Monthly Archives: May 2010

Senate Bill Passes with Broad Corporate Governance and Compensation Provisions

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP. This post is based on a Davis Polk client memorandum by Ning Chiu, William M. Kelly and Barbara Nims. This post relates to a previous Davis Polk post about the Senate Bill, available here.

Last night the Senate passed the Restoring American Financial Stability Act of 2010 . As discussed in a prior memorandum published on the Forum, the Senate Bill would federalize significant governance and executive compensation matters that have historically been a matter of state law. The bill would affect all US public companies and would especially be felt by midcap and smaller companies that have until now generally not been the target of governance activists.

We expect that next month Congress will begin reconciling the Senate Bill with the Wall Street Reform and Consumer Protection Act of 2009, which passed the House on December 11, 2009. We expect that the law that emerges will closely follow the Senate Bill.

This brief memorandum highlights the key corporate governance and disclosure provisions of the Senate Bill. We will shortly publish a detailed memorandum that will address the heart of the Senate Bill: the overhaul of financial institution regulation.


Are International Accounting Standards-Based and US GAAP-Based Accounting Amounts Comparable?

This post comes to us from Mary Barth, Professor of Accounting at Stanford University, Wayne Landsman, Professor of Accounting at the University of North Carolina at Chapel Hill, Mark Lang, Professor of Accounting at the University of North Carolina at Chapel Hill, and Christopher Williams, Assistant Professor of Accounting at the University of Michigan.

In our paper, Are International Accounting Standards-Based and US GAAP-Based Accounting Amounts Comparable? which was recently made publicly available on SSRN, we seek to determine the extent to which application of International Financial Reporting Standards (IFRS) as applied by non-US firms (hereafter, IFRS firms) results in accounting amounts that are comparable to those resulting from application of US Generally Accepted Accounting Principles (GAAP) by US firms. We do this by addressing two questions. The first is whether comparability is higher after IFRS firms apply IFRS than when they applied non-US domestic standards. The second is whether after IFRS firms adopt IFRS comparability differs depending on whether a firm adopted IFRS mandatorily, depending on the legal origin of an IFRS firm’s country, and for more recent reporting years. Although there is a growing literature examining whether application of IFRS affects quality of accounting amounts and has economic implications in capital markets, no study directly examines the extent to which application of IFRS by IFRS firms results in accounting amounts that are comparable to those based on application of US GAAP by US firms.


Inside the Corporate Governance Complex

Editor’s Note: Suzanne Stevens is a senior editor at The Deal. This post relates to a recent article by Ms. Stevens in The Deal, which is available here.

In an article titled What Berle and Means have wrought in the May 17 issue of The Deal magazine and available on, my colleague Michael Rudnick and I map the well-funded, sprawling and interlocking set of institutions that have grown up around corporate governance over the past 30 years or so. This governance complex, with major outposts across the country at research universities, law firms, the federal government, institutions, activist hedge funds and even blogs like this one, generates considerable intellectual and financial firepower. We lay out some of its fissures, schism and alliances, and talk to movers and shakers including legal icons Ira Millstein and Martin Lipton, Harvard’s Lucian Bebchuk, Stanford’s Joe Grundfest, Relational Investors’ Ralph Whitworth, Calpers’ Anne Simpson and The Corporate Library’s Nell Minow.

Why now? The financial crisis has propelled the issue of the role of boards and balance sheet transparency high onto regulatory and legislative agendas. Congress is threatening to reach deep into corporate boardrooms on executive pay, and the Obama-era SEC is taking a more activist approach to governance than at any time since the Enron Corp. and WorldCom Inc. scandals of the early 2000s.


Estimating the Effects of Large Shareholders Using a Geographic Instrument

This post comes to us from Bo Becker, Assistant Professor of Finance at Harvard Business School; Henrik Cronqvist, McMahon Family Chair in Corporate Finance, George R. Roberts Fellow, and Associate Professor of Financial Economics at Claremont McKenna College; and Rüdiger Fahlenbrach, Swiss Finance Institute Professor at Ecole Polytechnique Fédérale de Lausanne.

