Monthly Archives: June 2009

The Proper Limits of Shareholder Proxy Access

Editor’s Note: The post below by Commissioner Paredes is a transcript of remarks by him at the Center for Capital Markets Competitiveness, U.S. Chamber of Commerce on June 23, 2009 in Washington, D.C.

It is a pleasure to be speaking at this timely conference on “Shareholder Rights, the 2009 Proxy Season, and the Impact of Shareholder Activism” hosted by the U.S. Chamber of Commerce. Before I begin, I must remind you that the views I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or my fellow Commissioners.

As a practical matter, public company shareholders are not well-positioned to run the enterprises in which they invest. Managerial responsibility over a firm’s corporate strategy and day-to-day business and affairs instead is in the charge of directors and management. That said, shareholders retain the right to vote on fundamental corporate changes, such as a merger, a sale of all or substantially all of the corporation’s assets, and an amendment to the corporate charter or bylaws. Most notably, shareholders vote for board members. Shareholders also have the right of “exit,” as they can sell their shares if they disapprove of the company’s performance.

The animating question behind any discussion of shareholder rights thus presents itself: What is the proper institutional arrangement for ensuring that the company is managed in the best interests of shareholders when those who own the firm do not actively run it? [1]

Last month, in May, the SEC took a significant step toward setting the balance of control in corporations. [2] The Commission proposed new Exchange Act Rule 14a-11 creating a direct right of access for shareholders to the company’s proxy materials for nominating board members. For example, for the largest public companies, a nominating shareholder or group would have the right to include director nominees in the company’s proxy materials if the shareholder or group beneficially owned at least one percent of the company’s shares for at least one year.

The Commission also proposed amending Exchange Act Rule 14a-8(i)(8) to allow shareholders to include in the company’s proxy materials a proposal to amend the company’s bylaws to provide for a shareholder access regime. Notably, the SEC’s proposal prohibits shareholders from adopting a bylaw that opts out of the Rule 14a-11 access regime, even if shareholders want to.

As you may know, I voted against the Commission’s proposal and instead offered a counterproposal, which I will discuss later. [3] First, let me explain my core concern with what the SEC has advanced. As always, I look forward to considering the comments we receive on the proposal.


Toxic Tests

Editor’s Note: This post is Lucian Bebchuk’s current column in his series of monthly commentaries titled “The Rules of the Game” for the international association of newpapers Project Syndicate. The series focuses on finance and corporate governance and may be accessed here. Below is the text of Professor Bebchuk’s column:

The United States government is now permitting ten of America’s biggest banks to repay about $70 billion of the capital injected into them last fall. This decision followed the banks having passed the so-called “stress tests” of their financial viability, which the US Treasury demanded, and the success of some of them in raising the additional capital that the tests suggested they needed.

Many people have inferred from this sequence of events that US banks – which are critical to both the American and world economies – are now out of trouble. But that inference is seriously mistaken.

In fact, the US stress tests didn’t attempt to estimate the losses that banks have suffered on many of the “toxic assets” that have been at the heart of the financial crisis. Nevertheless, the US model is catching on. In a meeting this month, finance ministers of G-8 countries agreed to follow the US and perform stress tests on their banks. But, if the results of such tests are to be reliable, they should avoid the US tests’ fundamental flaw.

Until recently, much of the US government’s focus has been on the toxic assets clogging banks’ balance sheets. Although accounting rules often permit banks to price these assets at face value, it is generally believed that the fundamental value of many toxic assets has fallen significantly below face value. The Obama administration came out with a plan to spend up to $1 trillion dollars to buy banks’ toxic assets, but the plan has been put on hold.

It might have been hoped that the bank supervisors who stress-tested the banks would try to estimate the size of the banks’ losses on toxic assets. Instead, supervisors estimated only losses that banks can be expected to incur on loans (and other assets) that will come to maturity by the end of 2010. They chose to ignore any losses that banks will suffer on loans that will mature after 2010. Thus, the tests did not take into account a big part of the economic damage that the crisis imposed on banks.


