Yearly Archives: 2009

Auditing the Auditors

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, May 20, 2009
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This post comes to us from Clive Lennox of Nanyang Technological University Singapore and Jeffrey Pittman of the Memorial University of Newfoundland.

The recent major reforms to the external monitoring of U.S. audit firms which resulted in the independent inspection of audit firms by the Public Company Accounting Oversight Board (PCAOB) motivates our paper, Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms, which was recently accepted for publication in the Journal of Accounting and Economics.

We begin our analysis by dissecting the transition from self-regulation to impartial inspection under the PCAOB. We find that the PCAOB relied on peer review reports to target lower-quality audit firms in their initial round of inspections. In addition, our data reveal that many firms elected to leave the peer review program after the PCAOB began conducting inspections despite the fact that audit firms with public company clients can submit to both PCAOB inspections and peer reviews. Indeed, we find that the worst audit firms, which we measure with the presence of an adverse or modified opinion and the number of weaknesses in their prior peer review report, were more likely to abandon the program. Further, our tests suggest that the probability of a reviewer switch is significantly higher in the event of a modified or adverse opinion. Apart from corroborating prior research that peer review reports are informative, this evidence implies that audit firms were avoiding reviewers who previously gave unfavorable opinions against them. In contrast, the PCAOB prevents such opportunism since audit firms cannot influence the selection of their inspectors, the inspectors do not have current ties to audit firms, and the PCAOB is an independently funded organization.

Although the PCAOB is insulated from the accounting profession, several commentators cast doubt on whether the PCAOB and its inspectors have adequate technical expertise to properly regulate audit firms. In univariate tests, we document that the audit engagement weaknesses disclosed in PCAOB reports fail to predict subsequent changes in audit firms’ market shares, suggesting that the reports do not affect clients’ audit firm choices. In the multivariate analysis, we estimate a model that predicts the expected number of reported weaknesses and find that PCAOB reports identify more weaknesses if audit firms: (1) have more clients, and (2) previously received unfavorable peer review opinions. Next, we construct an unexpected opinion variable, which equals the number of weaknesses disclosed in the PCAOB report minus the number of weaknesses predicted by the model. Reinforcing our univariate evidence, we continue to find that audit firms’ market shares are insensitive to their PCAOB reports.

After the PCAOB began its inspections of public company audits, the scope of peer reviews was largely confined to the audits of private companies to avoid duplication in regulatory monitoring. Our evidence indicates that audit firm choice by public companies hinges less on the peer review reports issued in recent years, implying that the perceived information content of peer reviews falls under the restricted reporting format. Moreover, audit firms began leaving the peer review program after the introduction of PCAOB inspections, especially if their previous peer review opinions had been unfavorable. Accordingly, we conclude that peer reviews have become less relevant to public companies for gauging differential audit firm quality. We also demonstrate that the PCAOB’s failure to disclose certain information—specifically, the quality control weaknesses and overall ratings of audit firms—explains why clients do not find the inspection reports to be informative. Collectively, our findings suggest that the reporting model adopted by the PCAOB is not viewed by audit clients as being informative about audit firm quality.

The full paper is available for download here.

Did Corporate Governance “Fail” During the 2008 Stock Market Meltdown?

Posted by Brian R. Cheffins, University of Cambridge, on
Tuesday, May 19, 2009
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This post is by Brian R. Cheffins of the University of Cambridge.

In my paper Did Corporate Governance “Fail” During the 2008 Stock Market Meltdown? The Case of the S&P 500, a draft of which is currently available here, I provide the first detailed empirical analysis of the operation of U.S. corporate governance during the stock market turmoil of 2008. The study focuses on a sample of companies at “ground zero” of the stock market meltdown, namely the 37 firms removed from the iconic S&P 500 index. The results indicate that, despite U.S. stock markets experiencing their worst year since the 1930s, corporate governance performed tolerably well. This in turn implies it would be premature for policymakers to overhaul existing arrangements.

As the paper describes, over the past few decades U.S. corporate governance has been re-oriented towards the promotion of shareholder value. The sharp decline in share prices that occurred in 2008 implies this shareholder-focused corporate governance model “failed” and that reform is correspondingly justified. However, corporate governance is not the primary determinant of share prices, as reflected by the fact academic testing of the hypothesis that good corporate governance improves corporate financial performance has yielded inconclusive results. It therefore is possible that in 2008 corporate governance in public companies generally functioned satisfactorily amidst general market trends that inexorably drove share prices downwards. The paper examines whether this in fact might have been the case by examining corporate governance in companies removed from the S&P 500 index.

