Monthly Archives: January 2009

CEO Pay and the Lake Wobegon Effect

This post comes from Rachel Hayes and Scott Schaefer at the University of Utah.

In our paper, CEO Pay and the Lake Wobegon Effect, which was recently accepted for publication in the Journal of Financial Economics, we analyze a common explanation for the recent increase in CEO pay at US firms. Our model, which is based on asymmetric information in financial markets, is motivated by an observation made by former DuPont CEO Edward S. Woolard, Jr. speaking at a Harvard Business School roundtable on CEO pay: “The main reason (CEO) compensation increases every year is that most boards want their CEO to be in the top half of the CEO peer group, because they think it makes the company look strong. So when Tom, Dick, and Harry receive compensation increases, I get one too, even if I had a bad year…. (This leads to an) upward spiral”

We present a game-theoretic model of this phenomenon, which is known in the business press as the Lake Wobegon Effect. We study a firm and a manager who privately observe a parameter that affects the productivity of their match. Stock market participants cannot observe this parameter, but attempt to infer it from observing the manager’s wage. The firm maximizes a weighted sum of short-run and terminal firm value, and so may wish to distort the publicly observable wage contract in order to affect the market’s beliefs regarding firm value. Our model has three key features, all of which have been noted as important assumptions of the Lake Wobegon Effect: (i) there is asymmetric information regarding the manager’s ability to create value at the firm; (ii) the pay package given to the manager must convey information about the manager’s ability to create value at the firm; and, (iii) the firm must have some preference for favorably affecting outsiders’ perceptions of firm value.

We present three main results. First, we show the Lake Wobegon Effect can occur. That is, there are instances of our model in which the full-information benchmark is not an equilibrium, and firms distort pay upward to affect market perceptions of firm value.

Second, we characterize the settings in which the Lake Wobegon Effect does occur. We show that our three key assumptions — asymmetric information, managerial rents, and corporate myopia — are not sufficient to guarantee upward distortions in pay. In the basic version of our model, two additional conditions are necessary: (1) the marginal effect of increases in managerial ability on match surplus — defined as the difference between the parties’ output when working together and when pursuing their outside options — is positive, and (2) the weight placed by the firm on short-run share prices is greater than the fraction of the match surplus that is captured by the manager.

Third, we find that the temptation to distort pay upward is stronger when the information asymmetry pertains to characteristics of the firm rather than characteristics of the manager. When the manager’s ability is uncertain, increases in the manager’s pay do boost the market’s assessment of managerial ability; however, the manager — not the firm — captures rents associated with increases in managerial ability. Thus, the marginal increase in firm value associated with a dollar increase in managerial pay is low when the uncertainty pertains to a characteristic of the manager.

Our analysis suggests that greater shareholder involvement in the pay process — so-called “say on pay” — might be counterproductive. A potential solution to the problem of shareholder myopia is to delegate decisions to individuals with a longer-term view. That is, if shareholders care only about short-run share prices then they may be tempted to raise CEO pay in a (futile, in equilibrium) attempt to affect short-term market valuations. If instead, shareholders delegate pay decisions to directors and motivate those directors (using contracts) to take a longer-term view, then pay decisions can be insulated from myopia.

The full paper is available for download here.

Firms Gone Dark

This post is from Jesse Fried of Harvard Law School.

I have just posted on SSRN a revised version of a paper that focuses on firms that exit the mandatory disclosure system even though their shares remain publicly traded and may be held by thousands of investors, Firms Gone Dark. It will be published shortly in the University of Chicago Law Review.

The paper begins by explaining how firms go dark. The securities laws currently permit a firm to exit the mandatory disclosure system if certain conditions are met, one of which is that the firm not have any class of securities outstanding with three hundred or more “holders of record.” This “record holder” test would appear to prevent any firm with three hundred or more shareholders from exiting mandatory disclosure. However, the test currently does not define a “holder of record” as the real (or “beneficial”) owner of the firm’s stock, but rather as the party “identified as the owner” of the security on the firm’s records. Most shares in publicly traded firms are held by nominees, such as banks and brokerage houses, not by the beneficial owners themselves. Each nominee, in turn, holds its shares on behalf of dozens, hundreds, or even thousands of institutional and individual investors. Thus, a reporting company can easily have fewer than three hundred “holders of record” and thus be eligible to exit mandatory disclosure even though the company may have thousands of beneficial shareholders. Hundreds of publicly traded firms have taken advantage of this rule to exit mandatory disclosure in recent years. Such exiting firms are said to “go dark” because they subsequently provide little information to public investors. The paper also describes the characteristics of firms that go dark and the stock market’s sharply negative reaction to going-dark announcements.

