Monthly Archives: June 2009

Dutch decision has implications for global class actions

In an important development for class action suits in the United States and internationally, the Amsterdam Court of Appeals recently upheld a settlement between Royal Dutch Shell and a group of more than 150 institutional investors from 17 European countries, Canada, and Australia. The proposed settlement originally emerged in 2007 after Royal Dutch Shell side-stepped a class action filed in U.S. District Court that sought to include claims from both U.S. and non-U.S. investors, by independently pursuing a settlement in The Netherlands with the non-U.S. claimants.

This settlement under Dutch law intersects with recent limitations on subject matter jurisdiction in U.S. courts for claims brought by “foreign-cubed” plaintiffs under U.S. securities laws. A mechanism to settle group claims in The Netherlands may influence U.S. courts to place further limits on jurisdiction for foreign plaintiffs, while also providing a way for foreign issuers at risk of jurisdiction in the U.S. to effectively settle collective claims outside of the U.S.

In 2004, Royal Dutch Shell investors brought a securities fraud class action suit in the U.S. District Court for New Jersey alleging injury from Shell’s intentional overstatement of oil reserves. The suit followed Shell’s announcement in February of 2004 that it had recategorized 20 percent of its total proven reserves base, and an ensuing internal audit which uncovered an email from a Shell executive stating, “I am becoming sick and tired about lying about the extent of our reserves issues.”

In addition to U.S. shareholders, the class included “foreign-cubed plaintiffs” (foreign shareholders, suing a foreign corporation, regarding stock purchased on a foreign exchange). After the U.S. class, represented by the Bernstein Liebhard law firm, rejected a settlement offer from Shell in 2006, Shell’s attorneys approached Grant & Eisenhofer, another U.S. class action law firm, to obtain a settlement “class” of non-U.S. claimants out of the U.S. litigation. In early 2007, Shell announced a $352.6 million settlement with a group of non-U.S. shareholders comprising 150 institutional investors. The settlement provided for $47 million in legal fees.

The settlement announced in 2007 was expressly contingent on: (1) the U.S. District Court deciding not to certify the non-U.S. claimants as part of the class in the U.S., which occurred in November of 2007 when the District Court dismissed the foreign-cubed plaintiffs for lack of subject matter jurisdiction; and (2) the Amsterdam Court of Appeals approving the settlement under the Dutch Act on Collective Settlement of Mass Claims, which was just announced on May 29, 2009.


Improving the Role of the Securities Regulators in a Changing Global Financial System

The post below by Chairman Mary Schapiro is a transcript of remarks by her at IOSCO’s 34th Annual Conference on June 11, 2009 in Tel Aviv, Israel.

Good morning. And, thank you Hans [Hoogervorst, Chairman, Authority for the Financial Markets, Netherland, and Vice Chair of the IOSCO Technical Committee] for that kind introduction.

I’m delighted to be speaking with you today — even though it’s after 2:00 in the morning here in Washington. But, the way I see it, investor protection doesn’t sleep, so I thought I’d stay up too.

I would also like to express my warmest thanks and congratulations to our hosts, Professor Zohar Goshen [Chairman of the Israel Securities Authority], and Chairman Saul Bronfeld [of the Tel Aviv Stock Exchange], as well as Dr. Stanley Fischer [Governor of the Bank of Israel], for organizing this wonderful and important event.

And, I also would like to thank the IOSCO Executive Committee Chair Jane Diplock, Emerging Markets Committee Chair Guillermo Larraín Ríos, my colleague Technical Committee Chair Kathleen Casey, and Secretary General, Greg Tanzer — for their efforts in promoting IOSCO’s goals. I was truly looking forward to seeing so many old friends and colleagues from my many years of involvement with IOSCO.

I really wish that I could have joined you in person. But, here in the U.S. we are very deep in the process of reevaluating our regulatory landscape, as I’m sure you know, and we are having significant discussions within the Administration — so I felt I needed to remain behind.

