M&A activity is on the rise this year, which means the crews in the backroom will be busy processing tender offers and channeling your responses. Handling corporate actions — takeovers, rights issues, mergers, stock splits, redemptions — is a big business. Including dividends, it topped $2 trillion last year. With companies hoarding lots of cash for acquisitions, it's likely to get even bigger this year.
What you may not necessarily know, however, is that, despite all the investments in backroom technology and training, the processing of corporate actions ranks last in terms of efficiency, automation and standardization. What that translates into is a high potential for error. In fact, slip-ups and mistakes take place all the time. And because the business is so big — the industry will process upwards of a million corporate actions worldwide this year — the potential for error is magnified.
In other words, corporate actions processing can be a risky business. And investors everywhere, including your clients, can end up paying for that risk. Conflicting and incomplete announcement information, incorrect data and late notification are common problems that can result in delayed payments, market risk, loss of interest or missed opportunity. For example, even if your clients don't own the underlying securities involved in a corporate action, they may have puts or calls outstanding on them, and the value of those options can change dramatically in the wake of a corporate actions announcement. If word about the corporate action is late in getting to you and your clients, you could have considerable credit exposure from the derivatives — or you could miss an easy arbitrage opportunity.
So how risky is risky? Just as hospitals don't publish statistics on their mistakes, the securities industry doesn't announce its corporate actions error rate either. No one in the business wants to admit he screwed up and had to write off millions of dollars. So no one really knows the extent of the risk. And until now, there were no hard numbers either. But a study undertaken last year by Oxera, an independent economics consulting group in England, put the potential cost to the industry for poor information and bad communications at somewhere between $2 billion and $10 billion worldwide each year.
Many in the securities industry have a hard time getting their minds around these figures. They know that, in theory, corporate actions ought to be simple information or money flows between an issuer and its investors. In reality, however, a single event may involve hundreds of different market participants, including custodians, fund managers, b/ds, independent advisors and depositories. Ultimately, it cascades down further to tens of thousands of investors.
Everyone in this chain faces some risk. The large number of corporate actions and long chains of intermediaries mean that every day financial institutions around the globe are flooded with faxes, phone calls, telexes, emails and letters carrying news of various corporate action events, many of them with short deadlines. The information comes from a range of sources as diverse as custodians, b/ds, depositories and exchanges as well as news journals, wire services and data vendors. The information in the messages may be ambiguous, contradictory, outdated and sometimes just plain wrong.
These often hard-to-decipher messages can demand action or decisions on very complex transactions such as tender offers or takeovers. Responding to the messages typically requires communicating decisions back up through a daisy chain from investors to b/ds to asset managers to custodians to depositories to registrars to issuers. Few of these intermediaries have fully automated ways to receive or deliver messages. Too often, the instructions have to be manually processed and rekeyed, which only amplifies the potential for misinterpretation or mistakes.
The lack of standardization combined with the growing number of tender offers and other actions coming from overseas make the potential for error climb even higher. In cross-border corporate actions, one obvious challenge is the need to translate announcement information from one language into another. The last time cell-phone maker Nokia announced a corporate action, it put the word out in 10 different formats and several languages. Yet even when markets share a common language, there can be differences in the way some terms are interpreted. For instance, what we in the U.S. refer to as a two-for-one stock split — shareholders receive one new share for each share held — is known in the UK as a “one-for-one” stock distribution.
The Arbitrage Factor
Since a corporate action announcement often represents new information about an issuer, it may obviously impact the market value of securities. Corporate action events thus create temporary arbitrage opportunities for b/ds and fund management firms trading either on behalf of investors or their own proprietary account. Some larger firms even have specialized trading desks assigned to look for arbitrage opportunities arising from corporate actions.
In practice, trading desks within these firms tend not to rely on the standard corporate action information chain. It's too slow. Instead, they get their information on events through Web sites, newspapers, an email from a client, newswires and good old word of mouth. Typically, it's a few days later before the more formal, detailed notice of the action comes through, which the back office then relies on to process the event.
