Yearly Archives: 2009

CEO Stock Donations

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, January 23, 2009
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This post comes from David Yermack of NYU Stern.

In my paper Deductio Ad Absurdum: CEOs Donating Their Own Stock to Their Own Family Foundations, which was recently accepted for publication in the Journal of Financial Economics, I explore whether executives exploit the insider trading gift loophole to make well-timed charitable donations of stock in advance of price declines, a strategy that would allow the donors to use their access to inside information to obtain personal income tax benefits. Unlike open market sales, gifts of stock are generally not constrained by U.S. insider trading law, and company officers can often donate shares of stock to charities at times when selling the same shares would be prohibited.

I focus upon Chairmen and CEOs of U.S. public companies that establish private family foundations and then make large contributions to these foundations out of their personal holdings of company shares. Because these donors generally control the entities on either side of these transactions, while also having private information about the future prospects of their companies, one might expect well-timed donations to private family foundations to be relatively easy to accomplish and document. My sample consists of 150 large gifts made by 89 different executives between mid-2003, when the SEC established electronic filing requirements for stock transfers, and the end of 2005.

Consistent with their exemption from insider trading law, I find a pattern of excellent timing of Chairmen and CEOs’ large stock gifts to their own family foundations. On average these gifts occur at peaks in company stock prices, following run-ups and just before significant price drops. A variety of tests give some support for the hypothesis that CEOs time their gifts based on inside information. For instance, a few CEOs make gifts of stock just before adverse quarterly earnings announcements, a time at which company “blackout” periods would almost always prohibit open market sales. Other CEOs delay stock gifts until just after positive quarterly earnings announcements. In addition, tests used to infer the backdating of executive stock option awards yield results consistent with the backdating of CEOs’ family foundation stock gifts. For instance, I find that the apparent timing of certain subsamples of family foundation stock gifts improves as a function of the elapsed time between the purported gift date and the date on which the required stock gift disclosure is filed by the donor with the SEC. Stock gift backdating, if followed by the filing of a personal tax return claiming a charitable gift deduction, would likely represent tax fraud in violation of IRS rules.

Overall, these results suggest an odd juxtaposition of motives on the part of corporate executives who donate stock. While nominally transferring part of their fortunes to charitable foundations for civic purposes, many appear simultaneously to exploit gaps in the regulation of insider trading or even to backdate their donations to increase the value of personal income tax benefits. Data in the paper also cast a long shadow upon the increasingly popular role of private family foundations as conduits for charitable contributions by the wealthy.

The full paper is available for download here.

Embattled CEOs

Posted by Marcel Kahan, NYU School of Law, on
Thursday, January 22, 2009
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This post is from Marcel Kahan of the NYU School of Law.

In Embattled CEOs, Edward Rock and I argue that chief executive officers of publicly-held corporations in the United States are losing power to their boards of directors and to their shareholders. This loss of power is recent (say, since 2000) and gradual, but nevertheless represents a significant move away from the imperial CEO who was surrounded by a hand-picked board and lethargic shareholders.

The decline in CEO power has multiple, and interacting, causes and symptoms. On the dimension of shareholder composition and activism, reduced CEO power is related to the their continuing increase in the stock ownerships by institutional investors, especially mutual funds, and the concomitant decline in stock ownership by individuals; the recent rise of hedge funds, the most activists type of institutional investors; the increased level of activism by mutual funds; and the role of proxy advisory firms in targeting portfolio companies for and coordinating activism. On the dimension of governance rules, several developments may represent both symptoms of reduced CEO power and contribute to further declines in CEO power. These include the virtual demise of staggered boards among the largest US companies (and the less significant, but still pronounced decline, in staggered boards among smaller ones); the meteoric rise of majority voting for directors; and the increased number of shareholder proposals that receive majority support and, more importantly, that are implemented by the board. On the regulatory front, important recent developments include the NYSE proposal to end discretionary broker voting in director elections; the new rules governing the electronic delivery of proxy materials which reduce solicitation costs for both companies and dissidents; and the governance reforms adopted n the wake of Sarbanes-Oxley which, among others, require that companies create select committees exclusively composed of independent directors. On the board level, the loss of CEO power is related to the fact that directors who have long been nominally independent (i.e. have no business ties to the company) now act more substantively independent (i.e., defer less to the inside directors). This is reflected in the increased board time devoted to monitoring the CEO (and the increased overall time demands placed on outside directors); regular meetings of outside directors only in executive session and occasional ones with shareholders and independent consultants; the increased number of companies that have formal processes for evaluation CEOs, lead outside directors, or that split the CEO and Chairman position; and the increased level of CEO turnover, both overall and especially performance-related.

