Monthly Archives: June 2008

Accounting Information as Political Currency

This post is from Karthik Ramanna of Harvard Business School.

It is well known that firms contribute money to politicians. It is also widely held that such money, in the form of campaign contributions and lobbying expenditures, is used to buy access to and/or favors from politicians. Firms and politicians establish relationships with one another and the value to firms of such relationships likely increases over time. When a politician with a well-established relationship to a firm faces a tough election prospect, it is in the firm’s interest to secure that politician’s future. One obvious way to do so is to make further monetary contributions directly to the politician’s campaign. A priori, direct monetary contributions are not the only channel through which firms can deliver benefits to candidates during political campaigns. In a recent working paper, Sugata Roychowdhury of MIT and I investigate whether political contributions can take a non-cash form, specifically (accounting) information. In other words, we investigate whether (accounting) information can be used as political currency?

Our setting is the US congressional election of 2004, where outsourcing of US jobs was a campaign issue. Firms engaged in outsourcing activities had incentives to ensure that political candidates they were affiliated with did not suffer from negative media due to the outsourcing. These incentives were likely to be strongest when the candidates were in competitive races. We test whether outsourcing firms understated profits in the period leading up to the 2004 election, in circumstances where the firms’ affiliated candidates were in competitive races. Understating profits can help deflect attention away from the firms’ outsourcing activities, and thus spare the candidates considerable embarrassment. We find that outsourcing firms donating to congressional candidates in closely watched races managed their earnings downwards in the two quarters immediately preceding the 2004 election. We find no evidence of downward earnings management among outsourcing corporations donating to congressional candidates not in closely watched races.

Ceteris paribus, if donors’ downward earnings management is effective in deflecting attention away from outsourcing, thus sparing candidates from negative media, we expect such candidates to do better in the election (than the average candidate). In regression tests that control for likely determinants of election outcomes, we find vote shares for candidates are increasing in the extent of their corporate donors’ downward earnings management. Overall, our findings are consistent with firms managing accounting information in circumstances where this is likely to benefit allied politicians. The evidence is consistent the hypothesis that accounting information can be used as political currency.

You can read the entire paper here and an interview with me over the paper here.

Coming Clean and Cleaning Up: Is Voluntary Disclosure a Signal of Effective Self-Policing?

Editor’s Note: This post is from Jodi L. Short of Georgetown University.

As regulators increasingly embrace cooperative approaches to governance, voluntary public-private partnerships and self-regulation programs have proliferated. However, because few of these partnerships and programs have been subjected to robust evaluation, little is known about their effects. In my paper with Mike Toffel, “Coming Clean and Cleaning Up: Is Voluntary Disclosure a Signal of Effective Self-Policing?” we ask whether and in what ways self-regulatory practices at a subset of regulated facilities enhance the effectiveness of the regulatory scheme.

In the context of a program sponsored by the U.S. Environmental Protection Agency that encourages regulated entities to voluntarily self-police and self-disclose regulatory violations, we analyze whether such voluntary disclosures are a good signal of a facility’s effective self-policing practices. There are two components to this question. First, do facilities that send the self-regulation signal outperform those that do not? Second, what is the agency’s response to the signal? Are regulators effectively sorting the good facilities from the bad, and are they leveraging this information in a way that enhances the effectiveness of their enforcement efforts?

We find that, on average, self-policing facilities improved their environmental performance, as measured by a decline in the number and probability of abnormal events resulting in toxic pollution. However, upon closer examination, we find this effect to be significant only among “good apples,” or facilities with clean past compliance records. We find no evidence of improvement among facilities with more problematic compliance histories. In other words, it appears that voluntary disclosure is an effective signal for distinguishing the “great” apples from the merely “good” apples, but not for determining whether a “bad” apple has turned good.

With respect to the behavior of the regulatory agency, we find that regulators are interpreting these signals with a high degree of accuracy and responding accordingly. Our analysis shows that regulators significantly reduced their scrutiny of self-disclosers that were “good apples” (or those that improved their environmental performance) but continued to keep a watchful eye on the “bad apples” (who did not improve).

Taken together, these findings support the theoretical promise of meaningful self-policing practices and suggest that voluntary disclosure can serve as a reliable signal of future compliance under certain circumstances. But, at the same time, they highlight the way in which self-regulation outcomes are contingent on the organizational contexts into which self-regulatory practices are adopted. Our analysis also highlights the possibilities for gaming that self-regulation introduces into the regulatory system, but we demonstrate that, at least in this context, regulators do not appear to be fooled.