I then examine the disclosure practices of firms that have gone dark and explore their implications for the longstanding debate in securities regulation over whether mandatory disclosure is needed. Critics of mandatory disclosure argue that insiders can be counted on voluntarily to provide the “firm-optimal” level of disclosure—that which maximizes the joint wealth of insiders and public investors. Defenders of mandatory disclosure disagree, arguing that insiders often have an incentive to provide less than the firm-optimal level of disclosure. The disclosure practices of gone-dark firms, I show, cast doubt on the claim of mandatory disclosure’s critics. Only a small fraction of firms that go dark provide any financial information publicly to their hundreds or thousands of public investors. I explain why it is highly unlikely that, for the vast majority of these gone-dark firms, the firm-optimal level of disclosure is zero. The fact that stock prices drop substantially when firms announce they will exit mandatory disclosure provides further reason to be skeptical that post-exit disclosure levels are generally firm-optimal.

The paper concludes by addressing the question of how exits from mandatory disclosure should be regulated. It begins by explaining that when insiders can unilaterally decide to exit mandatory disclosure, they may have an incentive to exit even when such exit reduces firm value. The SEC is currently considering a proposal to prohibit firms with three hundred or more beneficial shareholders from exiting mandatory disclosure. Adoption of this proposal, I show, would decrease value-reducing exits but not eliminate them. I then put forward a new approach to regulating exits from mandatory disclosure: requiring public investor approval before insiders can turn off the lights. Such an approach would prevent a firm from exiting mandatory disclosure as a publicly traded company unless such exit increases firm value.

The current draft of the paper is available here.

As I am continuing to work on projects related to firms’ choice of disclosure arrangements, any comments would be most welcome.

Determinants of Explicit CEO Contracts

This post comes from Stuart L. Gillan of Texas Tech University, and Jay C. Hartzell and Robert Parrino of The University of Texas at Austin.

In Explicit vs. Implicit Contracts: Evidence from CEO Employment Agreements, which was recently accepted for publication in the Journal of Finance, we report evidence on the determinants of whether the relationship between a firm and its CEO is contractually defined in an explicit agreement. Our sample consists of the 494 U.S.-based firms in the S&P 500 on January 1, 2000 and their CEOs as of that date. We construct the sample by combining a set of explicit CEO EAs provided to us by The Corporate Library with agreements identified by searching the SEC filings of all remaining S&P 500 firms for any mention of an explicit EA. We define explicit EAs to include only comprehensive written agreements that specify the relationship between a firm and its CEO. We find that fewer than half of the CEOs of S&P 500 firms have comprehensive explicit employment agreements.

We find that comprehensive explicit EAs are used more frequently at firms operating in more uncertain business environments and at firms that are likely to face lower costs from altering the agreement with the CEO. This is consistent with the idea that firms facing greater uncertainty are more likely to encounter situations in which the benefits from altering an EA outweigh the costs. CEOs that have been hired from another firm (outside CEOs) are also more likely to have explicit EAs. These CEOs tend to face greater uncertainty about the sustainability of their relationships with their firms than CEOs who have been promoted from within. We find strong evidence that CEOs who can expect to earn greater abnormal compensation at their firms, both in the near future and over the estimated remainder of their career, are more likely to have an explicit EA. In addition, CEOs who receive a larger fraction of their pay as incentive-based compensation, which tends to be at greater risk if their employment agreement is altered, are more likely to have an explicit EA. Lastly, we find that the factors that explain the presence of an explicit EA also explain contract duration.

On balance, the evidence supports theoretical literature on the choice between explicit and implicit agreements and is consistent with optimal contracting.