Over the next while there likely will be numerous studies of how corporate governance functioned during the recent financial crisis. However, the 37 companies removed from the S&P 500 in 2008 provide an apt starting point. One reason is that big public companies are markedly more important from an economic and investment perspective than their smaller counterparts — the S&P 500 index covers approximately 75% of the total value of the U.S. equities market. Another is that among any sample of publicly traded firms “troubled” companies will likely be the center of the action with respect to corporate governance controversies (e.g. Enron), and companies dropped from the S&P 500 index are apt to fall into this category. Among the 37 companies removed in 2008 20 can be categorized as “at risk”, with 13 of the companies having been dropped due to a dramatic fall in their market value, six due to “rescue mergers” (i.e. mergers where the company would have likely otherwise ended up bankrupt) and one due to Chapter 11 bankruptcy. Of the 10 industrial sectors represented in the S&P 500, firms from the “financials” sector dominated both the overall sample (15 out of 37 firms) and the “at risk” cohort (12 out of 20).

The primary search strategy I used to assess the operation of corporate governance in the 37 companies removed from the S&P 500 during 2008 was a thorough analysis of press and newswire coverage. A wide-ranging set of searches was conducted for each of the sample companies using Factiva, which offers extensive coverage of newspapers, business magazines and trade journals. The searches were structured to find out what corporate governance mechanisms were activated in the six months before and six months after a company’s removal from the S&P index, with the objective being to assess how responsive and effective corporate governance was during the stock market turmoil.

Due to the prominence of companies that are part of the S&P 500, the Factiva searches should have brought to light most material corporate governance developments concerning the sample companies. Nevertheless, the Factiva searches were supplemented by analysis of Georgeson’s 2008 Annual Corporate Governance Review, the Stanford Law School Securities Class Action Clearinghouse database and an AFL-CIO website offering data on CEO pay for 2007.

The key findings of the study are as follows:

• There was little evidence of Enron-style fraud• Only a minority of the sample companies experienced overt criticism of the board or publicized boardroom turnover, with the firms involved almost exclusively being in the “at risk” category

• A sizeable minority of “at risk” companies experienced publicized turnover of senior management

• The executive pay policies of a sizeable minority of the sample companies were criticized, with the controversies being restricted to at risk companies and companies that paid their CEOs more than the S&P 500 average

• Private equity went AWOL in a difficult climate for public-to-private buyouts

• Institutional investors (i.e. mutual funds and pension funds) were largely silent

• Hedge fund activism affected only a small minority of the sample companies, though the interventions produced results when they occurred

To the extent that corporate governance did “fail” among the companies removed the S&P 500, the difficulties were restricted largely to the financials sector. Boards of a number of banks and thrifts were subjected to intense criticism and bonus-driven executive pay may well have provided senior managers of major financial companies with incentives to take risks that were ill-advised due to the hit their firms would take if things went wrong. The corporate governance challenges financial companies pose, however, are likely to diminish over the next while, with the entire sector retrenching due to a combination of market trends and regulatory factors.

Once the financials are removed from the equation, the case in favor of a regulatory overhaul of corporate governance is weakened considerably. Based on what happened with the companies removed from the S&P 500 during 2008, corporate governance performed tolerably well. Moreover, while the U.K. already has in place a number of the features of corporate governance popular among those who advocate reform in the U.S., the stock market meltdown was worse in Britain than in America. Future studies perhaps will uncover damning evidence of corporate governance breakdowns during the stock market meltdown of 2008. However, at this point the case for radical reform has not been made out.

The paper is available here.

Market Conditions and the Structure of Securities

Posted by Michael S. Weisbach, Fisher College of Business at The Ohio State University, on
Monday, May 18, 2009
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This post is by Michael S. Weisbach of the Ohio State University.

In a recent working paper Market Conditions and the Structure of Securities my co-authors, Isil Erel, Brandon Julio and Woojin Kim, and I investigate whether market downturns can affect both the ability and manner in which firms raise external financing. Our study was motivated in part by Richard Passov, the longtime treasurer of Pfizer, who argued that the possibility of being shut out of the capital markets during market downturns is the primary reason why Pfizer and other technology companies often place such importance on a high bond rating. The extent to which this concern is justified and macroeconomic factors can affect access to capital is an important issue in finance and has clear policy implications.