All of these changes have contributed to a decline in CEO power in several way. CEOs have less control over important strategic decisions, such a whether to sell the company. They have less control over setting the agenda presented to the board and to shareholders. They have less control over audit, compensation, director selection, and other governance matters. And even on the operational level, where CEOs retain significant over initial decisions, the CEO is more likely to be held accountable, and likely to be held accountable sooner, over operational decisions than in the past.

We believe that the shift in CEO power to outside directors and institutional shareholders represent in fundamental trend that will continue at least over the medium term. While we do not exclude the possibility of a regulatory backlash – analogous to the passage in anti-takeover laws and the sanctioning of the poison pill is response to the hostile takeover movement in the 1980s – we believe that such backlash is unlikely. As a result of this shift, outside directors will be increasingly composed of retired high-level executives or professionals, such as former CEOs or former partners in accounting firms; that “flavor of the year” shareholder resolutions will become harder to ignore; and that the locus of resistance to having the company be acquired will shift from inside managers to outside directors and shareholders. At the same time, we believe the change in this change in the governance regime represent a convergence of the U.S. to other Anglo-American countries (in which CEOs have long held a weaker role) and that it calls into question the case for legal change that further increases shareholders’ voting right.

The article is available here.

CEO Pay and the Lake Wobegon Effect

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, January 21, 2009
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This post comes from Rachel Hayes and Scott Schaefer at the University of Utah.

In our paper, CEO Pay and the Lake Wobegon Effect, which was recently accepted for publication in the Journal of Financial Economics, we analyze a common explanation for the recent increase in CEO pay at US firms. Our model, which is based on asymmetric information in financial markets, is motivated by an observation made by former DuPont CEO Edward S. Woolard, Jr. speaking at a Harvard Business School roundtable on CEO pay: “The main reason (CEO) compensation increases every year is that most boards want their CEO to be in the top half of the CEO peer group, because they think it makes the company look strong. So when Tom, Dick, and Harry receive compensation increases, I get one too, even if I had a bad year…. (This leads to an) upward spiral”

We present a game-theoretic model of this phenomenon, which is known in the business press as the Lake Wobegon Effect. We study a firm and a manager who privately observe a parameter that affects the productivity of their match. Stock market participants cannot observe this parameter, but attempt to infer it from observing the manager’s wage. The firm maximizes a weighted sum of short-run and terminal firm value, and so may wish to distort the publicly observable wage contract in order to affect the market’s beliefs regarding firm value. Our model has three key features, all of which have been noted as important assumptions of the Lake Wobegon Effect: (i) there is asymmetric information regarding the manager’s ability to create value at the firm; (ii) the pay package given to the manager must convey information about the manager’s ability to create value at the firm; and, (iii) the firm must have some preference for favorably affecting outsiders’ perceptions of firm value.

We present three main results. First, we show the Lake Wobegon Effect can occur. That is, there are instances of our model in which the full-information benchmark is not an equilibrium, and firms distort pay upward to affect market perceptions of firm value.