The full paper is available for download here.

A Wider Scope of Primary Liability?

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

In a recent novel decision in one of the mutual fund market timing cases brought by the SEC (SEC v. Tambone, ___ F.3d ___ (1st Cir. 2008), available at 2008 U.S. App. LEXIS 24457), the First Circuit held that the SEC had adequately alleged a primary violation of Section 10(b) and Rule 10b-5(b) for material misstatements “impliedly” made by the defendants. A sharply worded dissent criticized the Court’s holding for enlarging the scope of primary liability and blurring the line between primary and secondary liability that the Supreme Court recently drew in Stoneridge. Even though its impact remains to be seen, the First Circuit opinion has potentially significant implications for the scope of liability of defendants in both SEC enforcement actions and private civil securities litigation.

In an article entitled “A Wider Scope of Primary Liability?,Mark Schonfeld and Akita St. Clair address the implications of the SEC v. Tambone decision. This article recently appeared in Law360.

The article is available here.

Lawdragon 500

Lawdragon Magazine recently released its fourth annual list of the “500 Leading Lawyers in America.” Available here, the list includes 16 individuals who are affiliated with this Blog or its sponsor, the Harvard Law School Program on Corporate Governance.

The Lawdragon 500 includes private attorneys from a wide range of practices, in-house counsel, law professors, judges, government attorneys, and public interest lawyers. Conducted by legal journalists, the selection is based on a combination of on-line balloting and independent research.

The Lawdragon 500 list includes professor Lucian Bebchuk, who serves as director of the Program, and Leo Strine, Delaware Vice Chancellor and senior fellow at the Program.

The following five members of the Program’s advisory board were similarly honored: Peter Atkins (Skadden, Arps, Slate, Meagher & Flom), John Finley (Simpson Thacher & Bartlett LLP), Theodore Mirvis (Wachtell, Lipton, Rosen & Katz), James Morphy (Sullivan & Cromwell), and Paul Rowe (Wachtell, Lipton, Rosen & Katz).

In addition, the following guest contributors to this Blog were also selected:
George R. Bason (Davis Polk & Wardwell);
Richard Climan (Cooley Godward Kronish);
Jay Eisenhofer (Grant & Eisenhofer);
Adam Emmerich (Wachtell, Lipton, Rosen & Katz);
Robert Giuffra (Sullivan & Cromwell LLP);
Edward Herlihy (Wachtell, Lipton, Rosen & Katz);
David Katz (Wachtell, Lipton, Rosen & Katz);
Martin Lipton (Wachtell, Lipton, Rosen & Katz); and
Charles Nathan (Latham & Watkins).

Lawdragon’s announcement appears here. A post on this Blog featuring last year’s Lawdragton 500 is available here. The Blog and the Program had eight individuals represented then, including Lucian Bebchuk, Leo Strine, Peter Atkins, Ted Mirvis, James Morphy, Jay Eisenhofer, and Charles Nathan.

Overreactions to Ryan v. Lyondell Chemical Company

This post is from Steven M. Haas of Hunton & Williams 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.

Back in September, the Delaware Supreme Court accepted the defendants’ interlocutory appeal and stayed the lower court proceedings in Ryan v. Lyondell Chemical Company. Typically, the Delaware Supreme Court and the Court of Chancery work in close harmony, so the Supreme Court’s decision was unusual since the appeal had been denied by Vice Chancellor Noble.

The appeal centers on Vice Chancellor Noble’s decision to deny the defendant-directors’ motion for summary judgment on allegations that they breached their fiduciary duties in approving a cash-out merger with a strategic buyer. Charles Nathan posted on the background and analysis of the decision here. The decision generated swift criticism, with most commentary characterizing it as improperly second-guessing a disinterested board’s decision to approve an all-cash premium offer, and as lowering the bar for stockholder-plaintiffs to allege bad faith in change-of-control transactions.

Travis Laster and I recently addressed this criticism in an article entitled “Reactions and Overreactions to Ryan v. Lyondell Chemical Co.” We argued that many commentators have overreacted to the Lyondell decision. To be sure, the Court of Chancery’s opinion can be criticized on several grounds, but its outcome was driven primarily by its procedural posture and does not dictate any meaningful change in established deal practice.