The full paper is available for download here.

Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors

This post is from April Klein of New York University.

My paper entitled “Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors”, which I co-wrote with Emanuel Zur and which was recently accepted for publication in the Journal of Finance, examines recent aggressive campaigns by entrepreneurial shareholder activists, which we define as an investor who buys a large stake in a publicly held corporation with the intention to bring about change and thereby realize a profit on the investment.

We conduct our analyses on two samples of entrepreneurial activists. The first sample consists of 151 hedge fund activist campaigns conducted primarily between 2003 and 2005. The second sample contains 154 other entrepreneurial confrontational activist campaigns over the same time period. These activists are composed primarily of individuals, private equity funds, venture capital firms, and asset management groups for wealthy investors. The common feature of each group is that the investor is relatively free from the regulatory controls of the Securities Act of 1933, the Securities Exchange Act of 1934, and most notably the Investment Company Act of 1940.

We find similarities and disparities between our samples of hedge fund and other entrepreneurial activists.

The three main parallels are market reaction to the activism, a further significant increase in share price for the subsequent year, and the activist’s success in gaining its original objective. These findings suggest that the market, on average, believes activism creates shareholder value. Moreover, ex ante, the market is able to differentiate between overall successful and non-successful campaigns. For both groups of activists, the abnormal return surrounding the initial Schedule 13D filing is significantly higher for firms in which the activist gains its objective within one year, when compared to those firms in which the activist is unsuccessful.

The two main differences between the two categories of entrepreneurial shareholder activists are the types of companies each group targets and the activists’ post-13D filing strategies. Hedge fund activists target more profitable and financially healthy firms than other entrepreneurial activists. Hedge funds appear to address the free cash flow problem, since hedge fund activists frequently demand the target firm to buy back its own shares, cut the CEO’s salary, or initiate dividends, whereas other activists do not make these demands. In contrast, other entrepreneurial activists appear to redirect the investment strategies of their targeted firms.

The full paper is available for download here.

Shareholder Activism and the “Eclipse of the Public Corporation”

This post is from Martin Lipton of Wachtell, Lipton, Rosen & Katz.

On June 25, I presented a paper entitled “Shareholder Activism and the “Eclipse of the Public Corporation”: Is the Current Wave of Activism Causing Another Tectonic Shift in the American Corporate World?” at the 2008 Directors Forum of The University of Minnesota Law School. The paper discusses the pressures that have been pervasively eroding the centrality of the board of directors and transforming its role in the governance structure of public companies, with the end game being a new conception of the corporate organization. Against the backdrop of the subprime and leveraged loan financial crisis and other recent events, the paper addresses what I regard as the crux of the issue affecting public companies today: whether the institution of the corporate board can cope with these pressures and survive as the vital governing organ of public companies. Or, will a forced migration from director-centric governance to shareholder-centric governance, along with a concomitant transformation of the role of the board from guiding and advising management to ensuring compliance and performing due diligence, simply overwhelm American business corporations?

The paper is available here.

Corporate Governance of Non-listed Companies

This post is from J.A. McCahery of the University of Amsterdam.

My new book, Corporate Governance of Non-listed Companies (Oxford University Press, 2008), which I co-wrote with Erik Vermeulen, examines the set of legal rules and measures needed to improve the governance of non-listed companies. Studies of corporate governance traditionally focus on the governance problems of large publicly held firms, and policymakers’ recommendations often focus on such firms. However most small firms, and in many countries, even many large companies, are non-listed. We provide a comprehensive account of non-listed firms and their particular governance problems.

The book explores current discussions and reforms in Europe, the United States, and Asia providing a state of the art account of the law and the economics. Non-listed firms encompass a vast range, from corporations with the potential to go public through family-owned firms, group-owned firms, private equity and hedge funds, to joint ventures and unlisted mass-privatized corporations with a relatively high number of shareholders. The governance of non-listed companies has traditionally been concerned with protecting investors and creditors from managerial opportunism. However, the virtual elimination of the distinction between partnerships and corporations means that an effective legal governance framework must also offer mechanisms to protect shareholders from the misconduct of other shareholders. Our book examines policy and economic measurements to develop a framework for understanding what constitutes good governance in non-listed companies. We examine how control is gained in the various types of closely held firms and explore the techniques that contribute to the development of a modern and efficient governance framework for these companies. The book concludes with an exploration of how the non-listed firm is likely to stimulate growth and extend innovation and development.

