(Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published in today’s print edition of the Financial Times and available here.)

A bill requiring federal regulators to draw up rules for compensation structures in the   financial sector was passed by the US House of Representatives on Friday and will be taken up by the US Senate. Such pay regulations, which authorities around the world are considering, will meet stiff resistance from financial institutions. Yet the case in their favour is compelling.

While the need to reform pay arrangements is now widely accepted, many believe that such reforms should be left to corporate boards and that government intervention should be limited to ensuring the adequacy of corporate governance processes. The Basel committee on Banking Supervision has urged boards to be closely involved in pay-setting; and the bill passed on Friday mandates “say on pay” shareholder votes and bolsters the independence of compensation committees. Would improvements in governance obviate the need for regulating pay structures? Not at all.

Outside the financial sector, government intervention should indeed be limited to improving internal governance, leaving choices over pay structures to shareholders and the directors elected by them. But financial institutions are special, and their special circumstances warrant a broader role for government.

Regulation of pay in financial institutions is justified by the very same moral hazard concerns that provide the basis for existing regulation of the sector. Because the failure of such companies imposes costs on taxpayers that shareholders do not internalise, shareholders’ interests are served by more risk-taking than is socially desirable. For this reason, financial institutions have long been constrained by a substantial body of rules that restrict private choices with respect to loans, investments and capital reserves.

Shareholders’ interest in more risk-taking implies that they could benefit from providing executives with excessive incentives in this direction. Executives with such incentives can use their informational advantages, and whatever discretion they have been left by existing regulations, to increase risks. Regulation of pay structures is a way to counter this. It would make the executives of financial companies work for, not against, the goals of financial regulation.

Opponents of such regulation will argue that the government does not have a legitimate interest in telling shareholders how to spend their money. But it does. Given the government’s interest in financial companies’ stability, intervention in pay structures is as legitimate as the traditional forms of financial regulation.

Opponents may also argue that regulators are at an informational disadvantage when assessing pay arrangements. Yet more informed players inside financial companies lack incentives to internalise the interests of depositors and taxpayers when setting pay structures. Furthermore, limiting structures that incentivise risk-taking is not more demanding in terms of information than regulators’ traditional intervention in investment, lending and capital decisions.

In addition, opponents may argue that pay regulation will drive talent away. But the proposed rules would apply to pay structures and not total compensation, which financial institutions would be free to set at the levels necessary to retain employees.

The regulation of pay structures is considered against the background of news that compensation in the financial sector is returning to the lofty levels of before the crisis. It is thus worth stressing that, while the regulations under consideration would address concerns about incentives, they would not, nor are they intended to, address concerns about overall compensation amounts. Their goal is to promote the safety and soundness of the financial system, not to address shareholder concerns about excessive levels of pay. In the US, such concerns would be best addressed by supplementing the mandated “say on pay” votes with a substantial strengthening of shareholder rights.

Regulating compensation structures should become a critical instrument in financial regulators’ toolkits. It would help prevent in the future the excessive risk-taking that contributed to the current crisis.

(Editor’s Note: This post comes to us from Jeremy Bulow of the Graduate School of Business, Stanford University, and Paul Klemperer of Nuffield College, University of Oxford.)

In our paper Why Do Sellers (Usually) Prefer Auctions?, which was recently accepted for publication in the American Economic Review, we focus on comparing the two dominant methods for selling public companies - a simple “plain vanilla” simultaneous auction and an equally simple model of a sequential sales mechanism - when the seller has realistically-limited power and information. (Similar alternative ways of selling are observed for many other assets.) In both processes we model, an unknown number of potential bidders make entry decisions sequentially, before learning their values. In an auction, no credible bidding is possible until all entry decisions have been taken. In a sequential mechanism, potential bidders arrive in turn. Each one observes the current price and bidding history and decides whether to pay the entry cost to learn its value. If it does, and if it succeeds in outbidding any current incumbent (who can respond by raising its own bid), it can also make any additional “jump bid” it wishes to attempt to deter further entry. In both processes, we assume the seller does not have the power or credibility to commit to a take-it-or-leave-it minimum (reservation) price above a buyer’s minimum possible value.

Our central result is that the straightforward, level-playing-field competition that an auction creates is usually more profitable for a seller than a sequential process, even though the sequential mechanism is always more efficient in expectation (as measured by the winner’s expected value less expected aggregate entry costs). Bidders, by contrast, usually prefer to subvert an auction by making pre-emptive “jump bids” when they can. The sequential process is more efficient because although it attracts fewer bidders in expectation, it attracts more bidders when those bidders are most valuable - the existence or absence of early bids informs subsequent entry decisions and attracts additional bidders when the early ones turn out to be weak. But buyers’ ability to make pre-emptive jump bids, which inefficiently deter too many potential rivals from entering, harms the seller.

We identify several factors that may cause the expected revenue between the auction and the sequential mechanism to differ. First, even in the most favorable circumstances, a sequential process could only be superior if the queue of potential bidders is sufficiently longer than the number that would compete in an auction. Second, in a sequential mechanism bidders who deter entry choose a price where the expected distribution of winning values is such that an additional entrant would expect to earn zero. These two factors would be nullified with an infinite stream of potential bidders, and when parameters are such that the expected profits of the marginal bidder who does not enter the auction is exactly zero. The third factor is therefore crucial: the value of the winning bidder is generally less dispersed in the sequential process, because that process is more likely to attract one high-value bidder but will never attract more than one. But entrants prefer more dispersion in the value they have to beat, because dispersion makes the entrant’s option to buy more valuable. Therefore, the expected value of the top bidder in the auction must be higher than in the sequential mechanism to deter entry.

Thus, contrary to our usual instinct that auctions are profitable because they are efficient, it is precisely the inefficiency of the auction - that entry into it is relatively ill-informed and therefore leads to a more random outcome - that makes it more profitable for the seller.

The full paper is available for download here.

(Editor’s Note: This post is based on a client memo by Randall Guynn, Arthur Long, Annette Nazareth, Margaret Tahyar, Robert Colby, Courtenay Myers and Reena Agrawal Sahni of Davis Polk & Wardwell LLP.)

The Obama Administration is currently on the legislative leg of the regulatory reform marathon that began earlier this year with the release of its Rules of the Road and continued with its White Paper on Financial Regulatory Reform. The Obama Administration released last week its legislative text to implement many elements of the White Paper. Overall, the Administration’s proposed legislation hews closely to the White Paper, though it provides important details in a number of areas where the White Paper was more general. The proposal would expand the Federal Reserve’s powers to include those of a systemic risk regulator, and create a new interagency Financial Services Oversight Council to assist the Federal Reserve in its new mission.

No sooner had the proposed legislation been released, however, than critics began to pull apart the proposals in commentary and through counterproposals. FDIC Chairman Sheila Bair criticized aspects of the proposal to appoint the Federal Reserve as systemic risk regulator, and SEC Chairman Mary Schapiro argued that a council of federal regulators, on which the SEC would have a seat, should have enhanced authority. The House Republicans proposed their own regulatory reform legislation, which contained a number of alternative proposals, including to limit the Federal Reserve’s authority to overseeing monetary policy, to transfer all of the Federal Reserve’s current regulatory authority to a new financial institutions regulator, and to fundamentally reform Fannie Mae and Freddie Mac. House Financial Services Committee Chairman Barney Frank argued that the federal thrift charter should not be abolished, even if the OTS were merged into the OCC in the form of a new national bank supervisor.