Retaining Key Target Employees: Lessons For Acquirors

This post is by Eduardo Gallardo’s colleagues Jonathan Layne, Mark Lahive and Ben Ross. 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.

Common issues confronting acquirors involve retaining the target company’s key employees and protecting against the loss of business to defecting employees. A recent Delaware Court of Chancery decision addressed issues faced by an acquiror, where a group of the target company’s employees plotted to leave the target company and launch a competing business prior to the acquisition’s close. The court’s decision in Ivize of Milwaukee, LLC v. Compex Litigation Support, LLC [1] will likely cause acquirors to more aggressively seek and obtain employment and/or non-competition agreements from key target employees, particularly where the success of the acquisition depends upon a relatively small number of key employees.

The Case

In early 2007, Compex Legal Services (“Compex”), a provider of legal support services to law firms, decided to divest its Milwaukee and Kansas City facilities. Compex negotiated such divestures with another provider of legal support services, Ivize, LLC (“Ivize”), culminating in a simultaneous signing and closing on July 26, 2007 of a pair of Asset Purchase Agreements (one for each facility).

During the negotiations, Pete Cobb (“Cobb”), the manager of the Milwaukee facility, was advised of the transaction and that he would not be retained full-time after closing. In response, Cobb discussed the transaction with key salespeople who accounted for roughly 90% of Compex’s sales. Cobb and the key salespeople, in violation of existing non-competition agreements with Compex, (1) formed a rival entity (“Quantum”), (2) met multiple times to discuss Quantum business, (3) solicited key Compex employees, (4) rerouted business to Quantum, and (5) stole company records and equipment.

On the morning after closing, Ivize’s representatives found the Milwaukee facility abandoned and ransacked. In the days that followed, Ivize and Compex jointly uncovered Cobb’s activities.


Modernizing Pension Fund Legal Standards

This post comes from Keith L. Johnson, Program Director for the International Corporate Governance Initiative at the University of Wisconsin Law School, and Frank Jan de Graaf, Professor of International Business at Hanze University of Applied Sciences in the Netherlands.

In Modernizing Pension Fund Legal Standards for the Twenty-First Century, we explore the symbiotic relationship between sustainable success of the corporate sector and the ability of pension funds to successfully fulfill their mandate. We note that exponential growth in the size of pension fund assets since the 1970s and their current collective ownership of public corporations has turned pension fund governance into a major corporate governance factor. We argue that traditional views of pension fund governance and fiduciary responsibility, which developed during a time when pension fund investment practices had little effect on the markets, are outdated. With institutional investors owning 76 percent of the Fortune 1000, pension fund governance and corporate governance are now opposite sides of the same coin, with each exerting a major influence on long-term success of the other.

We concentrate on the pension fund side of this relationship and argue for a modernized interpretation of fiduciary duty. We maintain that prevailing interpretations of pension fund legal duties and common pension fund governance practices may be ill-suited for the complex investment instruments and the market-moving amount of assets now being managed by pension investors. We recommend changes in the interpretation of pension fund legal standards and identify priorities for improvements in pension fund governance to promote sustainability of wealth creation for both the pension and corporate sides of this symbiotic relationship.

The full paper appears in the Spring 2009 issue of the Rotman International Journal of Pension Management, published jointly by the Rotman International Centre for Pension Management and University of Toronto Press and is available for download here.

Compensation Peer Groups

This post comes to us from Michael Faulkender of the University of Maryland and Jun Yang of Indiana University.

In our forthcoming Journal of Financial Economics paper entitled “Inside the black box: the role and composition of compensation peer groups” we investigate how much compensation peer groups explain observed variation in CEO compensation and what determines the composition of these groups. Effective December 15, 2006, the SEC required that firms disclose “Whether the registrant engaged in any benchmarking of total compensation, or any material element of compensation, identifying the benchmark and, if applicable, its components (including component companies).” This study is the first to collect and examine the list of compensation peer companies used by the S&P 500 firms and S&P MidCap 400 firms in their first fiscal year ending after the compliance date of December 15, 2006.