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Shareholder Impact of Option Backdating

This post comes from Gennaro Bernile at the University of Miami and Gregg Jarrell at the University of Rochester.

In our paper “The Impact of the Options Backdating Scandal on Shareholders” which was recently accepted for publication in the Journal of Accounting and Economics, we analyze the excess returns that occurred in short windows surrounding ten distinct news events related to backdating of stock option grants.

Our analysis focuses on 129 firms identified by the Wall Street Journal as implicated in the backdating scandal as of December 31, 2006. We independently identify 764 firm specific backdating-related news events taking place on 580 separate firm-dates. For the first news event (typically the announcement of an internal investigation by the firm), we find a statistically significant excess return of about -4.50% in the -20 to -2 window and -2.40% in the -1 to +1 window. The magnitude of the implied wealth changes seems too large to be attributed to any reasonable estimate of direct out-of-pocket costs of the backdating scandal or to the resulting legal penalties disclosed to date (direct cost hypothesis). Therefore, the alternative hypothesis we propose, which we broadly label Agency Hypothesis, is that a firm’s involvement in the backdating scandal has significant economic implications, despite its limited (direct) impact on cash flows. Under this hypothesis, the losses generated by the option backdating scandal can arise because management’s involvement in backdating practices may prompt investors to reassess the agency costs stemming from the separation of ownership and control.

A series of multivariate show that measures we expect to be related to the effect of the scandal on the value of firms’ reputational capital and information risk are significantly related to changes in shareholders’ wealth. Conversely, variables one would expect to be related to the magnitude of direct out-of-pocket expenses, namely the number of past grants and/or their value, are not significantly related or are positively related to shareholders’ wealth effects, inconsistent with the direct cost hypothesis. In addition, consistent with this interpretation, the occurrence of government investigations or delisting notices have no incremental explanatory power, after controlling for firms’ likely culpability. We find that the losses are attenuated when tainted management of less successful firms is more likely to be replaced. We also find that institutional investors reduce their holdings in firms accused of backdating, possibly due to higher monitoring costs, and that firms involved in the scandal are very likely (10% of the sample) to receive arguably fair takeover offers.

Overall, the evidence is consistent with the hypothesis that the loss of investors’ confidence in the firm’s management is a first-order determinant of the economic consequences resulting from the option backdating scandal.

The full paper is available for download here.

Bribery Warrants Global War

Editor’s Note: This article by Ben Heineman and Al Larson was also posted on Bloomberg.com. Mr. Heineman is the former Senior Vice President for Law and Public Affairs at General Electric.

The bribery scandal involving Siemens AG, Europe’s largest engineering company, is the latest evidence that corruption of public officials remains a pernicious problem as globalization intensifies. Accepting or extorting bribes and misappropriating public funds erodes judicial institutions and the rule of law, distorts competition and injures the poor.

Anti-corruption rhetoric exceeds commitment and accomplishment, especially in emerging-market nations. Building durable, transparent and accountable institutions in the highly diverse developing world — with failed, failing, fragile and rising states — is key, though complex and time-consuming.

One part of the solution can be tackled immediately: vigorous enforcement of the 1997 OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions. The goal of the effort — part of Paris-based Organization for Economic Co-Operation and Development – is to stop, or significantly minimize, bribes made by multinational corporations headquartered in industrialized nations.

The need for such action was underscored last month, when Siemens agreed to pay a record $1.3 billion to U.S. and German authorities for accounting and conspiracy offences, resulting from probes that the Munich-based company allegedly paid more than $1.4 billion in bribes around the world.

‘Unprecedented’ Misconduct
This followed resignations by Siemens’s board chairman and chief executive; the payment of more than $300 million in other penalties; restatements of more than $500 million for expenses subsequently disallowed as improper payments; and outlays of more than $850 million for lawyers and forensic accountants used in the company’s internal inquiry.

U.S. authorities said Siemens’s improper payments were “unprecedented in scale and geographic reach” as well as “systematic” and “standard operating procedures.” If bribery was so pervasive, involving employees at all levels, in such an iconic multinational company, then similar behavior almost certainly exists within major exporters elsewhere in Germany and in other industrialized nations.

