Monthly Archives: September 2010

The Market Reaction to Corporate Governance Regulation

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, September 20, 2010
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The following post comes to us from David Larcker, Professor of Accounting at Stanford University; Gaizka Ormazabal of the Accounting Department at Stanford University; and Daniel Taylor, Assistant Professor at the University of Pennsylvania.

In the paper, The Market Reaction to Corporate Governance Regulation, which was recently made publicly available on SSRN, we investigate the market reaction to recent legislative and regulatory actions pertaining to corporate governance. The managerial power view of governance suggests that executive pay, the existing process of proxy access, and various governance provisions (e.g., staggered boards and CEO-chairman duality) are associated with managerial rent extraction. This perspective predicts that broad government actions that reduce executive pay, increase proxy access, and ban such governance provisions are value enhancing. In contrast, another view of governance suggests that observed governance choices are the result of value-maximizing contracts between shareholders and management. This perspective predicts that broad government actions that regulate such governance choices are value destroying.

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Moving Forward with Corporate Environmental, Social and Governance Disclosure in Canada

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Sunday, September 19, 2010
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Aaron A. Dhir is an Associate Professor at Osgoode Hall Law School of York University. This post first appeared (in modified form) in The Lawyers Weekly, published by LexisNexis Canada Inc.

Whether the issue is climate change, biodiversity, labour and supply chains, or human rights, corporate sustainability disclosure is of increasing relevance to shareholders.  In a recent report submitted to Ontario, Canada’s minister of finance, the Ontario Securities Commission (OSC) made various recommendations regarding corporate reporting that may be controversial to some, but are a step in the right direction.

The report follows the Ontario Legislature’s unanimous approval of a private member’s resolution calling on the province to review existing reporting requirements and issuers’ compliance.

The resolution asked the OSC to undertake a broad consultation in order to “establish best practice corporate social responsibility…and environmental, social and governance…reporting standards”. In response, the OSC – supported by the Hennick Centre for Business and Law at York University – convened a multi-stakeholder roundtable and held various consultations with interested parties.

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Shadow Banking and Financial Regulation

Posted by Morgan Ricks, Harvard Law School, on
Saturday, September 18, 2010
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Morgan Ricks is a visiting assistant professor at Harvard Law School. Through June 2010, he was a Senior Policy Advisor and Financial Restructuring Expert at the U.S. Treasury Department. The views expressed herein do not necessarily reflect the views of the Department of the Treasury or the U.S. Government. This post is based on his paper “Shadow Banking and Financial Regulation,” available here.

Without a safety net, banking is unstable. This proposition finds support in economic theory. In an influential analysis, Douglas Diamond and Philip H. Dybvig showed that banks without deposit insurance exhibit multiple equilibria—one of which is a bank run. [1] And financial history confirms this hypothesis. Banking panics were common in the U.S. before the enactment of deposit insurance, but nonexistent thereafter.

The apparent instability of banking has given rise to a standard policy response in the form of a social contract (a phrase borrowed from a marvelous speech by Paul Tucker of the Bank of England). [2] That contract entails certain privileges that are unavailable to other firms: most notably, access to central bank liquidity and federal deposit insurance. These privileges amount to a safety net, and they stabilize banking. The social contract also imposes obligations—activity restrictions, prudential supervision, capital requirements, and deposit insurance fees. These obligations are designed to counteract the moral hazard incentives implicit in the safety net and protect taxpayers from losses.

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CEO Turnover and Retention Light

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, September 17, 2010
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The following post comes to us from John Evans, Professor of Accounting at the University of Pittsburgh; Nandu Nagarajan, Professor of Business Administration at the University of Pittsburgh; and Jason Schloetzer of the Accounting Department at Georgetown University.

In the paper, CEO Turnover and Retention Light: Retaining Former CEOs on the Board, forthcoming in the Journal of Accounting Research, unlike prior CEO turnover literature which characterizes the board’s decision as a choice between retaining versus replacing the CEO, we focus instead on the CEO’s decision rights and introduce a third option in which the incumbent CEO is removed but retained on the board for an extended period. We call this Retention Light.

Firms may benefit from Retention Light because former CEOs possess unique monitoring and advising abilities, but the former CEO could also exploit available decision rights for personal benefit. A Retention Light CEO’s decision rights generally exceed those of CEOs who exit the firm entirely but fall short of the rights of a retained CEO.

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Shareholder Proxy Access: Time To Get Ready

Posted by Adam O. Emmerich, Wachtell Lipton Rosen & Katz, on
Thursday, September 16, 2010
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Adam Emmerich is a partner in the corporate department at Wachtell, Lipton, Rosen & Katz focusing primarily on mergers and acquisitions and securities law matters. This post is based on a Wachtell Lipton firm memorandum by Mr. Emmerich, Andrew R. Brownstein, Steven A. Rosenblum, Eric S. Robinson and Trevor S. Norwitz.

