Monthly Archives: October 2012

Which Skills Matter in the Market for CEOs?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, October 9, 2012
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The following post comes to us from Antonio Falato, economist at the Federal Reserve Board; Dan Li, economist at the Federal Reserve Board; and Todd Milbourn, Professor of Finance at Washington University in St. Louis.

In the paper, Which Skills Matter in the Market for CEOs? Evidence from Pay for CEO Credentials, which was recently made publicly available on SSRN, we show that boards’ compensation decisions reward several reputational, career, and educational credentials of CEOs using a panel of S&P 1,500 firms between 1993 and 2005.

Our study is motivated by anecdotal accounts of executive search consultants, recent empirical evidence, and a growing theoretical literature that point to an increased importance of the labor market for CEOs over the last two decades. The central message of these studies is that there are fundamental differences in CEOs’ skill sets and that these differences are an increasingly important determinant of CEO pay. However, we still have scant direct evidence on whether differences in CEO skills matter for their pay. Even less is known about which CEO skills actually carry a premium in CEO pay and whether skill pay premia can help to explain key stylized facts of CEO pay, such as its dramatic rising trend and the increasing gap between the most and the least paid CEOs. In order to fill this gap, we use new hand-collected biographical data on a large sample of CEOs to examine whether there is a credentials premium in CEO pay—i.e., do firms make inferences about otherwise difficult to observe CEO skills from readily available facts that can be gathered from CEO resumes and professional career track records? If so, is the relation between CEO pay and credentials consistent with market-based theories?

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Insider Trading Developments — Summer 2012

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, October 8, 2012
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The following post comes to us from Paul N. Roth, founding partner and chair of the Investment Management Group at Schulte Roth & Zabel LLP. This post is based on a Schulte Roth & Zabel newsletter by Eric A. Bensky, Harry S. Davis, Howard Schiffman and Katherine Earnest; the full publication, including a detailed chart of DOJ/SEC insider trading actions, is available here.

While the insider trading conviction of Rajat Gupta and SEC settlement with Hall of Fame baseball player Eddie Murray attracted headlines — and the 12-year prison sentence imposed earlier this summer on former corporate attorney Matthew Kluger set a new standard for criminal insider trading penalties — there have been several other legislative, regulatory and judicial developments in recent months relating to insider trading that are of equal or greater significance. All reflect an increased focus on preventing and prosecuting the trading of securities and commodities based on material nonpublic information.

Congress has passed legislation expressly prohibiting its members and other government officials from trading on nonpublic information they learn from their official positions, even as a prominent Congressman was investigated regarding (though ultimately not charged with) such alleged trading. Meanwhile, the Department of Justice and the SEC have continued their active pursuit of those they believe supplied and traded on inside information obtained and disseminated via “expert network” investment research firms. Finally, courts and prosecutors have demonstrated an inclination to find at least the possibility of illegal insider trading even when the information came from an indirect source or via seemingly benign means.

These recent developments all suggest that, in the current environment, investors and investment advisers should be particularly vigilant in ensuring that they and their employees do not acquire and trade on nonpublic information obtained directly or indirectly from an individual or entity who was not authorized to disclose it, or that otherwise is not in the public domain.

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Earnings Quality: Evidence from the Field

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, October 8, 2012
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The following post comes to us from Ilia Dichev, Professor of Accounting at Emory University; John Graham, Professor of Finance at Duke University; Campbell Harvey, Professor of Finance at Duke University; and Shiva Rajgopal, Professor of Accounting at Emory University.

In the paper, Earnings Quality: Evidence from the Field, which was recently made publicly available on SSRN, we provide insights about earnings quality from a new data source: a large survey and a dozen interviews with top financial executives, primarily Chief Financial Officers (CFOs). Why CFOs? While it is clear that there are important consumers of earnings quality such as investment managers and analysts, we focus on the direct producers of earnings quality, who also intimately know and potentially cater to such consumers. In addition, CFOs commonly have a formal background in accounting, which provides them with keen insight into the determinants of earnings quality, including the advantages and limitations of GAAP accounting. CFOs are also key decision-makers in company acquisitions (see Graham, Harvey and Puri 2012), which implies that they have working knowledge of how to evaluate earnings quality from an outside perspective.

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Financial Stability Through Properly Aligned Incentives

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Sunday, October 7, 2012
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Editor’s Note: Thomas M. Hoenig is director of the Federal Deposit Insurance Corporation. This post is based on Director Hoenig’s recent remarks before the Exchequer Club, Washington D.C.