Currently, 37 nations belonging to the OECD have ratified the anti-bribery convention and have enacted laws such as the U.S. Foreign Corrupt Practices Act (FCPA), prohibiting foreign bribery by U.S.-based transnational companies. These nations account for more than two-thirds of world exports.

Unfortunately, efforts to implement the convention at the national level have been inadequate. (The OECD itself has no enforcement powers; it can only monitor national efforts through its highly professional Working Group on Bribery.)

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Top 5 Delaware Cases from 2008 — Rebuttal to Professor Brown

This post is from Francis G.X. Pileggi of Fox Rothschild 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.

Last year, I replied to Professor J. Robert Brown’s list of the top 5 Delaware cases that, in his view, supported his negative perspective of Delaware law that remains the constant refrain on his blog called: The Race to the Bottom.

My introductory explanation from my rebuttal of last year was as follows:

… I realize that there are many more qualified experts who can rebut the professor’s arguments far more persuasively than I, and I am well aware that the Delaware bench certainly does not need my help to defend it. Nor have I been anointed by anyone to take on this role. Nonetheless, having just completed a review of key 2007 Delaware corporate decisions, I offer my own humble rebuttal and a “counter-list” of 5 cases in 2007 that demonstrate that the Delaware courts take shareholder rights and the duties of directors very seriously. If any readers can think of a better “top 5” list, than the one I compiled below, I welcome comments. Here is my top 5 “rebuttal list”:

Well, I just finished my 4th annual overview of selected Delaware corporate and commercial cases for 2008, which will be published soon in The Delaware Law Weekly, at which time I will also post it on these pages. I also just saw Professor’s Brown list of 5 cases from 2008 that he uses to support his unabashedly unflattering views of Delaware law. Here is his list and here is his introductory post.

My cursory review of the cases I selected below (from the approximately 200 or so that I have summarized on my own blog during 2008), is not as scholarly as the good professor’s treatment, and I do not have the time (thankfully, due to my busy practice) to engage in extended debate (at least for the next week or so), but until someone else picks up the baton, I offer the following cases to counterbalance the list offered by Professor Brown. I invite others to suggest other cases that they would rather see in my “top 5 list”.

• In Cargill, Inc. v. JWH Special Circumstance, LLC, (Del. Ch., Nov. 7, 2008), read opinion here, the Delaware Chancery Court issued a 68-page decision involving a Delaware statutory trust (formerly referred to as a business trust), and found that common law fiduciary duties would apply to a trustee as a “default rule” in light of the agreement among the parties being silent on the issue. Here is a more complete summary.

• In Julian v. Eastern States Construction Service, Inc., 2008 WL 2673300 (Del. Ch., July 8, 2008), read opinion here, the Chancery Court required directors to disgorge a $1.3 million bonus they had given themselves in a self-interested manner, without any independent protections, and based on their failure to satisfy their burden to demonstrate the entire fairness of their decision. Here is a more complete summary.

• In Ryan v. Lyondell Chemical Company, (Del. Ch., July 29, 2008), read opinion here, the Delaware Chancery Court found that at the procedural stage of a summary judgment motion, it would allow to proceed to trial the issue of whether the independent directors should be exposed to personal liability for their role in the sale of the company–despite selling the company to the only known buyer for a substantial premium. A whole article could be written on this case alone, and substantial commentary has already been penned about it. An equally weighty later decision denying a motion for reargument was summarized here. The case is now on appeal with the Delaware Supreme Court.

• In Steel Partners II, L.P. v. Point Blank Solutions, Inc., 2008 WL 3522431 (Aug. 12, 2008), the initial complaint was filed to force the holding of a shareholders meeting (which had not taken place since 2005), pursuant to DGCL Section 211. After a stipulation was entered into for a date to hold the meeting, the defendant moved for leave of court to postpone the date of the meeting by 90 days. The Chancery Court denied the request. The request was based on allegations that the plaintiff and its CEO together own about 40% of the stock and would attempt to install their own directors and then seek to buy the company at the lowest possible price for its own investors. In addition, the postponement was requested due to an alleged conflict that the plaintiff’s CEO had with the majority. The court reasoned that the best way to deal with the issues presented was to communicate them to the shareholders and let them decide, based on those facts, who they wanted as directors–instead of further delaying the exercise of the shareholder franchise, which under Delaware law is sacrosanct. The summary of the case on my blog is here.