Improving the Role of the Regulator

You might say that, in the U.S., we are attempting to do exactly what this panel is slated to discuss: “Improving the Role of [a] Securities Regulator in a Changing Global Financial System.”

But for us all to be effective regulators, improvement cannot just come once every financial crisis. No. Instead, we need to be constantly improving on our effectiveness. We need to be constantly considering whether there are gaps in and between our regulatory regimes through which certain players or products can easily slip. And, we need to be constantly doing whatever it takes to keep pace with the newest financial products of the day — so we can understand those products just as well as the people selling them. We need to be constantly alert to the risks that may attend dynamic innovation in the way financial products are packaged and sold.

The fact is that we need to do those things whether or not there is a financial crisis. But, in light of the crisis, we need to do those things even better. That’s because investors want to know that we’re looking out for them. They want to know that companies are being truthful and transparent in what they say. And, they want to know that it’s OK to put their money back into the markets.

In short, it is our time to prove ourselves. Because, we can help restore the confidence that is so desperately needed for capital markets to flourish — if we all succeed at what we do. And, if we work together, we increase the scope and impact of our individual successes.


My Last ExxonMobil Annual Meeting

This post is by Robert A.G. Monks of Lens Governance Advisors.

Walking to the Myerson Symphony Center past the various galleries, statues and plantings in the Arts District of downtown Dallas during the last week of May is a contemplative experience for me. As a Boston Irishman, I cannot but remember the fate of Jack Kennedy in this seemingly gentle, indeed beautiful, city. Living now year round on the coast of Maine where the leaves around my house are yet to flower, immersion in the foliage and scent of high spring are intoxicating. I am on my annual pilgrimage to the Annual Meeting of shareholders of the most profitable corporation in the history of the world – ExxonMobil. In times past, there was a subdued sense of violence. There was still the careful organization of crowd control barriers, uniformed and other police, the combination of horses and motorcycles, the almost robotic protest by the seemingly inevitable protesters, the politely insistent ticket issuers, takers and the possession examiners – resulting this year in the loss not only of my Blackberry but also of my small brief case except for the few pages I was allowed to retain when I protested that without props memory failure at my advanced age would not allow my presentation of the five motions – I waved the green tickets that proved my entitlement to have the floor for five times three minutes – without embarrassment to all.

Inside, all was a well organized exhibit of Exxon’s presence, together with an extremely lavish offering of coffees and various pastries. My long time friend Jamie Houghton was there for his last board meeting. He is very patient with me – our fathers were Harvard College Classmates and members of the Chapter of the National Cathedral – and we enjoy the exchange of views of civilized persons with diametrically opposed world views. I saw Rex Tillerson and tried to get close, with no success, but – to be honest – there was no visible precaution against our meeting.

Annual Meetings are one of the least commented upon contradictions in contemporary capitalism. Statutes advertise them as the time and place for management and owners to meet; for corporate executives to account for their stewardship of the investors resources; and for the shareholders to have the opportunity to hold these managers to account. The reality, alas, is otherwise – the preponderance of votes on all the business items have already been received by proxy and there is absolutely no chance that anything that occurs in the next several hours will affect the pre ordained results. That said, there is a certain charm to the choreographed process analogous to watching a theatrical performance embedded in our cultural memory – like Shakespeare or Corneille. The numerical result is not the object of the event. What needs to happen is that shareholders and managers have together to conjure up a myth of importance – something real is happening (Santa Claus will come tonight!). In the occasional interplay between management and questioners, a sense of the soul of the corporation is expressed. In the process by which the meeting is conducted a sense of the standards of decency are proclaimed. In the brief passages – presentations are limited to three minutes, and Exxon management for the second year in a row – notwithstanding my ignored letter of protest – will not permit human responsive discussion.

