Monthly Archives: February 2023

Why Do Large Positive Non-GAAP Earnings Adjustments Predict Abnormally High CEO Pay?

Nicholas Guest is an Assistant Professor of Accounting at Cornell’s Johnson Graduate School of Management; S.P. Kothari is the Gordon Y Billard Professor of Accounting and Finance at MIT’s Sloan School of Management; and Robert Pozen is a Senior Lecturer at MIT Sloan School of Management and a non-resident Senior Fellow at the Brookings Institution. This post is based on their recent paper forthcoming in The Accounting Review. Related research from the Program on Corporate Governance includes Pay without Performance: The Unfulfilled Promise of Executive Compensation; and Executive Compensation as an Agency Problem both by Lucian Bebchuk, and Jesse Fried; The CEO Pay Slice (discussed on the Forum here) by Lucian Bebchuk, Martijn Cremers and Urs Peyer; and What Matters in Corporate Governance? (discussed on the Forum here)  by Lucian Bebchuk, Alma Cohen, and Allen Ferrell.

For almost two decades, regulators, academics, and investor activists have attempted to understand the role of non-GAAP earnings, also commonly labeled “adjusted” or “pro forma” earnings. About two-thirds of S&P 500 firms announce non-GAAP earnings, which are significantly larger than GAAP earnings on average. Moreover, many of these same companies use non-GAAP earnings as a key criterion in setting CEO pay. We hypothesize and find that when non-GAAP earnings are large relative to GAAP earnings, CEO pay is abnormally high.

Our results are consistent with the managerial power framework of Bebchuk, Fried, and Walker (2002). In their model, all executives have at least some power to extract rents whenever the company lacks a controlling or dominant shareholder to provide discipline. However, outraged boards and dispersed shareholders who recognize rent extraction can impose some constraints. As a result, managers have an incentive to “obscure and legitimize – or, more generally, to camouflage – their extraction of rents.” In this study, we argue that non-GAAP earnings are one mechanism through which some managers limit outrage by camouflaging rent extraction.


2022 Silicon Valley 150 Corporate Governance Report

Richard Blake is a Partner, Courtney Mathes and Barbara Novak are Associates at Wilson Sonsini Goodrich & Rosati. This post is based on a WSGR memorandum by Mr. Blake, Ms. Mathes, Ms. Novak, Jose Macias and Jason Chan.

The SV150 is released each year by Lonergan Partners, and is comprised of the 150 largest public companies in Silicon Valley, based on annual sales. Among the SV150 are some of the most influential technology and life sciences companies in the world. We noted the following key conclusions from our survey of SV150 corporate governance.

  • Following the practice started during the COVID-19 pandemic, almost 92% of the SV150 opted to hold a virtual meeting in 2022 rather than a physical one.
  • ESG/CSR disclosure in the proxy statement and on websites continued to remain strong throughout the SV150, with more than 85% of the top 100 companies having such disclosure in their proxies and almost 85% of the top 100 companies having such disclosure on their website.


(Much Too Early) Observations on the Universal Proxy Card

Eleazer Klein is a Partner and Sean Brownridge is an Associate at Schulte Roth & Zabel LLP. This post is based on their piece. Related research from the Program on Corporate Governance includes Universal Proxies (discussed on the Forum here) by Scott Hirst.

A considerable amount of ink has already been spilled over the universal proxy rules, their potential impact, and what public companies and engaged shareholders should do to prepare for, adapt to, and take advantage of the required use of universal proxy cards in certain director election contests. In this article, we will not journey down the well-trodden path of summarizing the universal proxy rules and making predictions regarding how they could change the relationship between companies and their shareholders, but rather review what has occurred since the rules were announced and took effect, including by providing select observations regarding the first three contests in the universal proxy era.

Advance Notice Bylaws And The First Universal Proxy Contest That Wasn’t

Advance notice bylaws require shareholders that intend to make director nominations at a shareholder meeting to give the subject company notice of their intention to do so. In addition to timeliness requirements, these bylaws contain informational components that, in theory, are meant to facilitate shareholder assessment of nominee backgrounds and eligibility, as well as the interests of the nominating party. But, advance notice bylaws have transformed into highly technical, ever-expanding, and disconnected defensive mechanisms principally designed to discourage, frustrate, and entirely prohibit a shareholder vote on nominees selected by shareholders. That is, what was once meant to be a neutral tool to ensure electoral fairness and a knowledgeable electorate has developed into a potent defense to board-related activism and companies’ most significant solution to the adoption of the universal proxy rules (i.e., universal proxy cards (“UPC”) are of no consequence when a nomination notice is declared invalid at the outset and shareholders are denied the opportunity to vote for directors other than those selected by the incumbent board).


