Monthly Archives: October 2008

Consumer Biases and Firm Ownership

This post comes from Ryan Bubb of Harvard University.

This week in the Law, Economics, and Organization Seminar at Harvard Law School I presented my paper Consumer Biases and Firm Ownership (joint with Alex Kaufman). In the paper we examine the role of firm ownership in mitigating incentives of firms to exploit consumer biases. Recent work has explored the implications of behavioral biases among consumers and has documented that profit-maximizing firms exploit consumer biases in the contracts they offer consumers. This behavior can result in substantial social costs as the resulting contracts distort decision-making from the social optimum.

In the paper we show how ownership of the firm can be used as a commitment device to avoid using contracts that exploit consumer biases. In particular, if customers of the firm own the firm, as in a consumer cooperative, or if the firm has no owners, as in a nonprofit, then firm managers have less incentive to offer contracts that exploit consumer biases. We thus identify a “governance strategy” of shaping the incentives of firm management through assignment of ownership of the firm, rather than a regulatory strategy of dictating contractual terms or processes, as a way to reduce the social costs that result from consumer biases.

As a paradigmatic example, consider a bank that offers credit card services to consumers. Because of the complexity of the contractual relationship between banks and their customers, consumers have trouble understanding all of the charges, penalties, and other payments they are obliged to make to the bank under their credit card contract in various contingencies, such as the penalty interest rate that applies if they fail to make a minimum payment on time. Furthermore, many consumers have self-control problems that lead them to trigger commonly charged fees and penalties. Consequently, investor-owned for-profit banks have a strong incentive to charge high fees and penalties. The use of penalties in credit card contracts can persist even in competitive markets, since banks simply compete on the salient, easily observable and understood features of accounts (e.g., the introductory interest rate and rewards programs), and then cover their costs through penalty income.


Recent Developments Regarding Director Independence

This post is by John F. Olson of Gibson, Dunn & Crutcher LLP.

Several noteworthy developments recently occurred regarding director independence. First, on August 8, 2008, the Securities and Exchange Commission (the SEC) approved amendments to the definition of “independent director” under the NASDAQ Stock Market Rules, which have gone into effect. Second, on August 12, 2008, the New York Stock Exchange (the NYSE) filed rule changes with the SEC to amend two of its director independence tests; these rules do not require SEC approval and apply beginning September 11, 2008. Finally, on August 5, 2008, the SEC announced the settlement of an enforcement action involving a former director who failed to disclose a business relationship with the auditor of three companies on whose boards he served, thereby causing the companies to violate the federal securities laws.

NASDAQ Amendments

The SEC approved an amendment to NASDAQ Rule 4200(a)(15), which sets forth several tests to determine whether a director of a listed company is independent.[1] Prior to the amendment, Rule 4200(a)(15)(B) provided that a director would not be considered independent if the director or an immediate family member accepted any compensation from the listed company in excess of $100,000 during any period of 12 consecutive months within the three years preceding the determination of independence (excluding compensation for board or board committee service, compensation paid to an immediate family member as a non-executive employee, benefits paid under a tax-qualified retirement plan and non-discretionary compensation). The amendment increased the dollar threshold from $100,000 to $120,000. This amendment was adopted in response to the SEC’s 2006 amendment to Item 404 of Regulation S-K, which increased to $120,000 the dollar threshold applicable to disclosure of related party transactions. The NASDAQ rule change has gone into effect.

New York Stock Exchange Amendments

The NYSE amendments modify the bright line independence tests set forth in Section 303A.02(b) of the NYSE Listed Company Manual in two respects.[2] The first amendment modifies Section 303A.02(b)(ii) to increase from $100,000 to $120,000 the amount of direct compensation (other than director or committee fees and pension or other forms of deferred compensation for prior service), that a director or members of a director’s immediate family may receive from a listed company in a 12-month period within the prior three years and still be considered an independent director. As with the similar NASDAQ amendment, the NYSE’s amendment was adopted to align the NYSE rules with the disclosure requirements set forth in Item 404 of Regulation S-K.


Do Foreigners Invest Less in Poorly Governed Firms?

This post comes to us from Christian Leuz of the University of Chicago, NBER and ECGI, Karl V. Lins of the University of Utah, and Francis E. Warnock of the University of Virginia and NBER.

In our forthcoming Review of Financial Studies paper entitled Do Foreigners Invest Less in Poorly Governed Firms? we investigate the factors that make investors shy away from providing capital to foreign firms. Poor corporate governance is one factor that draws considerable attention from outside investors and regulators. Institutional investors frequently claim that they avoid foreign firms that are poorly governed. In addition, regulators are concerned that weak governance and low transparency hinder foreign investment and impede financial development. At the same time, outside investors who fear governance problems and expropriation by insiders can reduce the price they are willing to pay for a firm’s shares. As a result of price protection, even poorly governed firms should offer an adequate return, raising the questions of whether and why governance concerns manifest themselves in fewer holdings by foreign outside investors.