I asked Rex Tillerson, Chairman and CEO, whether I could modify the rules governing the presentation of shareholder proposals in order more clearly to explain a new development of general interest. I was the designated presenter for the first five proposals, and, therefore, entitled to fifteen minutes. Tillerson looked bewildered, conferred with corporate secretary Rosenbaum, and said: “We’ll see where you are after the first three minutes”. It was only later that I came to understand that Tillerson’s entire concern was to limit the “tax” of time that law imposed on Exxon’s top management requiring exposure to their owners and that his hesitation has nothing to do with the content of what I was saying. There was nothing I could say that would interest him in the least. It is sad that these fine engineers cannot conduct themselves so as to save participants in this meaningless meeting of any dignity. Exxon considers shareholder relations as a non cost effective demand on executive time. When a shareholder pointed out that as a New Jersey corporation, Exxon might consider holding meetings in that state, Tillerson pointed out “I like Texas” and, so it is – the CEO’s world.

Tillerson’s Exxon executives examined the New Jersey statute and instructed staff to do everything legally possible to limit the diversion of valuable CEO and director time. New Jersey requires an Annual Meeting, at which directors are elected. The SEC requires that Exxon include on its Annual Meeting proxy resolutions, deemed appropriate by the Commission. The company relentlessly challenges all resolutions before the Commission, requiring not insignificant legal expense for those wishing to advance their proposals. They induce law firms with fine names to opine to the SEC that even proposals like mine – plain vanilla in the world of corporate governance – are in violation of law and regulation. The SEC of years past will accede to Exxon’s experts unless I adduce comparable legal weight- and so, I do at a cost not far off $100,000. There is implicit in the SEC rules that proponents be allowed to present their resolutions to the meeting. Over the last several years, Exxon has massaged the choreography of the meeting so that all proposals are presented without any questions or interruptions beyond Tillerson’s mantra that “Management opposes this resolution, etc.” following each presentation. There then follows a random question period during which no exchange of views is possible. Tillerson doesn’t deign to answer questions, nor does he permit any of the board members to answer questions directed at them. A certain punctilio is always observed – all the company directors are present and non-participating, the company’s “performance puff piece” is aired for an hour, the Chairman and Secretary smirk and chat sometimes allowing speakers to talk through the red light signals.

Several of the proposals concerned the long time disagreement between Exxon and important shareholder constituencies who are concerned with the company’s policies towards climate change and alternate energy. This interest in climate culminated in the impassioned presentation of Father Mike who reminded Tillerson of the company’s commitment to the conclusion that man, and Exxon, in particular, were contributants to the problems of global warming. At this point, almost by magic, individuals were recognized who trashed all sentiment having to do with global warming or criticism of EM management. Father Mike rose again to ask Tillerson not simply to acquiesce in these public expressions of opinion that the company, on the record, opposed. He appealed to moral imperatives, to the obligations of leadership not to enable dissemination of false information. Tillerson was unmoved.

Essentially, Exxon’s view is that the shareholder meeting is an utter waste of time which they are legally compelled to endure. So, smirking and with time watch, they absolutely do not gave a tinker’s dam what anybody says, as it is all an imposition. I could feel this at the beginning when I actually tried to say something of importance to Exxon about the current state of governance – Tillerson could care less about anything any of us have to say as long as the time limits were observed. Sometimes my naïve optimism appalls me. For many years, I have felt it important to appear at these meetings as a “witness” to the atrocities of governance. I have now come to feel that one of the reasons I feel sick after these meetings is that I really am being an “enabler”. Appearing at this 2009 version of a show trial tends to legitimate it. Actually, the perfect epitaph for this experience is the ritual by which the Corporate Secretary casts votes for resolutions when no proponent is present – it is in that mode that I will be present in future years. The engineers will have saved three minutes!

Business Networks

This post comes to us from Camelia Kuhnen of the Kellogg School of Management.

Business connections can mitigate agency conflicts by facilitating efficient information transfers, but can also be channels for inefficient favoritism. In my forthcoming Journal of Finance paper Business Networks, Corporate Governance, and Contracting in the Mutual Fund Industry, I analyze the extent to which these effects are present in the mutual fund industry, and measure their impact on the welfare of fund investors.

