Monthly Archives: August 2009

The Need for a Principled Approach to Compensation Reform

This post by John F. Olson first appeared in BNA’s Corporate Accountability Report. This post was written together with Mark A. Borges, Charles M. Elson, Ann Habernigg, Michael J. Halloran and Carol Hansell.


The global economic crisis has aggravated existing concerns about executive compensation practices. Executive and key employee pay practices among large financial sector companies in particular have drawn public scrutiny and condemnation. Lost jobs and lost savings, as well as extensive government support for the financial sector and the automobile industry, means that executive compensation is a concern not just to shareholders, but for everyone affected by the faltering economy. The issues are now seen as so significant and systemic that our elected representatives are taking the matter out of the hands of the private sector. Congressional proposals for sweeping corporate governance and executive compensation reforms and the new Administration’s interest in tackling this subject means that there is a very real prospect for significant changes to executive compensation regulation later this year.

We do not advocate a political solution to executive compensation issues, but if a legislative response is inevitable, it is imperative that it take the right form. As we have seen in the past, a piecemeal response to an assortment of perceived, and often isolated, executive compensation abuses will create as many problems as it solves—and is unlikely to take account of the systemic issues that must be addressed. After all, the intricacies of determining the ‘‘right’’ executive compensation across the diverse range of businesses and industries comprising corporate America defy a single solution, no matter how well intended and thoughtfully crafted.

Any government regulation of executive compensation should encourage compensation practices that will contribute to the sustainable long-term value of America’s business as we emerge from this crisis, rather than simply ‘‘fixing’’ specific compensation practices which are seen as having contributed to the crisis. What is needed is a set of principles to guide the design and operation of any responsible executive compensation program. The guidelines announced by the Obama Administration recently do this, focusing in part on pay for performance and, in particular, long-term performance. However, for guidelines of this nature to have real practical application, they must provide guidance to—and reinforce accountability by—the body that makes the decisions about executive compensation—the board of directors. A measured and principled approach overseen by corporate boards is the only way to ensure that the eroding trust between companies and their shareholders is restored, based on a shared commitment to the sustainable long-term value of the enterprise. Under the Administration’s plan, responsibility for crafting this approach will fall largely to the Securities and Exchange Commission.

Fortunately, there is no need to create a new set of governing principles out of whole cloth. Legislators should look closely at the work that has already been done in this area. A useful example is the guidance developed by the Aspen Institute’s Corporate Values Strategy Group. The thinking of this group was motivated by a concern with excessive short-term pressures in the capital markets that result from intense focus on quarterly earnings and incentive structures that encourage companies and investors to pursue short-term gain with inadequate regard to long-term effects. The Aspen group recommends that companies and investors do three things to promote sustainable long-term value creation. First, define the metrics of long-term value creation. Second, focus corporate-investor communication around long-term metrics. Third, align compensation policies with those long-term metrics. While the group’s guidance describes several features of a compensation structure that supports long-term value creation, it does not purport to prescribe any particular framework.


Competitive Effects of IPOs

This post comes to us from Hung-Chia Hsu of the University of Wisconsin Milwaukee, Adam V. Reed of the University of North Carolina at Chapel Hill, and Jörg Rocholl of the ESMT European School of Management and Technology.


In our paper The New Game in Town: Competitive Effects of IPOs, which was recently accepted for publication in the Journal of Finance, we investigate the returns and operating performance of publicly traded firms around the time of large IPOs in their industry with two goals in mind.

First, we seek to measure the performance of publicly traded firms around IPOs in their industries. If IPO firms can successfully compete against publicly traded firms, then we would expect these competitors to perform worse after the IPO. We indeed show that industry competitors experience negative stock price reactions around IPOs and a significant deterioration in their operating performance after these IPOs. As further evidence that IPOs are responsible for this underperformance, we show that withdrawn IPOs have the opposite effect: publicly traded firms respond positively to the withdrawal of an IPO in their industry.