Our sample consists of 4,409 firms from 29 countries for which we have comprehensive data on foreign holdings by U.S. investors in 1997. As there can be a host of reasons why foreign investors avoid or seek stocks from a particular country, such as the degree of market integration, benefits from diversification, transaction costs, restrictions on capital flows, proximity, and language, we control for country fixed effects in our tests. Thus, we analyze which stocks U.S. investors choose within a given country. We find strong evidence that U.S. investors hold significantly fewer shares in firms with high levels of managerial and family control when these firms are domiciled in countries with weaker disclosure requirements, securities regulations, and outside shareholder rights, or in code-law countries. In contrast, firms with substantial managerial and family control do not experience less foreign investment when they reside in countries with extensive disclosure requirements and strong investor protection. This effect is particularly pronounced when earnings are opaque, indicating that information asymmetry and monitoring costs faced by foreign investors likely drive the results.

Our results across countries with different institutions are consistent with the interpretation that, for foreign investors, information problems for firms with potentially problematic governance structures play an important role. Stringent disclosure requirements make it less costly to become informed about potential governance problems. They level the playing field among investors making it less likely that locals have an information advantage. Strongly enforced minority shareholder protection reduces the consumption of private control benefits and thus decreases the importance of information regarding these private benefits. In contrast, low disclosure requirements and weak investor protection exacerbate information problems and their consequences.

The full paper is available for download here.

FINRA Proposes Changes to Research Quiet Period

This post from Margaret E. Tahyar is based on a memorandum by Michael Kaplan and Janice Brunner of Davis Polk & Wardwell.

FINRA has issued and is requesting comment on Proposed Research Registration and Conflict of Interest Rules. The proposed rules would replace the existing NYSE and NASD Rules governing research analyst conflicts of interest and would also supersede the proposed changes to those rules published by the SEC in January 2007.

Significantly, the proposed rules would shorten, and in some cases eliminate, the “quiet period” during which a member firm participating in an offering cannot publish or distribute research reports about the issuer, and the firm’s research analyst cannot make public appearances relating to the issuer.

Under current rules, the quiet period is:

• 40 days following the date of the initial public offering for lead underwriters and 25 days after the offering for other underwriters or dealers;

• 10 days following a follow-on offering; and

• 15 days before and after expiration, waiver or termination of a lock-up agreement.

Under the proposed rules, the quiet period would be limited to a single 10-day period following an IPO. Follow-on offerings and lock-up expirations, waivers and terminations would no longer trigger a quiet period. Note that the 25-day prospectus delivery period for an IPO may lead to all underwriters continuing to maintain a 25-day quiet period.

FINRA is requesting comment on the proposed rules by November 14, 2008. If, after receiving comment, FINRA determines to proceed with the proposed rules, it would need to file them with the SEC for approval. The SEC would publish the proposed rules in the Federal Register and subject them to an additional public comment period.

The proposed rules are available here.

Research on the Adoption of IFRS

This post is by Edward J. Riedl of Harvard Business School.

I have recently completed two working papers that address issues related to the adoption of International Financial Reporting Standards (IFRS).

In the first paper, entitled Market Reaction to the Adoption of IFRS in Europe, my co-authors and I examine the European stock market reaction to sixteen events associated with the adoption of International Financial Reporting Standards (IFRS) in Europe. European IFRS adoption represented a major milestone towards financial reporting convergence yet spurred controversy reaching the highest levels of government. We find a more positive stock market reaction for firms with lower quality pre-adoption information, which is more pronounced in banks, and with higher pre-adoption information asymmetry, consistent with investors expecting net information quality benefits from IFRS adoption. We also find that the reaction is less positive for firms domiciled in code law countries, consistent with investors having concerns over enforcement of IFRS in those countries. Finally, we find a positive reaction to IFRS adoption events for firms with high quality pre-adoption information, consistent with investors expecting net convergence benefits from IFRS adoption. Overall, the findings suggest that investors in European firms perceived net benefits associated with IFRS adoption. This paper is available for download here.