Introduction

In 2011, with significant input from others at the Federal Reserve Bank of Kansas City, I proposed that the U.S. financial system be restructured by business lines with accompanying money market reforms. Since then, I often have been asked why I think there is any stomach for a modern version of Glass-Steagall or any other major financial reform when Dodd-Frank has not yet been fully implemented.

I recognize that enactment of such a proposal [1] is no simple task, but doing so will reduce the subsidy for too-big-to-fail firms and better align their economic incentives and rewards. Importantly, a return to a more accountable financial system is an essential step if we expect to rebuild public trust in our financial institutions and in the government that regulates them. That trust can be reestablished and accountability can be put back into the system so that the banking industry can win without the rest of us losing.

It is well understood that our country faces many challenges that are beyond the financial system. Post financial crisis, the United States faces an expanding fiscal challenge that will affect future discussions on tax structure and spending priorities. We cannot hope to find meaningful solutions or common ground to work from regarding these challenges if the public fails to trust its financial and governmental institutions. Who will agree to make sacrifices for the good of the country if they judge that reforms will be poorly or unfairly applied? How can we possibly convince Americans that the fiscal steps will be equitable when we bailed out the largest banks and yet they remain — larger, more powerful, and insulated from the market’s discipline?

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How French Law Has Failed to Adapt to the Evolution of the Economy and Finance

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, October 6, 2012
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The following post comes to us from Sophie Vermeille of the Department of Law and Economics at Paris II University. Further discussion of French law and finance is available here.

In the paper, The Legal System and the Development of Alternative Methods of Financing to Bank Credit… Or How French Law Has Failed to Adapt to the Evolution of the Economy and Finance, which was recently made publicly available on SSRN, I evaluate the French legal system following the strengthening of the “Basel III” prudential regulations and advocate urgent reform. A large number of commentators have predicted that Basel III is likely to result in a reduction in the contribution made by banks to financing the economy. This evolving role for banks invites us to re-examine French law (to the extent that the legal system has an impact on the development of alternative methods to traditional bank financing, recourse to financial markets and the private equity market). It is indeed a major issue for France. Unlike the US and the UK, financial markets in France (as in the rest of Continental Europe), are bank-centered. Against the backdrop of a declining economy and the development of prudential regulations, France must therefore adjust quickly its legal system. This is the tenet of my paper, which is the long version of a report that I wrote initially at the request of the French National Economic Council for the office of the French Prime Minister.

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Derivatives Trading and Negative Voting

Posted by Holger Spamann, Harvard Law School, on
Friday, October 5, 2012
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Holger Spamann is an assistant professor at Harvard Law School.

Securities regulators, practitioners, and legal commentators worry that derivatives may provide shareholders and creditors incentives to destroy value in their corporation (references here). The basic concern is that if shareholders or creditors own a sufficient amount of off-setting derivatives such as put options or credit default swaps (CDS), any losses on their shares or debt will be more than off-set by the corresponding gains on their derivatives (“over-hedging”). In this case, shareholders and creditors benefit by using the control rights inherent in their shares or debt to reduce the corporation’s value (“negative voting”).

An important question that is generally not considered, however, is whether it would ever be profitable for shareholders or creditors to acquire so many derivatives in the first place. After all, any gains to shareholders and creditors come at the expense of their counterparties on their derivative contracts. These counterparties would therefore prefer not to sell the derivatives, or only at a price that compensates them for the future payouts, thus depriving shareholders and creditors of any profit in the overall scheme. This is an important difference from the related problem of vote-buying, which forces (dispersed) counterparties into a collective action problem approaching a prisoners’ dilemma. By contrast, derivative counterparties have the option simply to abstain from the transaction.

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Defining Pay in Pay for Performance

Posted by Matteo Tonello, The Conference Board, on
Friday, October 5, 2012
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Matteo Tonello is managing director of corporate leadership at the Conference Board. This post is based on an issue of the Conference Board’s Director Notes series by James D.C. Barrall, Alice M. Chung and Julie D. Crisp, attorneys at Latham & Watkins LLP; the full issue, including footnotes, is available for download here.