Second, we seek to explain the underperformance of publicly traded firms by examining the relation of cross sectional differences in performance and survival to firm competitiveness. We identify three determinants of the competitive advantage of IPOs over industry peers. First, as a direct consequence of the IPO, the offering recapitalizes the issuing firm in a way that generally results in a low debt-to-equity ratio. Low leverage may give issuing firms an advantage over their more highly leveraged competitors by allowing them more flexibility in their investments. This effect has been documented empirically in papers outside the IPO literature. Second, issuing firms have the advantage of being recently certified by investment banks. To the extent that the certification effect is stronger for new issues, the certification role of investment banks affects investors’ willingness to purchase new issues as opposed to shares of other firms in the same industry. Third, new entrants may have some nonfinancial advantage over their industry competitors; a non-financial advantage may make issuing firms more attractive to investors.

We find that performance and survival of publicly traded competitors are each related to all three of these determinants. Controlling for a number of factors such as market timing and the hotness of the IPO environment, we document that competing companies show relatively better operating performance after large IPOs in their industry if they have less leverage, if their IPO has been underwritten by a highly ranked investment bank, and if they spend more on research and development. In addition, we find empirical evidence that these factors also affect a competitor’s probability of survival for the three year period after the IPO.

The full paper is available for download here.

HLS and HBS Professors Recommend Modifying SEC’s Proposed Proxy Access Rules

(Editor’s Note: An earlier post regarding a comment letter by seven major corporate law firms in opposition to the SEC’s proposed proxy access reform is available on the Forum here.  An earlier post regarding a comment letter by 80 professors of law, business, economics, or finance in support of the proposed proxy access reform is available here.)

Several contributors to the Harvard Law School Forum on Corporate Governance and Financial Regulation — including four HLS professors, five HBS professors, and one HLS/HBS professor — submitted to the SEC last week a comment letter generally supporting the SEC in proposing proxy access for large shareholders, but recommending several modifications to the proposed rule that would reduce the odds that the rule, as adopted, would have unexpected disruptive effects on firms or markets, or force on shareholders a governance system that a majority would oppose at any given firm. A copy of the comment letter filed with the SEC is available here.

Stock Option Manipulation

This post comes to us from David Cicero of the University of Delaware.


In my forthcoming Journal of Finance paper The Manipulation of Executive Stock Option Exercise Strategies: Information Timing and Backdating, I identify three common option exercise strategies, and analyze executives’ incentives for manipulating the exercise of options to maximize their payoffs under each strategy.

In the first strategy, executives exercise options and immediately sell the shares to a third party (the “Stock Sale Subsample”). This strategy encompasses about two-thirds of executives’ option exercises. As executives clearly reduce their exposure to their company through these transactions, the incentive is to exercise when future returns are expected to be poor. Consistent with this hypothesis, I find that exercises in the Stock Sale Subsample are followed by abnormal returns of approximately -2% over a 120-day trading period.

The second strategy involves exercising options with cash and holding the acquired shares (the “No Disposition Subsample”). Executives engage in this exercise-and-hold strategy about one-fifth of the time. This strategy is thought to be employed for tax reasons. When executives exercise options, they pay ordinary income taxes on the spread between the exercise price and the stock price, but they pay capital gains taxes on any subsequent appreciation when they eventually dispose of the shares. Given these tax rules, if an executive expects his stock to perform well in the future, he has an incentive to exercise the options and hold the shares instead of holding the unexercised options: in doing so, the executive can minimize the amount that is taxed as income at the time of exercise, and cause the subsequent appreciation to be taxed as capital gains when he sells the shares. Consistent with executives manipulating option exercises to maximize their returns under this strategy, I find that exercises in the No Disposition Subsample are preceded by negative abnormal returns over the 20-day trading period prior to exercise of approximately -1.5%, and are followed by positive abnormal returns over the 20-day trading period after exercise of approximately 3%, which continue to increase to approximately 5% over a 120-day trading window.

