decision-making process].”

Textbook – P. 513; Prospectus Regulation – Art. 7.

The obligation to present clearly, concisely, and comprehensibly obtanis. Emphasis is also placed on a clear layout, and the summary should not exceed seven pages. It should clarify that it is only an introduction and that investment decisions should be based on the information contained thereafter.

Question 71

What is the Main Tool through which Mandatory Disclosure Obligations are imposed on Seasoned Issuers Issuers (Secondary Market Participants)?

Answer 71

• Ongoing periodic disclosures, e.g. quarterly and annual reports.
• Discolsure of Major Holdings.
• Disclosure of Directors’ Dealings (to hamper Insider Trading).
• Ad hoc disclosure, i.e. the requirement to imminently disclose price-sensitive information.

Lawcast (Wk. 16); Transparency Directive (ongoing disclosures); Regulation No. 596/2014 and Directive 2014/57/EU (market abuse); FSMA 2000 and FCA Handbook (generally).

Quarterly reporting is no longer a legal obligation, chiefly because it was regarded as stoking short-termism, but it is still a widespread market practice. The Second Point is a notification that is made whenever a firm’s proportion of holdings or votes in any listed company reaches, exceeds or falls below a certain threshold.

Question 72

Why is there a Lack of Intergration in European Capital Markets?

Answer 72

Home bias, i.e. the tendency of Investors to hold only modest amounts of foreign equity and to strongly favor company stock from their home nation.

Lawcast (Wk. 16).

Home bias also applies to Issuers, who tend to issue in their domestic market.

Question 73

Why is Home Bias and the Disintegration of European Capital Markets problematic?

Answer 73

• Decreased access to international finance increases cost of capital for Issuers and misallocation of resources.
  
  • Especially important during crises, where illiquidity is high and credit is scarce.
• Suboptimal returns for Investors given that they may not necessarily be exposed to the best investment opportunities.
• Lack of risk sharing increases losses from exogenous economic shocks by decreasing the ability of capital to flow from more to less affected areas in a common market.

Lawcast (Wk. 16).