Yearly Archives: 2009

Seventh Circuit Rejects Merger Litigation

Posted by William Savitt, Wachtell, Lipton, Rosen & Katz, on
Saturday, April 4, 2009
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This post is based on a client memorandum by Adam O. Emmerich and William Savitt of Wachtell, Lipton, Rosen & Katz.

Long after Sam Zell’s decision to sell Equity Office Properties (EOP) at the market top in an all-cash deal was followed by a near-complete collapse of the market for REITs and commercial office space, shareholder plaintiffs continued to pursue litigation claiming that they were ill-served by the transaction. In a decision of the United States Court of Appeals for the Seventh Circuit issued last Friday, Judge Richard Posner decisively rejected these claims. The opinion, which primarily affirms the dismissal of claims that EOP’s proxy solicitation was misleading, also touches on the appropriate role that break-up fee arrangements play in merger transactions as a matter of economic logic and fiduciary duty, and re-affirms the limited scope of the judicial process in supervising both the federal proxy rules and state-law fiduciary matters, correctly characterizing the plaintiff’s purpose as seeking to “sink[] the process of corporate acquisition into a sea of molasses.” Beck v. Dobrowski, et al., 2009 WL 723172 (7th Cir. March 20, 2009).

The case arose out of Blackstone’s all-cash deal to acquire EOP for $55.50 per share in early 2007. Blackstone clinched the deal only after a protracted bidding battle, and with the protection of a termination fee that was negotiated upwards to $720 million by the time the Blackstone’s prevailing bid was ultimately accepted. The shareholder plaintiff brought suit under § 14(a) of the Securities Exchange Act, alleging that the merger proxy should have included additional back-up valuation information and details on the benefits that top EOP executives were to receive in the Blackstone transaction, and complaining generally about the terms of the transaction and the conduct of the sale process. The complaint tacked on supplemental state law claims alleging that EOP’s directors breached their fiduciary duties, notwithstanding that fiduciary duty litigation was already pending in the courts of Maryland, the state of EOP’s incorporation.

The appeals court rejected the plaintiffs claims. As to the § 14(a) claim, Judge Posner confirmed that “the antifraud provisions of the federal securities laws are not a general charter of shareholder protection,” which, the court made clear, remains the proper province of state fiduciary duty law. (The court went out of its way, however, to note that the termination fees about which plaintiff complained are “not. . . generally improper under any body of law with which we are familiar.”) Then, applying the Supreme Court’s 2007 decision in Bell Atlantic v. Twombly with full force to the merger litigation context, the panel ruled that plaintiff’s merger proxy claims “were too feeble to allow the suit to go forward.” The court noted that “there is nothing in the complaint to suggest that any shareholder was misled or was likely to misled,” and no suggestion that any “shareholder drew a wrong inference” from any of the alleged factual omissions. Under Twombly, defendants “should not be burdened with the heavy costs of pretrial discovery. . . unless the complaint indicates that the plaintiff’s case is a substantial one.”

Turning to plaintiff’s supplemental state law claims, the panel struck a blow for judicial efficiency by affirming the district court’s determination to stay the Maryland fiduciary claims. To permit such claims to proceed in federal court while identical claims were pending in state court would allow “different members of what should be a single class [to] file identical suits in federal and state courts to increase their chances of a favorable settlement.” As Judge Posner observed, “[t]he state-law issues that our plaintiff has presented to the federal court will be definitively resolved by the courts of the state whose law governs these issues, and our court would be required to defer to that resolution because state courts are the authoritative expositors of their own state’s laws.” The court thus resolved the increasingly frequent problem of multi-jurisdiction merger litigation with a bright-line ruling in favor of the courts of the incorporating state.

The Beck decision constitutes a decisive affirmation of the business judgment rule. The complaint failed because “any evidence that the plaintiff would have presented . . . concerning the optimal strategy for EOP to have pursued would have been heavy on hindsight and speculation, light on verifiable fact.” Such second-guessing of directors remains impermissible in the courts, state or federal, and insufficient to state a claim challenging a merger agreement entered into in good faith.