To evaluate the extent to which these predictions hold in practice, we assemble a database containing information on alternative ways in which firms can raise capital. Our sample contains detailed information on 21,657 publicly-traded debt issuances and 7,746 seasoned equity offerings in the U.S. between 1971 and 2007. The latter part of our sample (from 1988 to 2007) also includes data on 40,097 completed and mostly syndicated loan tranches. Analysis of this sample provides stylized facts on the nature of public and private debt securities that have been issued recently in the US. The vast majority of external financing is supplied by debt rather than equity. Consequently, understanding the choice between alternative types of debt is likely to be equally important as, or even more important than, the choice between debt and equity. We first provide statistics documenting the average quantity of capital raised though issuance of different kinds of securities during different market conditions. A complicating factor when interpreting these numbers is the enormous increase in the total value of funds raised during our sample period. Nonetheless, there are some noticeable differences in the average proceeds per month raised during weak and strong economic conditions. For example, average proceeds raised per month through SEOs tend to drop during poor market conditions. However, short-term and highly-rated public debt increases noticeably relative to longer-term and lower-rated issues during poor market conditions.

Our multivariate analysis suggests that macroeconomic conditions affect both firms’ abilities to raise capital and the manner in which they choose to raise it. We find that the conditional probability of issuing less information sensitive securities, i.e., convertibles rather than equity, increases when credit markets are tight. We do not observe an increase in the demand for bank loans during economic downturns. However, we document that the borrowers of our sample of private loans tend to be of higher quality during bad economic times, consistent with the view that capital available to intermediaries goes down, leading them to tighten lending standards during these periods. In addition to the choice of securities, we also find that market-wide factors affect the structure of debt contracts. In particular, market downturns decrease the expected maturity of public bonds and private loans and increase the likelihood that these bonds and loans are secured. These findings are consistent with the view that market downturns lead firms to structure securities in ways that lessen their information sensitivity. Finally, we consider the quality of the public securities, measured by their ratings. For our sample of public bonds, our results suggest that market downturns do not reduce the issuances of high quality bonds, but are associated with a substantial drop in the likelihood of a junk or unrated bond issue. This pattern suggests that lower quality firms tend to be shut out of the credit markets during poor market conditions.

The full paper is available for download here.

SEC Brings First Insider Trading Case Regarding CDSs

Posted by John F. Savarese, Wachtell, Lipton, Rosen & Katz, on
Sunday, May 17, 2009
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This post is based on a client memo by John F. Savarese and David B. Anders of Wachtell, Lipton, Rosen & Katz.

For the first time, the SEC has brought an insider trading case involving the market for credit default swaps (“CDS”). In a civil complaint filed yesterday in the Southern District of New York, the SEC alleged that a CDS salesman with inside information regarding an upcoming bond offering improperly shared information about it with a portfolio manager for a hedge fund. SEC v. Rorech and Negrin, No. 09-Civ-4329 (May 5, 2009). According to the complaint, the portfolio manager used that information to trade in CDS that referenced bonds of the same issuer, and after the bond restructuring was publicly announced, the price of CDS referencing those bonds rose substantially, leading to a substantial profit.

The CDS market trades over the counter and its participants typically are sophisticated institutional players, and for those reasons, among others, it has not historically been a focus of SEC insider-trading enforcement activity, at least until now. In yesterday’s complaint, however, the SEC asserted that the CDS involved in this case qualified as security-based swap agreements under the Gramm-Leach-Bliley Act and hence are subject to the anti-fraud provisions of the federal securities laws — a proposition that has yet to be tested in court.

This broadening of the reach of SEC enforcement efforts against insider trading is consistent with signals sent in recent speeches by SEC Chairman Mary Schapiro and Division of Enforcement Director Robert Khuzami that they intend to expand and increase the Commission’s enforcement activities in this area. It is also worth pointing out that enforcement activity and private litigation regarding CDS may not be limited to insider trading actions, but may also extend to charges of market manipulation and other theories of liability. One example of a potentially manipulative use of the CDS market would be trading strategies designed to generate profits from short sales by widening CDS spreads and intentionally sending misleading signals on the company’s creditworthiness. CDS can form an effective part of a liability management or hedging strategy and the CDS market and participants in it can serve a helpful purpose in the capital formation process. However, writers and purchasers of CDS are well advised to be extremely careful in today’s volatile environment, where the distinction between appropriate market activity and improper speculation and manipulation is thin, and highly political.