We find that the median compensation of the peer group generates significant incremental explanatory power in understanding cross-sectional variation in the observed CEO compensation among disclosing firms even after including controls for CEO labor market conditions. We find that CEOs whose pay was below the median pay level of their counterparts in companies of similar size and in the same industry receive pay raises that are larger in both percentage and dollar terms. In contrast, having actual compensation peer group membership enables us to demonstrate that peer companies outside the firm’s industry and size group also have a significant influence on executive compensation.

When we examine the composition of peer groups, we find that firms select companies in the same industry, of similar size, and with a history of observed talent flows between them to be members of their compensation peer groups. Using both multivariate probit models and a propensity score matching (PSM) approach, we show that the level of CEO compensation at a potential peer company is statistically significant in determining its likelihood of being chosen as a compensation peer, after controlling for industry, size, visibility, talent flows and CEO characteristics. In other words, compensation committees seem to be endorsing compensation peer groups that include companies with higher CEO compensation, everything else equal, possibly because such peer companies enable justification of the high level of their CEO pay.

One interpretation of our results is that entrenched CEOs in firms with weak corporate governance are likely to have more power to influence their own compensation. An alternative interpretation of our findings is that higher CEO compensation (for more complex firms) is likely to be an equilibrium result in a well-functioning labor market. To distinguish between these two theories, we examine the variation in pay differences between selected and unselected peers across measures of corporate governance. We find that highly paid potential peers are more likely to be chosen as compensation peers by firms where the peer group is smaller, where the CEO is the Chairman of the BOD, where the CEO has been in the post longer, and where directors are busier serving on multiple boards.

The full paper is available for download here.

SEC Must Constrain Abusive Short Selling

This post sets forth the text of a letter to the Securities and Exchange Commission by Edward D. Herlihy and Theodore A. Levine of Wachtell, Lipton, Rosen & Katz in response to the Commission’s request for comments on its proposed amendments to Regulation SHO (short sale proposals). A facsimile of the letter is available here.

The repeated abuse of short selling over the past eighteen months has led to the destruction of businesses, cost countless numbers of jobs and created systematic risk in the global economy. Though some have asserted that short selling aids liquidity and price discovery in the market, the possibility of such functions should not be used to justify the damaging and corrosive consequences of abusive short sales. Since the repeal of the uptick rule in 2007, the market has suffered a resurgence of manipulative short selling, including widespread “bear raids,” in which short sales of equity securities are employed, sometimes in combination with other trading strategies, in a concentrated effort to drive down their prices. These practices have badly damaged institutions, destroyed billions of dollars in shareholder value, and crippled investor confidence.

We strongly urge the Commission to adopt effective regulation to constrain abusive short selling and related trading strategies, thereby protecting institutions, employees, shareholders and the wider economy from the manipulation and ensuing damage that have been pervasive over the past several years. [1]

First, we urge the Commission to adopt a short sale price test to decelerate the short selling process, thereby reducing short sellers’ ability to overwhelm companies’ shares and quickly profit from the resulting “downward spiral” in share prices. We believe that, in order to function effectively in the modern marketplace, a price test based on the national best bid is appropriate. To provide the most comprehensive protection against manipulation, any price test should be adopted through both the “policies and procedures” and “straight prohibition” approaches. The former requires that exchanges and other trading centers develop the policies, systems and technology necessary to ensure trades’ compliance with the price test, while the latter gives all market participants responsibility for compliance and provides the Commission with maximum enforcement authority over any violations.

Such a price test rule must not overlook the myriad ways traders are able to effect a short position in a company’s stock, including synthetic short positions created through the use of options and exchange traded funds. Thus, any short sale price test rule adopted by the Commission should address these strategies and provide the Commission with enforcement authority over synthetic shorting activity aimed at evading the price test.

