Yearly Archives: 2009

Strengthening and Streamlining Prudential Bank Supervision

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, August 13, 2009
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Editor’s Note: The post below by Sheila Bair is a transcript of her testimony last week to the Senate Committee on Banking, Housing, and Urban Affairs in its hearing on “Strengthening and Streamlining Prudential Bank Supervision.” Ms. Bair’s complete written testimony can be found here.)

Chairman Dodd, Ranking Member Shelby and members of the Committee, I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on the importance of reforming our financial regulatory system. Specifically, you have asked us to address the regulatory consolidation aspects of the Administration’s proposal and whether there should be further consolidation.

The proposals put forth by the Administration regarding the structure of the financial system and the supervision of financial entities provide a useful framework for discussion of areas in vital need of reform. The goal of any reforms should be to address the fundamental causes of the current crisis and to put in place a regulatory structure that guards against future crises.

There have been numerous proposals over the years to consolidate the federal banking regulators. This is understandable given the way in which the present system developed, responding to new challenges as they were encountered. While appealing in theory, these proposals have rarely gained traction because prudential supervision of FDIC insured banks has held up well in comparison to other financial sectors in the United States and against non-U.S. systems of prudential supervision. Indeed, this is evidenced by the fact that large swaths of the so-called shadow banking sector have collapsed back into the healthier insured sector, and U.S. banks — notwithstanding their current problems — entered this crisis with less leverage and stronger capital positions than their international competitors.

Today, we are again faced with proposals to restructure the bank regulatory system, including the suggestion of some to eliminate separate federal regulators for national- and state-chartered institutions. We have previously testified in support of a systemic risk council which would help assure coordination and harmonization in prudential standards among all types of financial institutions, including commercial banks, investment banks, hedge funds, finance companies, and other potentially systemic financial entities to address arbitrage among these various sectors. We also have expressed support for a new consumer agency to assure strong rules and enforcement of consumer protection across the board. However, we do not see merit or wisdom in consolidating federal supervision of national and state banking charters into a single regulator for the simple reason that the ability to choose between federal and state regulatory regimes played no significant role in the current crisis.

One of the important causes of the current financial difficulties was the exploitation of the regulatory gaps that existed between banks and the non-bank shadow financial system, and the virtual non-existence of regulation of over-the-counter (OTC) derivative contracts. These gaps permitted lightly regulated or, in some cases, unregulated financial firms to engage in highly risky practices and offer toxic derivatives and other products that eventually infected the financial system. In the absence of regulation, such firms were able to take on risks and become so highly levered that the slightest change in the economy’s health had deleterious effects on them, the broader financial system, and the economy.

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Shareholder Expropriation in the U.S.

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, August 12, 2009
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This post comes to us from Vladimir Atanasov of the College of William and Mary, Audra Boone of the University of Kansas, and David Haushalter of Pennsylvania State University.

Contrary to the general view that publicly-traded firms in the United States are diffusely owned, blockholders in these firms are both frequent and substantial. However, despite the prevalence of blockholders, their effect on firm value is unresolved. In our forthcoming Journal of Financial and Quantitative Analysis paper Is there shareholder expropriation in the United States? An analysis of publicly-traded subsidiaries, we seek to fill this void by examining majority and non-majority blockholdings separately, and by examining corporate blockholders exclusively.

Our analysis employs a sample of 264 U.S. subsidiaries that were each separated from their parent corporation via an initial public offering, known as an equity carve-out. We follow the financial performance of these subsidiaries for the four years following the initial carve-out; divide these subsidiaries into three groups based on the fraction of shares owned by the parent firm; and identify annual changes in ownership levels. Our three ownership groups break down as follows: 1) majority-owned subsidiaries in which the parent owns a 50 to 99% stake; 2) minority-owned subsidiaries in which the parent owns a 5 to 49% stake; and 3) completely divested subsidiaries in which the parent owns less than a 5% stake. In order to determine whether subsidiary performance is associated with parent ownership, we focus our empirical tests on the subsidiary’s financial performance and document several key results.

First, we find that subsidiary operating performance varies depending on the parent’s ownership stake. Indeed, while majority-owned and completely-divested subsidiaries experience normal performance, minority-owned subsidiaries perform poorly. Beginning in the second year following the carve-out, minority-owned subsidiaries exhibit negative abnormal operating returns which deteriorate further in subsequent years. Minority-owned subsidiaries which share top executives with their parents perform especially badly. Subsidiaries that switch from the majority- to the minority-owned group also demonstrate a significant decline in operating performance.