This memorandum, The Regulatory Reform Marathon, available here, builds on the analysis in our memorandum on the White Paper, A New Foundation for Financial Regulation?, by discussing the Obama Administration’s proposed legislation and the Republican counterproposal. Specifically, the memorandum discusses the Administration’s proposals for managing systemic risk, including the revised proposal for resolution authority and the proposal to designate certain large, systemically important financial companies as Tier 1 FHCs, subject to enhanced supervision and regulation by the Federal Reserve. The memorandum also discusses the Administration’s proposal to merge the OTS and the OCC, to eliminate the thrift charter, and to expand interstate branching; to expand bank and bank holding company regulation to include holding companies of insured depository institutions that have not otherwise been regulated as bank holding companies; and to enhance standards applicable to, and restrictions on, banks and bank holding companies. The memorandum also contextualizes other proposed regulatory enhancements, including the Administration’s proposal to give the Federal Reserve additional authority over payment, clearing and settlement systems and activities; the proposed reform of the asset-backed securitization markets; and the proposal to create an Office of National Insurance within the Treasury Department.

This post was written together with my colleague Wayne M. Carlin.

In a recently filed case, the SEC is for the first time seeking to “claw back” incentive-based compensation from a former CEO who is not accused of any wrongdoing. The case is emblematic of the new aggressiveness of the SEC’s enforcement program, and is an unfortunate contribution to the overheated atmosphere surrounding executive compensation generally.

The SEC is seeking a court order directing Maynard L. Jenkins, the former CEO of CSK Auto Corporation, to pay back to CSK over $4 million in bonuses and stock sale proceeds that Jenkins received during a period for which CSK’s financial statements were later restated. SEC v. Jenkins, No. CV 09-1510-PHX-JWS (D. Ariz. July 22, 2009). Earlier this year, the SEC brought a settled fraud case against CSK and a separate case charging four former CSK executives with fraud and other violations, all relating to the accounting practices from 2002 to 2004 that led to CSK’s restatement. The SEC has not charged Jenkins – either in the earlier enforcement actions against the company and other executives, or in the new clawback proceeding – with any involvement in or knowledge of accounting improprieties, or any other wrongdoing.

Section 304 of the Sarbanes-Oxley Act requires a CEO or CFO to return incentive-based compensation to an issuer in the event of a financial restatement that occurs “as a result of misconduct . . . .” The statute is at best ambiguous as to whether this obligation arises only where the “misconduct” has been committed by the CEO or CFO in question. As a result of that ambiguity, it has always been an open question whether the SEC would use this weapon against a CEO or CFO who did not personally engage in misconduct, and whether such an aggressive claim would be sustained in litigation.

The SEC’s decision to depart from its prior reasonable restraint in using Section 304 is a regrettable policy choice. Clearly, the SEC believes fraud occurred at CSK, but apparently can find no basis to assert that the CEO was culpable in it. The SEC has not even pursued any of the lesser charges that would be available against a blameworthy executive in these circumstances, such as a negligence-based administrative case. In these circumstances, it is difficult to discern what conduct by similarly situated CEOs the SEC may think this case will deter or encourage. It also remains to be seen whether a federal agency may constitutionally deprive a person who is not alleged to have violated any law of compensation that was lawfully received, particularly where the statute’s intended reach is ambiguous.

Finally, it is far from clear that the SEC’s policy choice in this case is well tailored to the goals of Section 304. Under Section 304, recovered compensation is paid back to “the issuer.” CSK, however, was sold in July 2008 and is now a wholly owned subsidiary of another company. The acquirer presumably paid what it thought CSK was worth one year ago, and the shareholders of CSK received that consideration at that time. The SEC now seeks to recover $4 million from a CEO that it cannot accuse of wrongdoing, in order to pay that money over to a company that was not harmed.

(Editor’s Note: This post is based on the Final Report of the Financial Crisis Advisory Group of the Financial Accounting Standards Board.)

On July 28, 2009, The Financial Crisis Advisory Group (FCAG), a high level group of recognized leaders with broad experience in international financial markets, published its recommendations related to accounting standard-setting activities, and other changes to the international regulatory environment following the global financial crisis.

The FCAG was formed at the request of the International Accounting Standards Board and the US Financial Accounting Standards Board to consider financial reporting issues arising from the crisis. Co-chaired by Hans Hoogervorst, Chairman, AFM (the Netherlands Authority for the Financial Markets) and Harvey Goldschmid, former Commissioner, US Securities and Exchange Commission, the FCAG met six times from January to July 2009.

The report of the FCAG (the “Report”) articulates four main principles and contains a series of recommendations to improve the functioning and effectiveness of global standard-setting.

The chief areas addressed in the Report are:
1. Effective financial reporting
2. Limitations of financial reporting
3. Convergence of accounting standards
4. Standard setter independence and accountability

Mr. Goldschmid said “As our Report emphasizes, improved financial reporting will help restore the confidence of financial market participants and thereby serve as a catalyst for increased financial stability and sound economic growth. The independence and integrity of the standard-setting process, including wide consultation, is critical to developing high quality, broadly accepted accounting standards responsive to the issues highlighted by the crisis.”

The Report includes a number of recommendations relating to each of the four principles, which are set out below. …continue reading: Financial Crisis Advisory Group Reviews Standard-Setting Activities Following Global Financial Crisis

(Editor’s Note: This post comes to us from Kee H. Chung of the State University of New York (SUNY) at Buffalo, John Elder of North Dakota State University and Jang-Chul Kim of Northern Kentucky University.)

In our paper, Corporate Governance and Liquidity, which was recently accepted for publication in the Journal of Financial and Quantitative Analysis, we examine how corporate governance affects stock market liquidity. We conjecture that corporate governance affects stock market liquidity because effective governance improves financial and operational transparency, which decreases information asymmetries between insiders (e.g., mangers and large shareholders) and outside investors (e.g., outside owners and liquidity providers), as well as among outside investors. Governance provisions may improve financial transparency by mitigating management’s ability and incentive to distort information. These provisions make it less likely that management, acting in its self-interest, does not fully disclose relevant information to shareholders or discloses information that is less than credible.

We examine the effect of corporate governance on liquidity using an index of governance attributes that are likely to affect financial and operational transparency. Our governance index, which is based on data compiled by Institutional Shareholder Services (ISS), consists of 24 such governance attributes. Our measures of liquidity include quoted spreads, effective spreads, and an index of market quality for a large sample of NYSE/AMEX and NASDAQ stocks. To examine the relation between corporate governance and information asymmetries more directly, we also estimate two measures of information-based trading, the price impact of trades and the probability of information-based trading.

Our results show that stocks of companies with better governance structure exhibit narrower quoted and effective spreads, higher market quality index, smaller price impact of trades, and lower probability of information-based trading. The estimated improvement in liquidity is economically significant, with an increase in our governance index from the 25th to 75th percentile decreasing quoted spreads on NASDAQ by about 4.5%. Our results are robust to different estimation methods (including fixed effects and error component model regressions), across markets, and alternative measures of liquidity. In addition, we find that changes in our liquidity measures are significantly related to changes in governance scores over time. These results suggest that firms may alleviate information-based trading and improve stock market liquidity by adopting corporate governance standards that mitigate information asymmetries.

The full paper is available for download here.

This post is by my colleague Louis G. Hering.

In its latest session, the Delaware legislature enacted several amendments to three of Delaware’s four “alternative entity” statutes – the Delaware Limited Liability Company Act (“DLLCA”), the Delaware Revised Uniform Limited Partnership Act (“DRULPA”) and the Delaware Revised Uniform Partnership Act (“DRUPA”). [1] The amendments become effective on August 1, 2009. Among other things, the amendments (i) effectively codify the doctrine of independent legal significance, as developed in Delaware corporation law, to apply to LLCs, limited partnerships and general partnerships; and (ii) confirm the ability by merger or consolidation to amend an operating or partnership agreement or adopt a new operating or partnership agreement for an entity that is the surviving or resulting entity in a merger or consolidation.