In addition to a price test based on the national best bid, we recommend that the Commission implement a “circuit breaker” rule that would impose additional restrictions on short sales of a security that has been the subject of a severe price decline. Following a decline of five percent in a security’s price from its previous day’s close, short sales in the security should be suspended for the remainder of the trading day. This suspension will prevent a destabilizing downward spiral in the triggering security and give the market time to arrive at a rational valuation. Short sales should be allowed to resume on the next trading day, albeit with additional restrictions, such as strict “pre-borrow” requirement for certain recovery period to ensure that aggressive short sellers are not permitted to further damage the security’s price during this sensitive time. A properly calibrated “circuit-breaker,” in combination with a short sale price test, will interrupt the instances of extreme intraday volatility that destabilize the market, prevent efficient price discovery and cause investors to doubt the fairness and integrity of the market.

Any action the Commission attempts to take against manipulative short selling will not be completely effective without parallel, reinforcing reforms applied to the derivatives market, particularly with respect to credit default swaps (“CDS”). The responsiveness of equity prices to changes in CDS spreads makes the purchase of CDS a powerful device for bear raids, particularly when used in connection with short sales. Combining a short sale with the purchase of CDS sends a false signal into the marketplace about a company’s credit and, accordingly, causes a drop in the stock price that makes the short position profitable. Such manipulation is dangerously cost-effective, as a relatively small investment in an institution’s CDS is sufficient to spark rumors of default or a ratings downgrade and immediately sink stock prices.

To prevent this and other abuses of the CDS market, we believe that only those who are economically exposed to the underlying credit risk of a company should be allowed to buy CDS protection on the company. The purchase of a “naked” CDS, made by a purchaser with no exposure to the reference company, is more akin to gambling than obtaining insurance, and such instruments are capable of causing serious distortions in the market. A prohibition on naked CDS would allow the appropriate use of these instruments while restraining those using the CDS market in a manipulative and abusive way. As an intermediate step, the Commission should use its ability to regulate short sales to require a waiting period between any purchase of a CDS and short sale involving the same reference company. In addition, to alert the marketplace to situations when CDS are being used to manipulate share prices in conjunction with short selling, the Commission should require disclosure when an actual or synthetic short position in a company’s equity securities is accompanied by a long position in the company’s CDS.

Stock and derivative markets must be effectively regulated so that a few profit-seeking bear raiders cannot contribute to a “run on the bank” that destroys an enterprise and risks global systemic collapse, as in the cases of Bear Stearns and Lehman Brothers. We urge the Commission to ensure that the regulatory scheme it formulates in response to the current financial crisis has sufficient flexibility to reach the many ways abusive and manipulative practices have affected the market and harmed small investors and the wider economy.

[1] In addition to the adoption of a price test and other actions described below, we believe that the Commission should extend and strengthen the rules it adopted last fall aimed at curbing naked short selling and requiring greater short selling disclosure.
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Sarbanes-Oxley and Corporate Risk-Taking

This post comes to us from Leonce L. Bargeron, Kenneth M. Lehn, and Chad J. Zutter of the Katz Graduate School of Business, University of Pittsburgh.

In our paper, Sarbanes-Oxley and Corporate Risk-Taking, which was recently accepted for publication in the Journal of Accounting and Economics, we empirically examine whether the adoption of SOX is associated with a subsequent decline in corporate risk-taking.

We examine whether several measures of corporate risk-taking changed significantly after SOX was signed into law in 2002 for publicly traded U.S. companies as compared with non-U.S. companies not bound by SOX. In an attempt to isolate effects associated with SOX, it is important to compare U.S. firms, which are subject to SOX, to non-U.S. firms that are most like U.S. firms with the exception that they are not subject to SOX. For this reason, the sample of non-U.S. firms is comprised of publicly listed U.K. and Canadian firms that are not cross-listed in the United States. We use publicly listed firms in the U.K. and Canada as a benchmark sample because these firms operate in similar capital market environments and under similar regulations to firms listed in the U.S.

