Monthly Archives: November 2008

Do Politically Connected Boards Affect Firm Value?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, November 3, 2008
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This post comes from Eitan Goldman at Indiana University Bloomington, Jörg Rocholl at ESMT European School of Management and Technology in Berlin, and Jongil So at the University of North Carolina at Chapel Hill.

In our paper “Do Politically Connected Boards Affect Firm Value?” which is forthcoming in the Review of Financial Studies, we explore how pervasive is the impact of political connections on the value of publicly traded U.S. companies. To address this question, the paper focuses on analyzing the value impact of political connections of major U.S. companies, including all companies in the S&P500. Testing for whether political connections impact value requires addressing two basic challenges. The first challenge is to identify and define an exogenous measure of political connections. Given a definition of political connections, the second challenge is to find a setting that would allow one to test whether they do indeed affect company value.

To address the first challenge, the paper employs a unique definition of a company’s political connections based on new hand-collected data, detailing the former political positions held by each of the board members of all companies that are in the S&P500 during the years 1996 and 2000. Information about the political background of board members is then used to sort companies into those that are connected to the Democrats and those that are connected to the Republicans. To address the second challenge, the paper looks at two different events. The first is the 2000 Presidential Election. The second is the announcement of the board nomination of all of the directors that are identified as having a political connection. The hypothesis is that if political connections matter then: 1) companies with political connections to the Republican Party will increase in value upon the Republican win while companies connected to the Democratic Party will suffer a drop in value; and 2) the nomination of a politically connected director to the board will result in an increase in firm value due to the anticipation of future political benefits.

We find that a portfolio of S&P500 companies classified as having a Republican board significantly outperforms in the post-election period a portfolio of S&P500 companies classified as having a Democrat board. We also find that, considered separately, the Republican portfolio exhibits a positive and significant cumulative abnormal return (CAR) following the election. Conversely, the Democrat portfolio exhibits a negative CAR following the election. In addition, we find that a company experiences a positive and statistically significant abnormal stock return following the announcement of a board nomination of a politically connected individual. The positive announcement effect holds true both for Republican and Democrat connected directors. In sum, these results indicate the following two points: First, a company’s value goes up in anticipation of future benefits following the nomination of politically connected individuals. Second, when the director’s political party gains control of the presidency, the value generated by her increases while the value generated by a director connected to the opposing party decreases.

The full paper is available for download here.

A Personal FAQ on the Financial Crisis of 2008

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Sunday, November 2, 2008
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Editor’s Note: This post is by Ivo Welch of Brown University.

In “A Personal FAQ on the Financial Crisis of 2008“, I muse about the magnitude of the mortgage losses, some of the problems that caused the current financial mess, and some potential remedies.

First, the financial crisis is not caused just by bad mortgages, although the crisis started with them. Reasonable estimes of the potential losses due to bad mortgages are on the magnitude of perhaps “only” about $300 billion. By now, the financial crisis has moved much beyond the subprime and alt-A mortgages. Moreover, even economists often forget that value is unique only in a perfect market. If the market for assets is not liquid (as is the case now), their values are a range, not a point. Thus, lamenting over the low values of bad bank assets right now is misleading: when the market for mortgage loans will return to normal liquidity, these assets will be worth more than a firesale right now would bring.

Second, there are multiple layers of causality of the crisis. Most economists have focused on shallow and middle layers, such as the fact that banks are not lending, that markets are illiquid and values are tough to come by, or (deeper) that real-estate prices have fallen and mortgages are defaulting. They have made many good suggestions on how to deal with these problems, especially when it comes to schemes to recapitalize banks and renegotiate loans with homeowners.

However, there are much deeper causes, and they need to be fixed after the immediate crisis is over. In order of importance:

Governance: Punishing bank shareholders, now or in the future, will not impose a market discipline that will prevent similar crises in the future. The fact is that shareholders have no real oversight over management, including their risk-taking activities. The Chairmen of the Boards did not see it in their interests to learn how much risks CEOs were really taking on, and firing CEOs that took on too much. After all, the CEOs were themselves these Chairman. The main culprits of the current crises will all walk away very rich, even though it is the shareholders that will ultimately be the losers.

Sidenote: It also makes no sense to limit the executive compensation of incoming CEOs. It punishes the wrong party. It is not future CEOs and bankers who have caused the crisis, but past ones. For discipline to be effective, it must punish those that are responsible for creating a mess, not those who are put in charge for cleaning it up.

Tax Code: Our tax code continues to encourage levered ownership over equity ownership.