Second, we characterize the settings in which the Lake Wobegon Effect does occur. We show that our three key assumptions — asymmetric information, managerial rents, and corporate myopia — are not sufficient to guarantee upward distortions in pay. In the basic version of our model, two additional conditions are necessary: (1) the marginal effect of increases in managerial ability on match surplus — defined as the difference between the parties’ output when working together and when pursuing their outside options — is positive, and (2) the weight placed by the firm on short-run share prices is greater than the fraction of the match surplus that is captured by the manager.

Third, we find that the temptation to distort pay upward is stronger when the information asymmetry pertains to characteristics of the firm rather than characteristics of the manager. When the manager’s ability is uncertain, increases in the manager’s pay do boost the market’s assessment of managerial ability; however, the manager — not the firm — captures rents associated with increases in managerial ability. Thus, the marginal increase in firm value associated with a dollar increase in managerial pay is low when the uncertainty pertains to a characteristic of the manager.

Our analysis suggests that greater shareholder involvement in the pay process — so-called “say on pay” — might be counterproductive. A potential solution to the problem of shareholder myopia is to delegate decisions to individuals with a longer-term view. That is, if shareholders care only about short-run share prices then they may be tempted to raise CEO pay in a (futile, in equilibrium) attempt to affect short-term market valuations. If instead, shareholders delegate pay decisions to directors and motivate those directors (using contracts) to take a longer-term view, then pay decisions can be insulated from myopia.

The full paper is available for download here.

Firms Gone Dark

Posted by Jesse Fried, Harvard Law School, on
Tuesday, January 20, 2009
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This post is from Jesse Fried of Harvard Law School.

I have just posted on SSRN a revised version of a paper that focuses on firms that exit the mandatory disclosure system even though their shares remain publicly traded and may be held by thousands of investors, Firms Gone Dark. It will be published shortly in the University of Chicago Law Review.

The paper begins by explaining how firms go dark. The securities laws currently permit a firm to exit the mandatory disclosure system if certain conditions are met, one of which is that the firm not have any class of securities outstanding with three hundred or more “holders of record.” This “record holder” test would appear to prevent any firm with three hundred or more shareholders from exiting mandatory disclosure. However, the test currently does not define a “holder of record” as the real (or “beneficial”) owner of the firm’s stock, but rather as the party “identified as the owner” of the security on the firm’s records. Most shares in publicly traded firms are held by nominees, such as banks and brokerage houses, not by the beneficial owners themselves. Each nominee, in turn, holds its shares on behalf of dozens, hundreds, or even thousands of institutional and individual investors. Thus, a reporting company can easily have fewer than three hundred “holders of record” and thus be eligible to exit mandatory disclosure even though the company may have thousands of beneficial shareholders. Hundreds of publicly traded firms have taken advantage of this rule to exit mandatory disclosure in recent years. Such exiting firms are said to “go dark” because they subsequently provide little information to public investors. The paper also describes the characteristics of firms that go dark and the stock market’s sharply negative reaction to going-dark announcements.

I then examine the disclosure practices of firms that have gone dark and explore their implications for the longstanding debate in securities regulation over whether mandatory disclosure is needed. Critics of mandatory disclosure argue that insiders can be counted on voluntarily to provide the “firm-optimal” level of disclosure—that which maximizes the joint wealth of insiders and public investors. Defenders of mandatory disclosure disagree, arguing that insiders often have an incentive to provide less than the firm-optimal level of disclosure. The disclosure practices of gone-dark firms, I show, cast doubt on the claim of mandatory disclosure’s critics. Only a small fraction of firms that go dark provide any financial information publicly to their hundreds or thousands of public investors. I explain why it is highly unlikely that, for the vast majority of these gone-dark firms, the firm-optimal level of disclosure is zero. The fact that stock prices drop substantially when firms announce they will exit mandatory disclosure provides further reason to be skeptical that post-exit disclosure levels are generally firm-optimal.