This enforcement action is also a timely reminder of the critical importance of ensuring that public companies and financial institutions adopt and maintain state-of-the art antiinsider trading compliance policies and procedures, as well as implementing regular training and effective controls to prevent and detect employee misconduct. Especially in periods of market volatility and economic distress, a program of prudent vigilance is necessary and appropriate.

Proposed New European Regulation of Investment Funds

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, May 16, 2009
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This post is by Selina Sagayam of Gibson, Dunn & Crutcher LLP.

The European Union has become the first jurisdiction to propose a comprehensive framework for direct regulation and supervision of the entire investment funds industry – the proposed Directive on Alternative Investment Fund Managers.

The EU already has an established regime for regulating investment funds known as UCITS (Undertakings for Collective Investment in Transferable Securities)[1]. UCITS invest in a prescribed range of transferable securities and/or other liquid financial assets and are composed of a collective pool of investments from retail investors.

The draft proposal which was published on 29 April aims to regulate investment funds within Europe which are not already covered by the UCITS regime, referred to in the proposal as alternative investment funds (AIFs). Rather than imposing requirements on the AIFs themselves, the proposals target AIF managers (AIFMs). It was considered that a broad regime focusing on those who manage investment funds rather than a defined set of entities prevalent in the investment fund world (e.g. hedge funds) would be more effective and less easy to circumvent, with enhanced scrutiny on leveraged hedge funds.

Currently, this sector is regulated in the EU through a combination of fragmented national legislation as well as some general provisions of EU law, in addition to voluntary industry standards in certain cases (e.g. the Walker Guidelines in the UK). With investor protection as its fundamental aim, the European Commission’s rationale for the proposals is the introduction of harmonised regulatory standards and enhanced transparency.

Early drafts of the directive had been leaked to the public weeks before and received a barrage of criticism particularly from different interest groups across various member states and not surprisingly, the hedge fund industry. The final draft proposals however have come under even greater attack with the UK Financial Services Secretary and key UK and European industry bodies (in particular the British Private Equity & Venture Capital Association and the European Private Equity & Venture Capital Association) voicing their strong opposition to proposals they consider are “deeply undesirable” and “immensely damaging” to industry.

Some of the main points under the proposed legislation are set out below.

Who Is Regulated?

All EU domiciled AIFMs that meet either of the two threshold tests below will be regulated:

• Leveraged AIFMs – Total assets under management equal to or above €100m (approx. US$1334m, £90m) where assets under management are acquired through use of leverage.

• Non-leveraged AIFMs – Total assets under management equal to or above €500m (approx. US$670m, £448m) where: (i) none of the assets under management were acquired through use of leverage; and (ii) investments are locked into the fund for 5 years or more from the date of its constitution.

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Disclosure and the Cost of Capital

Posted by Christian Leuz, The University of Chicago Booth School of Business, on
Friday, May 15, 2009
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This post is by Christian Leuz of the University of Chicago.

In our paper Disclosure and the Cost of Capital: Evidence from Firms’ Responses to the Enron Shock, which was recently updated after I presented it at the Law, Economics and Organizations seminar here at Harvard Law School, my co-author Catherine Schrand and I exploit the Enron debacle as an exogenous shock for other U.S. firms and relate cost of capital shocks to subsequent disclosure responses in an attempt to understand the critical link between disclosure and cost of capital. This approach is different from existing research, which has examined the relation cross-sectionally , relating disclosure levels to the cost of capital. Even though this research has found that firms with more extensive voluntary disclosure exhibit less information asymmetry and have a lower cost of capital, a causal interpretation of such findings has proved problematic due to endogeneity concerns for which valid instruments are very difficult to find. Our approach tackles the endogeneity concern in a different way, exploiting the Enron collapse acts as a natural experiment. In addition, there are a number of features of the Enron collapse that make this a powerful setting to address the broad question of the relation between disclosure and cost of capital. First, the shock led to investor concerns about a systematic lack of transparency in financial reporting. Hence, it seems reasonable to expect firms to consider disclosure responses. Second, the shock occurred during a relatively short window. Finally, it occurred during the fourth quarter of 2001. Thus, firms had the opportunity to respond in their annual financial reporting.