Second, we show that the relation between subsidiary value and parent ownership stake is nonlinear. Minority-owned subsidiaries are valued at a median discount of 23% relative to their peers; in contrast, fully divested subsidiaries have similar valuations to peers, while valuations of majority-owned subsidiaries actually increase with parent ownership stake. In fact, high levels of parent ownership translate into a valuation premium. We also find evidence that among all announcements of ownership change events, a subsidiary’s returns are lowest around a change in parent ownership from a majority to a minority stake.

Overall, our study suggests that blockholder opportunism, while not necessarily common in the United States, still poses a potential risk for small shareholders.

The full paper is available for download here.

Chrysler Opinion Reaffirms Flexible Standards Governing Section 363 Sales

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, August 11, 2009
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Editor’s Note: This post relates to the decision of the Court of Appeal for the Second Circuit in In re Chrysler LLC, Case No. 09-2311 (2d Cir. Aug. 5, 2009).)

This post was written together with my colleagues Richard G. Mason and Austin T. Witt.

The Second Circuit Court of Appeals has issued an extensive opinion setting forth the reasoning behind its previous approval of the sale of substantially all of Chrysler LLC’s assets to a newly-formed, Treasury-backed and Fiat-managed entity under section 363 of the Bankruptcy Code. In re Chrysler LLC (ibid.). The opinion in this closely watched case reaffirms that judicial assessment of section 363 sale transactions should be governed by a multi-faceted analysis with flexibility to meet the needs of individual situations.

Section 363(b) of the Bankruptcy Code permits a debtor, after notice and hearing, to sell its property outside the ordinary course of business. Courts have long held that a section 363 sale of all or substantially all of the debtor’s property is impermissible if it circumvents, to the detriment of creditors, the more comprehensive requirements of Chapter 11 for confirmation of a plan of reorganization. However, courts also have recognized that in certain cases (especially those involving wasting or deteriorating assets) the relatively quick procedures for a section 363 sale may be superior to a plan of reorganization. Indeed, the Chrysler court expressly recognized that this need is heightened in today’s constrained credit environment, where liquidation may be the sole alternative to a proposed section 363 transaction due to the debtor’s lack of financial wherewithal to survive the substantially longer process of confirming a Chapter 11 plan.

Reaffirming the standard it enunciated two decades ago in In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983), the Court of Appeals noted that as section 363 sales proliferate in the current downturn, the balance between a debtor’s need for flexibility and speed and the protections for creditors of a Chapter 11 plan of reorganization “is not easy to achieve, and is not aided by rigid rules and prescriptions.” In re Chrysler at *21. The Second Circuit explained that the size of the transaction and the residuum of corporate assets are factors that a bankruptcy court must consider, but are “just one consideration . . . along with an open-ended list” of other issues, such as whether the sale was on terms advantageous to the estate and whether a plan of reorganization might be proposed and confirmed in the near future. Id. at *21. If after reviewing all relevant factors, a bankruptcy court concludes that there is a “good business reason for the sale,” the bankruptcy court may approve the transaction. Id. at *24. Moreover, the Chrysler court specifically held that section 363(f) of the Bankruptcy Code allows a debtor to sell assets free and clear of “successor liability” for pre-petition tort claims.

The Second Circuit’s decision serves as a reminder that flexibility is a hallmark of transactions under the Bankruptcy Code and that, for substantial bankruptcy sales, there is no “onesize-fits-all” rule to determine whether the sale may go forward under section 363 or must await a reorganization plan.

ABA Taskforce asks that Corporate Governance Reform Reject Rigidity in Viewpoints

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, August 11, 2009
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Editor’s Note: This post is by Holly Gregory of Weil, Gotshal & Manges LLP.

A Task Force of the Corporate Governance Committee of the ABA Section of Business Law has released a report on how governance roles and responsibilities are apportioned between shareholders and boards of directors — an issue of relevance to the current discussion of corporate governance reforms in Congress and among regulators.

The 25 member Task Force, chaired by Holly J. Gregory of Weil, Gotshal & Manges LLP, was comprised of seasoned lawyers representing a broad array of shareholder, corporate and academic perspectives. A copy of the Task Force’s report, which was released on August 1, is available here. The Task Force concluded that “[r]eturning to solid economic growth over the long term will depend in part on the ability of policy makers to respond to concerns over corporate governance as a factor in the present crisis while avoiding reforms that are insensitive to positive aspects of the present legal ordering of decision rights and responsibilities within the corporation.”