Why 2012 Was the Year of Pay for Performance

Whether the pay of a company’s CEO and other executive officers is aligned with the company’s performance has been the single most important and controversial executive pay issue for U.S. public companies since the advent of mandatory say-on-pay votes under the Dodd-Frank Act, which applied to most U.S. public companies in 2011; smaller reporting companies will face these votes and issues in 2013. As we wrote in our Director Notes “Proxy Season 2012: The Year of Pay for Performance,” 2012 was indeed the year of “pay for performance.” This has been proven by the over 2,000 say-on-pay vote results reported through September 5, 2012.

The stage for the 2012 pay-for-performance debate was set in 2011, when Institutional Shareholder Services Proxy Advisory Services (ISS), which is widely regarded as the most influential U.S. proxy adviser, applied a crude two-step test to assess pay for performance in making its say-on-pay voting recommendations.

Generally, under its 2011 test, ISS concluded that a pay-for-performance “disconnect” existed if:

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A Spatial Representation of Delaware-Washington Interaction in Corporate Lawmaking

Posted by Mark Roe, Harvard Law School, on
Thursday, October 4, 2012
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Mark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law. 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.

Last month, the Columbia Business Law Review published “A Spatial Representation of Delaware-Washington Interaction in Corporate Lawmaking.” In this brief paper, I examine interaction between Delaware and Washington in corporate lawmaking, focusing on the shareholder access initiatives in each jurisdiction. The paper uses a straight-forward spatial model of the state-federal interaction, paralleling spatial models that political scientists have used to illustrate other instances of jurisdictional interaction.

In prior work I showed how Delaware corporate law can be, and often is, confined by, or influenced by, federal action. Sometimes Washington acts and preempts the field, constitutionally or functionally, leaving no space for state corporate law action. Sometimes Delaware tilts toward or follows Washington opinion, even if Washington opinion does not square perfectly with the state lawmakers’ own consensus view of the best way to proceed. I examined these channels in Delaware’s Competition, 117 Harvard Law Review 588 (2003), and Delaware’s Politics, 118 Harvard Law Review 2491 (2005).

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Working to Achieve the American Dream

Posted by Luis A. Aguilar, Commissioner, U.S. Securities and Exchange Commission, on
Thursday, October 4, 2012
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Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks to the Hispanic Bar Association of the District of Columbia (HBA-DC). The views expressed in this post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Hispanic Heritage Month

Latinos are a heterogeneous and growing group. We originate from different parts of the world. Moreover, some Latinos may be recent immigrants, while others may have had ancestors who lived on American soil prior to the founding of the United States. Despite our varied backgrounds, we share a deep appreciation for the freedom, values, and opportunities promised by the United States of America. We also share a strong belief in the “American Dream” and its promise of a better life.

The first official presidential observance of our country’s rich Hispanic heritage was in 1968. [1] Back then, Latinos represented only about 4½ % of the total U.S. population. [2] Today, the Census Bureau estimates that Americans of Hispanic origin make up 16.7% of the United States. [3] The growth of this diverse community is reflected in a growing awareness that Hispanic-Americans must play an important role as our nation faces the challenges of the 21st Century. [4]

Today’s young Hispanic-Americans are future leaders of our nation. Recently I met with an inspiring group of Latino college students from the “Latinos on Fast Track” Institute (LOFT). These students are on their way to becoming future teachers, doctors, lawyers, engineers, entrepreneurs, and community leaders. Moreover, as part of their commitment to LOFT, they have also agreed to return to their communities to serve as leaders and mentors. I was inspired and impressed.

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PCAOB: Protecting Investors and the Public Interest

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, October 3, 2012
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Editor’s Note: The following post comes to us from Jeanette M. Franzel, board member of the Public Company Accounting Oversight Board. This post is based on Ms. Franzel’s keynote address at the American Law Institute-Continuing Legal Education Group (ALI-CLE) conference on accountant’s liability. The views expressed in this post are those of Ms. Franzel and should not be attributed to the PCAOB as a whole or any other members or staff.

Since the Public Company Accounting Oversight Board was created 10 years ago by the Sarbanes-Oxley Act, the U.S. system of auditor oversight has been fundamentally reformed to better protect investors and the public interest.

In addition to creating the PCAOB, the Act also vested audit committees with expanded oversight of financial reporting and audit processes.

Initially, the Act was seen as an effort to address problems that appeared to be unique to the U.S., but after numerous financial reporting scandals erupted around the world, the U.S. model of audit regulation was adopted in varying forms in many other countries.

Following the recent financial crisis, we find ourselves in an era with new stresses on financial reporting and auditing around the world, and we are once again evaluating how best to protect investors in this environment.

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