Our sample comprises 1,868 U.S. firms with December fiscal-year ends and the required financial data from 1999 to 2001. Using this sample, we document that the cost of capital shocks are associated with an increase in the firms’ disclosures in their subsequent annual 10-K filings. Firms extend the number of pages in their 10-K filings, notably the sections containing the management discussion & analysis, related-party transactions, financial statements and footnotes. This link between cost of capital shocks and 10-K disclosure responses is robust to a broad set of alternative specifications. The increase in disclosure is particularly pronounced for firms that experience positive beta shocks and are likely to be more sensitive to their cost of capital because they have larger external financing needs and more growth opportunities. We also find that Arthur Anderson clients increase their 10-K pages and the section on related-party transactions more than firms that have other auditors, consistent with the idea that the disclosures are a response to the transparency concerns created by the Enron scandal.

We do not find a significant relation between the beta shocks and changes in the length of firms’ annual earnings announcements. However, an analysis of firms’ interim disclosures after the shock suggests that firms increase the number of 8-K filings in response to the crisis. We show that the 8-K disclosures mitigate the effects of the shock but such interim disclosures do not eliminate the relation between the cost of capital shocks and disclosure in the 10-K, consistent with the idea that firms’ 10-K filings and interim disclosures are complementary activities to reduce the transparency problems during this time period. The latter finding is important because it suggests that the annual 10-K filing contains relevant information that can alleviate investor concerns, despite its lack of timeliness. Finally, we show that firms’ disclosure responses subsequently reduce firms’ costs of capital and hence mitigate the impact of the transparency crisis.

The full paper is available for download here.

Federal Trade Commission Inquires Into Interlocking Boards

Posted by John G. Finley, Simpson Thacher & Bartlett LLP, on
Friday, May 15, 2009
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This post comes from John G. Finley’s colleagues Joe Tringali and Michael Naughton.


The Federal Trade Commission (FTC) has begun making inquiries into the fact that certain individuals hold seats on the boards of both Apple and Google, according to an article in today’s New York Times.[1] Section 8 of the Clayton Act ( Section 8 ) prohibits an individual from serving as a director or board elected or appointed officer of two or more competing companies, absent certain exceptions detailed below. Section 8 has not been seen as an enforcement priority of the antitrust agencies in recent years, but this FTC inquiry may reflect a shift in priorities brought on by the new administration. In light of this FTC inquiry, we review Section 8 and its exemptions below.

Section 8 is a prophylactic statute prohibiting, in certain circumstances, a person from serving as a director or officer of two or more corporations (an interlock) where the interlocked corporations are competitors. Its intent is to help ensure that a director or officer of one corporation cannot affect the competitive behavior of a competing corporation by serving that corporation in a high-level position in which he or she would be privy to confidential competitive information or could affect competitive decisions.

IN ORDER FOR SECTION 8 TO APPLY, THE FOLLOWING CONDITIONS MUST BE MET [2]

1) There is an interlock between two or more corporations. Section 8 does not apply to interlocks between noncorporate entities or between a corporation and a noncorporate entity. In addition, Section 8 does not apply to interlocks involving banks and other depository institutions and their holding companies;[3]

2) For interlocks involving officers, the officer in question must be elected or appointed by the board of directors.

3) Both corporations must be engaged, in whole or in part, in interstate commerce.

4) The two corporations must be considered competitors by virtue of their products and the location of their operations. Section 8 requires a horizontal, competitive relationship between the two companies such that the elimination of competition by agreement between them would constitute a violation of any of the antitrust laws. If the companies have a vertical or supplier relationship, Section 8 does not apply. Factors to consider in determining whether the corporations compete include whether their products are interchangeable, whether the industry and customers recognize the products as competing, whether production techniques are similar, and whether the products have distinctive customers. The statute applies only to actual competition; potential competition is not enough.

5) Each of the corporations concerned must have an aggregate net worth of more than $26,161,000 (threshold adjusted annually). Net worth is measured as the total of capital, surplus, and undivided profits. In calculating the aggregate net worth, only the interlocking corporate entities themselves are considered; the net worth of parents, subsidiaries, and other affiliates are not included.