The problem is that misinformation, or a lack of up-to-date information, can lead to unwise trading decisions which, in turn, can generate costs. Transaction costs for a single trade may be negligible, but if the trade proves to be a mistake and has to be unwound, then the “round trip” cost can become an issue. More likely, however, is that uninformed or misinformed traders will run the risk of adverse market movement. If the stock price does not instantaneously reflect the information contained in a corporate action announcement, a failure by individual traders to understand the corporate action places them at an informational disadvantage to the rest of the market. By the time they attempt to trade, or to unwind a mistaken trade, the stock price may well have moved against them.
Another place where the information chain can become uncoupled is in the communication of an investor's or client's response back to the broker or custodian. In a rights issue, for example, if an investor's instructions aren't properly communicated to a custodian, the custodian may fail to buy or sell the shares involved. Then, to re-establish a position once the error has been revealed, the custodian has to purchase or sell the requisite number of shares at the market price rather than the offering price. This can be costly.
A $10 Billion Risk
These are examples of the losses that the report from the Oxera group includes in its estimate of $2 billion to $10 billion in annual corporate action processing risk.
The group's estimate is actually based on a number of fairly conservative assumptions. They observed, for example, that only a subset of complex corporate actions such as takeovers, mergers and rights issues have the potential to move stock prices significantly — and that only a small proportion of traders will be misinformed at any point in time. Even so, on a global scale the estimate adds up to big numbers for losses from operational mistakes or misdirected trading.
Trading losses due to problems in processing corporate actions or in handling the related information are reflected in lower returns to fund managers and investors, and reduced net trading income to brokers, not to mention lost opportunity costs to many investors. As a result, while the direct costs of failure in handling corporate actions or disseminating information about them may not be readily observable, they are nevertheless real costs to the businesses. They are, in fact, real enough that automating and standardizing corporate actions is one of the current recommendations by the Group of Thirty, the international organization whose suggestions so often become standards worldwide.
Looking for Fixes
If global corporate action processing is such a problem — and it clearly is — the question is what's the securities industry doing to fix it…and how much might it cost. According to an estimate by Celent Communications, the industry's investment in automating corporate action processing will run to more than $200 million per year through 2007. That's a huge sum, although compared to an estimated minimum loss worldwide of $2 billion per year on corporate action processing, it doesn't appear out of line.
There is growing momentum within the industry to establish standardized message formats for announcing corporate actions and communicating details about them. Both the SIA in the U.S. and the International Securities Services Association (ISSA) in Europe are promoting initiatives to provide clear, consistent and uniform corporate action information in prospectuses and proxies.
Industry working groups are also reviewing the international ISO message standard and format that so many banks and securities firms use for other kinds of communication. The goal is to develop a functioning standard that can be used for the business needs of corporate actions. There's also a move to get stock exchanges and regulatory bodies to require corporations to issue their information in a uniform format. Ultimately, the aim is to shift some of the burden of automation from the financial intermediaries involved in processing corporate actions to the sources of the data — the corporations themselves.
In addition, there are the global financial service wirehouses that have developed and installed automated internal systems for coping with corporate actions. Their aim is not only to automate the process of handling corporate actions, but also to manage the critical information involved so that it reaches both the front and the back office on time. That gives the trading desk an opportunity to evaluate the information and devise a strategy even as the back office begins to automate the process of handling the corporate action itself. The systems also help the companies avoid many of the operational delays and mistakes that plague others in the industry.
And there are other individual company solutions, such as GCA the Global Corporate Action (GCA) Validation Service offered by The Depository Trust & Clearing Corporation (DTCC). The world's largest post-trade infrastructure organization, DTCC offers its validation service through its Global Asset Solutions LLC subsidiary. The service, which began operating two years ago, provides brokers, banks and other financial institutions an automated, standardized source of global corporate action announcement information on everything from elective dividends to rights offerings to tender offers to stock splits.
The question registered reps need to ask themselves when they receive information on various corporate actions is how accurate and timely the announcements are. If the announcement is both timely and accurate, you're in a position to help your clients with appropriate trading strategies and guide them in making a useful response to whatever the corporate action seeks from its shareholders. In short, you've probably beaten the odds in a set of practices that still costs the industry billions of dollars each year in operational and trading risk.
Editor's note: to view the full Oxera report, Corporate actions processing: What are the risks?, go to www.dtcc.com, click on Thought Leadership and then click on Industry Perspectives. For more information about DTCC's Global Corporate Action family of services, go to www.dtcc.com/gca.
James Femia is a DTCC managing director and head of the company's Global Corporate Actions business.