Monthly Archives: October 2019

Loosey-Goosey Governance: Four Misunderstood Terms in Corporate Governance

David F. Larcker is James Irvin Miller Professor of Accounting at Stanford Graduate School of Business and Brian Tayan is a Researcher with the Corporate Governance Research Initiative at Stanford Graduate School of Business. This post is based on their recent paper. Related research from the Program on Corporate Governance includes What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen, and Allen Ferrell and The Elusive Quest for Global Governance Standards by Lucian Bebchuk and Assaf Hamdani.

We recently published a paper on SSRN (“Loosey-Goosey Governance: Four Misunderstood Terms in Corporate Governance”) that examines four central concepts that are widely discussed—even foundational to the problem—but loosely defined and poorly understood.

A reliable corporate governance system is considered to be an important requirement for the long-term success of a company. Unfortunately, after decades of research, we still do not have a clear understanding of the factors that make a governance system effective. Our understanding of governance suffers from two problems. The first problem is the tendency to overgeneralize across companies—to advocate common solutions without regard to size, industry, or geography and without understanding how situational differences influence correct choices. The second problem is the tendency to refer to central concepts or terminology without first defining them. That is, concepts are loosely referred to without a clear understanding of the premises, evidence or implications of what is being discussed. We call this “loosey goosey governance.”


One Size Does Not Fit All

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 memorandum by Mr. Lipton.

In a well-researched and documented paper, David Larcker and Brian Tayan of the Rock Center for Corporate Governance at Stanford University have demonstrated the ringing truth of the oft heard “one size doesn’t fit all” criticism of the stylized corporate governance principles promulgated by organizations like Institutional Shareholder Services, Glass Lewis, Council of Institutional Investors and many major institutional investors.

The authors’ points are best summarized below:


ESG and Executive Remuneration—Disconnect or Growing Convergence?

Peter Reilly is Senior Director, Corporate Governance at FTI Consulting; and, Aniel Mahabier is CEO of CGLytics. This post is based on a joint FTI Consulting and CGLytics paper authored by Mr. Reilly based on data from CGLytics. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here) and Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).

In recent years, the level of capital flowing into funds that incorporate ESG criteria has grown considerably and what was once an issue on the fringes of investment is increasingly part of the material financial analysis of a company’s value.

Consequently, ESG rating agencies (who help investors identify ESG risk) have grown in prominence; regulators have commenced a clampdown on so-called “greenwashing”; and, investors continue to pressurise companies to provide greater details on ESG factors likely to affect their business—either through engagement or, less frequently, shareholder proposals. Indeed, a recent report found that, at least based on publicly disclosed documents, climate change was the number one issue for institutional investors in their stewardship of investee companies.

In this post, we have analysed whether the ratcheting up of pressure on companies to enhance their ESG frameworks has permeated another important area—executive remuneration at UK and Irish companies. For three decades, pay has been identified as a key driver of C-suite behaviour. Despite what appears to be a relentless focus on ESG, the incorporation of ESG measures into executive pay packages has lagged somewhat.


Institutional Investors’ Views and Preferences on Climate Risk Disclosure

Zacharias Sautner is Professor of Finance at Frankfurt School of Finance & Management. This post is based on a recent paper authored by Professor Sautner; Emirhan Ilhan, PhD candidate in Finance at Frankfurt School of Finance & Management; Philipp Krueger, Associate Professor of Finance at the University of Geneva; and Laura T. Starks, the Charles E. and Sarah M. Seay Regents Chair in Finance at the University of Texas at Austin McCombs School of Business. Related research from the Program on Corporate Governance includes Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).

Financial market efficiency relies on timely and accurate information regarding firms’ risk exposures. An increasingly important risk exposure relates to climate change. Climate risks can originate from more severe and more frequent natural disasters, government regulation to combat a rise in temperature, or climate-related innovations that disrupt existing business models. Consequently, high-quality information on firms’ climate risk exposures is necessary for making informed investment decisions and efficient pricing of the risks and opportunities related to climate change.