6) Finally, the interlock need not involve the same individual serving as the director or officer of two competing companies in order for a Section 8 violation to occur. In Reading Int’l Inc. v. Oaktree Mgmt. LLC, 317 F. Supp. 2d 301, 326 (S.D.N.Y. 2003), the court recognized plaintiffs’ theory that “when a parent company designates different persons to sit on the boards of competing subsidiaries, these persons are treated as ‘deputies’ for § 8 interlock purposes” (internal quotations and citation omitted). Accordingly, under Oaktree there can be a Section 8 violation where the parent corporation designates different persons to sit on the boards of competing companies if the relevant individuals’ service on the board is not in their individual capacity but rather “as the deputies of” the parent corporation “such that it can legitimately be said that it is” the parent company as an entity and not the individual that serves as a director. Id.

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Strategies for the New Reality of Shareholder Proxy Access

Posted by Theodore Mirvis, Wachtell, Lipton, Rosen & Katz, on
Thursday, May 14, 2009
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This post is based on a client memo from Theodore N. Mirvis, Steven A. Rosenblum, Adam O. Emmerich, David C. Karp, Andrew R. Brownstein, Eric S. Robinson and Trevor S. Norwitz of Wachtell, Lipton, Rosen & Katz.

Access to company proxy materials for board candidates nominated by shareholders is now an imminent reality. Since the SEC first proposed a shareholder proxy access regime in 2003, the wisdom of such a fundamental departure from traditional practice has been hotly debated. We have long been of the view that shareholder proxy access is a serious mistake, likely to impair the ability of public companies to attract and retain quality directors and lead to a further politicization and balkanization of the boardroom, with attendant negative consequences for American capitalism and competitiveness. (See our comment letters to the SEC in response to the SEC’s 2003 and 2007 proxy access rulemaking proposals.)

Political developments have turned the tide strongly in the other direction. SEC Chairman Schapiro has said that the SEC will consider a shareholder access rule later this month, and Senator Schumer has said that shareholder access will be an element of his so-called “Shareholder Bill of Rights Act of 2009.” In an effort to forestall these attempts to further federalize corporate law, Delaware last month enacted legislation which expressly enables the adoption by Delaware companies of bylaws permitting shareholder access to company proxy materials. Crucially, such bylaws can be adopted not only by a company’s board of directors, but also by shareholder action on shareholder initiative.

Due to the negative impact of shareholder proxy access, we expect that many companies will understandably resist the adoption of shareholder access bylaws of any sort. Others will favor a wait-and-see attitude, particularly since federal legislation or regulation may change the ground rules further. Some companies, however, may wish to consider the preemptive adoption of a reasonable and carefully tailored bylaw, in part to deter, or discourage adoption of, more extreme versions of shareholder access that may be proposed by short-term activist or special-interest shareholders. We have prepared a model shareholder access bylaw (attached) for consideration.

Our model permits shareholders holding at least 5% of a company’s common stock for at least a year to nominate a limited number of independent director candidates using the company’s proxy statement and card. Our model bylaw also contains features designed to prevent the use of shareholder access as a “Trojan Horse” for takeover activity. For shareholders seeking to effect a takeover via director election, the SEC’s existing proxy contest process, containing essential disclosure and procedural safeguards, remains the appropriate mechanism.

The potential variations on the model access bylaw are many, and a board’s decision whether to adopt a shareholder access bylaw at all and, if so, what features it should have, must be carefully considered in the context of each company’s particular situation. For that reason, we believe that if shareholder access is to be a part of our public company landscape, the private-ordering approach through company specific bylaws contemplated by the Delaware legislation is preferable to a federally mandated one-size-fits-all proxy access rule. We expect that significant, long-term shareholders that do not desire the companies in which they invest to be subject to director election free-for-alls – and the risks likely to result – should find that the attached model shareholder access bylaw offers a reasonable framework.

What Do Independent Directors Know?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, May 14, 2009
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This post comes from Enrichetta Ravina of Columbia Business School and Paola Sapienza of the Kellogg School of Management.

In our paper What Do Independent Directors Know? Evidence from Their Trading which was recently accepted for publication in the Review of Financial Studies, we take a first look at the question of whether independent directors have enough information to monitor the company’s executives by analyzing their trading behavior in the company stock. The independence of directors is a key focus of recent regulatory changes. A criticism of this focus is that if executives want to act against the interest of the shareholders, they can simply leave directors in the dark. We indirectly measure the level of inside information independent directors collect while serving on the board by comparing the market-adjusted returns associated with their trades to those associated with the executive officers’ trades.