The paper concludes by addressing the question of how exits from mandatory disclosure should be regulated. It begins by explaining that when insiders can unilaterally decide to exit mandatory disclosure, they may have an incentive to exit even when such exit reduces firm value. The SEC is currently considering a proposal to prohibit firms with three hundred or more beneficial shareholders from exiting mandatory disclosure. Adoption of this proposal, I show, would decrease value-reducing exits but not eliminate them. I then put forward a new approach to regulating exits from mandatory disclosure: requiring public investor approval before insiders can turn off the lights. Such an approach would prevent a firm from exiting mandatory disclosure as a publicly traded company unless such exit increases firm value.

The current draft of the paper is available here.

As I am continuing to work on projects related to firms’ choice of disclosure arrangements, any comments would be most welcome.

Determinants of Explicit CEO Contracts

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, January 19, 2009
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This post comes from Stuart L. Gillan of Texas Tech University, and Jay C. Hartzell and Robert Parrino of The University of Texas at Austin.

In Explicit vs. Implicit Contracts: Evidence from CEO Employment Agreements, which was recently accepted for publication in the Journal of Finance, we report evidence on the determinants of whether the relationship between a firm and its CEO is contractually defined in an explicit agreement. Our sample consists of the 494 U.S.-based firms in the S&P 500 on January 1, 2000 and their CEOs as of that date. We construct the sample by combining a set of explicit CEO EAs provided to us by The Corporate Library with agreements identified by searching the SEC filings of all remaining S&P 500 firms for any mention of an explicit EA. We define explicit EAs to include only comprehensive written agreements that specify the relationship between a firm and its CEO. We find that fewer than half of the CEOs of S&P 500 firms have comprehensive explicit employment agreements.

We find that comprehensive explicit EAs are used more frequently at firms operating in more uncertain business environments and at firms that are likely to face lower costs from altering the agreement with the CEO. This is consistent with the idea that firms facing greater uncertainty are more likely to encounter situations in which the benefits from altering an EA outweigh the costs. CEOs that have been hired from another firm (outside CEOs) are also more likely to have explicit EAs. These CEOs tend to face greater uncertainty about the sustainability of their relationships with their firms than CEOs who have been promoted from within. We find strong evidence that CEOs who can expect to earn greater abnormal compensation at their firms, both in the near future and over the estimated remainder of their career, are more likely to have an explicit EA. In addition, CEOs who receive a larger fraction of their pay as incentive-based compensation, which tends to be at greater risk if their employment agreement is altered, are more likely to have an explicit EA. Lastly, we find that the factors that explain the presence of an explicit EA also explain contract duration.

On balance, the evidence supports theoretical literature on the choice between explicit and implicit agreements and is consistent with optimal contracting.

The full paper is available for download here.

A Wider Scope of Primary Liability?

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on
Sunday, January 18, 2009
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This post is from John F. Olson of Gibson, Dunn & Crutcher LLP.

In a recent novel decision in one of the mutual fund market timing cases brought by the SEC (SEC v. Tambone, ___ F.3d ___ (1st Cir. 2008), available at 2008 U.S. App. LEXIS 24457), the First Circuit held that the SEC had adequately alleged a primary violation of Section 10(b) and Rule 10b-5(b) for material misstatements “impliedly” made by the defendants. A sharply worded dissent criticized the Court’s holding for enlarging the scope of primary liability and blurring the line between primary and secondary liability that the Supreme Court recently drew in Stoneridge. Even though its impact remains to be seen, the First Circuit opinion has potentially significant implications for the scope of liability of defendants in both SEC enforcement actions and private civil securities litigation.

In an article entitled “A Wider Scope of Primary Liability?,” Mark Schonfeld and Akita St. Clair address the implications of the SEC v. Tambone decision. This article recently appeared in Law360.

The article is available here.

Lawdragon 500

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Saturday, January 17, 2009
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Lawdragon Magazine recently released its fourth annual list of the “500 Leading Lawyers in America.” Available here, the list includes 16 individuals who are affiliated with this Blog or its sponsor, the Harvard Law School Program on Corporate Governance.