Using data for a large sample of U.S. and non-U.S. firms during the period of 1994 through 2006, we find that after SOX U.S. companies significantly reduced their investments, as measured by the sum of their capital and R&D expenditures, in comparison with their non-U.S. counterparts. In addition, U.S. firms significantly increased their holdings of cash and cash equivalents, which represent non-operating, low-risk investments, as compared with the non-U.S. firms. Also, we find that the standard deviation of stock returns, a conventional measure of a company’s equity risk, declined significantly for U.S. firms compared with non-U.S. firms, after SOX. Finally, these findings are consistent for an industry and size matched sample of U.S. and non-U.S. firms.

The changes in the risk-taking variables are significantly greater for large versus small U.S. firms, consistent with the view that the expected costs of complying with Section 404 are greater for firms characterized by more complexity. The changes are also significantly greater for firms with high versus low R&D expenditures before SOX, consistent with the view that the expected costs of complying with Section 404 are directly related to the degree of specialized knowledge in a firm. The changes in cash holdings and stock price volatility are significantly greater for firms that did not have a majority of outside directors before SOX, and hence were most affected by the SOX-related rules governing the independence of boards, than for other firms. The changes in capital and R&D expenditures were not significantly different across these two groups of companies.

While we cannot rule out the possibility that other factors, unique to U.S. firms and unrelated to SOX, might account for the relative decline in risk-taking by U.S. companies after SOX, we are not aware of any such factors, and as such, conclude that our evidence is most consistent with the view that SOX has discouraged risk-taking by U.S. companies.

The full paper is available for download here.

Proxy Access Proposed Rules Published by SEC

On June 10, 2009, the SEC published a proxy access rule proposal for public comment. The Commission’s release, entitled “Facilitating Shareholder Director Nominations,” gives concrete form to the broad objectives the Commission outlined at its May 20, 2009 open meeting (at which it approved publication of the rule by three votes to two).

As expected, the SEC is proposing to:

· create a new Rule 14a-11 that would require companies to include shareholder nominees for directors in company proxy materials under prescribed circumstances, and

· revise existing Rule 14a-8(i)(8) to allow shareholder proposals to amend a company’s governing documents regarding nominating procedures or disclosure related to shareholder nominations, thus reversing the SEC’s 2007 prohibition on using Rule 14a-8 for shareholder proxy access proposals.

Proposed Rule 14a-11

The key features of the proposed rule are as follows:

· Companies Subject to Proxy Access: The proposed rule would apply to all Exchange Act reporting companies subject to the proxy rules, regardless of their size, including investment companies and companies that have voluntarily registered their stock (under Section 12(g)) but excluding debt-only issuers and foreign private issuers.

· Minimum Ownership: The proposed rule would set a tiered minimum-ownership requirement for shareholders seeking to nominate directors:

· 1 percent of the shares of a large accelerated filer (net assets of $700 million or more),· 3 percent of the shares of an accelerated filer (net assets of $75 million or more, but less than $700 million), and

· 5 percent of the shares of a non-accelerated filer (net assets less than $75 million).

· Minimum Holding Period: Each nominating shareholder would be required continuously to have held the requisite number of shares for at least one year prior to the date it notifies the company of its intent to nominate a director, and must intend to hold the shares at least through the date of the annual or special meeting.

· Aggregation: Unaffiliated shareholders would be permitted to aggregate their holdings to meet the minimum share ownership threshold. There is no limit on the size of a nominating group. Communications for the purpose of forming a nominating group would be exempt from the proxy rules, provided they are limited in scope, do not request or solicit actual proxies and are filed with the Commission.