London v. Tyrrell, 2008 WL 2505435 (Del. Ch., June 24, 2008), read opinion here. This Chancery Court decision explained in detail the reasons why it denied a motion to dismiss a derivative claim based on Chancery Court Rules 9(b), 12(b)(6) and 23.1. The derivative complaint alleged that the defendants caused the company to issue stock options in contravention of an equity incentive plan by setting the exercise price of the issued options at an unfairly low value.After a thorough factual background description, the court emphasized that: “the burden remains on the movant to demonstrate that the plaintiff has not met the requirements of Rules 9(b), 12(b)(6) and 23.1.” (see footnote 12). Moreover, the court described in detail the demand futility analysis under the seminal case of Aronson v. Lewis, 473 A.2d 805 (Del. 1984) as well as Rales v. Blasband, 634 A.2d 927 (Del. 1993). The court explained the reasons why it concluded, as succinctly as I have seen it done, that both prongs of the Aronson case were satisfied. Specifically, the plaintiff demonstrated a reasonable doubt that: (1) the directors were interested and independent; or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.

The first prong was satisfied because the directors had a financial interest in the challenged stock option plan and also because they stood on both sides of the transaction that was challenged. Moreover, the second prong was satisfied because the allegations rebutted the business judgment rule to the extent that the allegations supported an inference that the directors intended to violate the terms of a stockholder approved option plan. The court also dismissed the arguments under Rule 9(b) that there was insufficient particularity regarding fraud allegations which apparently relied on Sections 152 and 157(b) of the DGCL.

Do Shareholder Rights Affect the Cost of Bank Loans?

In our paper Do Shareholder Rights Affect the Cost of Bank Loans? which was recently accepted for publication in the Review of Financial Studies, we analyze the relationship between firm-level corporate governance measured by the governance index of Gompers, Ishii, and Metrick (2003, henceforth GIM) and the cost of bank loans issued to publicly traded firms.

We use a panel data set of over 6000 loans issued to a wide cross-section of US firms between 1990 and 2004 as the basis for our analysis. Our basic result shows that firms that are more vulnerable to takeovers (i.e., firms with higher shareholder rights) are charged significantly higher loan spreads. To quantify this result, we follow GIM and construct corner portfolios of firms with the highest (democracy) and the lowest levels (dictatorship) of shareholder rights. We show that for a typical firm in our sample a switch from the democracy to the dictatorship portfolio decreases the expected loan spread by almost 25% (30 basis points) after controlling for the default risk as well as various firm-level factors and specific features of loan contracts.

In interaction regressions, we find that democracies with low leverage are charged significantly higher loan spreads. This provides evidence that the possibility of an increase in financial risk is an important consideration through which takeover vulnerability gets priced in bank loans. Additionally we find that conditional on high takeover vulnerability, long maturity loans have higher spreads than loans with short maturities. Loans with longer maturity expose banks to takeover risk for a longer time-period and our results indicate that banks charge a premium for taking such risks.

Though our focus remains on debt pricing, bank loan covenants and collateral can also mitigate a bank’s concern about potential losses in takeover. Consistent with this argument, we find that banks charge higher loan spread to those high takeover vulnerability borrowers that have fewer covenants or those who obtain unsecured loans. To investigate whether banks can also protect their interests by having bargaining power over their borrowers, we analyze the effect of syndicate size on the pricing effect of takeover vulnerability. We find that the effect of takeover vulnerability is significantly higher for loans with smaller syndicate size i.e., when the bargaining power is likely to be high. Thus, the bargaining power channel is less likely to explain away our results.

Our results have important implications for understanding the link between a firm’s governance structure and its cost of capital. Our study suggests that firms that rely too much on corporate control market as a governance device are punished by costlier bank loans. The full paper is available for download here.

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