Bankruptcy v. Bailouts

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, April 3, 2009
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This post comes to us from David Skeel of the University of Pennsylvania Law School and Ken Ayotte of Northwestern University School of Law.

Almost the only thing CEO’s, politicians and most commentators have agreed on during the current financial crisis is that bankruptcy cannot possibly be used to resolve the financial distress of a troubled financial institution. Indeed, the Chapter 11 filing by Lehman Brothers has been singled out by many as the primary cause of the severe economic and financial contraction that followed, and as proof that bankruptcy is disorderly and ineffective. Ad hoc rescue lending is widely viewed as a superior response.

In our article entitled “Bankruptcy or Bailouts?“, we provide a detailed analysis of the costs and benefits of the two approaches, and conclude that the preference for bailouts is not easily justified. We begin by showing that the bankruptcy laws address many of the most pressing concerns with troubled financial firms, such as the need for financing and the danger that creditors will race to grab the firm’s assets. We illustrate the effectiveness of bankruptcy both with historical case studies and with an analysis of the recent crisis. The most important historical precedent is Drexel Burnham, which filed for bankruptcy in 1990. Drexel’s bankruptcy shows that Chapter 11 can be used both for quick sales of time sensitive assets and for a more leisurely disposition of other assets. We also argue that the conventional wisdom about Lehman is deeply mistaken. The negative effects of Lehman’s financial distress were caused not by bankruptcy, but by the government’s last minute decision not to provide financial support and by the revelation that Lehman was in financial distress.

We do not claim that bankruptcy is always the best option. If a firm is suffering from a liquidity crisis and default will have serious spillover effects (such as harm to the market as a whole), a rescue loan may sometimes be preferable to bankruptcy. But rescue loans have several significant downside costs. The most obvious is that the prospect of rescue loans creates moral hazard—the incentive to engage in risky behavior is magnified if the consequences of the risktaking will be borne by the government. Although the government counteracted shareholder moral hazard by forcing the shareholders of Bear Stearns and AIG to take significant losses in connection with those bailouts, creditors were made whole in both cases– which magnified creditor moral hazard. In addition to creating moral hazard, bailouts also distort the corporate governance of the affected firms. Governance decisions are made not by the firm and its stakeholders, but by regulators, who often are influenced principally by public opinion. Bankruptcy avoids many of these distortions. Moreover, even in cases where government intervention is justified—as perhaps to guarantee the warranty obligations of General Motors—this often can be done in bankruptcy.

In the final section of the Article, we consider the treatment of derivatives in bankruptcy, which has played an important role in the recent crisis. Under current law, derivatives are exempt from many of the core provisions of bankruptcy, such as the stay on enforcement of contractual rights. Although these provisions were justified as a way to reduce the systemic consequences of a bankruptcy filing, we argue that they can sometimes have precisely the opposite effect. Bankruptcy might prove even more effective if these rules will altered by Congress.

Overall, our Article suggests that bankruptcy is a far more effective mechanism for resolving the financial distress than has been recognized.

The full paper is available for download here.

A Theory of Mergers

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, April 2, 2009
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This post comes from Gary Gorton of Yale University, Matthias Kahl of the University of North Carolina at Chapel Hill, and Richard J. Rosen from the Federal Reserve Bank of Chicago.

In our forthcoming Journal of Finance article Eat or Be Eaten: A Theory of Mergers and Firm Size we propose a theory of mergers that combines managerial merger motives with an industry-level regime shift that may lead to value-increasing merger opportunities. Two of the most important stylized facts about mergers are the following: First, the stock price of the acquirer in a merger decreases on average when the merger is announced. Second, mergers concentrate in industries that have experienced regime shifts in technology or regulation. The view that mergers are an efficient response to regime shifts by value-maximizing managers, the so-called neoclassical merger theory, can explain this second stylized fact. However, it has difficulties explaining negative abnormal returns to acquirers. Theories based on managerial self-interest such as a desire for larger firm size and diversification can explain negative acquirer returns. However, they cannot explain why mergers are concentrated in industries undergoing a regime shift. Our theory of mergers is able to reconcile both of these stylized facts.