I construct a large and unique data set containing information about advisory contracts for all U.S. mutual funds during 1993 to 2002, as well as information about the identity of the directors of these funds during the same period. This data set tracks business relationships between mutual fund directors and advisory firms, as well as between advisory firms themselves. I identify 257 cases of funds that hired a new subadvisor between 1993 to 2002. These events are used to study which candidates (from a pool of about 1,000 firms each year) win subadvisory contracts from funds. I also study a sample of 216 open-end U.S. mutual funds newly created in 1998 to test whether the connections of potential candidate directors (3,005 individuals) influence the assignment of board seats by the primary advisors of these new funds.

I show that when mutual funds choose among candidate subadvisors, the more connected such a firm is to the directors of these funds through past business relationships, the more likely it is to win the contract. This effect holds even after controlling for the candidate’s reputation, degree of specialization in the investment objective of the fund, cost, and also for the connections between the fund’s primary advisor and the candidate. The preferential selection of connected subadvisors by directors is mirrored by the preferential hiring of connected directors by primary advisory firms when these firms create (sponsor) new funds. In contrast, I find that connections do not have an economically significant impact on investors’ bottom line.

The strong effects of business ties on reciprocal hiring by directors and managers that I document are consistent with both of the possible roles of connections – as means for efficient information exchange, or as channels for favoritism. Overall, my results suggest that the two effects of board-management connections on investor welfare – improved monitoring and increased potential for collusion – balance out in this setting.

The full paper is available for download here.

Recent GAO Report on Sovereign Wealth Funds

This post is by Eduardo Gallardo’s partner Jeffrey Trinklein.

Government investment funds, often referred to as “sovereign wealth funds,” have become increasingly visible investors in the United States, a trend that has not escaped the attention of Congress. A series of recent investments led the Senate Banking, Housing and Urban Affairs Committee to raise concerns in 2008 over national security and the possible impact on the economy of large influxes of foreign governmental investment. Accordingly, Senators Christopher Dodd of Connecticut and Richard Shelby of Alabama, the senior Democrat and Republican members on the Senate Banking Committee, asked the Government Accountability Office (GAO) to address a variety of concerns and issues. The most recent report, the second in the series, was issued in May 2009 and looks at the laws that control foreign investment into the United States and whether those laws affect sovereign wealth funds.

The report makes several recommendations to Congress with the goal of increasing compliance with existing foreign investment laws. In particular, the GAO suggests that agencies that are not currently using other governmental agencies reports, like SEC filings, and private data sources, like Bloomberg, should use these sources to monitor changes in ownership of U.S. assets. The recommendation is minor in that it seeks only to increase compliance with already existing laws, but it demonstrates the continuing interest of Congress in reviewing foreign investment generally and investment by sovereign wealth funds specifically.


The United States generally has a policy of openness with regard to foreign investment, but some laws limit and restrict certain types of investments and the activities of foreign-controlled companies. Although federal and state laws affect sovereign wealth funds simply by placing limits on all foreign investment, no laws exist that directly address sovereign wealth funds. Some general laws can potentially affect investment in any industry, while other laws have specific industry requirements and will obviously have a greater impact on funds seeking to invest in those areas. Each of those industries has at least one governmental agency that exercises oversight to monitor compliance to the laws. According to the GAO report, the following industries are affected specifically by laws restricting foreign ownership:

• Banking, overseen by the Federal Reserve Board
• Communications, overseen by the Federal Communications Commission
• Transportation, overseen by the Department of Transportation
• Natural resources and energy including nuclear power, overseen by the Department of Energy, the Nuclear Regulatory Commission and the Department of the Interior
• Agriculture, overseen by the Department of Agriculture

Defense-related matters are also subject to restrictive investment laws, but span different industries and are not overseen by one specific government agency. Furthermore, the Department of the Treasury and the Department of Homeland Security are often involved in the oversight of foreign investment in these industries.