· Beneficial Ownership Reporting: The formation of a nominating group holding in excess of 5 percent of an issuer’s equity securities would still be required to be reported under Regulation 13D. However, the formation of a nominating group would not affect any group member’s otherwise existing eligibility to file on Schedule 13G rather than 13D. Moreover, an amendment to Rule 13d-1 would specifically allow groups formed solely to nominate a director pursuant to Rule 14a-11 to file on Schedule 13G.

· Timing of Nomination: Nominations would need to be submitted to the company on the same time schedule as Rule 14a-8 proposals (i.e., no later than 120 days prior to the date of publication of the prior year’s proxy material), unless a company’s advance notice bylaws provided for a shorter period.

· Mandated Disclosure and Filing: Each nominating shareholder (including each shareholder within a nominating group) would be required to represent as to a number of items, including that:

· the shareholder intends to hold its shares through the date of the annual meeting, as well as its intent with respect to continued ownership following the meeting (although the proposed rule is silent as to whether and how the shareholder’s lending of its shares during this period would affect either of these statements),· the shareholder’s nominees are in compliance with applicable objective stock exchange independence requirements,

· neither the nominee nor the nominating shareholder has an agreement with the company regarding the nomination,

· the shareholder is not attempting to effect a change of control (or to gain more than a minority of directors),

· the candidate’s nomination to or initial service on the board, if elected, would not violate controlling state or federal law or applicable listing standards, and

· the shareholder or shareholder nominating group is eligible to use Rule 14a-11 in terms of the minimum share ownership requirements.


A New Foundation for Financial Regulation?

This post is by Randall D. Guynn, Annette L. Nazareth, Margaret E. Tahyar, Robert Colby, and Reena Agrawal Sahni of Davis Polk & Wardwell LLP. A summary by Gibson, Dunn & Crutcher LLP of the provisions of the White Paper, with reactions from various industry groups, is available here.

In our memorandum, available here, we describe the Obama Administration’s White Paper on Financial Regulatory Reform. The White Paper is just the beginning of what is likely to be a legislative, regulatory and ideological marathon, despite the Administration’s best efforts to achieve domestic political support before its publication. It is far less revolutionary than some either feared or hoped for and reflects an “art of the possible” approach to regulatory reform by the Obama Administration. Ultimately the White Paper reflects a compromise designed to avoid as much as possible the most difficult regulatory, state and congressional turf battles.

As a result, the plan is notable as much for what it does not do as for what it does. It is not a once-in-a-lifetime regulatory overhaul. It does not propose a CFTC-SEC merger, it does not propose an optional federal insurance charter and it does not streamline the alphabet soup of financial regulatory agencies. If anything, it adds more regulators than it eliminates. Its key innovations involve expanded power for the Federal Reserve as the sole systemic risk regulator, with the creation of a Financial Services Oversight Council to mollify those who are concerned about the aggregation of power in the Federal Reserve; the long anticipated registration of advisers to hedge funds, private equity funds and venture capital funds; the regulation of OTC derivatives; the merger of the OTS and the OCC; the creation of a Consumer Financial Protection Agency with vast new powers delineated in such a way that future jurisdictional turf wars are inevitable; and the creation of a resolution regime for bank holding companies and Tier 1 FHCs. While the White Paper is an incomplete framework, one possible benefit is that it creates the skeleton of a “twin peaks” structure, with a prudential and a business conduct regulator, into which other agencies could be merged in the future.

The Administration has set a goal of passing its reform package by the end of the year and promises that legislative text will soon be sent to the Hill. Naturally, the political reaction has already begun, with Republicans outlining their own plan and individual Senators and Congressmen proposing, or soon to propose, competing proposals and language.