The utility of the Delaware alternative entity statutes, as well as the other advantages of using Delaware entities (for example, the predictability of the Delaware courts and the customer friendly attitude of the Delaware Secretary of State’s office), has resulted in significant use of Delaware alternative entities. According to the Delaware Secretary of State, 2,581 statutory trusts, 7,552 limited partnerships and 81,923 LLCs were formed in 2008, bringing the total number of each of these entities existing at the end of 2008 to 22,526, 70,503 and 501,670 respectively. The continued formation and use of Delaware’s alternative entities have predictably led to additional litigation, and we have again updated our survey of Delaware case law relating to alternative entities. The 2009 Cumulative Survey is now available on our website here under Publications.

The changes referenced above, together with other changes of particular interest, are summarized below.

Highlights

I. Certain 2009 Amendments To The Delaware Limited Liability Company Act, 6 Del. C. §§ 18-101 Et Seq.

A. Construction and Application of Chapter and Limited Liability Company Agreement [Section 18-1101(h)]

Newly added Subsection 18-1101(h) effectively codifies the doctrine of independent legal significance, as developed in Delaware corporation law. The amendment is in the form of a statement of the doctrine: that an action validly taken under one provision of the DLLCA shall not be deemed invalid solely because it is similar to an action that could have been taken under another provision of the DLLCA, but fails to satisfy the conditions of that other provision.

B. Merger and Consolidation [Section 18-209(f)]

Related to the amendment codifying the doctrine of independent legal significance, Section 18-209(f) was amended to confirm the ability by merger or consolidation to amend a limited liability company agreement or adopt a new limited liability company agreement for a limited liability company that is the surviving or resulting entity in a merger or consolidation by obtaining the approval of the requisite number of members to approve such merger or consolidation, unless the limited liability company agreement by its terms limits such amendment or adoption.

…continue reading: Delaware Amends Alternative Entity Statutes

(Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk and Alma Cohen published today on Wall Street Journal online and available here.)

New York State Attorney General Andrew Cuomo released yesterday a report on compensation and income at nine major banks during 2003-2009. An assessment of these figures raises serious concerns from the perspective of both investors and taxpayers.

The Cuomo report focuses on nine large financial institutions that received substantial TARP support from the government. Below we focus on the compensation decisions these firms made during the first half of 2009. Assuming that these decisions are a sign of things to come, the firms’ post-crisis pay policies appear to be, in the aggregate, even more lucrative to the firms’ employees than precrisis policies.

From shareholders’ perspective, it is useful to examine what may be labeled “Earnings before Compensation (“EBC”), which are equal to the sum of net income and compensation expenses. A financial firm’s ECB in any given year represents the total pie to be divided between the two groups crucial for the firm’s existence and operations — the firm’s employees and the shareholders providing the firm’s capital. Firms’ compensation decisions determine what fraction of ECB goes to employees rather than left in firms’ coffers (or distributed as dividends) to shareholders.

During the first half of 2009, with the exception of State Street, the banks in the group have enjoyed substantial ECB levels. The bar graph below displays the fraction of the banks’ aggregate EBC levels paid out as compensation to employees during the precrisis years as well as during the first half of 2009.

As the bar graph shows, during each of the years 2003-2006, this fraction was in the 52%-62% range. In contrast, during the first half of 2009, this fraction was about 74%. To the extent that employees were not under-compensated during 2003-2006, investors have a reason to wonder: might financial firms be letting employees eat part of the investors’ lunch?

Defenders of firms’ compensation decisions argue that firms are paying what is necessary to retain able employees and to prevent the flight of talent. The aggregate figures of pay and compensation can also be useful in considering this argument.

In 2006, aggregate ECB for the banks in the group equaled (in 2009 dollars) $244 billion and the banks’ total compensation expenses were $143 billion. By contrast, assuming that ECB and compensation in the second half of 2009 will be the same as in the first half, the firms will pay an aggregate $156 billion even though they will generate an aggregate EBC of only $211. Assuming that the behavior of these firms is representative of the financial sector, investors might wonder why financial firms need in the aggregate to spend more on compensation even though they generate less value.

We now turn from the perspective of investors to that of the government (two perspectives that somewhat overlap as the government owns shares in some of these banks). We believe that government policy toward compensation in banks should focus on the incentives produced by pay structures, not on compensation amounts. But the above compensation figures should be of interest to public officials for two reasons.

First, during the financial crisis, taxpayers have expended substantial resources to shore up the firms’ capital, with the firms covered by the report receiving a total of $165 billions in TARP funding. The compensation amounts taken by employees out of the firms — $156 billion in 2009 alone assuming the second half of the year is the same as the first — are sufficiently large to have a meaningful impact on the firms’ capital.

Second, during the past two decades, compensation in finance has increased relative to other parts of the economy, and the financial sector has attracted an ever-increasing share of the country’s best and brightest. Following the financial crisis, there is widespread recognition that, in the post-crisis world, finance should command a smaller share of these best and brightest. To the extent that relative pay in the financial sector remains at or above its lofty precrisis levels, the desirable adjustment in the allocation of talent will be impeded or delayed.

Assessing the compensation figures for the first half of 2009 indicates that the good days of compensation are clearly rolling again. Investors and taxpayers should closely watch how these figures evolve during the remainder of 2009 and beyond.

(Editor’s Note: This post is the written testimony (with footnotes and references omitted) submitted by Professor John Coates to the Senate Banking, Housing, and Urban Affairs Subcommittee on Securities, Insurance and Investment. Professor Coates testified on July 29, 2009 in the hearing on “Protecting Shareholders and Enhancing Public Confidence by Improving Corporate Governance.” Professor Coates’s complete written testimony can be found here.  Professor Coates’ testimony, and the research of other members of the Program on Corporate Governance, was discussed in this article published on July 29, 2009 in the Christian Science Monitor.)

Introduction

Chairman Reed, Ranking Member Bunning, and members of the Subcommittee, I want to thank you for inviting me to testify. Effective corporate governance is a crucial foundation for economic growth, and I am honored to have been asked to participate.

A. Are There Any General Lessons for Corporate Governance from the Financial Crisis?

Some have described the ongoing financial crisis as reflecting poorly on US corporate governance, as with the accounting scandals and stock market bubbles of the late 1990s and early 2000s that led to the Sarbanes-Oxley Act. Unlike those episodes, however, the ongoing financial crisis has not exposed new and widespread problems with the basic governance of most US publicly held corporations. Outside the financial and automotive sectors, most companies have suffered only as a result of the crisis, and did not contribute to or cause it. Stock prices have fallen across the board, but most price declines have more to do with the challenges facing the real economy, and the spillovers from the financial sector on companies in need of new capital, and little to do with any general problem with corporate governance. As a result, we have learned relatively little about many long-standing concerns and debates surrounding the governance of publicly held corporations – and there are few if any easy lessons that can be drawn from the crisis for corporate governance generally.

I do not mean to minimize those concerns and debates, or suggest lawmakers should remain passive in the field of corporate governance. To the contrary, the crisis makes reform more important and urgent than ever, because well-governed companies recover and adapt more readily than poorly governed firms. But the best reform path will need to attend to differences between governance across industries, and ways that corporate governance interacts with industry-based regulation – and in particular, financial industry regulation – if legal changes are not to make things worse, rather than better. Governance flaws at Citigroup differed dramatically from governance flaws at GM, and attempts to fix the problems at firms like GM through laws directed at all public companies could make things worse at firms like Citigroup.

