Yearly Archives: 2012

Proposals for Auditor Independence and Audit Firm Rotation

Posted by Richard C. Breeden, Breeden Capital Management LLC, on
Saturday, April 21, 2012
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Richard Breeden is the founder and chairman of Breeden Capital Management LLC and former chairman of the U.S. Securities and Exchange Commission. This post is based on Mr. Breeden’s statement before the Public Company Accounting Oversight Board’s public meeting on firm independence and rotation, available here.

It is an honor for me to participate in the Public Company Oversight Board’s public meeting to discuss proposals to enhance auditor independence, objectivity and professional skepticism, including the potential of imposing rules setting a maximum term limit for audit relationships. Sadly, many people in official Washington seem prepared to jettison the interests of investors without reason as would occur in the proposed JOBS legislation, which as currently written would unnecessarily savage important barriers against fraud and manipulation of markets. We should never be afraid to experiment with opportunities for reducing unnecessary regulatory costs, particularly for smaller companies. At the same time, we shouldn’t let anyone’s financial agenda be a pretext for allowing the unscrupulous a free rein to abuse savers and investors. In its current form this legislation has too many elements that are simply fantasies, such as that a company with $1 billion in revenue is a “small business”, when that is 10-20X too high a threshold.

When Jim Doty and I were at the SEC, the Commission created an entire set of registration statements and ’34 Act filings (eg, Form 10-KSB) geared for small companies to lower their costs in raising capital or being public companies. Companies could elect the simpler forms if they wished, although they might pay a market penalty for providing less information. We allowed things like requiring two years of audited financials rather than 3 years, and three years rather than five years of selected financial data. We simplified disclosure requirements for smaller firms with less than $25mm in revenue (about $41mm in today’s dollars), but nobody got a free pass for fraud and there was still transparency for investors in current results.

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Securities Class Action Settlements

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, April 20, 2012
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The following post comes to us from Narayanan Subramanian, principal at Cornerstone Research. This post discusses a Cornerstone Research report by Ellen M. Ryan and Laura E. Simmons, available here.

There were 65 court-approved securities class action settlements involving $1.4 billion in total settlement funds in 2011—the lowest number of approved settlements and corresponding total settlement dollars in more than 10 years, according to Securities Class Action Settlements—2011 Review and Analysis, an annual report by Cornerstone Research. The number of settlements approved in 2011 decreased by almost 25 percent compared with 2010 and was more than 35 percent below the average for the preceding 10 years. Further, the total dollar value of settlements declined by 58 percent, from $3.2 billion in 2010 to $1.4 billion in 2011. The change in the number of settlements from 2010 to 2011 is one of the two largest year-over-year declines and, combined with a year-over-year decrease in settlements in 2010, the first time there has been a decline in the number of settled cases for two consecutive years.

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Equity Risk Incentives and Corporate Tax Aggressiveness

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, April 20, 2012
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The following post comes to us from Sonja Olhoft Rego of the Department of Accounting at Indiana University and Ryan Wilson of the Department of Accounting at the University of Iowa.

In our forthcoming Journal of Accounting Research paper, Equity Risk Incentives and Corporate Tax Aggressiveness, we examine equity risk incentives as one determinant of corporate tax aggressiveness. As noted by Shevlin [2007], we have an incomplete understanding of why some firms are more tax aggressive than others. Prior accounting research finds that corporate tax avoidance is systematically associated with certain firm attributes, including profitability, extent of foreign operations, intangible assets, research and development expenditures (R&D), leverage, and financial reporting aggressiveness. Dyreng, Hanlon, and Maydew [2010] conclude that individual managers influence their firms’ tax avoidance, even after controlling for numerous firm characteristics. Prior research also examines whether income tax avoidance is associated with corporate compensation practices, but finds mixed evidence. We argue that tax avoidance is a risky activity, which imposes costs on both firms and managers. As a result, managers must be incentivized to engage in tax avoidance that involves uncertain outcomes.

Equity risk incentives capture the convexity of the relation between a manager’s wealth and stock price, and are measured as the change in value of a manager’s stock option portfolio for a given change in stock return volatility (e.g., Guay [1999]). In short, equity risk incentives reflect how changes in stock return volatility affect managerial wealth. Prior research provides evidence that equity risk incentives motivate managers to make more risky – but positive net present value – investing and financing decisions. However, these studies do not examine the relation between equity risk incentives and risky tax planning, which we also refer to as “risky tax avoidance” and/or “aggressive tax positions.” We argue that just as equity risk incentives motivate managers to make more risky investing and financing decisions, they also motivate managers to undertake more aggressive (i.e., risky) tax positions, and thus account for some variation in tax aggressiveness across firms.