Executive Pay and Independent Compensation Consultants

This post is from Tatiana Sandino of the University of Southern California. A post on April 30 by Brian Cadman also analyzed the role of compensation consultants in setting pay, and is available here.

My paper, Executive Pay and “Independent” Compensation Consultants, which I co-wrote with Kevin J. Murphy, analyzes two primary sources of conflicts of interest between consultants and their client firms. First, consultants have a conflict of interest whenever they design the pay packages of the same executives that have the power to reappoint them. Consultants who are hired by, or who work for, top management (rather than the board) have clear incentives to please the firm’s top executives by recommending generous pay packages. Second, while some consultants are “boutique” firms focused exclusively on executive compensation, many are large integrated corporations offering a full-range of compensation, benefits, and actuarial services, and therefore there is an incentive to cross-sell additional services. Consultants recommending a lower-than-expected level of CEO pay can jeopardize the opportunities to cross-sell other more lucrative services to the firm.

We use newly disclosed SEC data for 938 firms to investigate whether these conflicts of interest between consultants and their client firms lead to higher pay for CEOs, other top executives, and outside directors. We test the “repeat business” effect (i.e., the consultants’ concern with being reappointed) by examining whether pay is related to proxies for managerial influence over the decision to appoint (or reappoint) consultants, including whether the consultant is retained by the compensation committee or by management, whether the consultant works exclusively for the committee or also works for management, and whether the consult is described as “independent” in the company proxy statement. We test the “other services” effect by examining voluntary disclosures related to such services in the proxy statements, and by merging our data with 5500 filings with the IRS and Department of Labor that identify which of the consultants used by each of our sample companies also provide actuarial services to those firms.

We find that executive and director pay is higher in companies retaining consultants for pay advice than in companies not seeking advice, even after controlling for size, industry, and the mix of pay. However, we find no evidence that the higher pay is related to conflicts of interest: CEO pay is higher (and not lower) in companies where the consultant works exclusively for the compensation committee rather than management, and CEO pay does not increase when the consultant provides actuarial or other services to their client firms. Interestingly, we do find that pay is higher when the companies retain more than two consultants, suggesting perhaps that companies “shop around” until they get the answer they like!

The full paper is available for download here.

The Fiduciary Duties of Directors of Troubled Companies: Emerging Clarity

This post is from Marshall S. Huebner of Davis Polk & Wardwell LLP. This post 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.

For many years, there was a diversity of opinion — including judicial opinion — with respect to various issues connected to the duties of directors and officers in the troubled company situation. Can they be sued directly by creditors? Does the business judgment rule apply to protect them? Is there a tort called “deepening insolvency?” To whom are duties owed? Can directors and officers continue to take (prudent) risks to maximize the value of the enterprise?

I have recently published an article entitled “The Fiduciary Duties of Directors of Troubled U.S. Companies: Emerging Clarity,” which addresses two recent Delaware Supreme Court decisions that have shed needed light on these and related topics, and should provide much comfort to officers and directors. It opines that many ensconced buzzwords and doctrines — like “zone of insolvency” and “deepening insolvency” now have little to no meaning, and that the developing theme of these important decisions is the continuity (not any changes) in fiduciary duties, notwithstanding financial distress. It also provides some practical guidance for directors, suggesting that traditional questions like “are we in the zone yet” and “to whom are our duties owed” may be of much less value than a simplified “are we attempting to maximize the value of the enterprise.”

The article is available here.

2007 Shareholder Activism

This post comes to us from Glenn Curtis, Director, Strategic Research of Thomson Reuters.

As part of an effort to provide insight into what types of companies activist hedge funds and private equity firms are targeting, Thomson Reuters tracks proxy battles on a quarterly basis. To that end, we recently released a report, entitled 2007 Shareholder Activism, for the fourth quarter of 2007. The purpose of our research is to shed some light on the types of companies activists are targeting in terms of sector, and market cap. Our goal is to also provide some color on the success rates of activists and the most common demands they are making of boards. Our reported findings include the following:

  • Throughout 2007 activists attempted to exert their influence at 61 public companies. That is, they either sought to make changes to the target’s board of directors, or to effectuate some other sort of value enhancing action or transaction.
  • Between October and December 2007 (Q4) activists attempted to exert their influence at eight public companies. While it is impossible to definitively determine which party (the activist or the target) will prevail in each of these instances, there are two instances where it appears as though the activist will secure a victory.
  • The most common demand made by activist firms was for board seats. This is consistent with two studies that we have completed in the past.
  • The average target size in terms of market capitalization during Q4 was about $1.22 billion – well below the roughly $8.49 billion average for the first three quarters of 2007.
  • Consumer Discretionary companies were the most frequent targets in the fourth quarter. This too is consistent with studies that we have completed in the past.
  • Companies within the financial industry were not targeted in the fourth quarter. This is somewhat surprising given the large decline in equity prices in this group and given that many of these firms continue to maintain valuable and tangible assets on their balance sheets.
  • While Carl Icahn and entities controlled by Icahn appeared to be the most active for all of 2007, Ramius Capital was a close second, recording three cases of activism in Q4 and five for the full year.
  • Private equity firms and hedge funds remained the most common activists. Q4 did not see major mutual funds or individual investors lead any charges for corporate change as they did in the Q1 to Q3 time frame.
  • Perhaps not surprisingly, cash-strapped construction companies and builders were targeted the least by activist shareholders throughout 2007. There was no change from the first three quarters of the year.

To obtain a full copy of the report, please contact its author, Glenn Curtis, at

CEO Compensation and Board Structure

This post comes to us from Vidhi Chhaochharia of the University of Miami and Yaniv Grinstein of Cornell University. Their article was recently accepted for publication in the Journal of Finance.

The purpose of this article is to examine how the new board requirements that were enacted in response to corporate scandals in 2001 and 2002 affected compensation decisions. We use the difference-in-difference approach to compare changes in compensation between firms that were already complying with these requirements and firms that were not complying with them. Our sample consists of 865 firms that belong to the S&P 1500 index for the period 2000 to 2005. To measure level of compliance, we focus on three board structure variables that were required by the rules: the requirement for a majority of independent directors on a single board, the requirement for an independent nominating committee, and the requirement for an independent compensation committee.

We find that firms that did not comply with these requirements significantly decreased CEO compensation in the period after the rules went into effect, compared to the complying firms. The decrease is on the order of 17%, after taking into account performance, size, time varying shocks to different industries during that period, firm fixed effects, and other variables affecting compensation that changed during that time. We also find that the one requirement that is strongly associated with a drop in compensation is the requirement that the majority of board members be independent, and that the significant relative drop in compensation comes from the decrease in the bonus and the stock based compensation. We also find that the decrease in compensation is particularly pronounced in the subset of affected firms with no outside block holder on the board and in affected firms with low concentration of institutional investors. In short, our results suggest that the new board requirements affected CEO compensation decisions.

The full paper is available for download here.

A United Nations Proposal Defining Corporate Social Responsibility For Human Rights

This post is from Holly Gregory of Weil, Gotshal & Manges LLP. For a contrasting analysis of the UN proposal by Guest Contributor Martin Lipton of Wachtell, Lipton, Rosen & Katz, please see here.

On behalf of our pro bono client Oxfam America, my colleagues, Ira M. Millstein, E. Norman Veasey, Harvey Goldschmid, Steven Alan Reiss, Ashley R. Altschuler, and I have prepared a memorandum that discusses the report, Protect, Respect and Remedy: A Framework for Business and Human Rights, prepared by Harvard Professor John G. Ruggie, the Secretary-General’s Special Representative on Human Rights. Our memorandum is available on the UN Special Representative’s website here.

The Ruggie Report posits three “core principles”: (1) the State duty to protect human rights, (2) the corporate social responsibility to respect human rights, and (3) the need for access to appropriate remedies for human rights abuses.We believe the basic concepts embodied in the Report are sound and should be supported by the business community in the United States. In summary, our reasons are:

• In the first instance, the US and foreign governments have the primary responsibility for defining what human rights obligations are binding legal duties and how those duties are enforced;

• If the Report is taken seriously by foreign government and foreign companies, it will benefit US corporations by leveling the playing field in placing on foreign boards and management the responsibilities to adhere to many of the same fiduciary and binding legal obligations presently applicable to US companies;

• Given the interplay of fiduciary, disclosure, internal control and risk mangement obligations facing US boards and managers today, the Report does not implicate new legal obligations for US companies;

• Violations of human rights may constitute material risks for many US corporations, not only in the US, but also in foreign jurisdictions where they conduct business;

• While the report does not limit the scope of internationally-recognized human rights, each US company must presently determine for itself, what human rights risks may be material to its business;

• Additionally, and beyond the obligation to manage risks, and comply with law, there is a substantial business case in favor of safeguarding human rights wherever the company does business.

The Report is available here, and our memorandum is available here.

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