The third strategy involves either delivering previously held stock to the company or having some shares withheld to cover the exercise costs (the Company Disposition Subsample). These “stock swap” transactions constitute about one-tenth of executive option exercises. I show that executives benefit from executing stock swap exercises when the stock price is high, but, given that they continue to hold many of the shares, they also benefit from higher future stock prices. The return patterns are consistent with executives manipulating these exercises to maximize their returns. Abnormal returns are approximately -0.5% over the two months following exercise, and turn insignificant but positive thereafter.

My three samples generate much stronger evidence of option exercise manipulation than has been previously discovered. In particular, I find strong evidence that executives timed option exercises relative to private information to enhance the returns from each of the three exercise strategies in both the pre- and post-Sarbanes-Oxley (SOX) periods. In additional tests, I also find considerable evidence that before SOX executives sometimes backdated exercises to correspond with more favorable exercise prices when employing the two exercise strategies where the only counterparty is the executive’s own company (the No Disposition and Company Disposition Subsamples). Finally, I find that companies where executives likely backdated option exercises were also more likely to subsequently report weaknesses in internal controls over financial reporting.

The full paper is available for download here.

Beware the Idolatry of Numbers

(Editor’s Note: This post by Ben Heineman recently appeared in The Atlantic.)

In early August, The New York Times ran a front page story that statisticians–rather than “dronish number nerds”–are increasingly in demand, “even cool.” With reams of data generated in the computer age and new realms to explore for purposes as broad as protecting national security or creating financial products, statisticians, says the Times , are only a small part of an army of “data sleuths…from backgrounds like economics, computer science and mathematics.”

An important question raised by the story–and, of course, the broader, deeper trend of using mathematics and systems analysis to “understand” complex human behavior–is whether, before they have deleterious effects, emerging theories and products and ideas can be advanced with a strong measure of humility and put in the context of complex human society, where some key factors exist that cannot be quantified. Will the already potent but ever-emerging “numbers” class have the broad education and training to understand the “benefits” but also the “limits” of all this numbers crunching?

I raise this question of the potential effects of rigid application of mathematical and systems techniques because two of the most serious problems to beset this country–the Vietnam War and the financial meltdown–stemmed, in important ways, from overconfidence, indeed even cult-like behavior. These two problems are at the front of my mind due to two books that received attention in June and July that dealt with how the false idolatry of numbers and systems can lead people, institutions and nations far astray–with catastrophic results.

The first is former Defense Secretary Robert S. McNamara’s, In Retrospect: The Tragedy and Lessons of Vietnam. It was published in 1995, nearly 30 years after he left the Defense Department in 1968, but received much attention when McNamara died, at 93, in early July. As is well known, McNamara was a part of a World War II “systems analysis” team at Defense, led by Tex Thornton, a “whiz kid” who rose to the top of Ford Motor and a civilian technocrat who brought a powerful systems orientation to the Pentagon in the early 60s. While this approach certainly had relevant application to an attempt to rationalize the Pentagon’s corpulent competition between the Army, Navy and Air Force, it became famous in the Vietnam War when numbers like body counts, targets hit, enemy forces captured, weapons seized, tons of bombs dropped, and hamlets protected were used to argue that the war was being prosecuted successfully. The origins of the war were not in systems theories (rather, to take one strand, a belief that monolithic Russian-Chinese Communism would overrun Southeast Asia). But those theories played an important part in convincing McNamara and President Johnson that the war could be won and, therefore, in deepening our involvement, resulting in tragedy both for the U.S. and for Vietnam.


SEC Resolves Empty Voting Action Involving King-Mylan Merger

Editor’s Note: This post is by Steven M. Haas of Hunton & Williams LLP.

On July 21, 2009, the Securities and Exchange Commission (“SEC”) announced a settlement agreement with Perry Corp. (“Perry”) stemming from the hedge fund’s alleged failure to disclose its accumulation of nearly 10% of an issuer’s voting shares with the intent of influencing a merger vote. Those shares were also hedged through swap transactions in order to eliminate Perry’s economic exposure if the share price declined. The SEC argued that Perry should have promptly disclosed its 10% position on a Schedule 13D, which must be filed within ten days after initially obtaining 5% ownership, rather than on a Schedule 13G, which may be filed 45 days after the end of the calendar year. The SEC’s order is available here.