The Task Force Report emphasizes the common long-term interest that all parties share in corporate success and effective governance, and asks that participants in reform discussions “reject the rigidity in viewpoints that all too often gets in the way of thoughtful discourse on governance issues.”

The Report includes a number of key observations, including that:

• “Shareholders and boards of U.S. public companies have become increasingly active and engaged in their roles.”

• “Even for reforms that fall short of working a direct shift in decision-making authority, policy makers should be sensitive to how reforms will work in practice.”

• “Shareholder rights to elect the board and make other fundamental decisions should be meaningful. . . . [and] shareholders’ interests in the enhancement of corporate value deserve protection. . . .”

• “[B]oard flexibility and discretion to hire, motivate, guide and oversee the managers to whom they delegate [also] deserves protection.”

• “Divergent shareholder interests complicate the board’s task.”

The Task Force Report includes a set of recommendations for shareholders, boards and policy makers:

Shareholders should:

• “Act on an informed basis with respect to their governance-related rights in the corporation. . . . “

• “Apply company-specific judgment when considering the use of voting rights and contested elections to change board composition. . . . ”

• “Consider the long-term strategy of the corporation as communicated by the board in determining whether to initiate or support shareholder proposals. . . .”

Boards should:

• “Embrace their role as the body elected by the shareholders to manage and direct the corporation by: (a) affirmatively engaging with shareholders to seek their views; (b) considering shareholder concerns. . . . (c) facilitating transparency. . . . ”

• “Acknowledge that, at times, the company’s long-term goals and objectives may not conform to the desires of some shareholders. . . .”

• “Disclose with greater clarity how incentive packages are designed to encourage long-term outlook. . . .”

Policy makers and regulators should:

• “In the context of reform initiatives, understand the rationale for the current ordering of roles and responsibilities in the corporation and assess the impact of proposed reforms on such ordering. . . .”

• “Carefully consider how best to encourage the responsible exercise of power by key participants in the governance of corporations so as to promote long-term value creation. . . .”

• “Ensure that there is equal transparency of long and short, and direct and synthetic, equity positions of shareholder. . . .”

The Task Force concludes: “We all have a keen interest in finding ways to restore investor confidence while positioning the corporation to undertake the actions that will create sustainable long-term value-creation. While the pressures for regulatory solutions are considerable and understandable given the circumstances, caution is prudent with respect to the corporate institution around which so much of our economy is organized.”

U.S. Corporate Governance Today: Follow-up Discussion

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, August 10, 2009
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Editor’s Note: This post is by Peter Atkins of Skadden, Arps, Slate, Meagher & Flom LLP.

On July 29, the Harvard Law School Forum on Corporate Governance and Financial Regulation posted my memorandum entitled “U.S. Corporate Governance Today: A Reshaping of Capitalism.” The message of that memorandum was, in brief, as follows:

“Corporate governance” has become an expansive concept today, involving many parties collectively pursuing multiple agendas. The combined purposes and effects of this movement are reshaping the U.S. private enterprise economic system.
However, the nature and consequences of this reshaping are not being adequately explored — leading to the prospect that more harm than good may result from corporate governance reform as defined and pursued today. The memorandum (1) provides an understanding of what changes are afoot; (2) identifies some of the important challenges and risks they present to key underpinnings of U.S. capitalism; (3) highlights that over time, and notwithstanding significant stumbles, our free enterprise system has been the most vibrant and competitive economic system in the world; (4) offers a reminder that the very essence of capitalism is that it fosters risk-taking — and that “mistakes” will be made; and (5) in the context of pursuing corporate governance reform, urges applying the long-term view of our private enterprise system’s performance and the principle of restraint which that view dictates.

One of the key areas of governance initiatives today that raises these issues is executive compensation. As noted in my prior memorandum, executive compensation matters currently on the corporate governance agenda include:

(1) requiring annual advisory “say on pay” shareholder votes; (2) requiring independent compensation consultants in certain circumstances; (3) requiring companies to develop and disclose “claw-back” policies; (4) barring severance agreements for executives terminated for poor performance; (5) requiring proxy disclosure of specific performance targets for incentive compensation; (6) requiring shareholder approval of pay above a prescribed multiple (e.g., 100x, as provided in one Senate bill) of what the average company employee is paid; (7) requiring expanded compensation-related proxy disclosure, including regarding compensation paid to lowest and highest paid employees, average to all employees, number of employees paid more than prescribed multiple (e.g., 100x) of average employee compensation and total compensation paid to employees paid more than prescribed multiple; (8) making “excessive compensation” non-deductible for federal income tax purposes (e.g., pay above 100x average compensation to company employees, as provided in one Senate bill); (9) requiring “excessive compensation” reports to be filed with the Treasury Department; (10) providing additional requirements with respect to compensation committees regarding (a) enhanced independence standards, (b) direct responsibility for hiring, paying and overseeing compensation consultants, (c) authority to hire and pay outside counsel and advisors, and (d) independence standards to be applied to compensation consultants and outside counsel; (11) requiring discussion and analysis of risk related overall compensation policies and practices for employees generally, if the risks arising from those policies and practices “may have” a material effect on the company; (12) limiting payouts to families of executives who die in office; and (13) requiring that executive equity awards be held until retirement.

The purpose of this follow-up memorandum is to examine more closely the justification, efficacy, risks and motivations associated with this broad-based effort to increase significantly the regulation of executive and other compensation arrangements of U.S. publicly traded business corporations. This effort would be effected through a combination of substantive requirements, expanded disclosure and non-binding shareholder advisory votes imposed at the federal level through legislation and regulation, and also on a company-specific basis through proposals sponsored by shareholders.

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Risk Taking by Entrepreneurs

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, August 10, 2009
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This post comes to us from Galina Vereshchagina of Arizona State University, and Hugo A. Hopenhayn of UCLA.

Entrepreneurial activity is risky and poorly diversified. Most economic models would suggest that the high degree of entrepreneurial risk should be compensated by premium returns, but this is not borne out by the empirical evidence. Several hypotheses based on the idea that entrepreneurs have a different set of preferences or beliefs (e.g. risk tolerance or over-optimism) have been offered to explain this anomaly. In our forthcoming American Economic Review paper, Risk Taking by Entrepreneurs, we provide an alternative theory of endogenous entrepreneurial risk taking that does not rely on individual heterogeneity of preferences or beliefs.

The key ingredients in our theory are borrowing constraints, the existence of an outside opportunity and endogenous risk choice. A self-financed entrepreneur chooses every period how much to invest in a project, which is chosen from a set of alternatives. All available projects offer the same expected return but a different variance. After returns are realized, the entrepreneur decides whether to exit and take the outside opportunity (e.g. become a worker) or to stay in business. The possibility of exit creates a non-concavity in the entrepreneurs’ continuation value: for values of wealth below a certain threshold, the outside opportunity gives higher utility; for higher wealth levels, entrepreneurial activity is preferred.

Risky projects provide lotteries over future wealth that eliminate this non-concavity and are particularly valuable to entrepreneurs with wealth levels close to this threshold. As the level of wealth increases, entrepreneurs invest in less risky projects. In order to stress the role of risk taking, our model allows entrepreneurs to choose completely safe projects with the same expected return. All exits occur precisely because low wealth entrepreneurs purposively choose risk. If risky projects were not available, no entrepreneurs would ever exit from business. It is the relatively poor entrepreneurs that decide to take more risk. At the same time, due to self-financing, they invest less in their projects than richer entrepreneurs. Correspondingly, the model implies that survival rates of the business are positively correlated with business size. Moreover, if agents enter entrepreneurship with relatively low wealth levels (as occurs in the case with endogenous entry that we study), our model also implies that young businesses exhibit lower survival rates. It also appears that, conditional on survival, small (younger) firms grow faster than larger (older) ones.

One of the main contributions of our work is that we actually provide a very intuitive interpretation for lotteries—entrepreneurial project risk choice. This enables us to relate the implications of our model not only to the firm dynamics stylized facts, but also to the broad empirical evidence on entrepreneurial risk taking and the private equity premium puzzle. In addition, by incorporating the project risk choice in an occupational choice model with exogenous borrowing constraints, we are also able to illustrate how lotteries might lead to expected gains in lifetime consumption and can be used to relax the borrowing constraints.

The full paper is available for download here.

SEC Announces Short Sale Rule Changes and Initiatives

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Sunday, August 9, 2009
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This post by Annette L. Nazareth is based on a Davis Polk & Wardwell client memorandum.