In our paper, Estimating the Effects of Large Shareholders Using a Geographic Instrument, forthcoming in the Journal of Financial and Quantitative Analysis, we develop and test a new instrumental variable framework which allows us to separate selection effects from treatment effects for a large group of blockholders and to quantify their impact on several aspects of firm behavior. We start by documenting that non-managerial individual shareholders hold blocks in firms that are headquartered close to where they live. We then use this empirical fact to create an instrumental variable (the geographic variation in the density of wealthy individuals) for the presence of a large shareholder in a publicly traded U.S. firm. This instrument predicts the presence of a block in a firm with surprising power, and it is robust to the inclusion of variables that vary geographically, reducing concerns about its validity.


Red Flags for Say-on-Pay Voting

Ann Yerger is Executive Director of the Council of Institutional Investors. Other articles on say-on-pay on the Forum are available here.

Update: In related news on say-on-pay, the first U.S. public company has lost a say-on-pay vote. Only 46% of votes cast at Motorola’s annual meeting this year voted “yes” on the company’s say-on-pay resolution, which it included in this year’s proxy voluntarily, available here.

For investors, the advent of advisory shareowner votes on executive compensation — at more than 300 companies in 2010 — is an opportunity and a challenge. These votes can be catalysts for shareowner discussions with directors and management about pay concerns, including the structure and size of executive compensation. But they also oblige shareowners to analyze compensation in a thoughtful way.

Many investors, however, lack the time and resources to do deep dives on compensation at each of the hundreds of companies in their portfolios. They need rules of thumb to identify executive pay programs that are ticking time bombs. Poorly-designed incentives can promote excessive risk-taking and get-richquick mentalities — key contributors to the financial crisis.

Accordingly, the Council has developed the following list of red flags to help members target companies where pay deserves careful scrutiny and where dialogue may be most urgent. The list was crafted by Council staff after a thorough review of Council policies and comment letters on executive compensation, checklists developed by other organizations and the recommendations of 15 pay experts who briefed members in a series of teleconferences in 2009.

The list is a guide to problematic pay practices but is not meant to be exhaustive.


CEO Replacement under Private Information

This post comes to us from Roman Inderst, Professor of Finance and Economics at the Goethe University Frankfurt, and Holger Mueller, Associate Professor of Finance at New York University.

In the paper, CEO Replacement under Private Information, forthcoming in the Review of Financial Studies, we derive joint implications for the optimal CEO compensation and replacement policy based on a model of “information-based entrenchment.” In our model, the CEO’s desire to become entrenched is endogenous and does not derive from exogenously specified private benefits of control. Rather, it derives from the optimal compensation scheme inducing the CEO to work hard, which must promise him an ex-post quasi rent (in the form of generous on-the-job pay) in case he continues. This biases the CEO towards continuation which, together with his private information at the interim stage, drives a wedge between efficient CEO replacement and actual CEO turnover.

High-powered incentive pay, and possibly also severance pay, can mitigate CEO entrenchment. Incentive pay ensures that the CEO’s expected on-the-job pay is high precisely when the firm value under his continued leadership is high, thus aligning the CEO’s continuation preferences with those of the firm at the replacement stage. The role of severance pay in our model is more nuanced, as an increase in severance pay must be accompanied by a simultaneous increase in the CEO’s on-the-job pay. Otherwise, there would be too high a reward for failure and the CEO would shirk. As a result, each dollar of severance pay constitutes a dollar of rent for the CEO. Importantly, however, whether severance pay can mitigate entrenchment depends on the structure of the CEO’s on-the-job pay. As our model shows, the firm gets the biggest “bang for the buck” (i.e., the biggest reduction in entrenchment) if an increase in severance pay is accompanied by a simultaneous increase in incentive pay, not base pay.


The Wall Street Takeover and the Next Financial Meltdown: Problems and Solutions

Editor’s Note: This post comes to us from James Kwak, co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, and co-founder of the blog The Baseline Scenario.