The Rules of the Game

Professor Lucian Bebchuk will be writing a monthly column for Project Syndicate, an international association of 425 newspapers in 150 countries, with a total circulation of about 56 million copies. The series of columns sponsored by the association seeks to bring distinguished voices from across the world to audiences in member newspapers’ countries.

Professor Bebchuk’s series of monthly commentaries, titled “The Rules of the Game,” will focus on finance and corporate governance. His commentaries, which will be available in eight languages, can be accessed here. Others contributing a monthly column to Project Syndicate include economists Martin Feldstein, Robert Shiller, and Joseph Stiglitz, former German Foreign Minister Joschka Fischer, former French Prime Minister Michel Rocard, political scientist Joseph Nye, and Oxford University’s Chancellor Lord Chris Patten.

The Forum is planning to feature Professor Bebchuk’s monthly columns as they become available. Professor Bebchuk’s first column, “The False Promise of Global Governance Standards,” builds on his paper The Elusive Quest for Global Governance Standards, co-authored with Professor Assaf Hamdani, and recently issued by the Program on Corporate Governance.

Below is the text of the Professor Bebchuk’s column.

The False Promise of Global Governance StandardsProfessor Lucian Bebchuk

In the wake of last year’s global financial meltdown, there is now widespread recognition that inadequate investor protection can significantly affect how stock markets and economies develop, as well as how individual firms perform. The increased focus on improving corporate governance has produced a demand for reliable standards for evaluating governance in publicly traded companies worldwide. World Bank officials, shareholder advisers, and financial economists have all made considerable efforts to develop such standards.


Draft Obama Administration White Paper on Financial Regulatory Reform

This post is by Luigi L. De Ghenghi, Randall D. Guynn, Ethan T. James, Arthur S. Long, Annette L. Nazareth, Lanny A. Schwartz, Margaret E. Tahyar, Gerard Citera, Robert Colby, Courtenay Myers, and Reena Agrawal Sahni of Davis Polk & Wardwell.

Editor’s UPDATE: The Obama Administration’s White Paper on Financial Regulatory Reform, which was released after preparation of this post, is available here.

This post, and the accompanying memorandum, summarizes the key proposals in the Obama Administration’s White Paper on Financial Regulatory Reform based on the “near final” draft White Paper posted by the Washington Post on June 16th. It has also been prepared in advance of the President’s news conference on June 17th and Secretary Geithner’s testimony on June 18th and assumes a reader that is familiar with U.S. regulatory reform. Readers are cautioned that there may be changes in the final version of the Obama White Paper. We will post a full memorandum with analysis and commentary in the coming days, but, in the meantime, we hope readers will find this factual outline helpful.

* * * * *

Executive Summary
The five areas covered in the White Paper are:

1. Supervision and regulation of financial firms, including:

• creation of a Financial Services Oversight Council,
• identification of systemically important firms, which are called “Tier 1 FHCs,”
• enhanced standards for all banks and BHCs,
• BHC status for any firm owning a thrift, ILC, credit card bank, trust company, or other non-traditional bank,
• subjecting Tier 1 FHCs and firms owning non-traditional banks to non-financial activities restrictions in the BHC Act,
• merger of the OTS and OCC into a new National Bank Supervisor,
• registration and reporting requirements for most advisers of private pools of capital including hedge funds,
• establishment of an Office of National Insurance in Treasury, but no federal insurance charter, and
• stronger requirements for money market funds and government sponsored enterprises;

2. Regulation of financial markets, including:

• skin-in-the-game and compensation requirements for originators and sponsors of asset-backed securities,
• regulation of OTC derivatives and OTC derivatives dealers,
• proposal to harmonize futures and securities regulation, and
• enhanced oversight by the Federal Reserve over systemically important payment, clearing and settlement systemsand activities of major participants;