In the second paper, entitled Consequences of Voluntary and Mandatory Fair Value Accounting: Evidence Surrounding IFRS Adoption in the EU Real Estate Industry, my co-authors and I examine the causes and consequences of European real estate firms’ decisions to provide investment property fair values prior to the required disclosure of this information under International Financial Reporting Standards (IFRS). We find evidence that investor demand for fair value information—reflected in more dispersed ownership—and a firm’s commitment to transparency increase the likelihood of providing fair values prior to their required provision under International Accounting Standard 40 – Investment Property. We also find that firms not providing these fair values face higher information asymmetry. However, we fail to find that the relatively higher information asymmetry was reduced following mandatory adoption of IFRS. Rather, we find that differences in information asymmetry largely remain. Taken together, this evidence suggests that common adoption of fair value accounting due to the mandatory adoption of IFRS does not necessarily level the informational playing field. This paper is available for download here.

Hiring Cheerleaders: Board Appointments Of “Independent” Directors

In our recent working paper entitled Hiring Cheerleaders: Board Appointments Of “Independent” Directors, we test the hypothesis that boards appoint independent directors who, while technically independent according to regulatory definitions, nonetheless may be overly sympathetic to management. Rather than adopting the typical approach in the literature, which seeks to relate measures of board independence (e.g., increases in the number of independent directors on a board) to future performance of the firm, we investigate a subset of independent directors for whom we have detailed, micro-level data on their views regarding the firm prior to being appointed to the board. We use these track records to compare the roles of optimism (i.e., hiring a cheerleader for management) versus skill (i.e., hiring an objective and able observer) in the board appointment process.

The agents we examine are former sell-side analysts who end up serving on the board of companies they previously covered. Unlike former CEOs or other senior executives who sometimes end up on corporate boards, for whom past performance attribution is complicated by the fact that firm performance is difficult to disentangle from individual performance, sell-side analysts can be easily assessed. We can explicitly compute measures of skill/ability and optimism by examining the composition and stock return performance of analysts’ past buy/sell recommendations, coupled with the accuracy of their earnings forecasts. In doing so we find evidence that boards appoint overly optimistic analysts who exhibit little in the way of skill in terms of evaluating the firm itself, other firms within the firm’s industry, or other firms in general. In particular, board-appointed analysts issue significantly more positive recommendations on companies for whom they end up on the board of directors; both relative to the other stocks they cover, and relative to other analysts covering these stocks. The magnitude of this result is large: 80.4% of these recommendations are strong-buy or buy recommendations, compared to 56.9% for all other analyst recommendations. By contrast, we find little evidence that board-appointed analysts’ recommendations are more profitable, or that their earnings forecasts are more accurate. Finally, when predicting the probability of a board appointment, optimism on the firm is a strong predictor of appointment while accuracy is not. Taken together, these results challenge the conventional view that appointing independent directors necessarily adds objectivity to the board of a firm.

The full paper is available for download here.

M&A Perspectives – The Failure of Private Equity

This post is from Andrea Unterberger of the Corporation Service Company.

We call your attention to a special M&A event, “M&A Perspectives – The Failure of Private Equity,” which will be accessible at no cost by web seminar on October 30, 2008 in Wilmington, DE, from 3:00 p.m. – 4:30 p.m. Eastern Time.

With the Lyondell Chemical case on appeal, and with the Huntsman/Hexion merger still generating litigation activity, M&A lawyers are looking forward to the presentation next Thursday afternoon by Professor Steven M. Davidoff (Click here for more information and to register). His principal topic (The Failure of Private Equity), on which he writes in a forthcoming article, is expected to focus on highlights from Delaware court decisions and proceedings in the past, tumultuous year, particularly as they reflect ambiguous contracting that has often proven ineffective to address the now-evident potential for market reversals. Additionally, Vice Chancellor Leo E. Strine, Jr. will join Professor Davidoff as commentator.

Writing as The Deal Professor, Davidoff is a commentator for the New York Times DealBook on the legal aspects of mergers, private equity and corporate governance. A former corporate attorney at Shearman & Sterling, he is a professor at the University of Connecticut School of Law. His columns are available at The Deal Professor blog.

This event is sponsored by the Widener University School of Law, Corporation Service Company, and The Delaware Counsel Group, LLP.

Click here for more information and to register for online or in-person attendance. Email if you have any questions.

Third Circuit Upholds Validity of SEC: Amendments Clarifying Exemptions from Section 16 Liability

This post is based on a memorandum by Paul Vizcarrondo and Michael Winograd of Wachtell, Lipton, Rosen & Katz.

The Third Circuit recently upheld the validity of two clarifying amendments adopted by the SEC in 2005. The amendments clarified two important exemptions from shortswing-profit liability under Section 16(b) of the Securities Exchange Act: (1) Rule 16b-3, which exempts certain transactions between an issuer and its officers or directors; and (2) Rule 16b-7, which exempts certain mergers, reclassifications, and consolidations. In so doing, the Court expressly overruled a prior decision of the Third Circuit that imposed novel restrictions on the applicability of the two exemptions.

