Yearly Archives: 2008

Key Principles for Strengthening Corporate Governance

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, November 4, 2008
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Editor’s Note: The NACD, in its report, acknowledges the extraordinary and pro bono efforts of Ira Millstein and Holly Gregory and their colleagues at Weil, Gotshal & Manges LLP for their assistance with preparation of the principles.

The National Association of Corporate Directors, with the support of the Business Roundtable, recently released Key Agreed Principles for Strengthening Corporate Governance. The Principles identify the core areas that boards, management and shareholders agree should be the basis for good corporate governance and cover topics including independent board leadership, protecting against entrenchment of the board, shareholder participation in corporate decision making, and board communication with shareholders. In recognition of the legitimate concerns that exist about the rigid and prescriptive use of best practice recommendations by some proponents, the Principles are intended to reflect a distillation and articulation of fundamental principles-based aspects of governance on which there appears to be broad consensus. They are also intended to stimulate informed debate about issues on which consensus does not yet exist.

The International Corporate Governance Network, a global network of institutional investors, has welcomed the Principles, emphasizing that “[t]his is a good start which we believe should encourage further discussion on how to improve practice in corporate governance and develop much better understanding between companies and the shareholders who own them. The ICGN believes this is a constructive way towards long term value creation, which has become all the more important in the light of the current economic crisis.”

The principles are available here. A comparison of Significant Views on Corporate Governance Best Practice, which is Appendix A to the report, is available here. A comparison of Sarbanes Oxley, SEC and Listing Rule provisions related to the composition and functioning of the board of directors of a publicly traded company, Appendix B to the report, is available here.

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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Consumer Biases and Firm Ownership

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, October 31, 2008
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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.

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Recent Developments Regarding Director Independence

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on
Thursday, October 30, 2008
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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.

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Do Foreigners Invest Less in Poorly Governed Firms?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, October 30, 2008
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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

Posted by Margaret E. Tahyar, Davis Polk & Wardwell LLP, on
Wednesday, October 29, 2008
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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

Posted by Edward J. Riedl, Harvard Business School, on
Wednesday, October 29, 2008
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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

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, October 28, 2008
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This post comes to us from Lauren Cohen and Christopher Malloy of the Harvard Business School, and Andrea Frazzini of the Graduate School of Business at the University of Chicago.

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.

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