The Lawdragon 500 includes private attorneys from a wide range of practices, in-house counsel, law professors, judges, government attorneys, and public interest lawyers. Conducted by legal journalists, the selection is based on a combination of on-line balloting and independent research.

The Lawdragon 500 list includes professor Lucian Bebchuk, who serves as director of the Program, and Leo Strine, Delaware Vice Chancellor and senior fellow at the Program.

The following five members of the Program’s advisory board were similarly honored: Peter Atkins (Skadden, Arps, Slate, Meagher & Flom), John Finley (Simpson Thacher & Bartlett LLP), Theodore Mirvis (Wachtell, Lipton, Rosen & Katz), James Morphy (Sullivan & Cromwell), and Paul Rowe (Wachtell, Lipton, Rosen & Katz).

In addition, the following guest contributors to this Blog were also selected:
• George R. Bason (Davis Polk & Wardwell);
• Richard Climan (Cooley Godward Kronish);
• Jay Eisenhofer (Grant & Eisenhofer);
• Adam Emmerich (Wachtell, Lipton, Rosen & Katz);
• Robert Giuffra (Sullivan & Cromwell LLP);
• Edward Herlihy (Wachtell, Lipton, Rosen & Katz);
• David Katz (Wachtell, Lipton, Rosen & Katz);
• Martin Lipton (Wachtell, Lipton, Rosen & Katz); and
• Charles Nathan (Latham & Watkins).

Lawdragon’s announcement appears here. A post on this Blog featuring last year’s Lawdragton 500 is available here. The Blog and the Program had eight individuals represented then, including Lucian Bebchuk, Leo Strine, Peter Atkins, Ted Mirvis, James Morphy, Jay Eisenhofer, and Charles Nathan.

Overreactions to Ryan v. Lyondell Chemical Company

Posted by Steven M. Haas, Hunton & Williams LLP, on
Friday, January 16, 2009
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This post is from Steven M. Haas of Hunton & Williams LLP. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Back in September, the Delaware Supreme Court accepted the defendants’ interlocutory appeal and stayed the lower court proceedings in Ryan v. Lyondell Chemical Company. Typically, the Delaware Supreme Court and the Court of Chancery work in close harmony, so the Supreme Court’s decision was unusual since the appeal had been denied by Vice Chancellor Noble.

The appeal centers on Vice Chancellor Noble’s decision to deny the defendant-directors’ motion for summary judgment on allegations that they breached their fiduciary duties in approving a cash-out merger with a strategic buyer. Charles Nathan posted on the background and analysis of the decision here. The decision generated swift criticism, with most commentary characterizing it as improperly second-guessing a disinterested board’s decision to approve an all-cash premium offer, and as lowering the bar for stockholder-plaintiffs to allege bad faith in change-of-control transactions.

Travis Laster and I recently addressed this criticism in an article entitled “Reactions and Overreactions to Ryan v. Lyondell Chemical Co.” We argued that many commentators have overreacted to the Lyondell decision. To be sure, the Court of Chancery’s opinion can be criticized on several grounds, but its outcome was driven primarily by its procedural posture and does not dictate any meaningful change in established deal practice.

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Shareholder Impact of Option Backdating

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, January 15, 2009
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This post comes from Gennaro Bernile at the University of Miami and Gregg Jarrell at the University of Rochester.

In our paper “The Impact of the Options Backdating Scandal on Shareholders” which was recently accepted for publication in the Journal of Accounting and Economics, we analyze the excess returns that occurred in short windows surrounding ten distinct news events related to backdating of stock option grants.