…continue reading: Protecting Shareholders and Enhancing Public Confidence through Corporate Governance

On July 16 the Walker review of corporate governance of UK banks and other financial institutions (BOFIs) released a consultation paper on the future of corporate governance in the UK financial services sector (the Review).

We have recommended substantial changes to the way the boards of BOFIs function in particular through boosting the role of non-executives in the risk and remuneration process.

We recommend strengthening bank boards, making rigorous challenge in the boardroom a key ingredient in decisions on risk and measures to encourage institutional shareholders to play a more active role as engaged owners of BOFIs.

Sir David said “These proposals are designed to improve the professionalism and diligence of bank boards, increasing the importance of challenge in the board environment. If this means that boards operate in a somewhat less collegial way than in the past, that will be a small price to pay for better governance.”

Five key themes of the Review are as follows:

First, the Combined Code of the Financial Reporting Council (FRC) remains fit for purpose. Combined with tougher capital and liquidity requirements and a tougher regulatory stance on the part of the Financial Services Authority (FSA), the “comply or explain” approach to guidance and provisions under the Combined Code provides the surest route to better corporate governance practice in BOFIs. The relevant guidance and provisions require amplification and better observance but there are no proposals for new primary legislation.

Second, principal deficiencies in BOFI boards related much more to patterns of behaviour than to organisation. The right sequence in board discussion on major issues should be presentation by the executive, a disciplined process of challenge, decision on the policy or strategy to be adopted and then full empowerment of the executive to implement. The essential challenge step in the sequence was missed in some board situations and must be unequivocally embedded in future. The most critical need is for an environment in which effective challenge of the executive is expected and achieved in the boardroom before decisions are taken on major risk and strategic issues. For this to be achieved will require close attention to board composition to ensure the right mix of both financial industry capability and critical perspective from high-level experience in other major business. It will also require a materially increased time commitment from non-executive directors (NEDs), from whom a combination of financial industry experience and independence of mind will be much more relevant than a combination of lesser experience and formal independence. In all of this, the role of the chairman is paramount, calling for both exceptional board leadership skills and ability to get confidently and competently to grips with major strategic issues. With so substantial an expectation and obligation, the chairman’s role will involve a priority of commitment that will leave little time for other business activity.

…continue reading: Review Proposes Fundamental Changes to Strengthen UK Bank Governance

One way to sum up the “big picture” of corporate governance in the U.S. today is as follows:

We are in the midst of a true revolution in our private enterprise economic system, much of which is being driven in the name of “corporate governance” by multiple parties with an ever-expanding agenda.

This may sound like one of those deliberately extreme statements sometimes designed to stimulate debate—but I offer it simply as a description of where things are. In fact:

• The roster of participants in the U.S. corporate governance arena today is extraordinarily large and diverse, the collective agenda of these participants is very broad, and the level of dedication of these various participants to achieving their agendas is quite high.

• The common purpose or effect of their efforts is to redesign in significant ways the publicly traded business corporation, a central instrument of U.S. capitalism.

• This redesign involves sources of capital, the role of risk-taking, the fundamental purpose of business corporations and the role of directors.

The bottom line reality is that today’s corporate governance reform movement is reshaping materially our private enterprise economic system. Moreover, inadequate attention is being paid to assessing the scope and magnitude of the changes — and the risks they present to our economy. This inattention needs to be corrected promptly, before the law of unintended consequences produces considerable harm to our economic system in the name of “corporate governance.”

Participants in the Corporate Governance Universe Today

There is no question that the ranks of the participants in the corporate governance dialogue have been steadily expanding over the past decade, and as a result of the recent financial crisis and global recession, this has significantly accelerated in the past year or so. These participants now include: (1) the SEC; (2) the NYSE and Nasdaq; (3) shareholder governance activists; (4) hedge funds/other shareholders with shortterm or special economic interests; (5) public pension funds and other institutional investors; (6) corporate governance rating services; (7) proxy advisory firms; (8) academics in various disciplines; (9) labor unions; (10) the President/White House; (11) Congress; (12) the Treasury Department; (13) the Federal Reserve System; (14) the Federal Deposit Insurance Corporation; (15) the Department of Justice; (16) state Attorneys General; (17) the media; and (18) state corporate law (legislatures and courts).

Each of these parties or groups has become an active voice of corporate governance “reform.” The growth of this universe is a clear testament to the dramatically increased visibility and importance ascribed to “corporate governance” in today’s world.

…continue reading: U.S. Corporate Governance Today: A Reshaping of Capitalism

(Editor’s Note: This post comes to us from Robert E. Hall of Stanford University and the National Bureau of Economic Research, and Susan E. Woodward of Sand Hill Econometrics, Inc.)

An entrepreneur’s primary incentive is ownership of a substantial share of the enterprise that commercializes the entrepreneur’s ideas. An inescapable consequence of this incentive is the entrepreneur’s exposure to the idiosyncratic risk of the enterprise. Diversification or insurance to ameliorate the risk would necessarily weaken the incentives for success. In our forthcoming American Economic Review paper, The Burden of the Nondiversifiable Risk of Entrepreneurship, we study this issue in the case of startup companies backed by venture capital.

We make use of a rich body of data, which we believe is not a sample, but close to the universe of companies receiving venture funding from 1987 to the present. Standard venture deals involve three parties: entrepreneurs, general partners, and limited partners. The entrepreneurs have leveraged positions; that is, they receive no payoff until other claimants have received prescribed payoffs. The general partners, who arrange financing and supervise the startup company by holding board seats, are compensated in proportion to the amount invested and the capital gains on the investment. The limited partners are passive investors who hold debt and equity claims on the startup. General partners are somewhat diversified across investments and the limited partners are highly diversified. The burden of specialization falls mainly on the entrepreneurs.

We focus on the joint distribution of the duration of the entrepreneur’s involvement in a startup what we call the venture lifetime and the value that the entrepreneur receives when the company exits the venture portfolio. Exits take three forms: (1) an initial public offering, in which the entrepreneur receives liquid publicly-traded shares or cash (if she sells her own shares at the IPO or soon after) and has the opportunity to diversify; (2) the sale of the company to an acquirer, in which the entrepreneur receives cash or publicly-traded shares in the acquiring company and has the opportunity to diversify; and (3) shutdown or other determination that the entrepreneur’s equity interest has essentially no value. Most IPOs return substantial value to an entrepreneur. Some acquisitions also return substantial value, while others may deliver a meager or zero value to the entrepreneur. The joint distribution shows a distinct negative correlation between exit value and venture lifetime. Highly successful products tend to result in IPOs or acquisitions at high values relatively quickly.

In addition, we develop a unified analysis of the factors affecting the entrepreneur’s risk-adjusted payoff, based on a dynamic program. The analysis takes account of the joint distribution of exit value and venture lifetime and of salary and compensation income. We use it to calculate the certainty-equivalent value of the entrepreneurial opportunity the amount that a prospective entrepreneur would be willing to pay to become a founder of a venture-backed startup. For a risk-neutral individual, the certainty-equivalent is $3.6 million. With mild risk aversion and savings of $100,000, however, the amount is only $0.7 million and with normal risk aversion and that amount of savings, the certainty-equivalent is slightly negative.

Our most important finding is that the reward to the entrepreneurs who provide the ideas and long hours of hard work in these startups is zero in almost three quarters of the outcomes, and small on average once idiosyncratic risk is taken into consideration.

The full paper is available for download here.