The Perry settlement arose from the failed attempt by Mylan Laboratories, Inc. to acquire King Pharmaceuticals, Inc. in 2004. Perry had a significant ownership stake in King and stood to benefit from the merger, which offered King stockholders a 61% premium. Once the merger was announced, Perry also shorted Mylan shares, betting that Mylan’s stock price would decline as the merger became more likely.

The King-Mylan merger was conditioned on Mylan’s stockholders’ approval. When Carl Icahn emerged as a large Mylan stockholder vocally opposed to the merger, Perry began accumulating up to 10% of Mylan’s outstanding voting stock with the intent to vote it in favor of the merger. The purchases were done after US markets closed in a manner that avoided public volume-reporting. Perry then entered into swap transactions that hedged risk from any potential drop in Mylan’s share price. As a result, Perry could vote the Mylan shares without any potential economic downside facing other Mylan stockholders in order to realize value from the merger as a King stockholder.

While the King-Mylan merger was never consummated, the SEC brought an enforcement action alleging that Perry should have disclosed its ownership on a Schedule 13D once it acquired 5% of Mylan’s stock. Perry argued that the purchases were made in the “ordinary course of business” and therefore could be disclosed after the end of the calendar year on a Schedule 13G. The SEC took the position that:

When institutional investors, such as Perry, acquire ownership of securities for the purpose of influencing … the outcome of a transaction—such as acquiring shares for the primary purpose of voting those shares in a contemplated merger—the acquisition is not made… in the “ordinary course” of business….

Pursuant to the settlement, Perry paid a $150,000 fine without admitting any wrongdoing.


Comment Letter of Eighty Professors of Law, Business, Economics, or Finance in Favor of Facilitating Shareholder Director Nominations

This post is by Lucian Bebchuk of Harvard Law School.

I submitted to the SEC yesterday a comment letter on behalf of a bi-partisan group of eighty professors of law, business, economics, or finance in favor of facilitating shareholder director nominations. The submitting professors are affiliated with forty-seven universities around the United States, and they differ in their view on many corporate governance matters. However, they all support the SEC’s “proxy access” proposals to remove impediments to shareholders’ ability to nominate directors and to place proposals regarding nomination and election procedures on the corporate ballot. The submitting professors urge the SEC to adopt a final rule based on the SEC’s current proposals, and to do so without adopting modifications that could dilute the value of the rule to public investors.

A copy of the comment letter filed with the SEC is available here. Below is the text of the main part of the comment letter followed by the list of the eighty professors.


This comment letter is submitted on behalf of a bi-partisan group of eighty professors of law, business, economics, or finance whose names appear below (the “Submitting Professors”). The Submitting Professors are affiliated with forty-seven universities around the United States. All of the Submitting Professors have research or professional interests relating to how publicly traded firms are run and how their affairs are governed by corporate and securities laws. The Submitting Professors welcome the opportunity to provide comments to the Securities and Exchange Commission (the “SEC”) on its proposed rule Facilitating Shareholder Director Nominations (the “Proposed Rule”).

There is substantial variance among the views of the Submitting Professors on many corporate governance matters. However, all of the Submitting Professors support the SEC’s proposals to remove impediments to the exercise of shareholders’ rights to nominate and elect directors and to enable shareholders to place proposals regarding nomination and election procedures on the corporate ballot. All of the Submitting Professors urge the SEC to adopt a final rule based on the SEC’s current proposals, and to do so without adopting modifications that could dilute the value of the rule to public investors. While all of the Submitting Professors share the views expressed in this paragraph, each individual professor may not endorse each and every statement below.

The ability of shareholders to replace directors is supposed to play a key role in the governance structure of public companies. However, shareholders seeking to replace directors face considerable impediments. One significant impediment to replacing directors is incumbents’ control of the company’s proxy card – the corporate ballot sent by the company at its expense to all shareholders. We believe that providing shareholders with rights to place director candidates on the company’s proxy card, as the SEC proposes doing, would improve director accountability.