The basic elements of our theory are as follows: First, we assume that managers derive private benefits from operating a firm in addition to the value of any ownership share of the firm they have. Second, we assume that there is a regime shift that creates potential synergies. The regime shift makes it more likely that some future mergers will create value, with larger targets being more attractive merger partners due to economies of scale. Third, we assume that a firm can only acquire a smaller firm, which is consistent with the majority of actual market acquisitions.

In our models, the anticipation of potential mergers after the regime shift creates incentives to engage in additional mergers. We show that a race to increase firm size through mergers can ensue for either defensive or “positioning” reasons. Defensive mergers occur because when managers care sufficiently about staying in control, they may want to acquire other firms to avoid being acquired themselves. By growing larger through acquisition, a firm is less likely to be acquired as it becomes bigger than some rivals. This defensive merger motive is self-reinforcing and hence gives rise to merger waves: one firm’s defensive acquisition makes other firms more vulnerable as takeover targets, which induces them to make defensive acquisitions themselves. This leads to an “eat-or-be-eaten” scenario, whereby unprofitable defensive acquisitions preempt some or all profitable acquisitions. We show that in industries in which many firms are of similar size to the largest firm, defensive mergers are likely to occur.

A central implication of our models is that the firm size distribution in an industry matters for merger dynamics. In particular, our models predict that acquisition profitability is positively correlated with the ratio of the size of the largest firm in an industry to the size of other firms in the industry. Additionally, it predicts that firms in industries with more medium-sized firms have a higher probability of making acquisitions. We use data on U.S. mergers during the period from 1982 to 2000 to test these hypotheses and find support for them.

The full paper is available for download here.

Treasury’s Framework for Regulatory Reform

Posted by Margaret E. Tahyar, Davis Polk & Wardwell LLP, on
Wednesday, April 1, 2009
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This post is based on client memorandum by Randall Guynn, Annette Nazareth, and Margaret Tahyar of Davis Polk & Wardwell.

It has been obvious for some time that the outdated US system of financial regulation is badly in need of reform. There have, however, been limited opportunities to unblock the political obstacles to reform, despite valiant attempts by the Paulson Treasury to spur debate with its Blueprint for a Modernized Financial Regulatory Structure and also by many other groups, private, public and academic. The silver lining in the financial crisis may be that at least some elements of reform can now be achieved. Secretary Geithner’s carefully calibrated announcements last week—timed to become public just in advance of the G-20 meetings scheduled in London this week—are an attempt to stage regulatory reform in such a way that those elements where there is the deepest consensus are treated first before more divisive proposals. The need for increased systemic risk regulation and the need for resolution authority for a wide range of systemically important financial institutions are among those priority proposals.

In announcing his new “rules of the road,” Secretary Geithner identified four major axes of reform: addressing systemic risk, protecting consumers and investors, eliminating gaps in the regulatory structure and fostering international coordination. The most detailed elements of the reform package involved systemic risk, including proposed legislation for the resolution of systemically important financial institutions. More detailed frameworks for the other three areas are promised in the coming weeks.

Our recent memorandum, entitled “Treasury’s Rules of the Road for Regulatory Reform,” describes Treasury’s framework for regulatory reform, focusing on the comparatively more detailed proposals for addressing systemic risk, and sets forth some of the issues the government and the private sector may consider as the details are hammered out. A companion memorandum by Randall Guynn, entitled “Treasury’s Proposed Resolution Authority for Systemically Significant Financial Companies” discusses Treasury’s proposed legislation for resolution authority.

The memorandum entitled “Treasury’s Rules of the Road for Regulatory Reform” is available here, and the memorandum entitled “Treasury’s Proposed Resolution Authority for Systemically Significant Financial Companies” is available here.

A Fix for Geithner’s Plan

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, March 31, 2009
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Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published in today’s print edition of the Washington Post. Professor Bebchuk’s September 2008 Harvard Discussion Paper and WSJ op-ed piece in which he put forward the idea of buying troubled assets through private managed and competing funds are available here and here. His February 2009 Harvard Discussion Paper proposing a detailed design for such a program is available here, and his Forum post summarizing the analysis of this paper is available here.