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Giving Shareholders a Voice

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, April 19, 2012
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Editor’s Note: Lucian Bebchuk is a Professor of Law, Economics, and Finance and Director of the Shareholder Rights Project (SRP) at Harvard Law School. This post is based on an op-ed article by Professor Bebchuk published today in the New York Times DealBook, available here. The post responds to a critique of the SRP’s activities in a memorandum issued by Wachtell, Lipton, Rosen & Katz, which appears in a post here. Any views expressed and positions taken by the SRP and its representatives should be attributed solely to the SRP and not to Harvard Law School or Harvard University.

Staggered boards have long been a key mechanism for insulating boards of publicly traded firms from shareholders. This year, several institutional investors and a program working on their behalf have used shareholder proposals to move a large number of publicly traded firms away from such structures. Despite strong and expected criticism from the usual suspects, shareholders should welcome and support this work.

The Shareholder Rights Project, a clinical program that I run at Harvard Law School, assists public pension funds and charitable organizations in improving corporate governance at publicly traded companies. During this proxy season, we represented and advised five such clients – the Illinois State Board of Investment, the Los Angeles County Employees Retirement Association, the Nathan Cummings Foundation, the North Carolina State Treasurer, and the Ohio Public Employees Retirement System – in connection with their submission of proposals for a vote at the annual meetings of more than 80 companies on the Standard & Poor’s 500-stock index.

The proposals urge companies with a staggered board, which allow shareholders to replace only a few directors each year, to place all board members up for election every year. Such a move to annual elections is viewed by investors as a best practice of corporate governance. By enabling shareholders to register their views on all directors each year, annual elections make boards more accountable to shareholders.

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April 2012 Dodd-Frank Progress Report

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, April 18, 2012
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The following post comes to us from Margaret E. Tahyar and Gabriel D. Rosenberg of the Financial Institutions Group at Davis Polk & Wardwell LLP. This post discusses a Davis Polk report which is available here. A post about the previous progress report is available here. Other posts about the Dodd-Frank Act are available here.

This posting, the April 2012 Davis Polk Dodd-Frank Progress Report, is the thirteenth in a series of Davis Polk presentations that illustrate graphically the progress of the rulemaking work that has been done and is yet to occur under the Dodd-Frank Act. The Progress Report has been prepared using data from the Davis Polk Regulatory Tracker™, an online subscription service offered by Davis Polk to help market participants understand the Dodd-Frank Act and follow regulatory developments on a real-time basis.

In this report:

  • As of April 2, 2012, a total of 222 Dodd-Frank rulemaking requirement deadlines have passed. Of these 222 passed deadlines, 155 (69.8%) have been missed and 67 (30.2%) have been met with finalized rules.
  • In addition, 100 (25.5%) of 393 total required rulemakings have been met with finalized rules. Rules have not yet been proposed to meet 138 (35.1%) rulemaking requirements.

Investor Horizons and Corporate Cash Holdings

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, April 18, 2012
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The following post comes to us from Jarrad Harford, Professor of Finance at the University of Washington; and Ambrus Kecskés and Sattar Mansi, both of the Department of Finance at Virginia Tech.

It is well known that the separation of ownership and control in public firms causes tension between investors and managers. These so-called “agency problems” are particularly pronounced in the use of corporate cash holdings because it is both easy for managers to misuse cash and hard for investors to evaluate the appropriateness of mangers’ use of cash. Moreover, cash holdings account for a substantial proportion of corporate assets (about 25% of total assets in recent years). Therefore, since firms with better internal corporate governance tend to use their cash holdings more for the benefit of their investors rather than their managers, it is not surprising that investors are willing to pay a higher price for them.

In the paper, Investor Horizons and Corporate Cash Holdings, which was recently made publicly available on SSRN, we study how the investment horizons of a firm’s institutional investors affect the agency costs of corporate cash holdings. It is widely recognized that monitoring by institutional investors of managers increases firm value. However, not all institutional investors are created equal, and, one important way in which they differ is their investment horizons. Differences in investment horizons arise, for example, because of differences in investment strategies (e.g., short-term hedge funds) and/or differences in the maturity of liabilities (e.g., long-term pension funds).

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Learning and the Disappearing Association between Governance and Returns

Posted by Lucian Bebchuk, Alma Cohen and Charles C.Y. Wang, Harvard Law School, on
Tuesday, April 17, 2012
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Lucian Bebchuk, Alma Cohen, and Charles C.Y. Wang are all affiliated with Harvard Law School’s Program on Corporate Governance.