Law Firms Comment on SEC’s Proposed Proxy Access Rules

(Editor’s Note: This post is by Theodore Mirvis of Wachtell, Lipton, Rosen & Katz. In addition to participating in the comment letter discussed in this post, Wachtell, Lipton, Rosen & Katz also filed its own comment letter, which is available here.)

Seven major law firms — Cravath, Swaine & Moore LLP, Davis Polk & Wardwell LLP, Latham & Watkins, LLP, Simpson Thacher & Bartlett LLP, Skadden, Arps, Slate, Meagher & Flom LLP, Sullivan & Cromwell LLP and Wachtell, Lipton, Rosen & Katz — collaborated on a 40-page comment letter that was submitted to the SEC today on its proposed proxy access rules. The joint 7 Firm letter recommends:

  • The SEC should amend Rule 14a-8(i)(8) to permit stockholders to utilize Rule 14a-8 for proxy access proposals.
  • The SEC should not adopt Rule 14a-11 until there has been sufficient experience with private ordering of proxy access under amended Rule 14a-8 to permit the SEC to make a more informed decision as to whether a prescriptive rule governing proxy access is necessary and desirable.
  • If the SEC disagrees with the firms’ view, the SEC should not adopt a prescriptive proxy access rule any earlier than the 2011 proxy season.
  • Finally, any prescriptive proxy access regime should permit private ordering under state law so as to permit stockholders to modify the SEC’s proxy access regime as they see fit, including by opting out entirely.

The letter includes detailed discussion and recommendations regarding the workability issues raised by the SEC’s proposed proxy access rules.

The complete comment letter can be downloaded here.

Corporate Political Contributions and Stock Returns

This post comes to us from Michael J. Cooper of The University of Utah, Huseyin Gulen of Purdue University, and Alexei V. Ovtchinnikov of Vanderbilt University.


In our paper Corporate Political Contributions and Stock Returns, which was recently accepted for publication in the Journal of Finance, we study whether there is a robust relation between firm contributions and contributing firm returns. Using data from the U.S. Federal Election Commission (FEC), we create a new and comprehensive database of publicly traded firms’ political action committee (PAC) contributions to political campaigns in the U.S. from 1979 to 2004. After merging the FEC contributions data with CRSP/Compustat data, we have approximately 819,000 contributions made by 1,930 firms over the past twenty five years or so – thus, we have a remarkably rich dataset to test for systematic contribution/return effects arising from publicly traded firms’ involvement in the U.S. political process. Our sample captures over 70% of the total dollar volume of all hard-money corporate contributions and represents on average 60% of the market value-weighted capitalization of all publicly traded firms in the U.S.

We develop a simple measure to describe firms’ political contribution practices that takes advantage of the comprehensive nature of the FEC data. We view each firm as supporting a portfolio of candidates and simply sum up, over a rolling multiyear window, the number of candidates that each firm supports. We find that the average firm participating in the political donation process contributes to 73 candidates over any five-year period, 53 of whom go on to win their elections. There is substantial variability across firms in the number of supported candidates, with a standard deviation of approximately 96 candidates.

We perform panel regressions of annual abnormal returns on the lagged number of supported candidates and other control variables. We find that the number of supported candidates has a statistically significant positive relation with future abnormal returns for firms which contribute to political candidates. The relation is evident in univariate regressions of abnormal returns on the number of supported candidates as well as in multivariate regressions after controlling for other established predictors of returns such as book-to-market, firm capitalization, and momentum, measured by lagged 12-month buy-and-hold returns. We find that our results are robust to three alternative contribution definitions: the total strength of the relationships between candidates and the contributing firm (as measured by the length of the firm-candidate relationship), the ability of the candidates to help the firm (as measured by the home state of the firm and the candidate), and the power of the candidates (as measured by a candidate’s committee ranking). We document especially strong effects for a measure related to the ability of the candidate to help the donating firm. Thus, the contribution effect appears to increase for firms that have longer relationships with candidates, support more home candidates, and support more powerful candidates.