With the world’s attention shifting to London and the upcoming Group of 20 summit, it’s possible that the Treasury’s proposal for dealing with banks’ “troubled assets” will become old news. It shouldn’t. The administration plans to provide as much as $1 trillion to privately managed funds that will buy troubled assets, which is indeed the best way for jump-starting this market. But it is important to add to the program a mechanism that would prevent excessive subsidies to private parties and keep costs to taxpayers at a minimum.

The first government plan to purchase banks’ toxic assets, put forward by then-Treasury Secretary Henry Paulson, was withdrawn after objections that Treasury wouldn’t be able to value the assets. In a white paper issued last September, “A Plan for Addressing the Financial Crisis,” I proposed using privately managed and competing funds as an alternative and argued that such funds would better set prices for these sorts of assets.

The program that Treasury Secretary Timothy Geithner announced last week will lead to the creation of such competing funds. It is structured to produce a market with a significant number of potential sellers facing a significant number of potential buyers.

But while the program is intended to partner public and private capital, the partnership it sets up is quite unequal. As things stand, the private side — the private manager and investors possibly affiliated with it — would capture 50 percent of the upside but would bear a disproportionately small share of the downside, contributing as little as 8 percent of the fund’s capital.

Treasury officials believe that because private parties have not thus far established funds dedicated to buying troubled assets, favorable terms are needed to induce their participation. This logic is reasonable, but it is important to keep the government subsidy at a minimum. Without any market check, the terms set by the government could substantially overshoot what is necessary to induce private participation and end up imposing large and unnecessary costs on taxpayers.

A program of public-private funds should be designed to minimize costs to taxpayers. To attain this objective, the government should base the terms of participation on a process in which private managers compete to be in the program.

If the private side were to contribute only 8 percent of the capital, the government should seek to keep the highest fraction of the upside that would be consistent with inducing such participation. To this end, potential private managers would submit bids indicating the minimum share of the fund’s upside that each manager would be willing to accept for an 8 percent investment, as well as the size of the fund that the manager would establish if accepted into the program. Treasury officials should then set the share of the upside going to the private side in each of the funds under the program at the lowest level consistent with establishing funds that collectively have the aggregate target capital.

Alternatively, assuming that the private side’s share of the upside is fixed at 50 percent, the government should seek to get the largest possible contribution of private capital. Under this scenario, managers would submit bids indicating both the size of the fund each manager would establish and the maximum fraction of the fund’s capital that the manager would commit to raising privately in return for 50 percent of the upside. Based on the bids, the government would set the fraction of capital provided by the private side at the highest level consistent with establishing funds that have the target amount of aggregate capital.

This second scenario would not only keep the government’s subsidy at a minimum but would also induce the largest amount of private capital, thus conserving some of the government gunpowder that the program’s current design would use. Because many banks might well remain undercapitalized even when their assets are valued fairly, restarting the market for troubled assets won’t make these banks healthy; rather, it will make clear the need to recapitalize them and might require the government to inject substantial sums of additional capital.

Establishing privately managed funds that are financed with both private and public capital offers the best approach to restarting the market for troubled assets. Adding a market mechanism for setting the level of government subsidy is necessary to reduce the program’s cost to taxpayers and would leave the government with the most ammunition for the tasks that still lie ahead.

Holding business leaders accountable

Posted by Benjamin W. Heineman, Jr., Harvard Law School Program on Corporate Governance and Harvard Kennedy School of Government, on
Monday, March 30, 2009
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This post is based on an op-ed piece by Mr. Heineman that appeared today in the Washington Post online.

The just deposed GM leadership team has been in control for nearly a decade. During this period, market share, profitability and stock price have declined precipitously, while debt has risen dramatically. One of the fundamental issues raised by the economic crisis, primarily in the financial sector but also in failing industries like automobile industry, is: Where was the board of directors to set meaningful performance goals (not simply stock price) and hold business leaders accountable? This question, in turn, has raised even more fundamental issues about whether, despite endless governance writing, conferences and academic centers, corporations are capable of governing themselves when hard decisions need to be made.

