Tag: Agency costs

The Effect of Relative Performance Evaluation

Frances M. Tice is Assistant Professor of Accounting at the University of Colorado at Boulder. This post is based on an article authored by Ms. Tice.

In the paper, The Effect of Relative Performance Evaluation on Investment Efficiency and Firm Performance, which was recently made publicly available on SSRN, I examine the effect of explicit relative performance evaluation (RPE) on managers’ investment decisions and firm performance. Principal-agent theory suggests that firms can motivate managers to act in shareholders’ interest by linking their compensation to firm performance. However, firm performance is often affected by exogenous factors, and as a result, performance-based compensation may expose managers to common risk that they cannot directly control. In such cases, RPE enables the principal to compensate managers on their effort and events under their control by removing the effect of common shocks from measured performance, thus improving risk sharing and incentive alignment. However, RPE use as implemented in practice may not be effective in addressing agency costs because of potential peer group issues, such as availability of firms with common risk or a self-serving bias in peer selection. In addition, prior research also suggests that a large gap in ability between the RPE firm and peers (“superstar effect”) may actually reduce managers’ effort because the probability of winning is low. Therefore, the question of whether explicit RPE use in executive compensation does indeed reduce agency costs remains unanswered in the empirical literature.


Banker Loyalty in Mergers and Acquisitions

Andrew F. Tuch is Associate Professor of Law at Washington University School of Law. This post is based on an article authored by Dr. Tuch, and is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

As recent decisions of the Delaware Court of Chancery illustrate, investment banks can face conflicts of interest in their role as advisors on merger and acquisition (“M&A”) transactions. In a trilogy of recent decisions—Del Monte[1] El Paso [2] and Rural Metro [3]—the court signaled its concern, making clear that potentially disloyal investment banking conduct may lead to Revlon breaches by corporate directors and even expose bank advisors (“M&A advisors”) themselves to aiding and abetting liability. But the law is developing incrementally, and uncertainty remains as to the proper obligations of M&A advisors and the directors who retain them. For example, are M&A advisors in this context properly regarded as fiduciaries and thus obliged to act loyally toward their clients; gatekeepers, and thus expected to perform a guardian-like function for investors; or simply arm’s length counterparties with no other-regarding duties? [4] The Chancery Court in Rural Metro potentially muddied the waters by labelling M&A advisors as gatekeepers and—in an underappreciated part of its opinion—by also suggesting they act consistently with “established fiduciary norms.” [5]


New Direction from Delaware on Merger Litigation Settlements

David A. Katz is a partner specializing in the areas of mergers and acquisitions and complex securities transactions at Wachtell, Lipton, Rosen & Katz; William Savitt is a partner in the Litigation Department of Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton memorandum, and is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In a series of rulings culminating in a recent memorandum opinion, the Delaware Court of Chancery has reset the rules for settling merger-related litigation. In re Riverbed Tech. Inc. S’holders Litig., C.A. No. 10484-VCG (Del. Ch. Sept. 17, 2015).

Nearly every public company merger now draws class action litigation, and the great majority of these suits have long been resolved by “disclosure-only” settlements in which the target company makes supplemental disclosures related to the merger in exchange for a broad class-wide release of claims. The only money that changes hands is an award of fees for the plaintiff’s lawyers. In recent bench rulings, members of the Court of Chancery have noted that these settlements seem to provide very little benefit to stockholders and questioned whether plaintiffs and their counsel had investigated their claims sufficiently to justify what some judges call the customary “intergalactic” release of all potential claims relating to a challenged merger.


Is Institutional Investor Stewardship Still Elusive?

Simon C.Y. Wong is an adjunct professor of law at the Northwestern University School of Law, and a visiting fellow at the London School of Economics and Political Science. This post is based on an article that recently appeared in the Butterworths Journal of International Banking and Financial Law.


The idea that institutional investors should behave as active, long-term oriented “stewards” has caught on globally. Five years after the launch of the landmark UK Stewardship Code, counterparts can be found on four continents (see Figure 1).

When the UK code was promulgated, I argued that institutional investor stewardship was an elusive quest due to, inter alia: ––

  • Inappropriate performance metrics and financial arrangements that promote trading and a short-term focus;
  • ––Excessive portfolio diversification that makes monitoring of investee companies challenging; ––
  • Lengthening chain of ownership that weakens an ownership mindset; ––
  • Passive/index funds that pay scant attention to corporate governance; and ––
  • Pervasive conflicts of interest among asset managers.

The fifth anniversary of the UK code provides an opportune moment to examine the notable achievements and continuing challenges in the drive to encourage institutional investors to be informed and engaged owners.


Comparative Study on Economics, Law and Regulation of Corporate Groups

The following post comes to us from Klaus J. Hopt, a professor and director (emeritus) at the Max-Planck-Institute for Comparative and International Private Law, in Hamburg and was advisor inter alia for the European Commission, the German legislator and the Ministries of Finance and of Justice.

The phenomenon of the groups of companies is very common in modern corporate reality. The groups differ greatly as to structure, organization, and ownership. In the US, groups with 100-per cent-owned subsidiaries are common. In continental Europe, the parents usually own less of the subsidiaries, just enough to maintain control. In Germany and Italy pyramids are frequent, i.e., hierarchical groups with various layers of subsidiaries and subsidiaries of subsidiaries forming very complicated group nets. The empirical data on groups of companies are heterogeneous because they are collected for very different regulatory and other objectives, for example for antitrust and merger control regulation or for bank supervision.


Do Long-Term Investors Improve Corporate Decision Making?