On July 27, 2009, the Securities and Exchange Commission (“SEC”) adopted final Rule 204 of Regulation SHO (“Rule 204” or the “final rule”) under the Securities Exchange Act of 1934, making permanent, with minor changes, the firm delivery and close-out requirements for sales of equity securities contained in temporary Rule 204T of Regulation SHO (“temporary Rule 204T” or the “temporary rule”). Among the minor changes, the final rule provides broker-dealers with some limited increased flexibility by allowing them to close out fails by either borrowing or purchasing securities in certain situations where the temporary rule required purchases, and expanding the class of securities eligible for a 35-day close-out period to include certain securities the seller is deemed to own.

The rule is part of the SEC’s efforts to curtail potential “naked” short selling abuses and reduce fails to deliver. Rule 204 will become effective on July 31, 2009, upon the expiration of temporary Rule 204T.

In its press release regarding Rule 204, the SEC also indicated that it will not renew temporary Rule 10a-3T (Form SH), which is set to expire on August 1, 2009. Under this temporary rule, which has been in effect since September 2008, institutional investment managers have been required to report their short positions. In lieu of renewing temporary Rule 10a-3T, the SEC announced a joint effort with self-regulatory organizations (“SROs”) aimed at increasing public availability of short sale data by providing short sale volume and transaction data on SRO websites. Details regarding the program have not yet been announced, although it appears that the intent is not to publicly identify individual short sellers or position holders.

The SEC is also planning to hold a roundtable to discuss other potential reforms affecting securities lending and short sale markets. The SEC release did not address pending proposals to reinstate a short sale price test.

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The Board’s Role in Risk Management

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, August 8, 2009
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This post comes to us from Jeff Stein and Bill Baxley of King & Spalding.

Risk management is currently a topic of considerable interest to public company boards. While taking measured and informed risks is an important element of any company’s strategy, the financial and economic crisis has led companies and boards to change their approaches to risk management. Moreover, given the events in the capital markets over the past year, institutional investors, regulators and the public are scrutinizing public company boards’ oversight of risk more closely.

Against this background, the Lead Director Network, a group of lead directors, presiding directors and non-executive chairmen from many of America’s leading companies created by King & Spalding and Tapestry Networks, met on July 8, 2009 to discuss the board’s role in risk management. Following this meeting, King & Spalding and Tapestry Networks have published the ViewPoints report here, to present highlights of the discussion that occurred at the meeting and to stimulate further consideration of this subject. The following provides highlights from the meeting, as described in the ViewPoints report.

Greater emphasis on strategic risk assessment. Members of the Lead Director Network generally see room for improvement in the way companies approach risk management. Directors noted that, while the Sarbanes-Oxley Act resulted in boards focusing on compliance and internal controls, the financial crisis is now requiring them to focus on identifying and mitigating broader strategic risks. Directors are thinking about risk in broader terms, moving beyond financial and accounting risks to considering factors that could threaten a company’s operations or business model. At the extreme, directors are seeking to identify and address “black-swan” risks, the seemingly improbable events that could threaten a company’s survival.

The lead director’s role. Lead directors and other board leaders can play a valuable role in the board’s oversight of risk management. While companies have been forming committees or subcommittees to focus on specific or unique risks, directors noted that, given the many types of risk that companies must address, it is essential for the risk oversight function to include active participation from all directors. Directors pointed to situations in which the contemplation of certain risks has essentially been “stuck in committee” — that is, certain risks were being addressed by board committees but not the full board. Lead directors can add value to the risk management process by ensuring that risk management is actively considered by the full board and that committees are used effectively, by acting as a conduit between the board and management and by facilitating open communication and robust debate.

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Directors’ and Officers’ Insurance

Posted by Igor Kirman, Wachtell, Lipton, Rosen & Katz, on
Friday, August 7, 2009
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This post is by Igor Kirman of Wachtell, Lipton, Rosen & Katz. This post was written together with his colleagues Warren R. Stern and Martin J.E. Arms.

At a time of historically significant dislocation in the corporate world, directors and officers now more than ever need to focus their attention on directors’ and officers’ (“D&O”) insurance, as part of their overall strategy involving effective corporate governance and risk management. Although the best protection should continue to come from conscientious attention to directorial and management responsibilities, an effective D&O insurance program, in combination with well-drafted indemnification and exculpation provisions in corporate charters and by-laws, is a critical component of protection for directors and officers at a time of increased scrutiny by shareholders, courts and regulators. Recent judicial developments further highlight the need for careful attention to policy terms, which can be outcome-determinative in significant litigation. Below are some thoughts on D&O insurance in these troubled times.