13 Bankers, the book that I co-write with Simon Johnson, was released one month ago. The book has gotten more attention than I had anticipated, for which I am grateful. Senator Christopher Dodd even told Don Imus that he was reading “13 Banks, by this other fellow,” although he later said this to Ezra Klein:

“I’ve looked at the 13 Bankers book, and so forth, that approach, and I hear this, by the way, not just from them, but from CEOs of major corporations. This is not some left/right question. But I just don’t think that it makes a lot of sense. I don’t think it’ll prevail.”

By far the part of the book that has gotten the most attention is the recommendation, in the last chapter, that our six largest banks be broken up and capped in size at 4 percent of U.S. GDP (with a lower limit for riskier or more interconnected banks). This idea has also been the target of many criticisms, from Paul Krugman (“Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions.”), Larry Summers, and Tim Geithner, among others.


The Corporate Responsibility to Respect Human Rights

John Ruggie is the Berthold Beitz Professor of International Affairs at the Kennedy School of Government, and an Affiliated Professor in International Legal Studies at Harvard Law School. He is currently serving as the United Nations Secretary-General’s Special Representative for Business and Human Rights. This post relates to an interim report by the Special Representative, which is available here.

Late last month, the latest report under my mandate as Special Representative of the U.N. Secretary General on business and human rights was released in advance of the June session of the U.N. Human Rights Council (Council). This is my last interim report before I submit my final recommendations next year. In this posting I share the report’s discussion on the corporate responsibility to respect, the second pillar in a policy framework I proposed, and which the Council unanimously welcomed, for better managing business and human rights challenges. In particular, I focus on the links between human rights due diligence – a key process for companies to know and show that they respect human rights – and legal compliance, including with corporate governance and securities laws.


The Consequences of Entrepreneurial Finance

Josh Lerner is a Professor of Entrepreneurial Management and Finance at Harvard Business School.

In the paper, The Consequences of Entrepreneurial Finance: A Regression Discontinuity Analysis, which was recently made publicly available on SSRN, my co-authors (William Kerr and Antoinette Schoar) and I document the role of angel funding for the growth, survival, and access to follow-on funding of high-growth start-up firms. We use a regression discontinuity approach to control for unobserved heterogeneity between firms that obtain funding and those that do not. This technique exploits that a small change in the collective interest levels of the angels can lead to a discrete change in the probability of funding for otherwise comparable ventures.

The results of this study and our border analysis in particular, suggest that angel investments improve entrepreneurial success. By looking above and below the discontinuity in a restricted sample, we remove the most worrisome endogeneity problems and the sorting between ventures and investors. We find that the localized increases in interest by angels at break points, which are clearly linked to obtaining critical mass for funding, are associated with discrete jumps in future outcomes like survival and stronger web traffic performance.


Current Corporate Governance Trends in Germany

Ken Altman is the President and founder of The Altman Group. This post is based on an Altman Group Governance & Proxy Review article by Asha Doogah and Frank J. Cifarelli.

About a decade or so ago, publicly traded German operating companies were characterized by stable management boards with mostly German nationals serving as board members, and stable shareholder bases characterized by a preponderance of cross-holdings by German banks, insurance companies and other operating companies. In general, there was little shareholder activism and German companies were run using a consensus style basis, with different parties giving input and decisions being made that strived for unified outcomes among the different stakeholders. This source of stability aided the German economy and allowed Germany to develop into one of the wealthiest, most prosperous Western Democracies in the world. In fact, Germany became the world’s leading exporter until only overtaken by China this past year.

However, Germany’s foray into the global economy now makes German companies recognize the important topic of corporate governance, which is a world-wide phenomenon that publicly traded companies must address. Currently, foreign investors are investing in German companies to a larger degree than in the past and activist shareholders are making their views known to management and taking action as a result. In their 22nd of August, 2008 edition, the highly respected German newspaper, Handelsblatt, published their leading story with the headline “Foreigners increase pressure on companies – international investors use general meetings for criticism.”


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