(Editor’s Note: This post is based on a client memo by David Katz and Laura McIntosh of Wachtell, Lipton, Rosen & Katz.)

In recent weeks, regulators and lawmakers have proposed a dizzying array of reforms that, if implemented, would exacerbate short-termism, undercut directorial discretion, further empower shareholder activists, and impose unnecessary and potentially costly burdens on public companies. Few of the proposed reforms are truly new and nearly all are ill-conceived. They appear to proceed in part from a misguided impulse on the part of regulators and lawmakers to be seen as “doing something” about the current recession—though hardly any of the proposed reforms have even a remote connection to the origins of the credit crisis that precipitated the economic downturn—and in part from an opportunistic desire to use the financial crisis as an excuse to enact an activist “wish list” of reforms.

Overview

Members of Congress, the Department of the Treasury and the Securities and Exchange Commission (SEC) are all currently engaged in putting forth corporate governance initiatives. The proposed reforms include shareholder proxy access rules, corporate governance proxy disclosure requirements, executive compensation proxy disclosure requirements, requirements as to the structure, composition and election of the board of directors, executive compensation clawbacks, say-on-pay and independence requirements for compensation committees and their outside consultants, and mandatory majority voting. Pending federal legislation includes the Shareholder Bill of Rights Act of 2009 (Bill of Rights Act), sponsored by Senators Charles Schumer and Maria Cantwell, the Shareholder Empowerment Act of 2009 (Empowerment Act), sponsored by a group of Representatives, the Excessive Pay Shareholder Approval Act (Excessive Pay Approval Act), sponsored by Senator Richard Durbin, and the Treasury’s Investor Protection Act of 2009 (Investor Protection Act).

Amidst this veritable avalanche of reform, the SEC has already approved the New York Stock Exchange’s (NYSE) proposal to eliminate broker discretionary voting in uncontested elections beginning next year. The key features of the proposed initiatives are discussed below.

Shareholder Proxy Access

The latest chapter in the continuing saga of proxy access began in June 2009 as the SEC released proposed proxy access rules for the third time this decade. The first proposal, in 2003, was the subject of fierce debate—the SEC received a record number of comment letters on the proposal—and was shelved in 2004. The prevailing sentiment at that time was that the issue of proxy access was highly complex and carried many hidden consequences. For a time, it appeared that the issue had been largely superseded by the widespread adoption of a majority voting standard for the election of directors. In 2007, in response to a court ruling that unsettled the SEC’s long-held position that shareholder proposals on proxy access could be excluded from the proxy statement, the SEC took the unusual step of issuing two conflicting alternative proposals on shareholder access, each approved by votes of 3-2 among the SEC Commissioners. Later that year, the SEC voted to continue its policy of permitting companies to exclude shareholder proposals relating to board nominations or director elections from the company proxy statement. Now comes the latest installment, and, under the new leadership of SEC Chair Mary Schapiro, the SEC seems poised to take definitive action. The SEC comment period ends August 17, 2009, and the SEC has announced its intention to adopt final rules by November 2009 so that they will be in place for the 2010 proxy season. As part of its proposal, the SEC raised more than 500 questions that it asked be addressed in the comment process.

…continue reading: Populist Wish Lists Offer Legislative Parade of Horribles

In an editorial titled “Of Banks and Bonuses,” The New York Times today expresses support for reforming pay in banks. Among possible reforms, the editorial describes as an “insightful reform” a proposal put forward recently in a discussion paper by Lucian Bebchuk and Holger Spamann that the Harvard Program on Corporate Governance issued recently. The New York Times describes the proposal and the rationale for it as follows:

“An insightful reform recommended by Lucian Bebchuk, a Harvard Law professor and director of the law school’s Program on Corporate Governance, would require that executive compensation be tied not only to the company’s stock performance, but also to the long-term value of the firm’s other securities, like bonds. That would encourage executives to be more conservative about using borrowed money to juice returns to capital, because it would expose them to the losses that leverage can exert on all the firm’s investors.”

The New York Times editorial can be found here. The Bebchuk-Spamann discussion paper, “Regulating Bankers’ Pay”, can be found here. The proposed reform is also discussed in Lucian Bebchuk’s testimony before the Financial Services Committee of the House of Representatives, which is available here.

(Editor’s Note: This post comes to us from Martijn Cremers of Yale University, Joost Driessen of the University of Amsterdam, Pascal Maenhout of INSEAD and David Weinbaum of Syracuse University.)

In our forthcoming Journal of Financial and Quantitative Analysis paper, Does Skin in the Game Matter? Director Incentives and Governance in the Mutual Fund Industry, we investigate whether effective governance, particularly director ownership, is associated with superior mutual fund performance, and if so, what economic mechanism could explain that.

We assemble a unique database on the fund holdings of the members of the largest equity mutual fund boards of directors, and investigate whether mutual fund performance is related to the ownership stakes of the directors overseeing those same funds. Specifically, for all actively managed equity funds that belong to the top 25 equity mutual fund families as of January 1996, we collect information on the ownership stakes of all independent and non-independent directors.

We find that directors’ ownership stakes in the funds they oversee are related to the subsequent performance of the funds: funds with low director ownership perform poorly. This underperformance has sizeable statistical significance and is economically large. This is true for ownership both at the fund family level and at the individual fund level. Funds in mutual fund families in which ownership by independent directors is low generate average annual abnormal returns of -2.54%. Similarly, funds with low ownership by non-independent directors generate average annual abnormal returns of -2.48%, and funds with low ownership by independent directors generate annual abnormal returns of -2.01%. The relation between ownership and performance is not linear, rather it is driven by the significant underperformance of low (and often zero) ownership funds. We do not find significant underperformance for funds with intermediate or high ownership.

In order to interpret our results, we distinguish between the monitoring and private information hypotheses by considering the performance of directors’ investments in the funds they oversee. In contrast to the results at the fund level, we find no link between lack of ownership and underperformance at the director level, which is evidence against the private information hypothesis. Further, we use various proxies for the importance of monitoring to show that the relation between director ownership and fund performance is driven by the underperformance of funds where monitoring is important, but ownership by directors is low. Third, we investigate the extent to which our results are driven by fees. We find that while fees are indeed higher in low director-ownership funds, and this does explain part of our results, it in fact explains a surprisingly small fraction of the results. This suggests that the role of mutual fund boards of directors extends well beyond fee negotiations.

The full paper is available for download here.

(Editor’s Note: This post is by Andrew J. Nussbaum, William Savitt, and Ryan A. McLeod of Wachtell, Lipton, Rosen & Katz.)

In a decision that could increase the litigation risk associated with short-form mergers under 8 Del. C. § 253, the Delaware Supreme Court has ruled that where there is a breach of the duty of disclosure in connection with a short-form merger, the appropriate remedy is an automatic “quasi appraisal” action in which the minority shareholders may adopt an “opt-out” class approach and need not escrow any of the merger consideration they have already received. Berger v. Pubco Corp., No. 509, 2008 (Del. July 9, 2009).

Under Delaware’s short-form merger statute, a parent corporation that owns at least
90% of its subsidiary’s outstanding stock may summarily cash out the minority holders by the unilateral adoption of a resolution setting forth the consideration to be given. In 2001, the Supreme Court ruled that controlling stockholders owed no duty to pay a fair price in a short-form merger, and a minority stockholder’s only recourse is to seek appraisal. Consequently, the only obligation of a company effecting a short-form merger is to provide minority shareholders with all information material to the decision of whether or not to seek appraisal. Glassman v. Unocal Exploration Corp., 777 A.2d 242, 248 (Del. 2001).