1. Side A excess coverage:

The main types of coverage provided by many D&O insurance policies are known as A, B and C coverage. The “A” coverage directly indemnifies a director or officer with respect to claims for which the company is not able to indemnify that director or officer, either by reason of law or financial insolvency. (Some companies purchase only A coverage.) The “B” coverage reimburses the company for amounts that it pays to a director or officer through indemnification. The “C” coverage is for claims directly against the company, but, for public companies, that coverage is almost always limited to securities claims. These types of coverage work together to provide broad protection for individuals and the company. But be wary: coverage can be exhausted by claims made on the B and C coverage, i.e., coverage that, in the end, insures the company and not the directors and officers themselves. This may leave directors and officers exposed when they need coverage most — when there is a claim for which the company cannot indemnify them. To avoid this problem, to the extent they do not do so already, companies that purchase A, B, C coverage should consider purchasing additional A-only coverage in excess of the A, B, C coverage. This A-only excess coverage will protect directors and officers if nonindemnifiable claims or obligations arise after the underlying A, B, C coverage has been exhausted. There is also a more comprehensive (and thus more expensive) version of A-only excess coverage known as A-only Difference-in-Conditions (“DIC”) excess coverage. Under DIC coverage, the excess policy will “drop down” to provide coverage when another insurer fails to pay a claim (including as a result of insurer insolvency) or when a company fails to indemnify. DIC policies generally provide broader coverage terms than traditional A-only excess coverage. A DIC policy should also provide coverage if a bankrupt estate successfully argues that the underlying A, B, C policy is the property of the estate. In order to provide the greatest protection against insurer insolvency, companies that purchase DIC excess coverage should consider purchasing it from an insurer that is not on the underlying A, B, C insurance program.

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Bank CEO incentives and the credit crisis

Posted by René Stulz, Ohio State University Fisher College of Business, on
Thursday, August 6, 2009
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This post is by René Stulz of Ohio State University.

In the search of explanations for the dramatic collapse of the stock market capitalization of much of the banking industry in the U.S. during the credit crisis, one prominent argument is that executives at banks had poor incentives. Rudiger Fahlenbrach and I have completed a working paper titled “Bank CEO incentives and the credit crisis” that investigates how closely the interests of the CEOs of banks were aligned with those of their shareholders before the start of the crisis, whether the alignment of interests between CEOs and shareholders can explain the performance of banks in the cross-section during the credit crisis, and how CEOs fared during the crisis. Traditionally, corporate governance experts and economists since Adam Smith have considered that management’s interests are better aligned with those of shareholders when managers’ compensation increases when shareholders gain and falls when shareholders lose. On average, bank CEOs had powerful incentives to maximize shareholder wealth as of 2006. We show that in our sample the median value of a CEOs equity stake (taking into account options) was $36 million. Typically, a CEO’s equity stake was worth more than ten times his compensation in 2006.

Our results show that there is no evidence that banks with a better alignment of CEOs’ interests with those of their shareholders had higher stock returns during the crisis and some evidence that banks led by CEOs whose interests were better aligned with those of their shareholders had worse stock returns and a worse return on equity. In particular, whether our sample includes investment banks or not, stock return and accounting equity return performance are negatively related to bank CEOs dollar incentives, measured as the dollar change in a CEOs wealth for a 1% change in the stock price. This effect is substantial and is not explained by a few banks where CEOs had extremely high ownership. An increase of one standard deviation in dollar ownership is associated with lower returns of 10.2%. Similarly, a bank’s return on equity in 2008 is negatively related to its CEO’s holdings of shares in 2006 – a one standard deviation increase in dollar ownership is associated with approximately a 10.1% lower return on equity. Though options have been blamed for leading to excessive risk-taking, there is no evidence in our sample that greater sensitivity of CEO pay to stock volatility led to worse stock returns during the credit crisis.

A plausible explanation for these findings is that CEOs focused on the interests of their shareholders in the build-up to the crisis and took actions that they believed the market would welcome. Ex post, these actions were costly to their banks and to themselves when they produced poor results. These poor results were not expected by the CEOs to the extent that they did not reduce or hedge their holdings of shares in anticipation of poor outcomes. Using data on insider trading to estimates sales of shares, we find that CEOs made extremely large losses on their holdings of shares in their bank because they typically did not sell shares. Further, CEOs made large losses on their options.

Our research shows that bank CEOs had very high incentives to maximize shareholder wealth. This evidence makes it implausible that the credit crisis can be blamed on a misalignment of incentives between CEOs and shareholders.

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