Yearly Archives: 2013

The Dark Side of Analyst Coverage

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, June 28, 2013
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The following post comes to us from Jie (Jack) He of the Department of Finance at the University of Georgia and Xuan Tian of the Department of Finance at Indiana University.

In our paper, The Dark Side of Analyst Coverage: The Case of Innovation, forthcoming in the Journal of Financial Economics, we examine the effect of analyst coverage on firm innovation and test two competing hypotheses. We find that firms covered by a larger number of analysts generate fewer patents and patents with lower impact. To establish causality, we use a difference-in-differences approach and an instrumental variable approach. Our identification tests suggest a causal effect of analyst coverage on firm innovation. The evidence is consistent with the hypothesis that analysts exert too much pressure on managers to meet short-term goals, impeding firms’ investment in long-term innovative projects. Finally, we discuss possible underlying mechanisms through which analysts impede innovation and show a residual effect of analyst coverage on firm innovation even after controlling for such mechanisms. Overall, our study offers novel evidence of a previously under-explored adverse consequence of analyst coverage, namely, its hindrance to firm innovation.

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Appellate Court: Madoff Trustee Lacks Authority to Go After Banks

Posted by John F. Savarese, Wachtell, Lipton, Rosen & Katz, on
Thursday, June 27, 2013
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John Savarese is a partner in the Litigation Department of Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Savarese, Stephen R. DiPrima, Emil A. Kleinhaus, and Jonathon R. La Chapelle.

The U.S. Court of Appeals for the Second Circuit held today that the trustee for Bernard L. Madoff Investment Securities (BLMIS) lacks authority to pursue common-law claims for damages suffered by Madoff’s customers. Based on that ruling, the Court affirmed the dismissal of a variety of damages claims against JPMorgan, HSBC and other banks relating to Madoff’s historic Ponzi scheme. See Picard v. JPMorgan Chase & Co., No. 11-5044 (2d Cir. June 20, 2013). Our firm represented JPMorgan both in the district court and on appeal.

Since the Supreme Court’s landmark decision in Caplin v. Marine Midland, 406 U.S. 416 (1972), it has been well-established that a bankruptcy trustee — as the legal successor to the debtor — may not bring damages claims that belong to creditors. It is also well-established that, under the doctrine of in pari delicto, the bankruptcy trustee for a fraudulent debtor may not sue third parties for harms caused by the debtor’s own fraud.

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Why High Leverage is Optimal for Banks

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, June 27, 2013
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The following post comes to us from Harry DeAngelo, Professor of Finance at the University of Southern California, and René Stulz, Professor of Finance at Ohio State University.

In our paper, Why High Leverage is Optimal for Banks, which was recently made publicly available on SSRN, we focus on banks’ role as producers of liquid financial claims. Our model assumes uncertainty and excludes agency problems, deposit insurance, taxes, and other distortions that would lead banks to adopt levered capital structures. We show that, under these idealized conditions, high bank leverage is optimal when there is a market premium for the production of (socially valuable) liquid claims. The analysis thus implies that high bank leverage – not Modigliani and Miller’s (1958) leverage irrelevance principle – is the appropriate idealized-world baseline for analyzing bank capital structure in the presence of a demand for liquid financial claims per se.

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The Costs of “Too Big To Fail”

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, June 26, 2013
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Editor’s Note: Mark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law. This post is Professor Roe’s most recent op-ed written for the international association of newspapers Project Syndicate, which can be found here.

The idea that some banks are “too big to fail” has emerged from the obscurity of regulatory and academic debate into the broader public discourse on finance. Bloomberg News started the most recent public discussion, criticizing the benefit that such banks receive — a benefit that a study released by the International Monetary Fund has shown to be quite large.

Bankers’ lobbyists and representatives dismissed the Bloomberg editorial for citing a single study, and for relying on rating agencies’ rankings for the big banks, which showed that several would have to pay more for their long-term funding if financial markets didn’t expect government support in case of trouble.

In fact, though, there are about ten recent studies, not just one, concerning the benefit that too-big-to-fail banks receive from the government. Nearly every study points in the same direction: a large boost in the too-big-to-fail subsidy during and after the financial crisis, making it cheaper for big banks to borrow.

But a recent research report released by Goldman Sachs argues the contrary — and deserves to be taken more seriously than the first dismissive views. The report concludes that, over time, big banks’ advantage in long-term funding costs relative to smaller banks has been one-third of one percentage point; that this advantage is small; that it narrowed recently (and may be reversing); that it comes from the big banks’ efficiency and their bonds’ liquidity; and that historically it has been mostly small banks, not big ones, that have failed.