Other stakeholders, both domestic and international, will also have a view and, in some cases, a voice. Indeed, the White Paper proposals are made at a time of parallel UK and European regulatory reform driven in part, as is the White Paper, by the G-20 proposals. The European Council of Ministers proposed its own plan this past week for which legislative text is expected in the fall, and the UK is expected to publish more details on its own version shortly. The era when financial regulation was purely a matter for domestic politics is over. More and more the domestic US financial regulatory agenda is being influenced by international fora, by an active EU regulatory structure which has created extraterritorial standards and imposed requirements of comparability and by the international and US domestic push for harmonization of standards across regulatory bodies.

The shifting dynamics of the regulatory reform proposals and the politics involved in any consolidation, reorganization or redistribution of regulatory responsibilities mean that it is too early to predict with certainty which proposals are likely to be enacted and in what form. In light of the many competing proposals and legislative texts, we believe that it is possible that some elements, such as the Consumer Financial Protection Agency, will be enacted separately and attached to other bills rather than as an omnibus package.

Our memorandum discusses the White Paper’s proposals from a range of perspectives, domestic and international, and sets forth how the proposals may impact a range of institutions, financial and non-financial.

The memorandum is available here.

CFO Incentives Post-SOX

This post comes to us from Raffi Indjejikian and Michal Matějka of the Ross School of Business at the University of Michigan.

In our forthcoming Journal of Accounting Research paper, CFO Fiduciary Responsibilities and Annual Bonus Incentives, we examine how firms evaluate and compensate their CFOs. In addition to participating in decision making much like other senior executives, CFOs also have fiduciary responsibilities for reporting firms’ financial results and safeguarding the integrity of financial reporting. Although other top executives have fiduciary responsibilities for financial reporting as well, CFOs typically have more of an expertise and capacity to determine what numbers get reported. Responsibility for financial reporting raises the question of whether it is appropriate to reward CFOs bonuses contingent on financial performance that is effectively self-reported.

To provide a framework to understand why CFO compensation is tied specifically to financial performance, our paper presents an agency model with two executives, a CEO focused on production and a CFO entrusted with dual responsibilities. Our model generates two insights that have implications for changes in CFO compensation practices in the post Sarbanes-Oxley (SOX) environment. First, we find that if CFOs personally bear greater misreporting costs, then firms offer their CFOs steeper incentives tied to financial performance. The intuition is straightforward; if CFOs are more conscientious in discharging their fiduciary duties, then firms are more comfortable offering steeper incentives since rewards for reported performance are less susceptible to unwarranted overpayments. Second, we find that as misreporting becomes more costly, firms are less willing to tolerate misreporting. Hence, firms offer their CFOs weaker incentives tied to financial performance to expressly motivate them to focus more on their fiduciary duties.

We rely on a proprietary survey of CFO performance evaluation and compensation practices of public and private firms to conduct our empirical tests. Since public firms were affected by SOX much more than private firms, the public versus private distinction allows for an identification strategy of the SOX-effect on CFO compensation that has not been feasible in prior literature. Our survey was sent to approximately 30,000 members of the American Institute of Certified Public Accountants who are CFOs, CEOs, or other executives informed about CFO and CEO compensation. We received 1,353 responses from both public and private entities.

Our data indicates that annual bonuses are by far the most common incentive component of CFO compensation plans and that, on average, about 50 percent of the CFO bonus is based on accounting-based financial performance. In addition, the extent to which CEO and CFO incentives are tied to financial performance are highly correlated. More importantly, we find that from 2003 to 2007 public entities (relative to private entities) lowered the percentage of CFO bonuses contingent on financial performance. Specifically, we compare the bonus weight on financial performance measures that is expected in 2007 with the actual bonus weight in 2003 (indicative of incentives in the pre-SOX environment) and find marked differences for public versus private entities. For example, predicted values from one of our regressions suggest that public companies (with median sample characteristics) lowered the percentage of their CFO’s bonus that depends on financial performance by about six percent while comparable private companies with similar characteristics increased the percentage by about three percent. We interpret this result as evidence that firms mitigate earnings management or other misreporting practices in part by deemphasizing CFO incentive compensation.

The full paper is available for download here.

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