Monthly Archives: November 2010

Pricing Corporate Governance

Lucian Bebchuk is Professor of Law, Economics, and Finance and Director of the Corporate Governance Program at Harvard Law School. This post is Professor Bebchuk’s most recent op-ed in his column series titled “The Rules of the Game,” written for the international association of newspapers Project Syndicate, which can be found here. This op-ed draws on his study with Alma Cohen and Charles C.Y. Wang, “Learning and the Disappearing Association between Governance and Returns,” available here.

Do markets appreciate and correctly price the corporate-governance provisions of companies? In new empirical research, Alma Cohen, Charles C.Y. Wang, and I show how stock markets have learned to price anti-takeover provisions. This learning by markets has important implications for both managements of publicly traded companies and their investors.

In 2001, three financial economists – Paul Gompers, Joy Ishii, and Andrew Metrick – identified a governance-based investment strategy that would have yielded superior stock-market returns during the 1990’s. The strategy was based on the presence of “entrenching” governance provisions, such as a classified board or a poison pill, which insulate managements from the discipline of the market for corporate control.

During the 1990’s, holding shares of firms with no or few entrenching provisions, and shorting shares of firms with many such provisions, would have outperformed the market. These findings have intrigued firms, investors, and corporate-governance experts ever since they were made public, and have led shareholder advisers to develop governance-based investment products.

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Premium Pay for Executive Talent

The following post comes to us from Mary Ellen Carter of the Accounting Department at Boston College, Francesca Franco of the Accounting Department at London Business School, and Irem Tuna of the Accounting Department at London Business School.

In the paper, Premium Pay for Executive Talent: An Empirical Analysis, which was recently made publicly available on SSRN, we study the extent to which executive talent affects executive compensation design. Although the effect of executive-specific characteristics on firm choices and outcomes is the subject of a large literature in organizational theory, economics, and finance, not much direct evidence is available on the association between executive-specific characteristic of talent and compensation contracts.

We derive three proxies to capture the executive’s talent using principal components analysis. The first component captures the “perceived” dimension of talent, based on whether the executive was a CEO at the previous firm, tenure in a prior top position, excess pay at the previous firm, and the press coverage while at the previous firm. Our other two proxies capture measurable outcomes of actions at the prior employer. One measures talent using accounting and stock price performance at the prior firm. The other captures talent by relying on reporting quality, namely whether the prior firm has been subject to an AAER or has restated its earnings.

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Test-Driving a Hybrid Go-Shop

David Fox is a partner at Kirkland & Ellis LLP, focusing on complex mergers and acquisitions as a member of that firm’s Corporate Group. This post is based on a Kirkland & Ellis M&A Update by Mr. Fox and Daniel Wolf.

By now dealmakers are no doubt familiar with the “go-shop” which gained popularity during the 2006-2008 LBO boom as an alternative formulation to the traditional “no-shop” in sale agreements for public company targets. In a number of recent strategic deals an interesting hybrid formulation has been used under which the traditional no-shop prohibitions on post-announcement active solicitation of competing offers apply but the bifurcated termination fee structure feature of the go-shop is used, with a lower break-up fee applying in the event the topping bid surfaces during a defined initial period after the deal signing.

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Synthetic Ownership Arrangements for Ambush Equity Accumulation

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 and William Savitt. A portion of their memo was quoted in a recent DealBook column from the New York Times, available here.

We have recently witnessed equity accumulations on both sides of the Atlantic that were first announced long after they began and long after the acquiring parties had effectively passed applicable disclosure thresholds.  Here in the U.S., Pershing Square and Vornado earlier this month announced a combined stake of almost 27% in J.C. Penney.  And last weekend French luxury-goods conglomerate LVMH announced that it had amassed a previously undisclosed stake in excess of 14% in Hermès, including through transactions extending over a period of years.  Although the details of both accumulation programs are as yet not fully known, they appear to have been conducted on the assumption that the U.S. and French regulatory regimes requiring prompt and current disclosure of share accumulations can be evaded through derivatives and other synthetic and structured ownership arrangements, even when they involve ownership of actual shares by counterparties, up until the point when such trades are settled by taking options on or physical delivery of the underlying shares.

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Ownership Structure and the Cost of Corporate Borrowing

The following post comes to us from Chen Lin, Professor of Finance at the Chinese University of Hong Kong; Yue Ma, Professor of Economics at Lingnan University, Hong Kong; Paul Malatesta, Professor of Finance at the University of Washington; and Yuhai Xuan, Assistant Professor of Business Administration at the Finance Unit of Harvard Business School.