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Bebchuk, Cohen, and Wang Win the 2013 IRRCi Academic Award for “Learning and the Disappearing Association between Governance and Returns”

Posted by Kobi Kastiel, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, June 26, 2013
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In an award ceremony held in New York City on Tuesday, the Investor Responsibility Research Center Institute (IRRCi) announced the winners of its the 2013 prize competition. The academic award, coming with a $10,000 award prize, went to HLS professor Lucian Bebchuk, HLS Senior Fellow and Tel-Aviv University Professor Alma Cohen, and HBS professor Charles Wang. Bebchuk, Cohen, and Wang received the award for their study, Learning and the Disappearing Association between Governance and Returns, available on SSRN here.

The Bebchuk-Cohen-Wang study was published last month by the Journal of Financial Economics. In presenting the award, IRRCi chair announced that the winning paper “will be valuable … for investors, policymakers, academia, and other stakeholders.”

The 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, which is based on twenty-four governance provisions (Gompers, Ishii, and Metrick (2003)) and the E-Index, which is based on the six provisions that matter most (Bebchuk, Cohen, and Ferrell (2009)). The study shows that this correlation did not persist during the subsequent period 2000-2008. Furthermore, the study provides 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, the study finds that:

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Court of Chancery Upholds Forum-Selection Bylaws Under the DGCL

Posted by Allen M. Terrell, Jr., Richards, Layton & Finger, on
Wednesday, June 26, 2013
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Allen M. Terrell, Jr. is a director at Richards, Layton & Finger. This post is based on a Richards, Layton & Finger publication, and is part of the Delaware law series, which is co-sponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

The Court of Chancery has rejected statutory and contractual challenges to forum-selection bylaws adopted unilaterally by the boards of directors of Chevron Corporation and FedEx Corporation. In an opinion deciding motions for partial judgment on the pleadings in Boilermakers Local 154 Retirement Fund, et al. v. Chevron Corp., et al., C.A. No. 7220-CS, and Iclub Inv. P’ship v. FedEx Corp., et al., C.A. No. 7238-CS, Chancellor Strine determined that a board of directors, if granted authority to adopt bylaws by the certificate of incorporation, has the power under the Delaware General Corporation Law to adopt a bylaw requiring litigation relating to the corporation’s internal affairs to be conducted exclusively in the Delaware courts, and that such a bylaw may become part of the binding agreement between a corporation and its stockholders even though the stockholders do not vote to approve it. The Court emphasized, however, that stockholder-plaintiffs retain the ability to challenge the enforcement of such a bylaw in a particular case, either under the reasonableness standard adopted by the Supreme Court of the United States in The Bremen v. Zapata Off-Shore Co., 407 U.S. 1 (1972), or under principles of fiduciary duty. The Court also left open the possibility that the boards’ actions in adopting such bylaws could be subject to challenge as a breach of fiduciary duty.

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Innovation, Reallocation, and Growth

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, June 25, 2013
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The following post comes to us from Daron Acemoglu, Professor of Economics at MIT; Ufuk Akcigit of the Department of Economics at the University of Pennsylvania; Nicholas Bloom, Professor of Economics at Stanford University; and William Kerr of the Entrepreneurial Management Unit at Harvard Business School.

In our paper, Innovation, Reallocation, and Growth, which was recently made publicly available on SSRN, we build a micro-founded model of firm innovation and growth, enabling us an examination of the forces jointly driving innovation, productivity growth and reallocation. In the second part of our paper, we estimate the parameters of the model using simulated method of moments on detailed U.S. Census Bureau micro data on employment, output, R&D, and patenting during the 1987-1997 period.

Our model builds on the endogenous technological change literature. Incumbents and entrants invest in R&D in order to improve over (one of) a continuum of products. Successful innovation adds to the number of product lines in which the firm has the best-practice technology (and “creatively” destroys the lead of another firm in this product line). Incumbents also increase their productivity for non-R&D related reasons (i.e., without investing in R&D). Because operating a product line entails a fixed cost, firms may also decide to exit some of the product lines in which they have the best-practice technology if this technology has sufficiently low productivity relative to the equilibrium wage. Finally, firms have heterogeneous (high and low) types affecting their innovative capacity—their productivity in innovation. This heterogeneity introduces a selection effect as the composition of firms is endogenous, which will be both important in our estimation and central for understanding the implications of different policies. We assume that firm type changes over time and that low-type is an absorbing state (i.e., high-type firms can transition to low-type but not vice versa), which is important for accommodating the possibility of firms that have grown large over time but are no longer innovative.