3. Consumer and investor protection, including:

• creation of a Consumer Financial Protection Agency with rule making, supervisory and enforcement authority over credit products,
• creation of a Financial Consumer Coordinating Council to advise on gaps in consumer and investor protection and to promote best practices, and
• other initiatives to bolster the authority of the SEC, FTC and to address retirement security;

4. Resolution authority and Section 13(3) authority, including:

• giving Treasury resolution authority over BHCs and Tier 1 FHCs modeled on the FDIC’s resolution authority over insured banks and thrifts, with the FDIC (or in the case of a group that is primarily a securities firm, the SEC) acting as receiver or conservator, and
• requiring the Federal Reserve to obtain prior approval from Treasury for all lending under Section 13(3); and

5. International regulatory standards and cooperation, including:

• support for existing G-20 and other initiatives, and
• rules for determining whether a foreign financial firm is a Tier 1 FHC.

Our memorandum, available here, provides a more detailed outline of the key proposals.

Public Pension Fund Reform Code of Conduct

This memo is based on a client memorandum by Edward Greene’s colleague Robert Raymond of Cleary Gottlieb Steen & Hamilton LLP.

Recently, New York Attorney General Andrew M. Cuomo announced an agreement with private equity firm The Carlyle Group (“Carlyle”) in connection with the Attorney General’s investigation, started in 2007, into relationships between New York State’s Common Retirement Fund (“NYCRF”) and investment firms doing business with it.[1] Carlyle agreed to pay $20 million to resolve its part in the investigation, and to abide by the Attorney General’s “Public Pension Plan Reform Code of Conduct” (the “Reform Code”). The Reform Code imposes strict requirements and prohibitions on dealings with retirement plans for federal or state governmental employees (“Public Pension Funds”),[2] including an outright ban on the use of placement agents, finders, lobbyists and other intermediaries (collectively referred to as “placement agents”) in arranging investments by Public Pension Funds.

The principles reflected in the Reform Code are likely to extend beyond the agreement with Carlyle, whether other industry participants voluntarily agree to abide by them or they are incorporated into new federal and/or state legislation or regulations. The Attorney General’s office has indicated that it expects the Reform Code to establish a generally applicable framework for relationships between Public Pension Funds and investment firms going forward; at a minimum, it appears likely that firms seeking to do business with New York Public Pension Funds will be asked to be bound by the Reform Code. Attorney General Cuomo has described the Reform Code as representing the “new rules of the game” [3] and praised Carlyle for “leading the industry toward critical change of the public pension investment system.” [4] However, as noted below, the Reform Code includes a number of provisions that are ambiguous or may be difficult to implement in practice. It remains to be seen whether other jurisdictions will adopt new rules similar to the Reform Code and, if so, whether and how they may refine the details and mechanics of these rules.

In our memorandum entitled “The New York Attorney General’s Public Pension Fund Reform Code of Conduct: “New Rules of the Game“” we outline the key provisions of the Reform Code and suggest action steps for investment firms that do business (or seek to do business) with Public Pension Funds and may become subject to its requirements or similar requirements. The full text of the Reform Code and the Assurance of Discontinuance issued by the New York Attorney General in respect of Carlyle (“Assurance of Discontinuance”), are available here and here, respectively.

The memorandum is available here.


[1] The investigation is being conducted under New York’s “blue sky” law, the Martin Act, which permits very broad pre-lawsuit discovery by the Attorney General.
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[2] The term “Public Pension Fund,” as used in the Code of Conduct, means “any retirement plan established or maintained for its employees (current or former) by the Government of the United States, the government of any State or political subdivision thereof, or by any agency or instrumentality of the foregoing.” Thus, the restrictions that Carlyle agreed to by adopting the Code of Conduct are not, by their terms, limited to New York plans but purport to apply to any federal or state governmental pension plan. In a related development, New York State Comptroller Thomas P. DiNapoli announced on April 22, 2009 that he has banned the involvement of placement agents, paid intermediaries and registered lobbyists in investments with NYCRF.
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[3] “Cuomo Announces Carlyle Settlement; Firm Will Adopt Code of Conduct for Funds,” Pension & Benefits Daily (May 18, 2009).
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[4] “Cuomo Announces Landmark Agreement With the Carlyle Group to Eliminate Pay-to-Play in Public Pension Funds Nationwide” (announcement on New York Office of the Attorney General website, May 14, 2009), available here.
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Equity Compensation for Long-Term Results