In the paper, Ownership Structure and the Cost of Corporate Borrowing, forthcoming in the Journal of Financial Economics, we study the financial consequences of the divergence between control rights and cash-flow rights in a large sample of companies across 22 East Asian and Western European countries during the period from 1996 to 2008. Specifically, we analyze the effects of control rights-cash-flow rights divergence on firms’ cost of borrowing and provide new insights into the link between the separation of ownership and control and corporate value.

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The (Agency) Problem of Risk Incentives within Financial Institutions

The following post comes to us from Sjoerd van Bekkum of the Finance Department at New York University and the Erasmus School of Economics at Erasmus University.

In the paper, Downside Risk and Agency Problems in the U.S. Financial Sector: Examining the Effect of Risk Incentives from 2007 to 2010, I consider risk incentives within financial institutions in the presence of two types of potential agency problems: the standard manager-shareholder agency problem and the risk-shifting problem between shareholders and society. First, I evaluate the effect of risk incentives on shareholder returns during the financial crisis. Next, I examine the relation between risk incentives and three downside risk statistics. Value-at-risk resembles a financial institution’s tolerance to losses, expected shortfall resembles losses when the firm does poorly, and marginal expected shortfall resembles an institution’s exposure to loss spillovers from its peers.

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SEC Shapes New Disclosure Requirements

H. Rodgin Cohen is a partner and chairman of Sullivan & Cromwell LLP focusing on acquisition, corporate governance, regulatory and securities law matters. This post is based on a Sullivan & Cromwell LLP publication. The proposed rules discussed in this post can be found here.

At an open meeting in September, the SEC voted to propose rules that would require a public company to provide certain enhanced disclosures about its short-term borrowings in its filings with the SEC. The SEC also voted to approve the issuance of an interpretive release to provide guidance regarding the SEC’s current disclosure requirements in the MD&A relating to liquidity and capital resources. The objective of these initiatives is to address so-called “balance sheet window-dressing” by requiring disclosure about a public company’s leverage and liquidity throughout the course of the relevant reporting period rather than only at period-end.

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How to Fix Bankers’ Pay

Lucian Bebchuk is a Professor of Law, Economics, and Finance at Harvard Law School.

In a recent essay, written for a special issue of the American Academy of Arts and Sciences’ Daedalus journal on lessons from the financial crisis, I discuss how bankers’ pay should be fixed.

The essay, How to Fix Bankers’ Pay, discusses two distinct sources of risk-taking incentives: first, executives’ excessive focus on short-term results; and, second, their excessive focus on results for shareholders, which corresponds to a lack of incentives for executives to consider outcomes for other contributors of capital. I then discuss how pay arrangements can be reformed to address each of these problems and conclude by examining the role that government should play in bringing about the needed reforms.

The essay is available here. It draws on, and provides an accessible summary of the analysis developed in, three studies:

Management as a Profession: A Business Lawyer’s Critique

Editor’s Note: Ben W. Heineman, Jr. is a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government. An article related to this post appeared in the online edition of the Harvard Business Review.

As debates about the purpose of business and business schools continue apace, one recurrent theme is that business management should be a profession like law and medicine in order to promote responsible conduct and trustworthy business leadership.

This thesis in its contemporary form was propounded in 2005 by two highly regarded scholars, Rakesh Khorana (professor at the Harvard Business School) and Nitin Nohria (then HBS professor, now HBS dean), and an HBS research associate (read their op-ed here). It remains a subject of debate and controversy today. (See Khurana’s response to Professor Richard Baker’s recent HBR critique, available here.)

If implemented, their ideas could have a significant impact on corporate governance. Business people would take a licensure exam on set of subjects; they would be subject to a code of professional responsibility; and a professional association would impose sanctions on those who violated the code. Thus a new set of norms would guide and constrain business leaders beyond the policies and practices of the individual firm, standard setting on narrow topics (consistent with the antitrust laws) by discrete industry groups and the law and regulations of state and federal government.

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The Financial Panic of 2008 and Financial Regulatory Reform

Randall Guynn is head of the Financial Institutions Group at Davis Polk & Wardwell LLP. This post is based on a report issued by the Task Force on the Financial Crisis of the International Bar Association. Mr. Guynn authored the U.S. chapter of this report, and an abridged version of this chapter appears below; the complete chapter is available here. The full report is available here.

The Financial Panic of 2008

The first signs of an impending financial crisis appeared in the US in 2007, when US real estate prices began to collapse and early delinquencies in recently underwritten sub-prime mortgages began to spike. It culminated in a genuine financial panic during September and October of 2008. The most serious recession since the Great Depression of the 1930s followed. The Federal Reserve and other organs of the US Government responded by flooding the markets with money and other liquidity, reducing interest rates, providing extraordinary assistance to major financial institutions, increasing Government spending, and taking other steps to provide financial assistance to the markets.

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