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CEO-Board Chair Separation: If It Ain’t Broke, Don’t Fix It

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, June 25, 2013
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The following post comes to us from Matthew Semadeni, Associate Professor of Strategy at Indiana University. This post relates to an issue of The Conference Board’s Director Notes series authored by Mr. Semadeni and Ryan Krause; the full publication, including footnotes, is available here.

One of the most contentious corporate governance issues for boards of directors is board leadership, and specifically whether sitting CEOs should also serve as board chairs. This report examines three types of CEO-board chair separation and their consequences on company performance.

To date, research on CEO-chair separation has yielded only one overarching conclusion: a CEO who also serves as board chair is no better or worse for company performance than an independent director serving as board chair. Nevertheless, many in the corporate governance field advocate for separation of the CEO and board chair roles. Here, we examine three possible types of CEO-board chair separation and their performance consequences. Our results suggest that if a company chooses to separate the CEO and board chair positions, particularly by demoting the CEO, the reason for the separation should extend beyond the conventional wisdom that doing so is “best practice.”

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Responding to Objections to Shining Light on Corporate Political Spending (7): Claims About the Costs of Disclosure

Posted by Lucian Bebchuk, Harvard Law School, and Robert J. Jackson, Jr., Columbia Law School, on
Monday, June 24, 2013
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Lucian Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School. Robert J. Jackson, Jr. is Associate Professor of Law, Milton Handler Fellow, and Co-Director of the Millstein Center at Columbia Law School. Bebchuk and Jackson served as co-chairs of the Committee on Disclosure of Corporate Political Spending, which filed a rulemaking petition requesting that the SEC require public companies to disclose their political spending, discussed on the Forum here. Bebchuk and Jackson are also co-authors of Shining Light on Corporate Political Spending, published in the April issue of the Georgetown Law Journal. This post is the seventh in a series of posts, based on the Shining Light article, in which Bebchuk and Jackson respond to objections to an SEC rule requiring disclosure of corporate political spending; the full series of posts is available here.

The Securities and Exchange Commission is currently considering a rulemaking petition urging the Commission to develop rules requiring public companies to disclose their political spending. In our first six posts in this series (collected here), we examined six objections raised by opponents of such rules and explained why these objections provide no basis for opposing rules requiring public companies to disclose their spending on politics. In this post, we consider a seventh objection: the claim that disclosure rules in this area would impose substantial costs on public companies—and that the SEC lacks the authority to develop such rules because these costs would exceed any benefits that the rules would confer upon investors.

Several opponents of the petition have argued that the SEC may not require public companies to disclose their spending on politics because the costs of such rules would exceed their benefits. For example, the American Petroleum Institute and the U.S. Chamber of Commerce, which are both significant intermediaries through which undisclosed corporate political spending is currently channeled, recently argued in letters to the SEC that the “Commission could not rationally find that the benefits of such a rule” “could outweigh the huge costs.” There is currently considerable debate over the precise weight that cost-benefit analysis should be given in the SEC rulemaking process generally. Whatever position one takes on that general issue, however, cost-benefit analysis does not preclude the SEC from adopting rules requiring public companies to disclose their spending on politics.

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Is Your Board Governing Itself Effectively?

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, June 24, 2013
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The following post comes to us from Maureen Errity, Director, Center for Corporate Governance at Deloitte LLP, and is based on an article featured in a Center for Corporate Governance newsletter.

Never before has the role of board members been so important to organizations and investors. With many boards stretched beyond capacity trying to meet stakeholder needs and compliance requirements, board members must provide strategic leadership, stewardship, and governance.

Effective governance requires a proactive, focused state of mind on the part of directors, the CEO, and management, all of whom must be committed to business success through maintenance of the highest standards of responsibility and ethics. Recent studies, such as the 2012 Board Practices Report: Providing Insight into the Shape of Things to Come (previously discussed here), a publication from the Deloitte Center for Corporate Governance and the Society of Corporate Secretaries and Governance Professionals, suggest that there has been progress in revamping governance practices and establishing board infrastructure, effectiveness, and engagement.

The Deloitte Governance Framework, as outlined in Framing the Future of Corporate Governance: Deloitte Governance Framework, helps organizations form the basis for the tools that help boards and executives quickly identify potential opportunities to improve both effectiveness and efficiency and provide an end-to-end view of corporate governance. Within the framework, the board can develop a set of key objectives for each of the six elements (see Figure 1).

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