Bankruptcy code: Our bankruptcy code is not equipped to deal with systemic financial institution failure. As a result, financial liquidity crises become self-fulfilling prophesies.

Rating agencies and mortgage qualification: Like banks, these are rife with agency conflicts. The agencies made bundles of derivative securities appear safer than the underlying mortgages—and earned more in fees by doing so.

Related causes, such as mortgage buyer stupidity, are not easy to fix. Intelligent buyers of mortgage securities could have understood the conflicts of the rating industry. (This does not absolve the rating agencies.)

Third, it is naive to argue for or against regulation. Zero or infinite regulations are inferior to an intermediate amount of regulation. We need good, efficient, and effective regulation—and not too much and not too little. We know from experience that good government regulation is not an easy thing to come by. On the one hand, over-hasty regulation right now may only lead to more bad choices, as it did in the case of SOX. On the other hand, waiting too long may allow the lobbyists in Washington to torpedo good and meaningful governance reforms.

In my judgment, we should execute two corporate governance reforms:

[1] We should establish a “Corporate Governance Standards Board” (similar to FASB) in charge of “Generally Acceptable Corporate Governance Standards” (similar to GAAP). This board should be endorsed by the SEC, with additional safe-harbor provisions for firms following these standards and fewer protections for CEOs not following these standards.

[2] We should appoint a (legal) economist as head of the SEC, rather than a politician or pure lawyer. The SEC focus needs to tilt away from its traditional focus on enforcement and pure rule-based thinking and more towards effective economic regulation.

Clearly, reforms of the tax and bankruptcy codes are similarly important. However, I am less optimistic that our political system can manage these.

Sovereign Wealth Funds Adopt Voluntary Best Practices

Posted by Adam O. Emmerich, Wachtell Lipton Rosen & Katz, on
Saturday, November 1, 2008
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This post is based on a client memorandum by Adam Emmerich, Mark Gordon, Sabastian V. Niles, Shaun J. Mathew, and Jason M. Williams from Wachtell, Lipton, Rosen & Katz.

With the explosion in natural resource prices and trade surpluses, the corresponding
increase in the size and investing profile of sovereign wealth funds (SWFs), and the unprecedented stress on the global financial system, SWFs have faced substantial and increasing political and popular suspicion and pressure from the international community to address concerns that their investment decisions may be motivated by political, rather than economic, considerations. (See our December 2007 and June 2008 memos.) In a much-anticipated response, on October 11, a group of 26 nations with SWFs (the “International Working Group”) unveiled a set of 24 non-binding best practices, known as the “Santiago Principles,” designed to safeguard the operational independence of SWFs from political influences, promote greater transparency and accountability, and enhance internal investment and management frameworks, thereby encouraging continued political and popular acceptance of SWF investment in the developed world.

Intended to demonstrate that SWFs are soundly established and that investment decisions will be made on an economic and financial basis, the Santiago Principles address three broad areas of concern regarding SWFs: (i) their legal structure and relationship with the state, policy and investment objectives, and degree of coordination with their sovereign’s macroeconomic policies; (ii) their institutional structure and governance mechanisms; and (iii) their investment and risk management framework. While much will turn on how SWFs actually implement these aspirational guidelines (and it is worth noting that all of the principles are well caveated and subject to home country laws, regulations, requirements and obligations), the Santiago Principles may help reduce political influence in SWF investing and encourage the flow of sovereign wealth across borders.

Notably, the Santiago Principles provide for public disclosure of an SWF’s legal relationship with state bodies, general investment policies and goals, details of funding, withdrawal and spending arrangements, and audited financial information compliant with international or national auditing standards. In addition, the guidelines call for public disclosure of relevant financial information to demonstrate the SWF’s economic and financial orientation. Preferred governance frameworks would establish clear divisions of responsibilities to facilitate the operational independence of the SWF, and governing bodies would be appointed in accordance with defined procedures and with adequate authority to function in an independent manner. Disclosure regarding the SWF’s approach to exercising ownership and voting rights is provided for as is an explicit prohibition on seeking or taking advantage of privileged information or inappropriate influence by the broader government in competing with private entities. The Santiago Principles also make explicit that SWFs will comply with applicable recipient country regulatory and disclosure requirements. Of course, the capacity of the Santiago Principles to allay concerns about the transparency of SWF operations and objectives and their investment motivations will ultimately depend on the level and robustness of each SWF’s compliance with the letter and spirit of these voluntary guidelines.

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