The Court of Chancery in Berger found several inadequacies in the parent’s disclosure notice, including that it had failed to provide any information about the method used to determine the consideration offered. Because the merger had already been effected and consideration had already been paid, the Court of Chancery ordered a “quasi appraisal,” which would replicate a statutory appraisal action by requiring minority shareholders to “opt-in” to the proceeding and place in escrow a portion of the consideration they had already received.

Reversing, the Supreme Court held that principles of “fairness” dictated that “majority stockholders that deprive their minority shareholders of material information should forfeit their statutory right to retain the merger proceeds payable to shareholder who, if fully informed, would have elected appraisal.” Consequently, the Court held that the proper remedy for disclosure violations in a short-form merger is a quasi appraisal action on behalf of an automatic class of all minority stockholders with no escrow requirement.

Because the Supreme Court’s remedy removes the ordinary downside risks of an appraisal action and facilitates class action-style proceedings, this decision may encourage increased litigation following short-form mergers. At the same time, however, Berger reemphasizes the limited fiduciary remedies available to minority stockholders in a short-form merger, and its holding applies only in circumstances where the merger was accompanied by material disclosure violations. The decision thus serves as a useful reminder to Boards and controlling shareholders pursuing shortform mergers that appropriately complete disclosure is critical to obtaining the statutory benefits to acquirors of the Delaware short-form merger and appraisal provisions.

This post is by my colleagues James T. Rothwell, Mark M. Mendez, and Katia Brener.

In Zacharias v. SEC, the U.S. Court of Appeals for the District of Columbia Circuit affirmed an SEC order finding that two officers and directors of a public company and an unaffiliated third party engaged in a “scheme” to sell securities in violation of the registration requirement of Section 5 of the Securities Act, despite the fact that the only shares sold to the public were freely tradable shares owned by the third party. The Court’s praise of the SEC decision as “a triumph of substance over form” [1] and the reasoning of the case (as well as the result) stand in contrast to the recent decisions of three U.S. District Courts that rejected the SEC’s claims of Section 5 violations in the hedging of “PIPEs” securities. [2]

The “Swap” Transactions

Christopher Zacharias and John Carley (the “Option Holders”) were officers and directors of Starnet Communications International, Inc. (“Starnet”) and held options to purchase Starnet shares. Starnet registered the exercise of the options on Form S-8, but the registration statement did not cover resales of underlying shares. Thus, the Court stated that “[s]ales to the public of shares acquired by exercise of their options would have been illegal unless a registration statement under § 5 had been in effect” but noted that the Option Holders “did not . . . have a registration statement filed.” [3]

Separately, Alfred Peeper controlled foreign entities (the “Peeper Entities”) that held several million Starnet shares that “they could lawfully resell to the public.” [4] The Peeper Entities also held warrants to purchase several million additional shares that had not yet been exercised.

The “scheme” consisted of two transactions:

Transaction 1: The Peeper Entities sold their shares of Starnet to the public, and also exercised their warrants and sold the resulting shares to the public. It appears that absent the other facts of the combined transactions, the sale of the shares initially owned by the Peeper Entities would have been legal, and the sale of the shares issued upon exercise of the warrants “would likely have been legal as well.” [5]

Transaction 2: Shortly after these sales by the Peeper Entities, the Option Holders exercised their options and sold the underlying shares to the Peeper Entities in a private placement. [6] The number of shares the Option Holders so sold to the Peeper Entities was apparently equal to the number of shares the Peeper Entities sold in Transaction 1 (hence the SEC’s characterization of the transactions as a “swap” of the shares sold by the Peeper Entities for the shares purchased by the Peeper Entities). It appears that this sale also would not have been problematic absent
Transaction 1 – the Court explained that a “simple sale to the Peeper Entities . . . would likely have been lawful had such a sale . . . not been part of any ‘chain of transactions . . . involving any public offering.’” [7]

The apparent purpose of the two transactions was to enable the Option Holders to sell their option shares at a price that reflected little or no “liquidity discount” to the prevailing market price for freely tradable shares, without having to file a registration statement. If the Option Holders had sold their shares to a buyer who did not have other shares to sell to the public, that buyer would have paid a discounted price because the shares would be “restricted” under the Securities Act and therefore illiquid. However, the Peeper Entities (a) currently owned shares, and (b) presumably intended to remain invested (but not increase their investment) in the company for the long term. Therefore, the Peeper Entities likely cared less about liquidity than a typical investor and thus were willing to pay a price that was closer to the prevailing market price. By buying shares from the Option Holders and selling an equal number of shares to the public (albeit in reverse order in this case), the Peeper Entities maintained their level of investment in Starnet.

…continue reading: D.C. Circuit Adopts Expansive Meaning of Underwriter

(Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published today on Wall Street Journal online and available here.)

Last week, after reporting stellar second-quarter profit of $3.4 billion, Goldman announced the setting aside of $11.4 billion for compensation – which, broken down per employee, is similar to what Goldman set aside in the first half of the boom year of 2007.

Goldman’s CFO argued that its pay decisions reflect the firm’s “pay for performance culture.” However, if Goldman proceeds to pay record cash bonuses this year, as many now expect, these payments would reflect a return to flawed pay structures, as well as a failure to implement effectively the compensation principles Goldman recently put forward.

The setting aside of $11.4 billion for compensation, it should be stressed, doesn’t yet commit Goldman to any amounts of cash bonuses. Goldman still has time to determine the magnitude and structure of its 2009 compensation. In doing so, it should give substantial weight to lessons drawn from the financial crisis.

The crisis has highlighted a substantial flaw in compensation structures that provide rewards for short-term performance – which is what Goldman’s paying super cash bonuses for 2009 would do. Such rewards can over-compensate executives as well as produce excessive incentives to take risks.

Rewards for short-term results can produce over-compensation by enabling executives to cash out large amounts of compensation on account of results that are subsequently reversed. In many financial firms whose aggregate earnings over the past several years are negative, executives have still been able to cash out large amounts of bonus compensation during the first part of this period – and they kept these amounts despite the large losses subsequently borne by the firms.

In addition, and perhaps most importantly, bonuses for short-term results provide incentives to seek improvements in short-term results even at the expense of excessive taking of risks of an implosion later on. The short-term distortion caused by standard compensation structures, which Jesse Fried and I first highlighted in our “Pay without Performance” book, has recently become widely accepted. Treasury Secretary Geithner stated last month that “[s]ome of the decisions that contributed to this crisis occurred when people were able to earn immediate gains without their compensation reflecting the long-term risks they were taking for their companies and their shareholders.”

Indeed, the flaws in the standard compensation structures of financial firms have been explicitly recognized by Goldman’s own leaders. Last April, in a widely praised speech before the Council of Institutional Investors, Goldman’s CEO Lloyd Blankfein called for compensation reform, stating that “[financial firms'] decisions on compensation … look self-serving and greedy in hindsight.” Evaluation of employees’ performance, Blankfein stressed, “must be made on a multi-year basis to get a fuller picture of the effect of an individual’s decisions.”

Goldman subsequently adopted compensation principles and announced them in its annual shareholder meeting last May. According to these principles, “cash compensation in a single year should not be so much as to overwhelm the value ascribed to longer term stock incentives that can only be realized through longer term responsible behavior.”

…continue reading: Paying for Performance at Goldman

(Editor’s Note: This post is the first part of a two-part series, and is based on a recent article in Lombard Street.)