One important perspective on the Obama administration’s decision about transforming the GM leadership and Board is a demand for accountability. While the failures of the past decade form the critical backdrop, the administration’s “Determination of Viability Summary” holds GM accountable for the failures of the “Restructuring Plan Report” submitted on February 17, 2009, pursuant to the US-GM loan agreement signed at the end of last year. Simply stated, that government summary finds the GM report unrealistic in assumptions about market share, price, brands, dealers, Europe, product mix and legacy costs—and far too slow in its actions. That Ford’s new management team is not seeking bail-out funds is the strongest argument that the time for accountability has arrived. This is not change for
change’s sake.

Of course, from a different perspective, this is all about negotiations (or, when the government is involved, politics). It is a negotiation with the GM stakeholders (especially the unions, bondholders and dealers) to make faster, bigger voluntary moves in 30 days to avoid the more unpredictable and potentially Draconian rigors of formal bankruptcy (even if on an expedited basis). It is a negotiation with the a broad spectrum in Congress to show reluctance to throw more good money after bad and to base the future on realistic plans, while holding out hope that GM can rise again (and get more durable financial assistance from the taxpayers).

It is, ultimately, a negotiation with the American people to see if combining hard actions now with the prospect of more support under specific conditions later can, in the midst of the economic maelstrom and now too-numerous-to-count government anti-recession programs, create political support down the road for longer-term federal involvement in GM. (On the subject of negotiation: it would be enjoyable to be in Fiat’s position when Chrysler comes to negotiate a joint venture with the alternative that the government will cut off support if no deal is done.)

In his announcement, President Obama gave the expected disclaimers: “The United States government has no interest in running GM. We have no intention of running GM.” His auto and financial analysts have found GM’s restructuring plan wanting. So a new plan will be developed. But they also found GM’s execution too slow. The unanswered question today, with removal GM’s leader, is who will take the GM helm, and join the GM Board, actually to “operate” the new GM for the longer term—and under what kind of “super-board” operational oversight from Uncle in Washington. A new age of GM accountability is dawning, but how will it work is in execution, not just in planning.

Corporate Crime

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, March 30, 2009
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This post comes from Wallace P. Mullin of George Washington University and Christopher M. Snyder of Dartmouth College.

Our chapter, “Corporate Crime,” (to appear in the handbook Criminal Law and Economics, edited by Nuno Garoupa, Edward Elgar, 2009) provides a new survey of the law and economics literature on corporate crime. We focus primarily on the relevant theoretical research but also touch on empirical research and policy issues.

We set the stage by updating some stylized facts about prosecuted firms. The data come from various tables in the U.S. Sentencing Commission’s Sourcebook of Federal Sentencing Statistics. Our descriptive analysis is similar to earlier studies using this data source, but we update these earlier studies with the most recent data. The most up-to-date of these earlier studies (Cohen 1996) used data for the 1984-90 period, while our analysis covers the period 2002-06. We also focus on facts that relate to the theory which we go on to survey.

We find that around a third of the cases involved fraud, 20 percent involved environmental violations, around 7 percent involved antitrust, and about an equal fraction involved a general “product” category which includes food, drugs, other consumer products, and agriculture. Around a third of the cases (40 percent in 2006) involved managerial tolerance of behavior of lower-level employees. This figure sheds some light on the theoretical and empirical controversy over whether criminal agents are acting in the interest or against the interest of principals higher up in the organization (firm owners or managers). The figure suggests that different models of corporate crime may apply to different cases. While there are some cases in which the criminal employee may have been acting as a maverick against the interests of the firm’s owners and upper-level management, in a substantial minority of cases the other cases the criminal agent may have been benefitted his principals (at least in the absence of sanctions).

We then proceed to a survey of the theoretical literature, organizing the discussion within a unified framework provided by the principal-agent model. Our model follows closely on Garoupa (2000), since his comprehensive analysis nests much of the previous work.