The Journal of Financial Economics has recently accepted for publication our study, Learning and the Disappearing Association between Governance and Returns. The paper, which was earlier issued as a working paper of the Program on Corporate Governance, is available here.

Our study seeks to explain a pattern that has received a great deal of attention from financial economists and capital market participants: during the period 1991-1999, stock returns were correlated with the G-Index based on twenty-four governance provisions (Gompers, Ishii, and Metrick (2003)) and the E-Index based on the six provisions that matter most (Bebchuk, Cohen, and Ferrell (2009)). We show that this correlation did not persist during the subsequent period 2000-2008. Furthermore, we provide evidence that both the identified correlation and its subsequent disappearance were due to market participants’ gradually learning to appreciate the difference between firms scoring well and poorly on the governance indices. Consistent with the learning hypothesis, we find that:

(i) The disappearance of the governance-return correlation was associated with an increase in the attention to governance by a wide range of market participants;
(ii) Until the beginning of the 2000s, but not subsequently, stock market reactions to earning announcements reflected the market’s being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms;
(iii) Stock analysts were also more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms until the beginning of the 2000s but not afterwards;
(iv) While the G-Index and E-Index could no longer generate abnormal returns in the 2000s, their negative association with Tobin’s Q and operating performance persisted; and
(v) The existence and subsequent disappearance of the governance-return correlation cannot be fully explained by additional common risk factors suggested in the literature for augmenting the Fame-French-Carhart four-factor model.

Here is a more detailed account of our analysis:

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Hedge Fund Activism in Technology and Life Science Companies

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, April 17, 2012
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This post is based on a Latham & Watkins LLP commentary by Nicholas O’Keefe, available here.

Hedge fund activism has received a lot of attention in the legal and financial communities since the middle of the last decade, and has been identified as a major threat to U.S. public companies. Some of the early literature suggested that hedge funds avoid companies with high levels of R&D (such as technology and life science companies), in part because their businesses are more complicated and it takes longer for efforts of the hedge funds to be appreciated by the investment community and to generate returns. There has also been an assumption among legal practitioners that many technology and life science companies are dependent on the skills of their founders, and thus a hedge fund campaign faces the risk that the main assets of the company may walk out the door. However, a review of campaigns of 33 hedge funds from 2005 through the end of 2011 indicates that hedge fund activism is not only a significant risk that technology and life science companies face, but one that may disproportionately target them relative to companies in other industries. This Commentary summarizes some of the findings regarding the funds involved and their campaigns, and makes recommendations to technology and life science companies on how to address the risks.

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Shadow Banking and Financial Instability

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, April 16, 2012
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Editor’s Note: Lord Adair Turner is chairman of the United Kingdom Financial Services Authority. This post is based on a speech delivered by Lord Turner at the Cass Business School; the speech and accompanying slides are available here.

In autumn 2008 the developed world’s banking system suffered a severe crisis. In response the world’s regulators and central banks have focused on building a more stable banking system for the future: less leveraged, more liquid, better supervised and with even the largest banks able to be resolved without taxpayer’s support. The implementation of that bank-focused regulatory agenda is still unfinished, but much progress has been made.

Looking back to the year 2007/08, however, it’s striking that the crisis did not at first look like a traditional banking crisis, but rather one related to a new phenomenon: shadow banking. Initially the problems seemed concentrated in the US, where the development of non-bank credit intermediation was most advanced, and many of the events which marked the developing crisis related to non-bank institutions and markets.

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Insider Trading Restrictions and Insiders’ Supply of Information

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, April 16, 2012
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The following post comes to us from Ivy Zhang of the Department of Accounting at the University of Minnesota and Yong Zhang of the Department of Accounting at Hong Kong University of Science and Technology.

In our paper, Insider Trading Restrictions and Insiders’ Supply of Information: Evidence from Reporting Quality, which was recently made publicly available on SSRN, we exploit a natural experiment involving first-time enforcement of insider trading laws around the world in order to examine the impact of insider trading restrictions on insiders’ supply of information. Following the existing literature, we measure the quality of financial reporting along four dimensions: earnings smoothing, earnings management towards positive earnings, loss recognition, and value relevance.

Empirical analyses indicate that reporting quality improves following a country’s first-time enforcement of insider trading laws only in countries with strong macro governance infrastructure, suggesting that a country’s legal infrastructures play an important role in determining earnings quality. Consistent with the prediction that firm-level governance structures significantly affect insiders’ incentives and their responses to regulations, we also find that the improvement in earnings quality is concentrated in less closely held firms.

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