On June 17, the Treasury Department issued an 88-page report entitled Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation. The Report (as I’ll call it) is a blueprint for reform of financial regulation, with the aim of preventing another financial crisis. In this first part of a two-part article, I discuss weaknesses in the overall approach that the Report takes to the problem of reform, as well as weaknesses in the Report’s proposals for limiting “systemic risk.” Part II (which will be published in August) will discuss the proposals concerning executive compensation and consumer and investor protection, and will also suggest some alternative proposals for regulatory reform.

The Report’s fundamental weaknesses are its prematurity, overambitiousness, reorganization mania, and FDR envy. Let me start with the last. It is natural for a new President, taking office in the midst of an economic crisis, to want to emulate the extraordinary accomplishments of Franklin D. Roosevelt’s initial months in office. Under Roosevelt, within what seemed the blink of an eye, the banking crisis was resolved, public-works agencies that hired millions of unemployed workers were created, and economic output rose sharply. But that was 76 years ago. The federal government has since grown fat and constipated. The program proposed in the Report cannot be implemented in months or years, or perhaps even in decades—as would be apparent had the Report addressed costs, staffing requirements, and milestones for determining progress toward program goals and had the Report attempted an overall assessment of feasibility.

The Report is premature in two respects. The first is that it advocates a specific course of treatment for a disease the cause or causes of which have not been determined. Now it is not always necessary to understand the cause of something you don’t like in order to be able to eliminate the effect. If you have typical allergy symptoms you may get complete relief by taking an antihistamine; it is not necessary to find out what you’re allergic to. But generally, and in the case of the current economic crisis, unless the causes of a problem are understood, it will be impossible to come up with a good solution. The causes of the crisis have not been studied systematically, and are not obvious though they are treated as such in the Report. (Remember, the Great Depression of the 1930s ended 68 years ago and economists are still debating its causes.) We need some counterpart to the 9/11 Commission’s investigation of an earlier unforeseen disaster.

The Report asserts without evidence or references that the near collapse of the banking industry last September was due to a combination of folly—a kind of collective madness—on the part of bankers (in part reflected in their compensation practices), of credit-rating agencies, and of consumers (duped into taking on debt, particularly mortgage debt, that they could not afford), and to defects in the regulatory structure. This leaves out many potential causes that other students of the crisis have emphasized. The Report does not mention the errors of monetary policy by the Federal Reserve that pushed interest rates down too far in the early part of this decade. Because houses are bought mainly with debt (for example, an 80 percent mortgage), a reduction in interest rates reduces the cost of owning a house and can and did cause a housing bubble, which when it burst took down, along with the homeowners, the banks and related institutions that had financed the bubble. Mortgage debt is huge—$12 trillion—and the banks (a term I use broadly, to include other financial intermediaries as well) were therefore deeply invested in the housing industry and incurred substantial losses when housing values fell precipitously.

…continue reading: A critique of the President’s financial regulation reforms

This post is by my colleague Susan Grafton.

On July 15, 2009, the Obama administration (the “Administration”) delivered to Congress draft legislation, the Private Fund Investment Advisers Registration Act of 2009. Under the proposed legislation, managers of most hedge funds, private equity funds and venture capital funds in the U.S. would be required to register with the Securities and Exchange Commission (the “SEC”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The existing exemption for investment advisers with fewer than 15 clients would be eliminated, and specific information reporting would be required for advisers to any “private fund.” A limited exemption will continue to apply to certain “foreign private advisers.” The existing threshold of $30 million of assets under management for mandatory SEC registration would continue to apply.

Andrew Donohue, the SEC’s Director of Investment Management, discussed these and other potential regulatory reforms in his testimony on July 15, 2009, before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs concerning the regulation of hedge funds and other private investment pools.

Applicability to Advisers to Private Funds

The new reporting requirements will generally apply to investment advisers to any “private fund,” which would be any investment fund that is relying on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 for exemption from registration, and that is either organized in or created under the laws of the U.S. or has 10 percent or more of its outstanding securities owned by U.S. persons.

Additional Reporting to the SEC

In addition to the existing regulatory obligations of registered investment advisers to private funds, the draft legislation would require all registered investment advisers to private funds (including newly registered advisers) to submit reports to the SEC as are necessary or appropriate in the public interest and for the assessment of systemic risk by the Federal Reserve Board (the “Federal Reserve”) and the proposed Financial Services Oversight Council (the “FSO Council”).

The reports would include at least the following information for each private fund:

1. Amount of assets under management;
2. Use of leverage, including off-balance sheet leverage;
3. Counterparty credit risk exposures;
4. Trading and investment positions;
5. Trading practices; and
6. Such other information as the SEC and the Federal Reserve determines are necessary or appropriate.

These records and reports would be deemed records and reports of the investment adviser, which would be required to maintain and keep them in accordance with retention requirements prescribed by the SEC. The SEC would be required to make the new systemic risk data and reports available to the Federal Reserve and the FSO Council. In addition, because the private fund’s records would be deemed records of the investment adviser, they would be subject to periodic examination by the SEC and its staff.

Although the draft legislation provides that the SEC would not be required to disclose the reports or their content, the SEC would not be permitted to withhold information from Congress or any federal agency or self-regulatory authority. Accordingly, confidentiality would not be completely safeguarded.

…continue reading: Administration Proposes Regulations for Private Fund Investment Advisers

(Editor’s Note: This post comes to us from Amar Gande of the Edwin L. Cox School of Business, Southern Methodist University, and Craig M. Lewis of the Owen Graduate School of Management, Vanderbilt University.)

In our forthcoming Journal of Financial and Quantitative Analysis paper, Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillovers, we analyze shareholder initiated class action lawsuits and the associated stock price reaction. Our analysis uses a comprehensive sample obtained from the Securities Class Action Lawsuit Clearinghouse (see here) at Stanford University (which tracks federal securities class action lawsuits since 1996). This service reports that 1,915 class action lawsuits were filed over the period 1996 through 2003 with litigation peaking in 2001 when 493 suits were filed. Not only do we examine price reactions on the lawsuit filing date, but we consider the possibility that these lawsuits signal that comparable firms are susceptible to similar lawsuits. If true, we expect these comparable firms to have negative stock price reactions that are significantly related to the probability of being sued.

We develop an econometric model for the propensity to be sued based on both firm and industry-specific factors. We show that shareholder wealth losses on the date that the filing of a lawsuit is announced are understated because investors partially anticipate these lawsuits and capitalize part of the losses in advance. In this regard, our methodology is consistent with the literature on conditional event study methods that emphasizes the role of explicitly conditioning for the expected information (i.e., partial anticipation of lawsuits) in estimating announcement effects, and suggests that the probability of an event (i.e., of being sued) is, as we find in this study, significantly related to the event date announcement effect. While other studies have examined whether investors partially anticipate corporate events, such as acquisitions and debt offerings, they are based only on firm-specific information. In contrast to these studies, we incorporate spillover effects based on industry specific information, such as the litigation environment, to determine both the propensity of a firm to be sued and the associated shareholder losses. We focus on the relation between investor reactions and the probability of being sued and demonstrate that prior expectations about the likelihood of being sued are significant determinants of the anticipated losses prior to the filing of an actual lawsuit and on the lawsuit filing date.

Our main findings are as follows. First, we find that investors partially anticipate lawsuits based on firm-specific and industry-specific information and capitalize losses prior to the filing of a lawsuit. Second, we show that filing date effects understate the magnitude of shareholder losses on average by approximately a third. Finally, we demonstrate that prior expectations about the likelihood of being sued are important determinants of the losses that investors capitalize in anticipation of being sued and of the losses on the lawsuit filing date. In particular, we show that the more likely a firm is to be sued, the larger is the partial anticipation effect (shareholder losses capitalized prior to a lawsuit filing date) and smaller is the filing date effect (shareholder losses measured on the lawsuit filing date). Our evidence suggests that previous research that typically focuses on the filing date effect understates the magnitude of shareholder losses, and such an understatement is greater for firms with a higher likelihood of being sued.