While many regulators and investors acknowledge the fact that firms’ climate risk exposures are important, they also believe current climate risk disclosure practices are insufficient. For example, Mark Carney, Governor of the Bank of England, called in a speech in 2015 for more to be done “to develop consistent, comparable, reliable, and clear disclosure around the carbon intensity of different assets.”.

On a more positive note, there have been attempts by regulators, governments, and NGOs to address the shortcomings in current climate risk disclosures. For instance, in 2015, the Financial Stability Board initiated the Task Force on Climate-related Financial Disclosures (TCFD), with the objective of developing voluntary climate-related financial risk disclosures. On behalf of investors representing over $87 trillion in assets under management, CDP collects climate-related information through a questionnaire. In addition to these initiatives, some countries started to mandate climate-related disclosures.


Board Oversight of Corporate Compliance: Is it Time for a Refresh?

Robert Biskup is a managing director at Deloitte Risk & Financial Advisory, Krista Parsons is a managing director at Deloitte & Touche LLP, and Robert Lamm is Independent Senior Advisor at the Center for Board Effectiveness at Deloitte LLP. This post is based on their Deloitte memorandum.

Introduction—Compliance oversight as a board responsibility

Nearly 25 years have passed since a landmark decision of the Delaware Chancery Court involving the board’s role in compliance oversight. The case was based upon claims that the board in question had breached its fiduciary duty regarding compliance with legal requirements applicable to health care providers, leading to an extensive federal investigation, an indictment charging multiple federal felonies, and fines, penalties, and damages approximating $250 million. Among its other findings, the Chancery Court concluded that:

“a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and . . . failure to do so under some circumstances may . . . render a director liable for losses caused by non-compliance with applicable legal standards.” [1]

As a result of this decision and its progeny, it is now settled doctrine that a board of director’s fiduciary duties include establishing that management has an effective corporate compliance program in place, exercising oversight of that program, and taking regular steps to stay informed of the program’s content and operation. Aside from the many adverse consequences of an inadequate compliance program, a breach of these duties can result in shareholder derivative litigation, and may even subject board members to personal liability under some circumstances (though that did not happen in the case cited above). Of equal or greater importance, a compliance failure can lead to critical operational, reputational, and other business challenges that can haunt a company for years—or even destroy it.


Observations on Clovis Oncology, Inc. Derivative Litigation

Peter J. Walsh, Jr. is a partner, and Nicholas D. Mozal is counsel, at Potter Anderson & Corroon LLP. This post is based on their Potter Anderson memorandum and is part of the Delaware law series; links to other posts in the series are available here.

On October 1, the Delaware Court of Chancery denied a motion to dismiss a Caremark claim in In re Clovis Oncology, Inc. Derivative Litigation. Under In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996), directors have a duty to exercise oversight and monitor a corporation’s operational viability, legal compliance, and financial performance. Clovis is the first decision to allow a Caremark claim to proceed beyond the pleadings since the Delaware Supreme Court’s June 2019 decision in Marchand v. Barnhill, which reversed a Court of Chancery decision dismissing a Caremark claim. The Clovis decision highlights (i) the importance of board level efforts to oversee compliance with governing law and regulatory mandates, particularly in situations where compliance issues are critical to a “monoline” company, and (ii) how stockholders are using books and records demands under 8 Del. C. § 220 to pursue fiduciary claims focused on those same compliance issues.


Delaware Choice-of-Law Provisions in Restrictive Covenant Agreements

Christopher B. Chuff is an associate at Pepper Hamilton LLP. This post is based on a Pepper memorandum by Mr. Chuff, Joanna J. Cline, Matthew M. Greenberg, and Taylor B. Bartholomew. This post is part of the Delaware law series; links to other posts in the series are available here.

It is well-settled that California has a strong public policy against the enforcement of restrictive covenants against employees. Because of this, there has been a recent trend where employers have sought to circumvent California’s public policy by invoking Delaware law in restrictive covenant agreements with their employees. However, in a number of recent opinions, the Delaware Court of Chancery has resisted those efforts, instead choosing to invalidate the Delaware choice-of-law provisions and apply California law to void the restrictive covenants.