Board Governance Structures and ESG

Lee Ballin, and Maureen Bujno are Managing Directors, and Kristen Sullivan is a Partner and leads Sustainability and ESG at Deloitte & Touche LLP. This post is based on their NACD publication. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; Does Enlightened Shareholder Value add Value (discussed on the Forum here) by Lucian Bebchuk, Kobi Kastiel, Roberto Tallarita; Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr.; and Stakeholder Capitalism in the Time of COVID (discussed on the Forum here) by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita.

Companies are facing increasing pressure to manage a growing range of risks as a result of rapidly evolving environmental, social, and governance (ESG) issues. Climate-related factors have gained a great deal of attention among ESG matters, but the scope of ESG is much broader, including social aspects of a company’s relationships with its stakeholders and a growing demand for effective governance and transparency.

As disruptive forces accelerate change and elevate expectations, many companies are facing challenges in protecting and promoting a sense of trust among their stakeholders, safeguarding their brands and reputations, and fostering business resilience. The increasing volume and complexity of challenges are causing an increase in the number and variety of issues landing on corporate board agendas.

How might boards adapt their governance structures to provide effective oversight in such a rapidly changing environmental and social landscape? What kinds of changes might boards make in the coming year READ MORE »

2022 Investor Voting Report

Brigid Rosati is Managing Director of Business Development; Kilian Moote is Managing Director; and Rajeev Kumar is Senior Managing Director at Georgeson. This post is based on their Georgeson memorandum. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors (discussed on the Forum here) by Lucian Bebchuk, Alma Cohen, and Scott Hirst; Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy (discussed on the Forum here) and The Specter of the Giant Three (discussed on the Forum here) both by Lucian Bebchuk and Scott Hirst; and The Limits of Portfolio Primacy (discussed on the Forum here) by Roberto Tallarita.


Following the October 2022 release of our report on the 2022 proxy season, our investor voting report offers an expanded analysis of investor voting decisions on key shareholder proposals, as well as management say-on-pay proposals and director elections.

We consider the 2022 proxy season to include company meetings occurring July 1, 2021 through June 30, 2022. Data presented in this report relates to companies in the Russell 3000, unless otherwise noted.

In partnership with Insightia, data was collected from public filings:

  • Shareholder Proposals: Investor voting decision data was collected from public filings, including N-PX filings released in August 2022 for companies in the Russell 3000. For certain proposals, we’ve reported on individual investor vote decisions using a color-coded system. In other instances, we detail historical institutional investor vote support by large investors by assets under management (AUM). Each shareholder proposal chart includes a unique mixture of institutional investors researched for that specific topic.
  • Say-on-Pay: Investor voting decision data was collected from public filings, including N-PX released in August 2022, for companies in the S&P 500 and Russell 3000 for the big three asset managers (a.k.a “Big 3”), BlackRock, Inc., Vanguard Group, State Street Global Advisors. The “For” (%) is based on the percentage of times an investor voted “For” the say-on-pay proposal.
  • Director Elections: Investor voting decision data was collected from public filings, including N-PX released in August 2022, for companies in the S&P500 and Russell 3000 for the “Big 3” (described above). The “For” (%) is based on the percentage of times an investor voted “For” a director.

Georgeson partnered with Insightia to coordinate investor voting data. Insightia Ltd., a Dilligent brand, was instrumental in sourcing the annual meeting and proxy voting data contained in this report.


The Complex Materiality of ESG Ratings: Evidence from Actively Managed ESG Funds

Martijn Cremers is Bernard J. Hank Professor of Finance at University of Notre Dame Mendoza College of Business; Timothy B. Riley is Assistant Professor in the Department of Finance at the University of Arkansas; and Rafael Zambrana is Assistant Professor of finance at the University of Notre Dame. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; How Much Do Investors Care about Social Responsibility? (discussed on the Forum here) by Scott Hirst, Kobi Kastiel, and Tamar Kricheli-Katz; Does Enlightened Shareholder Value add Value (discussed on the Forum here) by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita; Companies Should Maximize Shareholder Welfare Not Market Value (discussed on the Forum here) by Oliver D. Hart and Luigi Zingales; and Exit vs. Voice (discussed on the Forum here) by Eleonora Broccardo, Oliver Hart, and Luigi Zingales. 

ESG (Environmental, Social, and Governance) investing—alternatively, socially responsible investing or sustainable investing—is growing rapidly in popularity. In the fourth quarter of 2019, the assets of ESG-based mutual funds stood globally at nearly $1 trillion. Just two years later, in the fourth quarter of 2021, those assets stood at nearly $3 trillion. That growth has created controversy: In the states of Florida and Texas, limits have been put forth on ESG investing, with the Florida resolution stating that the state would invest “without consideration for nonpecuniary beliefs.”