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Sponsor-backed Going Private Transactions

Posted by Ira M. Millstein, Weil, Gotshal & Manges LLP, on
Sunday, March 29, 2009
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This post is by Ira M. Millstein of Weil, Gotshal & Manges LLP.

The Private Equity Group at my firm has recently issued its third annual survey of sponsor-backed going private transactions. The survey analyzes and summarizes the material transaction terms of going private transactions involving a private equity sponsor in the United States, Europe and Asia-Pacific.

We surveyed 39 sponsor-backed public-to-private transactions announced from January 1, 2008 through December 31, 2008 with a transaction value (i.e., enterprise value) of at least $100 million (excluding target companies that were real estate investment trusts). Fifteen of this year’s surveyed transactions involved a target company in the United States, 13 involved a target company in Europe and 11 involved a target company in Asia-Pacific.

The survey’s key conclusions for the United States transactions include the following:

• 2008 witnessed a 97% collapse in aggregate transaction value for sponsor-backed going private transactions when compared to 2007. The largest transaction announced in 2008 had a transaction value of approximately $2.1 billion, a 95% decline from the largest transaction announced in 2007. There was also a 76% decline in transaction volume when compared to 2007.

• The percentage of club deals involving two or more private equity sponsors declined significantly in all transaction sizes in 2008. Only 7% of the 2008 transactions constituted a club deal whereas 37% of the 2007 transactions did so.

• The tender offer again made an appearance in 2008, continuing a trend that started in 2006. The same cannot be said for stub equity. There was no transaction in 2008 in which the sponsor offered stub equity to the target’s public shareholders.

• Not surprisingly, the credit crisis continued to adversely impact the debt-to-equity ratios of sponsor-backed going private transactions. Equity accounted for an average of 64% of acquiror capitalization for transactions between $100 million and $1 billion in value and 51% of acquiror capitalization for transactions greater than $1 billion in value.

• The credit crisis has forced sponsors to tap alternative financing sources, including traditional mezzanine lenders and hedge funds.

• The go-shop provision continued to be a common feature of going private transactions in 2008 with 53% of surveyed transactions including this form of post-signing market check. Interestingly, sponsors were more resistant this year to giving a significantly reduced go-shop break-up fee (only one transaction had a go-shop break-up fee of less than 50% of the normal break-up fee).

• Although far from the norm, there was an increase in 2008 in sponsor-backed going private transactions with a financing out (20% in 2008 compared to 3% in 2007).

• When compared to pre-credit crunch transactions, the 2008 transactions reveal a material decrease in the number of MAE exceptions.

• Reverse break-up fees were again the norm in 2008, appearing in 87% of all surveyed transactions (a slight increase from 84% in 2007). In an effort to limit the optionality built-in to the reverse break-up fee structure and incentivize sponsors to consummate the transaction, target boards in a significant minority of surveyed transactions negotiated for a higher second-tier reverse break-up fee or a higher cap on monetary damages.

• Interestingly, specific performance provisions enforceable against the buyer were very rare in 2008. Only 7% of the 2008 transactions permitted the seller to seek specific performance against the buyer rather than be limited to a reverse break-up fee or monetary damages (whereas 33% of the surveyed transactions in 2007 allowed the seller to seek specific performance).

The survey is available here.

UK Rules for Disclosure of Derivatives

Posted by Adam O. Emmerich, Wachtell Lipton Rosen & Katz, on
Saturday, March 28, 2009
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This post is based on a client memo by Theodore N. Mirvis, Adam O. Emmerich, William Savitt, David E. Shapiro, and Adam M. Gogolak of Wachtell, Lipton, Rosen & Katz.

Forthrightly addressing the continued proliferation of swaps, options and other equity derivatives, the UK’s Financial Services Authority (“FSA”) has now adopted final rules requiring the disclosure under the UK’s Disclosure and Transparency Rules of swaps, options and other derivative contracts, including those providing for cash settlement. See Policy Statement 09/3. The new rules require disclosure of aggregate equity positions (including derivatives) beginning at the 3% level (with an exemption for the writers of equity derivatives acting as intermediaries).