This post is based on an op-ed piece by Lucian Bebchuk and Jesse Fried published today on Wall Street Journal online. The piece is based on Lucian Bebchuk’s testimony at the House Financial Services committee last Thursday, which is available here, and their forthcoming white paper, “Equity Compensation for Long-Term Performance.”

Treasury Secretary Timothy Geithner announced on Wednesday the Obama administration’s strong belief in tying executive compensation to long-term company performance. The regulations issued that day direct the new “compensation czar” to ensure that financial firms receiving “exceptional assistance” from the government don’t “reward employees for short-term or temporary increase in value.” Companies not covered by regulations are also currently seeking to tighten the link between pay and long-term performance. The question is how this could best be done.

With respect to equity compensation – a central component of modern executive pay arrangements – companies should prevent executives from cashing out vested grants of options and shares for a fixed number of years. But companies should avoid arrangements that block executives from cashing out options and shares until the executive’s retirement, or any other event that is at least partly under that person’s control.

Grants of equity incentives – options and restricted shares – usually vest gradually over a period of time. A specific number of options or shares vest each year, and the vesting schedule provides executives with incentives to remain with the company. Once options and shares vest, however, executives typically have unrestricted freedom to cash them out, and executives often liquidate them quickly after vesting.

The ability to cash out large amounts of equity-based compensation has provided executives with powerful incentives to seek short-term stock gains even when doing so involves excessive risk-taking. This short-termism problem, which was first highlighted in a book we published five years ago, “Pay without Performance,” has become widely recognized in the aftermath of the crisis – including by business leaders such as Goldman’s Lloyd Blankfein in a Financial Times op-ed.

The short-term distortions can be addressed by separating the time that options and restricted shares can be cashed out from the time that they vest. As soon as an executive has completed an additional year at her firm, the restricted options or shares that were promised as compensation for that year’s work should vest, and they should belong to the executive even if the executive immediately leaves the firm. But the executive should be allowed to cash them out only down the road. This would tie the executive’s payoffs to long-term shareholder value.

Some experts have called, including at Thursday’s hearing at the Financial Services Committee of the House of Representatives, for permitting executives to cash out shares and options only upon retirement from the firm. Shareholder proposals have also been urging companies to adopt such “hold-till-retirement” requirements. Such requirements, however, would be the wrong way to go.


Empire-Building or Bridge-Building

This post comes to us from Yuhai Xuan at Harvard Business School.

In my paper Empire-Building or Bridge-Building? Evidence from New CEOs’ Internal Capital Allocation Decisions, which was recently accepted for publication in the Review of Financial Studies, I examine CEOs’ decision-making processes for capital allocation in the context of power and relationships within corporations by investigating whether the job histories of CEOs influence their capital allocation decisions when they preside over multi-divisional firms. I investigate the capital allocation decisions made by 265 new CEOs at 230 diversified firms after turnovers between 1993 and 2002. CEO turnovers provide a good opportunity for this study because CEOs are likely to be most vulnerable to political complications at work when they are new to the post. In particular, I focus on the 98 new CEOs in my sample who advanced through the ranks from certain, but not all, divisions in their firms. I call these CEOs specialists and separate the segments in their firms into two groups based on their affiliation with the CEOs: divisions that the CEOs advanced through the ranks from (labeled the in-group), and the rest of the divisions (labeled the out-group). The empirical analysis in the paper focuses on changes in segment capital expenditures around CEO turnovers to determine whether specialist CEOs treat the in-group and the out-group segments differently when allocating capital after succession, and if so, whether they favor the in-group (“empire-building”) or the out-group (“bridge-building”) in their allocation decisions.