Using a comprehensive sample of reported executives’ and directors’ transactions in U.S. companies from 1986 to 2003, we find that executive officers earn higher abnormal returns than the market, when they make open market purchases, and that the independent directors do as well. We find that the difference between the returns earned by executives and independent directors is relatively small at most of the horizons analyzed. The results are robust to the inclusion of firm fixed effects in the regression, which allows us to compare officers and independent directors of the same firm, and to control for time-invariant, firm-specific characteristics that might affect returns, as well as individuals’ incentives and constraints. The results are also robust to using a variety of alternative specifications (e.g., controlling for the size of the transaction and stock holdings in the firm, the firm’s size, and book-to-market, and past return volatility). In addition, we find that the excess return earned by executives in the best governed firms (using the Gompers, Ishii, and Metrick Governance Index) are low and indistinguishable from zero, where as the excess return in the worst governed firms is 21%. The independent directors earn less than the executives at all governance levels. However, the gap in excess return between executives and directors is larger in the firms with the weakest governance, while it disappears for firms with the best governance.

To study whether independent directors are also informed in bad times, we analyze their trading performance when they make open market sales. To increase the power of our tests, we focus on the return from sales in two situations when trading is more likely to be driven by information rather than diversification motives: bad news (i.e., events in which the firm is experiencing a substantial market-adjusted drop in stock price) and earnings restatements. In both cases, we find that independent directors and executives outperform the market. These results are consistent with the hypothesis that independent directors are informed ahead of the market in critical situations.

Overall, these results suggest that independent directors are informed about the firm. The full paper is available for download here.

Stress Testing the Government’s Chrysler Plan

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, May 13, 2009
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Editor’s Note: This post by Professor Mark Roe appeared today on Forbes.com.

Capital markets players have been grumbling that Chrysler’s creditors are being badly treated and that their contract is being ignored. Warren Buffett said last week that there’ll be “a whole lot of consequences” if the government’s Chrysler plan keeps on its current trajectory. If priorities are tossed aside, “that’s going to disrupt lending practices in the future,” he said. “If we want to encourage lending in this country,” Buffett added, “we don’t want to say to somebody who lends and gets a secured position that the secured position doesn’t mean anything.”

This is not a good economic time to disrupt lending to troubled companies. That’s just the kind of lending that the Treasury is trying to unglue with TARP and the plans to sign-up private investors to buy the toxic mortgage assets off bank balance sheets.

But is this gelling capital market opinion on the Chrysler plan right or wrong? Maybe there really isn’t any more value in the government’s last offer than belongs to the Chrysler creditors. If there isn’t, Buffett and lenders are getting themselves unnecessarily worked up.

The trouble is that with the bankruptcy set-up approved this week, no one can tell. There’s no real market check on the Treasury plan, just a pseudo-market test that won’t fool any market player. This pseudo-test, approved by the court last week, led Chrysler’s dissenting creditors to give up.

In the test approved, outsiders can bid the deal away from Fiat and the U.S.,But bidders can bid on only one deal — the same UAW deal that the government negotiated before the bankruptcy. The court agreed to Chrysler’s and the Treasury’s proposal that no one be allowed to bid on the assets alone. But that’s what Buffett and the capital markets grumblers are complaining about: the government, and now the bankruptcy judge, is ignoring creditors’ contracts priority access to a first cut at Chrysler’s assets. The deal on the table gives them no access to those assets.

But there was a way to check the bona fides here to convince Buffett and financial players that the deal was fair: the court could have market-tested the plan. If the court and the Treasury had given Buffett and others the chance to outbid the Treasury for those assets and Buffett didn’t bid more than the Treasury, grumbling would have ended. If Buffett or someone else credible came in with a better bid, the Treasury and Chrysler would then have had to top it.

The best way to think about the bankruptcy plan is that the government is buying Chrysler from the creditors, giving it to the UAW, and hiring FIAT to manage it. Financial markets players are grousing that the UAW and the retirees are doing much better than the secured creditors. The UAW is owed $10 billion and they’ll get a big fraction of that back while the secured creditors take a big hit to their $6.9 billion in loans. But if the Chrysler winners are doing better with the government’s money and not the creditors’ money, that’s not for the creditors to complain about in the deal itself (as opposed to complaining as citizens and taxpayers.)

Bankruptcy law entitles the secured creditors to the liquidation value of the company. With that in mind, the government and the court ought to have set up a true market test: find out how much an outsider would pay for the company’s facilities, shorn of its operations, employees and dealers.

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