This controversy raises a natural question: is ESG investing only about aligning investments with nonpecuniary beliefs or is ESG investing spotlighting oft ignored, but financially material, information?

The existing research on ESG with respect to mutual funds has primarily focused on whether funds incorporate ESG considerations into their investment process and, if they do, whether investing in stocks with high or low ESG ratings impacts their performance (i.e., whether ESG ratings themselves are financially material). The primary contribution of our work is to investigate more broadly—focusing on the materiality of the information underlying ESG ratings. We do so by measuring the extent to which fund managers incorporate ESG information into their portfolio decisions.

We measure the extent of ESG information incorporation through a novel metric we label ‘Active ESG Share.’ Importantly, a fund can be active with respect to ESG information by investing more in stocks with higher ESG ratings or by investing more in stocks with lower ESG ratings. Therefore, a fund manager with a high Active ESG Share—that is, one aggressively using ESG information—could have a portfolio of stocks that tend to have high or low ESG ratings.

Our hypothesis is not that high Active ESG Share is unconditionally beneficial. Rather, we contend that the material component of ESG information is complex, such that processing it effectively should require specialization. Accordingly, we expect that the impact on fund performance of Active ESG Share will be concentrated among ESG funds, who presumably have managers specialized in processing ESG information. In addition, ESG rating providers often disagree on their ratings. We expect the impact of Active ESG Share on performance to be stronger among funds that tend to hold stocks with greater rating disagreement, since those stocks offer greater opportunity to identify and utilize material information.

We measure Active ESG Share over the period 2004 through 2021 for a large sample of actively managed U.S. equity mutual funds. We classify a fund as ESG focused if Morningstar identifies it as such or if a fund has certain key terms in its name (e.g., ‘climate’ or ‘social’). Our sample of actively managed funds contains 243 ESG funds and 1,875 non-ESG funds. Consistent with the growth we discussed earlier, the proportion of ESG funds in our sample increases over time, from 10% of funds and 15% of assets in 2004 to 18% of funds and 20% of assets in 2021.

Our empirical evidence within this sample is consistent with our expectations. On average, Active ESG Share does not have a significant relation with future fund performance. Higher Active ESG Share does, however, predict better future performance among ESG funds. A one standard deviation increase in Active ESG Share for ESG funds predicts a performance increase of about 0.57% per year. Furthermore, that impact is concentrated among those ESG funds that tend to buy stocks with a high level of ratings disagreement. If the Active ESG Share of an ESG fund with that tendency increases by one standard deviation, our model predicts performance will improve, on average, by about 0.87% per year.

A feature of ESG investing that adds to its complexity is its aggregation of disparate components. How a firm approaches their carbon emissions (environmental) and whether a firm staggers its board (governance) have little relation, but those decisions both fall under the heading of ESG investing. We further detail the relation between Active ESG Share and performance by disaggregating E, S, and G. We find that, among ESG funds, the environmental component is the most impactful. A one standard deviation increase in Active E Share predicts a performance improvement of about 0.65% per year, while analogous increases for Active S Share and Active G Share predict performance improvements of 0.37% and 0.32% per year, respectively.

Our results with respect to the average ESG ratings of the stocks held by these funds are also consistent with the idea that ESG information is complex. For non-ESG funds, there is no relation between average ESG rating and future fund performance. For ESG funds, a one standard deviation increase in average rating predicts that performance will decrease by about 0.55% per year. From a financial perspective, ESG ratings themselves appear to not provide useful information, but rather serve as a means of coordinating the trading of ESG funds, leading to stock overpricing and fund underperformance.

In conclusion, our results from studying actively managed mutual funds support the hypothesis that ESG information is financially material, but complex. Specialized fund managers can incorporate such information into their investment process to the benefit of their investors, especially when investing in stocks with a high level of disagreement in ESG ratings. Thus, regardless of an investor’s nonpecuniary beliefs, ESG information should not be ignored.

Vanguard-Advised Funds’ Perspective on Contested Elections

John Galloway is Global Head of Investment Stewardship at Vanguard, Inc. This post is based on a publication by Vanguard Investment Stewardship.

Executive summary

  • New rules requiring the use of a universal proxy card in contested director elections at U.S. public companies are expected to alter the dynamics under which contested director elections are conducted.
  • Vanguard’s internally managed funds’ approach to evaluating contested director elections remains the same with the adoption of a universal proxy card.[1] In contested director elections, the funds assess the strategic case for change, evaluate the company’s approach to governance, and review the skills and qualifications of both the management and dissident director nominees.
  • We believe that companies should continue to proactively engage with shareholders, making independent directors available for such conversations; provide adequate disclosure of board composition that explains how the board’s collective and individual talents and skills align with the current and future needs of the company; and communicate steps the board is taking to measure and enhance its effectiveness, including how it conducts board assessments and ongoing director education and training.