The following post comes to us from Jarrad Harford, Professor of Finance at the University of Washington; Ambrus Kecskés of the Schulich School of Business at York University; and Sattar Mansi, Professor of Finance at Virginia Polytechnic Institute & State University.

It is well established that managers of publicly traded firms, left to their own devices, tend to maximize their private benefits of control rather than the value of their shareholders’ stake in the firm. At the same time, imperfectly informed market participants can lead managers to make myopic investment decisions. One of the most important mechanisms that have been proposed to counter this mismanagement problem is longer investor horizons. By spreading both the costs and benefits of ownership over a long period of time, long-term investors can be very effective at monitoring corporate managers.

We explore this subject in our paper entitled Do Long-Term Investors Improve Corporate Decision Making? which was recently made publicly available on SSRN. We ask two questions. First, do long-term investors in publicly traded firms improve corporate behavior? Second, does their influence on managerial decision making improve returns to shareholders of the firm? To answer these questions, we study a wide swath of corporate behaviors.


Corporate Investment and Stock Market Listing: A Puzzle?

The following post comes to us from John Asker, Professor of Economics at UCLA; Joan Farre-Mensa of the Entrepreneurial Management Unit at Harvard Business School; and Alexander Ljungqvist, Professor of Finance at NYU.

Economists have long worried that a stock market listing can induce short-termist pressures that distort the investment decisions of public firms. Back in 1985 Narayanan wrote in the Journal of Finance that “American managers tend to make decisions that yield short-term gains at the expense of the long-term interests of the shareholders.” More recently, a growing number of commentators blame the sluggish performance of the U.S. economy since the 2008–2009 financial crisis on short-termism. For example, in a recent Harvard Business Review article, Barton and Wiseman, global managing director at McKinsey & Co. and CEO of the Canada Pension Plan Investment Board, respectively, argue that “the ongoing short-termism in the business world is undermining corporate investment, holding back economic growth.”

Yet, systematic empirical evidence of widespread short-termism has proved elusive, largely because identifying its effects is challenging. A chief challenge is the difficulty of finding a plausible counterfactual for how firms would invest absent short-termist pressures. In our paper, Corporate Investment and Stock Market Listing: A Puzzle?, which is forthcoming at the Review of Financial Studies, we address this difficulty by comparing the investment behavior of stock market-listed firms to that of comparable privately held firms, using a novel panel dataset of private U.S. firms covering more than 400,000 firm years over the period 2001–2011. Building on prior work, our key identification assumption is that, on average, private firms suffer from fewer agency problems and, in particular, are subject to fewer short-termist pressures than are their listed counterparts. This assumption is motivated by the fact that private firms are often owner managed and, even when not, are both illiquid and typically have highly concentrated ownership. These features encourage their owners to monitor management more closely to ensure long-term value is maximized.


Executive Compensation in Controlled Companies

Kobi Kastiel is a fellow at the Harvard Law School Program on Corporate Governance. His article, Executive Compensation in Controlled Companies, is forthcoming in the January 2015 issue of Indiana Law Journal and available here. Additional work from the Program on Corporate Governance on executive compensation includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried, discussed on the Forum here.

More than a decade ago, Professors Lucian Bebchuk and Jesse Fried published the seminal work on the role and significance of managerial power theory in executive compensation. Their work cultivated a vivid debate on executive compensation in companies with dispersed ownership. The discourse on the optimality of executive pay in controlled companies, however, has been more monolithic. Conventional wisdom among corporate law theorists has long suggested that the presence of a controlling shareholder should alleviate the problem of managerial opportunism because such a controller has both the power and incentives to curb excessive executive pay.

My Article, Executive Compensation in Controlled Companies, forthcoming in the Indiana Law Journal, challenges that common understanding by proposing a different view that is based on an agency problem paradigm, and by presenting a comprehensive framework for understanding the relationship between concentrated ownership and executive pay. On the theoretical level, the Article shows that controlling shareholders often have incentives to overpay professional managers instead of having an arm’s-length contract with them, and therefore it suggests that compensation practices in a large number of controlled companies may have their own pathologies.


Buybacks Around the World

The following post comes to us from Alberto Manconi of the Department of Finance at Tilburg University and Urs Peyer and Theo Vermaelen, both of the Finance Area at INSEAD.

Due to regulatory changes, share repurchases have become increasingly common around the world in the last 15 years. As such, in our paper, Buybacks Around the World, which was recently made publicly available on SSRN, we first examine whether the findings based on U.S. data hold up in an international setting, and whether examining non-U.S. data can change the way we think about buybacks. Second, we examine whether the original concerns about managers using buybacks to prop up the share price were somewhat warranted in countries outside the U.S.


What Happens in Nevada? Self-Selecting into Lax Law

The following post comes to us from Michal Barzuza, Professor of Law at the University of Virginia School of Law, and David Smith, Professor of Finance at the University of Virginia.

In our paper, What Happens in Nevada? Self-Selecting into Lax Law, forthcoming in the Review of Financial Studies, we study the financial reporting behavior of firms that incorporate in Nevada, the second most popular state for out-of-state incorporations, after Delaware. Compared to Delaware, Nevada law has weak fiduciary requirements for corporate managers and board members. We find evidence consistent with the idea that lax shareholder protection under Nevada law induces firms prone to financial reporting errors to incorporate in Nevada, and that lax Nevada law may also cause firms to engage in risky reporting behavior. [1] In particular, we find that Nevada-incorporated firms are 30 – 40% more likely to report financial results that later require restatement than firms incorporated in other states, including Delaware. These results hold when we narrow our set of restatements to more serious infractions, including restatements that reduce reported earnings, and to restatements that raise suspicions of fraud or lead to regulatory investigations.


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