In Levy v. Sterling Holding Co., 314 F.3d 106 (3d Cir. 2002) (“Levy I”), the Third Circuit held that grants, awards, and other issuances to officers or directors must be compensation-related to be eligible for exemption under Rule 16b-3(d). The Third Circuit also suggested that Rule 16b-7 would not exempt reclassifications that involve classes of securities with different risk-return characteristics (such as an exchange of non-convertible preferred stock for common stock) or that increase shareholders’ percentage of common-stock ownership. (See our memo dated March 10, 2003.)

In response to the Third Circuit’s holding in Levy I, the SEC adopted clarifying amendments to Rules 16b-3 and 16b-7. The amendment to Rule 16b-3 made clear that the exemption would apply regardless of whether a compensation-related purpose could be demonstrated. The amendment to Rule 16b-7 made clear that the only condition for exempting a reclassification is that the company whose securities are acquired or disposed of owns 85% or more of the equity or assets of all companies that are parties to the transaction. Thus, where a single issuer reclassifies one class of its securities into another, there is effectively 100% “crossownership” and the exemption is available. (See our memo dated August 8, 2005.)


The Trust Has Left the Building: $23,000 on Spa Treatments

This post is from Broc Romanek of

It looks like the folks at AIG have taken “tone at the top” to heart. Unfortunately, their tone isn’t of the type that is good news for taxpayers, who now own 80% of AIG. As this Washington Post article describes, two former AIG CEOs were grilled during a House Committee on Oversight and Government Reform hearing this week (one of whom received a $5 million performance bonus just before he left – in addition to a $15 million golden parachute – and another AIG executive was fired still receives $1 million per month for consulting services). The former CEOs expressed no remorse for their actions that drove AIG into the arms of the government and didn’t acknowledge making any mistakes. Rather, they blamed the accounting. The House committee members were visibly disturbed by the sheer audacity of these so-called corporate leaders. Given the long list of troubling practices at AIG described in this front-page WSJ article, we may well see these two in pinstripes someday.

The topper is the fact that AIG is now getting an additional $37.8 billion loan from the taxpayers, which is lumped on top of the $80 billion load the government provided last month. This came a day after it was revealed that the company held a junket for sales reps at a resort, spending unbelievable amounts of the taxpayer’s money. How exactly does one spend $23,000 on spa treatments or $5,000 at the bar? The story is outrageous and listening to the radio, it’s fair to say that AIG already has become the posterchild of all that is broken in Corporate America. If this doesn’t get you mad, nothing will.


Corporate Governance, Enforcement, and Firm Value: Evidence from India

This post comes from Dhammika Dharmapala of the University of Connecticut, and Vikramaditya Khanna of the University of Michigan Law School.

Recently in the Law and Economics Seminar here at Harvard Law School, we presented our paper entitled Corporate Governance, Enforcement, and Firm Value: Evidence from India. This paper analyzes the connections between corporate governance, stock market development and firm value using a sequence of reforms to India’s corporate governance regime as a source of exogenous variation. Despite the widespread interest in this area of research, finding evidence that corporate governance causes changes in firm value has posed a significant challenge since most governance reforms in the US have applied to all firms, making it difficult to isolate a credible control group. For this reason, and because of the relatively limited variation in governance practices in an economy such as the US, attention has increasingly been directed to the relationship between governance and firm value outside the US, especially in emerging markets.

There were a number of reforms enacted in India that were phased in over the period 2000‐2003, and severe financial penalties for violations were subsequently introduced in 2004. The exemption of a large number of firms from the new rules and the complex criteria for their application give rise to treatment and control groups of firms with overlapping characteristics. Using a large sample of over 4000 firms from 1998‐2006, a difference‐in‐ difference approach (controlling for various relevant factors and for firm‐ specific time trends) reveals a large and statistically significant positive effect (amounting to over 10% of firm value) of the reforms in combination with the 2004 sanctions. A regression discontinuity approach focusing on the thresholds for the application of these reforms leads to similar conclusions. In addition, the estimated effect of the initial announcement of the sequence of reforms in 1999 is weaker than the effect of the 2004 sanctions, highlighting the importance of sanctions. Some channels through which the 2004 effect may have occurred are explored, but the results are preliminary because there are only two years of post‐2004 reform data. There is some evidence of improvements in accounting performance and increases in foreign institutional investment, but this is not robust across specifications. In addition, the 2004 reforms are not associated with a reduction in tunneling within business groups.

Our results, taken together, present a strong case for a causal effect of the reforms on firm value. They also underscore the importance of the enactment of severe sanctions, though it is not entirely clear whether this effect operates through formal enforcement alone or in conjunction with some additional channel.

The full paper is available for download here.

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