Trust, Transparency, and Complexity

Richard T. Thakor is Assistant Professor of Finance at the University of Minnesota Carlson School of Management, and Robert Merton is Professor of Finance at the MIT Sloan School of Management. This post is based on their recent paper, forthcoming in The Review of Financial Studies. 

In recent years, there has been increasing complexity in both physical and financial products, due to higher demand for customization and financial innovation. Customers—who may have trouble understanding all relevant product attributes—have to trust the producers in order to buy their products, and investors have to trust these producers in order to invest in them. This has elevated the role of trust in enabling the adoption of these products. The importance of trust has led to significant discussion about how it is built, and transparency (disclosure) is viewed as a common tool for building trust (e.g. Offermann and Rosh (2012)). This has first-order policy relevance, as laws and policies are frequently proposed and put into place to mandate disclosure and verification.

Despite this common view that transparency can help build trust in product sellers, thereby helping buyers cope with complexity, the empirical evidence on the issue is mixed—there is little direct causal evidence on the relationship between transparency and trust in the cross-section. Indeed, anecdotal evidence suggests that greater transparency need not be associated with greater trust: some of the most trusted institutions often disclose less information than their less-trusted counterparts.

In our paper, “Trust, Transparency, and Complexity” (forthcoming in The Review of Financial Studies), we examine the interaction between trust, transparency, and verification theoretically in a model of endogenous product complexity and transparency. In contrast to the common view, we show that transparency does not build trust per se—in the sense that becoming more transparent does not directly lead to the firm becoming more trusted—but rather it substitutes for trust in that if a product is fully transparent to its user, there is no need for trust. There are however limits to the degree of complexity a product can have in order for it to be transparent.


Change management for the legal function

Lori Lorenzo, and Bob Taylor are Managing Directors, and Lee Merovitz is a Leader at Deloitte LLP. This post is based on a Deloitte memorandum by Ms. Lorenzo, Mr. Taylor, Mr. Merovitz, and Erin Hess.

It’s not unusual for organizations to struggle with organizational change. In-house legal departments are no exception.

In the past year, more than 43% of chief legal officers (CLOs) indicated that transformation is a top priority within their legal function, with a focus on technology (86%) and strategy (14%).[1] Many of these CLOs may be heading up their organization’s transformation efforts beyond the legal department: According to a recent Deloitte survey, legal executives lead a third or more of enterprise-wide digital, workforce, and cybersecurity transformation initiatives. Meanwhile, 82% expect their workload to increase from the previous 12 months. All told, these conditions may be prompting CLOs to consider more efficient and effective ways to drive transformation in their organizations.[2]

We recently asked legal executives about possible challenges they’re facing with transformation. The most common concerns they raise are the inability to generate value from technology solutions (65%) and the difficulty of demonstrating return on investment (ROI) for new technology (63%). But most also cite a range of other challenges, from obtaining enough funding to remote work and lack of expertise (figure 1).[3]


Who Are Quality Shareholders and Why You Should Care

Lawrence A. Cunningham is Special Counsel at Mayer Brown LLP, Principal of the Quality Shareholders Group and Henry St. George Tucker III Professor Emeritus at George Washington University. The following post is based on Professor Cunningham’s address delivered as the 37th Annual Francis G. Pileggi Distinguished Lecture in Law at Delaware Law School on February 10, 2023. This post is part of the Delaware law series; links to other posts in the series are available here.

The stated purpose of the Pileggi Lecture is to create an opportunity for those “distinguished” in corporate law and governance to address those “most responsible for shaping it:” the Delaware bench and bar. The message I’d like to share is: you are doing an excellent job, and please keep it up. A few takeaways upfront:

  • I concur with the widely held view that Delaware’s corporate law is a national treasure
  • evidence shows that Delaware’s “made-to-measure” approach to corporate governance is supported by America’s most patient and focused investors—called “quality shareholders”
  • there’s reason for great skepticism about the trend toward “one-size-fits-all” governance favored by America’s indexing investor community and to resist efforts by certain shareholders to rule corporate boardrooms.

In this lecture, after summarizing the “Delaware way,” I present my research on shareholder typologies, then canvas core topics in corporate governance today along with current debates about corporate purpose. The review shows not only the soundness of the Delaware approach but Delaware’s critical role in maintaining the boundaries to protect it.


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