We further break the contributions data up into House and Senate categories. We find that there is an incremental House effect after controlling for the Senate effect, although contributions to both branches of government result in positive economic effects for the contributing firms. Our finding of an incremental effect for firms supporting House candidates may be related to the constitutional provision that revenue and appropriations bills must originate in the House. Thus, firms may find that it is more expedient to support House members, where potential firm value increasing actions may be more suitably created. We also split our sample along political party lines. The FEC data show that Republican candidates typically receive higher total dollar contributions than do Democrats and that Republican candidates’ contributions come from a larger number of supporting firms than do Democrat candidates’ contributions. However, despite the fact that Republicans receive more contributions than Democrats, we find an incremental contribution effect for Democrats after controlling for Republican effect, but do not find an incremental Republican effect after controlling for the Democrat effect.

The full paper is available for download here.

Impact of the Credit Crunch on Acquisition Agreements

(Editor’s Note: This post by John G. Finley is based on a Simpson Thacher & Bartlett memorandum, which first appeared as an article in the New York Law Journal.)

This post was written together with Simpson Thacher & Bartlett associate Salvatore Gagliardi.

While the pace of M&A activity has been subdued, the significance of contractual developments in dealmaking has been pronounced. Over the past year, the difficulty of the credit markets has resulted in significant developments in how practitioners draft cash acquisition agreements for strategic buyers (e.g., corporate buyers seeking to further their strategic objectives). These developments have resulted in such buyers having greater flexibility in deciding not to close, particularly if the reason is financing related. These changes have been especially pronounced in multi-billion dollar transactions where the buyer is dependent on third party financing to effect the proposed transaction. This trend began with strategic buyers utilizing the termination provisions used in private equity deals under which a seller’s only remedy if a buyer were to fail to close were a fixed fee from the buyer (i.e., a reverse break fee). In such cases, this reverse break fee structure was analogized to an option or referred to as providing the buyer with “optionality.” The practice has, however, now developed beyond the use of the reverse break fee model as utilized in private equity deals. Although there are variations in the benefits of these provisions to prospective buyers, a common element is that they mitigate the risk to a buyer from failing to close due to a financing failure.

Private Equity Precedent

The optionality used in recent strategic deals was based on a structure used in private equity deals that developed after 2005. Prior to 2005, private equity transactions were structured with the private equity firm forming a shell company that entered into the acquisition agreement and undertook the obligations contained therein. There was no risk to the private equity firm, as distinguished from the shell company, other than reputational risk and the theoretical possibility of piercing the corporate veil (i.e., disregarding the corporate entity and treating obligations of the shell company as obligations of shareholder/owner). Further, the acquisition agreement was typically conditioned on the availability of financing (although the shell company often agreed to be subject to the remedy of specific performance pursuant to which it could be required to use its reasonable best efforts to obtain financing). Given that the shell company was without resources, sellers were put in the position of relying on the reputational risk to the private equity firm if its wholly owned shell company breached its obligations as well as the possibility of veil piercing. This latter risk was viewed as remote but the consequences were grave if realized.

Beginning in 2005, the private equity structure utilizing financing conditions as described above was superseded by a reverse break fee structure. This structure arose out of a desire by sellers to eliminate the financing condition and reduce the reliance on the reputational risk to the buyer arising from a breach. Under this structure, a break fee of roughly 3 percent was payable by the shell company for a failure to close, which fee was guaranteed by the private equity firm. This created significant optionality for the private equity firm as it guaranteed the payment of a fixed fee, but the firm was no longer subject to the in terrorem risk of veil piercing or any other liability. Moreover, although there were exceptions, the norm that developed was that even the shell company was not subject to specific performance. This meant that there was no risk that the shell company would sue the private equity firm under the equity commitments or lenders under the debt commitments. Some deals sought to increase the cost to the buyer of failing to close by providing that the private equity firm could be subject to, in addition to the reverse break fee, the payment of damages in excess of a break fee for a willful breach. Those deals were, however, a small minority.


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