The FSA noted two important changes from its prior thinking in adopting the final rules.

First, while the FSA’s prior intention was to make the new rules effective in September 2009, it determined, “in light of the changes in market conditions since last summer and the need for increased transparency driven by these changes,” to accelerate the effectiveness of the new rules to June 1, 2009.

Second, the FSA decided that disclosures should be made on a delta-adjusted (rather than nominal) basis, which the FSA believes is a more accurate reflection of the actual extent of economic interest held at any one time. As a transition matter, the FSA will allow reporting on either a nominal or a delta-adjusted basis for a period of seven months following effectiveness of the new rules, provided that firms choosing to report on a nominal basis during the transition period will be required to provide sufficient information – including the strike or exercise price of each financial instrument reported and the total number of voting rights relating to shares referenced by each financial instrument reported – to allow market participants to calculate the underlying adjusted economic interest.

The FSA’s decisive action to require disclosure of accumulations of significant stakes in publicly traded companies through derivative instruments – and its corresponding approach toward disclosure of short positions (see Discussion Paper 09/1) – only further highlights the inadequacy of the current U.S. disclosure and regulatory regime. While there has been piecemeal reform and adjustment in the U.S. – through judicial decisions such as that in CSX, through private and contractual ordering in by-laws, rights plans and other contracts, and through a variety of other mechanisms – the need for comprehensive reform and market transparency has not been met. There continues to be an overwhelming global consensus towards full and fair disclosure of equity derivatives and other synthetic and non-standard ownership and control techniques. We remain strongly of the view that U.S. regulation should be comprehensively reformed to address derivative arrangements in a clear and uniform manner, generally treating all such arrangements that are coupled with direct or indirect ownership of actual shares by counterparties as in all respects equivalent to actual ownership, and requiring appropriate disclosure of all such arrangements involving more than 5% economic equivalent ownership, whether long or short, and whether accompanied by underlying ownership positions or otherwise.

Superstar CEOs

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, March 27, 2009
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Editor’s Note: This post comes from Ulrike Malmendier of the University of California, Berkeley and Geoffrey A. Tate of the University of California, Los Angeles.

Compensation, status, and press coverage of managers in the U.S. follow a highly skewed distribution: a small number of ‘superstars’ enjoy the bulk of the rewards. However, the “tournament” for CEO status and public attention is not designed by shareholders as an incentive device, but is largely conducted by the media. As a result, the value consequences of superstar status are unclear. While increased media exposure may boost profitability, it could also shift power towards the CEO and induce perquisite consumption. In our paper, Superstar CEOs, which was recently accepted for publication in the Quarterly Journal of Economics, we analyze the ex-post value consequences of the managerial superstar system.

We use several empirical methods to identify a credible counterfactual for the winning CEOs. As our main identification strategy, we construct a nearest neighbor matching estimator. We estimate a logit regression to identify observable firm and CEO characteristics that predict CEO awards. We then match each award winner to the non-winning CEO who, at the time of the award, had the closest predicted probability of winning. Lastly, we verify that award winners and the control sample are indistinguishable along most observable dimensions, including firm and CEO characteristics not explicitly included in the match procedure. We exploit shifts in CEO status due to CEO awards conferred by major national media organizations. We link award-induced changes in status to corporate performance and CEO decision-making, using matched non-winning CEOs as a benchmark.

We find that firms with award-winning CEOs subsequently underperform, both in terms of stock and operating performance. At the same time, CEO compensation increases, CEOs spend more time on activities outside the company like writing books and sitting on outside boards, and they are more likely to engage in earnings management. The ex-post effects are strongest in firms with poor corporate governance, compared to a matched sample of non-winners with no ex ante differences in governance. Our findings suggest that the superstar system has negative ex-post value consequences for shareholders. The net effect of the superstar system, after accounting for ex-ante incentives created by the tournament for status, is hard to assess. However, the ex post value destruction we measure is large and it appears to be avoidable. Firms with strong shareholder rights do not experience a decline in performance when their CEOs win awards, suggesting that it is optimal to increase monitoring after CEOs win awards.

The full paper is available for download here.

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