My results are broadly consistent with the bridge-building hypothesis. I find that, on average, the out-group segments experience a significant increase in capital expenditures after CEO turnover relative to the in-group segments. The average change in segment investment ratio (capital expenditures over assets) after a specialist CEO takes office is 0.013 higher for the out-group than the in-group, statistically significant at the 5% level or better. This difference of 0.013 is economically meaningful as it represents more than 20% of the average pre-turnover investment ratio of 0.06. Moreover, these findings also hold for specialist CEOs hired from outside the firm and are robust to the inclusion of segment-level, firm-level, and turnover-related controls as well as changes in the test specifications including the definition of specialists, the measure for capital expenditures, the time frame around turnover, and the sample period. I further test for the bridge-building hypothesis by examining whether the in-group and out-group difference in capital allocation change around turnover is related to the specialist CEO’s relative bargaining power within the firm. I find that the difference is more pronounced if the specialist CEO does not hold a corporate-level executive title such as chief operating officer or president before succession or if the in-group segments and the out-group segments are not in related industries. The results from the finer tests are consistent with the prediction of the bridge-building hypothesis that a specialist CEO with less power should engage in more bridge-building efforts, which imply a more pronounced pattern of reverse-favoritism in capital allocation.

While my results are consistent with the bridge-building hypothesis, a key concern is the issue of endogeneity. CEOs are chosen by the board of directors, and the job histories of CEOs are observable by the board and may be an important selection criterion in the board’s choice for nomination. Even though the most obvious and natural endogeneity story is one that would lead to a bias that works in precisely the opposite direction to the empirical findings in this paper, I consider alternative versions of the endogeneity story in which the CEO might be chosen to grow the segments in the out-group or to reduce investments in the in-group, leading to the relative increase in the capital expenditures of the out-group segments observed in the data. I use two approaches to address this concern. First, I try to discriminate against this type of endogeneity story by identifying weak divisions in the firm based on segment cash flow and segment Q. I find that the in-group and the out-group segments experience differential capital allocation change regardless of segment operating performance and segment investment opportunity. The difference in capital expenditure change is significant and of the same magnitude even when one compares the strong segments in the in-group with the weak segments in the out-group, inconsistent with what the endogeneity story might suggest. Second, I estimate a segment’s propensity to be a member of the out-group based on pre-turnover segment characteristics, and use the propensity scores as a summary measure to match the out-group segments and the in-group segments. Again, I find a relative increase in the average change in capital expenditures for the out-group compared with those of the in-group after a specialist CEO takes office. The magnitude and significance level of the estimate are similar to those of the main results, further alleviating the concern that endogeneity might account for the findings.

Finally, I investigate whether having a specialist CEO affects segment investment efficiency by studying the changes in the sensitivity of segment investment to Q before and after the CEO turnover. My results show that the sensitivity of segment investment to Q increases significantly after CEO turnover in a generalist’s firm, indicating an improvement in investment efficiency. Segments under a specialist CEO, however, do not experience such improvements: the investment sensitivity to Q for these segments is virtually unchanged after the turnover. In addition, I examine the market’s reaction to the announcement of the appointment of specialist versus generalist CEOs and find that the cumulative abnormal returns around announcements are significantly higher for incoming CEOs who are generalists. The market’s response corroborates the finding that generalist CEOs are associated with improved segment investment efficiency after turnover and suggests that appointments of generalist CEOs are perceived by the market as positive news for the conglomerates.

Overall, my results suggest that the job histories of CEOs are an important determinant of their capital allocation decisions and that new specialist CEOs are affected by political concerns in the capital allocation process. New specialist CEOs use the capital budget as a bridge-building tool to elicit cooperation from powerful divisional managers in previously unaffiliated divisions.

The full paper is available for download here.

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