Our analysis focuses on 129 firms identified by the Wall Street Journal as implicated in the backdating scandal as of December 31, 2006. We independently identify 764 firm specific backdating-related news events taking place on 580 separate firm-dates. For the first news event (typically the announcement of an internal investigation by the firm), we find a statistically significant excess return of about -4.50% in the -20 to -2 window and -2.40% in the -1 to +1 window. The magnitude of the implied wealth changes seems too large to be attributed to any reasonable estimate of direct out-of-pocket costs of the backdating scandal or to the resulting legal penalties disclosed to date (direct cost hypothesis). Therefore, the alternative hypothesis we propose, which we broadly label Agency Hypothesis, is that a firm’s involvement in the backdating scandal has significant economic implications, despite its limited (direct) impact on cash flows. Under this hypothesis, the losses generated by the option backdating scandal can arise because management’s involvement in backdating practices may prompt investors to reassess the agency costs stemming from the separation of ownership and control.

A series of multivariate show that measures we expect to be related to the effect of the scandal on the value of firms’ reputational capital and information risk are significantly related to changes in shareholders’ wealth. Conversely, variables one would expect to be related to the magnitude of direct out-of-pocket expenses, namely the number of past grants and/or their value, are not significantly related or are positively related to shareholders’ wealth effects, inconsistent with the direct cost hypothesis. In addition, consistent with this interpretation, the occurrence of government investigations or delisting notices have no incremental explanatory power, after controlling for firms’ likely culpability. We find that the losses are attenuated when tainted management of less successful firms is more likely to be replaced. We also find that institutional investors reduce their holdings in firms accused of backdating, possibly due to higher monitoring costs, and that firms involved in the scandal are very likely (10% of the sample) to receive arguably fair takeover offers.

Overall, the evidence is consistent with the hypothesis that the loss of investors’ confidence in the firm’s management is a first-order determinant of the economic consequences resulting from the option backdating scandal.

The full paper is available for download here.

Bribery Warrants Global War

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, January 14, 2009
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Editor’s Note: This article by Ben Heineman and Al Larson was also posted on Bloomberg.com. Mr. Heineman is the former Senior Vice President for Law and Public Affairs at General Electric.

The bribery scandal involving Siemens AG, Europe’s largest engineering company, is the latest evidence that corruption of public officials remains a pernicious problem as globalization intensifies. Accepting or extorting bribes and misappropriating public funds erodes judicial institutions and the rule of law, distorts competition and injures the poor.

Anti-corruption rhetoric exceeds commitment and accomplishment, especially in emerging-market nations. Building durable, transparent and accountable institutions in the highly diverse developing world — with failed, failing, fragile and rising states — is key, though complex and time-consuming.

One part of the solution can be tackled immediately: vigorous enforcement of the 1997 OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions. The goal of the effort — part of Paris-based Organization for Economic Co-Operation and Development – is to stop, or significantly minimize, bribes made by multinational corporations headquartered in industrialized nations.

The need for such action was underscored last month, when Siemens agreed to pay a record $1.3 billion to U.S. and German authorities for accounting and conspiracy offences, resulting from probes that the Munich-based company allegedly paid more than $1.4 billion in bribes around the world.

‘Unprecedented’ Misconduct
This followed resignations by Siemens’s board chairman and chief executive; the payment of more than $300 million in other penalties; restatements of more than $500 million for expenses subsequently disallowed as improper payments; and outlays of more than $850 million for lawyers and forensic accountants used in the company’s internal inquiry.

U.S. authorities said Siemens’s improper payments were “unprecedented in scale and geographic reach” as well as “systematic” and “standard operating procedures.” If bribery was so pervasive, involving employees at all levels, in such an iconic multinational company, then similar behavior almost certainly exists within major exporters elsewhere in Germany and in other industrialized nations.

Currently, 37 nations belonging to the OECD have ratified the anti-bribery convention and have enacted laws such as the U.S. Foreign Corrupt Practices Act (FCPA), prohibiting foreign bribery by U.S.-based transnational companies. These nations account for more than two-thirds of world exports.

Unfortunately, efforts to implement the convention at the national level have been inadequate. (The OECD itself has no enforcement powers; it can only monitor national efforts through its highly professional Working Group on Bribery.)

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