As we described in our recent memo, the SEC has adopted rules affording shareholders access to company proxy statements for the nomination of director candidates. The new regime, which includes new access Rule 14a-11 and amendments to Rule 14a-8, is expected to become effective in early November and will be applicable for the 2011 proxy season for most companies. It is now time for companies to take action to prepare for these sweeping changes. We opposed proxy access as an unnecessary and imprudent step. However it is now law and companies need to implement structures and procedures designed to make the proxy access regime work with minimum damage to the ability of boards to build long-term value for all shareholders. This memo highlights some of the major actions companies should consider:

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Managerial Miscalibration

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, September 15, 2010
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The following post comes to us from Itzhak Ben-David, Assistant Professor of Finance Department at the Ohio State University; John Graham, Professor of Finance at Duke University; and Campbell Harvey, Professor of Finance at Duke University.

In the paper, Managerial Miscalibration, which was recently made publicly available on SSRN, we study whether top corporate executives are miscalibrated as well as the determinants of their miscalibration. Miscalibration is a form of overconfidence examined in psychology, economics, and law. Although it is often analyzed in lab experiments, there is scant evidence about the effects of miscalibration in practice.

Over the past nine years, we collected over 11,600 S&P 500 forecasts as well as 80% confidence intervals from Chief Financial Officers. The width of the confidence interval gives us a measure of miscalibration. Importantly, the CFOs are forecasting a common market-wide measure. This allows us to exploit cross-sectional heterogeneity in both optimism and miscalibration. By comparing forecasts to realizations over many periods, we also present a simple measure of miscalibration.

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Spotlight on Boards

Posted by Martin Lipton, Wachtell, Lipton, Rosen & Katz, on
Tuesday, September 14, 2010
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Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton firm memorandum by Mr. Lipton.

Current focus on the performance of corporate boards prompts revisiting what is expected from the board of directors of a major public company – not just the legal rules, but also the aspirational “best practices” that have come to have almost as much influence on board and company behavior.

Boards are expected to:

  • Choose the CEO, monitor his or her performance and have a detailed succession plan in case the CEO becomes unavailable or fails to meet performance expectations.
  • Plan for and deal with crises, specially crises like HP where the tenure of the CEO is in question, BP where there has been a major disaster or J&J and Toyota where hard-earned reputation is threatened by product failure.

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Do Peer Firms Affect Corporate Financial Policy?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, September 13, 2010
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The following post comes to us from Mark Leary of the Finance Department at Washington University and Michael Roberts of the Finance Department at the University of Pennsylvania.

In the paper, Do Peer Firms Affect Corporate Financial Policy? which was recently made publicly available on SSRN, we show that corporate financial policies are highly interdependent. Firms make financing decisions in large part by responding to the financing decisions of their peers, as opposed to changes in firm-specific characteristics.

We find that, on average, a one standard deviation change in peer firms’ leverage ratios is associated with an 11% change in own firm leverage ratios—a marginal effect that is significantly larger than that of any other observable determinant and one that is driven by interdependencies among debt and equity issuance decisions.

Consistent with information- based theories of learning and reputation, we find that smaller, more financially constrained firms with lower paid and less experienced CEOs are more likely to mimic their peers. Additionally, we quantify the externalities engendered by these peer effects, which can amplify the impact of changes in exogenous determinants on leverage by almost 70%.

The full paper is available for download here.

Using Cash-Settled Derivatives to Hide Corporate Ownership

Posted by Matteo Tonello, The Conference Board, on
Sunday, September 12, 2010
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This post comes to us from Matteo Tonello, Director of Corporate Governance for The Conference Board, Inc., and is based on a recent paper published by the Conference Board, which is available here.

In a recent paper, Know Your Shareholders: The Use of Cash-Settled Equity Derivatives to Hide Corporate Ownership Interests, The Conference Board offers guidance for directors of public companies to address or prevent situations where shareholders accumulate undisclosed equity stakes by means of cash-settled derivatives.

Derivatives are an important class of financial instruments that has taken center stage in today’s capital markets. The reason for their increasing popularity is that they offer risk protection while also allowing innovative investment strategies. In particular, in a regulatory environment where disclosure requirements are triggered by voting rights rather than economic interest, derivatives can be used to conceal equity ownership of a public company—a practice generally known as “hidden ownership.”

The new report by The Conference Board cites anecdotal evidence—including the most notable recent cases regarding Continental, Fiat, and Volkswagen-Porsche—that cash-settled derivatives are increasingly being used by investors and strategic bidders to discretely expand their ownership positions in business corporations listed on European stock exchanges.

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Defending Against Shareholder Proxy Access

Posted by J.W. Verret, George Mason University School of Law, on
Saturday, September 11, 2010
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J.W. Verret is an Assistant Professor at George Mason University School of Law and a Senior Scholar at the Mercatus Center’s Financial Markets Working Group. This post is based on a working paper by Mr. Verrett, which is available here. Additional posts on proxy access are available here.

In my paper Defending Against Shareholder Proxy Access: Delaware’s Future Reviewing Company Defenses in the Era of Dodd-Frank, I propose a variety of new defenses boards can implement to subvert and limit the reach of proxy access under the new federal proxy access regime to be implemented under Dodd-Frank.  I also consider the legality of those defenses under Delaware law and the prospect of federal pre-emption.

The debate over shareholder access to the corporate proxy has been a vibrant one, culminating recently in a provision in the Dodd-Frank Wall Street Reform Act authorizing the SEC to adopt a proxy access rule.   Recent reports indicate that the SEC is scheduled to adopt a final rule August 25.  This blog has featured commentary almost since its inception on the issue, particularly Professor Bebchuk’s work advocating for shareholder empowerment.

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