Indeed, despite the fact that Delaware is typically a contractarian state, the Court of Chancery has reasoned that, unless one or more conditions (summarized below) are met, California-based companies will not be permitted to effectuate an end run around California’s strict public policy by invoking Delaware law in contracts with their employees. Furthermore, although not directly addressed by the Court of Chancery’s recent decisions, it is likely, based on the Court’s reasoning in these decisions, that Delaware courts will apply California law to void noncompetition and nonsolicitation provisions within an agreement between employers with their principal places of business outside of California and their employees that live and work primarily in California, notwithstanding the existence of a Delaware choice-of-law provision.


CEO Pay Growth and Total Shareholder Return

Joseph Bachelder is special counsel at McCarter & English LLP. This post is based on a memorandum by Mr. Bachelder. Andy Tsang, a senior financial analyst with the firm, assisted in the preparation of this post. Related research from the Program on Corporate Governance includes The Growth of Executive Pay by Lucian Bebchuk and Yaniv Grinstein; The CEO Pay Slice by Lucian Bebchuk, Martijn Cremers and Urs Peyer (discussed on the Forum here); and Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

One of the methodologies used to assess the reasonableness of CEO pay is a comparison of the growth rate in CEO pay with the company’s total shareholder return (TSR) over a period of time. TSR generally represents (a) the change in stock price of the company over the period of time being measured plus dividends paid during such period divided by (b) the stock price at the beginning of the period. In 2015 the SEC proposed a new rule that would require each issuer to disclose in its proxy statements over a period of five years (initially, over three years) (a) the levels of CEO pay (as well as that of the other NEOs) and (b) the TSR of the issuer (as well as the TSR of a peer group of companies). See Pay Versus Performance, SEC Release No. 34-74835; File No. S7-07-15 (April 29, 2015), 80 Fed. Reg. 26329 (May 7, 2015).

Today’s column takes a look at the growth rate of CEO pay and TSR over the five-year period 2014-2018 for the following groups: (i) the S&P 500 companies and (ii) large companies in three industries: commercial banking, retail sales and computer software.


Recent Trends in Shareholder Activism

Richard Grossman is partner and Alexander J. Berg is an associate at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on their Skadden memorandum. Related research from the Program on Corporate Governance includes Dancing with Activists by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch (discussed on the Forum here); The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); and Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System by Leo E. Strine, Jr. (discussed on the Forum here).

Shareholder activism remains pervasive in the corporate landscape, as many companies continue to face new, and sometimes more sophisticated, activist situations. Recent activism-related trends indicate that the landscape is continually shifting, and companies’ strategies for dealing with activism should therefore also evolve and adapt.

Increase in M&A Activism

Mergers and acquisitions activity has increasingly become a focus for activists. Lazard’s Shareholder Advisory Group (Lazard) reported that approximately 46% of all activist campaigns in the first half of 2019 had an M&A angle, as activists continue to see these transactions as opportunities to increase returns for shareholders. Comparatively, from 2014 to 2018, M&A-related objectives arose in only one-third of all activist campaigns.


Naming and Shaming: Evidence from Event Studies

John Armour is Professor of Law and Finance at the University of Oxford; Colin Mayer is Peter Moores Professor of Management Studies at University of Oxford Saïd Business School; and Andrea Polo is Assistant Professor of Finance at LUISS Guido Carli University. This post is based on their article, forthcoming in Cambridge Handbook of Compliance (Cambridge University Press).

A firm’s “reputation” reflects the expectations of its partners of the benefits of trading with it in the future. An announcement by a regulator that a firm has engaged in misconduct may be expected to impact negatively on trading parties’ (i.e. consumers or investors) expectations for a firm’s future performance, and hence on its market value. How can we identify reputational losses from share price reactions? How large are these losses for different types of misconducts? In the article Naming and Shaming: Evidence from Event Studies, forthcoming in the Cambridge Handbook of Compliance (Cambridge University Press), we describe the results of previous studies, discuss the event study methodology and underline the empirical challenges. We then present the evidence from one unique study that meet all necessary conditions for identification of reputational sanctions from event studies (Armour et al. 2017) and draw implications for regulatory enforcement policy.


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