The full paper is available for download here.

(Editor’s Note: This post by Professor Mark Roe appears today on Forbes.com)

Bernanke and Paulson are still taking heat from Congress for pressing Bank of America’s Lewis into going forward with the Merrill Lynch purchase, a deal that shackled Bank of America with significant losses. And Bank of America’s Lewis took considerable heat from its shareholders for not telling them how bad Merrill looked at the time of the purchase.

Eventually, the Treasury put another $20 billion into Bank of America and documents now indicate that the government raised the possibility of ousting the bank’s senior management if the deal had not gone through.

Several core transactions in the financial crisis have the government in a dual role, as simultaneously being a regulator and a market-like player. It’s as if the referee in a sport started fielding his own team. Even first-rate refs doing their job well, and as fairly as they can, can distort how everyone else plays the game, once the referee becomes a player too. This problem also emerges when the governmental regulator becomes a market player too, as was the case three times in the past year: with Bank of America’s purchase of Merrill Lynch, when the government was standing behind Bank of America as a vital lender; with Morgan’s purchase of a failing Bear Stearns last year with the Fed and the Treasury brokering the deal; and with Chrysler’s rescue via government loans.

A standard objection to the government as market player–as, say, an owner of companies like GM and Chrysler–is that it’s a bad manager. It wastes resources, makes mistakes and misallocates capital. It’s insulated from market incentives.

But recent evidence suggests it might not be so bad as a manager. And when the government meddles with or replaces failed managements–viz. the American auto industry–it’s not replacing America’s most admired management teams, but its worst. The bar for it to clear is not all that high.

The government’s goals are usually seen as the bigger issue. Rather than profits, the government-as-owner seeks to maintain employment or another nonprofit goal. Sometimes these further sensible social policy. But because it isn’t focused on profits, the government often puts capital where it’s less effective in the long run. These reservations to the government as market player are standard.

There’s a third issue with the government as market actor, one that’s potentially as insidious as any of the others, but less vivid.

…continue reading: What Happens When The Government Enters The Ring?

When credit markets froze up in the fall of 2008, many economists pronounced the crisis both inexplicable and unforeseeable. That’s because they were economists, not lawyers.

Lawyers who specialize in financial regulation, and especially the small cadre who specialize in derivatives regulation, understood what went wrong. (Some even predicted it.) [1] That’s because the roots of the catastrophe lay not in changes in the markets, but changes in the law. Perhaps the most important of those changes was the U.S. Congress’s decision to deregulate financial derivatives with the Commodity Futures Modernization Act (CFMA) of 2000.

It was the deregulation of financial derivatives that brought the banking system to its knees. The leading cause of the credit crisis was widespread uncertainty over insurance giant AIG’s losses speculating in credit default swaps (CDS), a kind of derivative bet that particular issuers won’t default on their bond obligations. Because AIG was part of an enormous and poorly-understood web of CDS bets and counter-bets among the world’s largest banks, investment funds, and insurance companies, when AIG collapsed, many of these firms worried they too might soon be bankrupt. Only a massive $180 billion government-funded bailout of AIG prevented the system from imploding.

This could have been avoided if we had not deregulated financial derivatives.

Derivatives “De”regulation?

Wait a minute, some readers might say. What do you mean, “de”regulated derivatives? Aren’t derivatives new financial products that have never been regulated?

Well, no. Derivatives have a long history that offers four basic lessons. First, derivatives contracts have been used for centuries, possibly millennia. Second, healthy economies regulate derivatives markets. Third, derivatives are regulated because while derivatives can be useful for hedging, they are also ideal instruments for speculation. Derivatives speculation in turn is linked with a variety of economic ills—including increased systemic risk when derivatives speculators go bust. Fourth, derivatives traditionally are regulated not through heavy-handed bans on trading, but through common-law contract rules that protect and enforce derivatives that are used for hedging purposes, while declaring purely speculative derivative contracts to be legally unenforceable wagers.

…continue reading: Why re-regulating derivatives can prevent another disaster

(EDITOR’S UPDATE: The recent decision of the Court of Appeals for the Second Circuit in SEC v. Dorozhko further illustrates the uncertain state of the limits of insider trading. Reversing an earlier District Court decision, the Court held that while a breach of a fiduciary duty is required where the fraud is premised on silence, no such breach is required where there has been an affirmative misrepresentation. A memo by Davis Polk & Wardwell LLP, available here, discusses the decision.)

This post is by my colleagues William M. Kelly, Joseph A. Hall, Michael Kaplan, William J. Fenrich, and Janice Brunner.

On Friday, a federal district court in the Northern District of Texas dismissed the SEC’s insider trading case against Dallas Mavericks owner Mark Cuban. While the celebrity of the defendant has undoubtedly contributed to the widespread publicity of the dismissal, the real news is that the SEC has, for the moment at least, lost a case on what might seem to have been slam-dunk facts:

What’s missing here? Mr. Cuban, abetted by a group of law professor amici, argued that Rule 10b-5 liability requires a fiduciary or fiduciary-like relationship with the provider of the information, and that a mere agreement cannot provide a basis for liability. The court rejected this view, but it also rejected the SEC’s long-held view, reflected in its adoption of Regulation FD and Rule 10b5-2, that third parties who accept material nonpublic information from a company on a confidential basis are precluded from trading on the information. The court held that Mr. Cuban’s oral agreement to maintain confidentiality, without an agreement not to trade, was not enough.

What does this decision mean for potential providers and recipients of material nonpublic information?

For providers—for example, companies interested in sharing information with potential investors or acquirers—the case says that if you want the recipient not to trade, you had better be specific. The safest approach, of course, is to seek a written contractual standstill from recipients. But agreements of this sort are often difficult to get parties to agree to, especially where, as in this case, the recipient would be asked to sign the agreement “blind”, without knowing the nature of the information. As a practical matter, providers may have to content themselves with a “sole use” provision, along the lines of “recipient agrees to use the information solely for the purpose of considering an investment”. Had such a provision been in place, the result in this case might well have been different.

For recipients of material nonpublic information, our advice is not to rely on this decision. The case was decided at the trial court level, is not binding on other courts, and the SEC has been given the right to file an amended complaint. Whether or not the SEC chooses to replead the case or to appeal the decision, we are certain that it will not accept the case as the final word and will continue to seek enforcement action on facts like these. Thus, while the decision will provide comfort to parties who have to defend themselves for what they have done, we would not use it as a basis for deciding what you should do. The prudent judgment continues to be that if you have agreed to keep information confidential, you should not use it as a basis for trading.

Lastly, the case highlights the curious fact that, 75 years after the enactment of the Securities Exchange Act and the creation of the SEC, and after decades of judicial exegesis of the Delphic text of Section 10(b), we still don’t quite know when insider trading is illegal.

See S.E.C. v. Cuban, No. 3:08-CV-2050-D (N.D. Tex. July 17, 2009)

(Editor’s Note: This post is based on a client memo by Martin Lipton and Ted Mirvis of Wachtell, Lipton, Rosen & Katz.)

Since the apex of the economic crisis last year, American companies have been buried in an avalanche of corporate governance initiatives designed to increase the power of fund managers to dictate corporate policies to boards of directors. Unfortunately, few, if any, of the proposals focus on what must be the overriding objective of corporate governance—encouraging long-term economic growth: the type of growth that is achieved without risking the environment or the financial system; the type of growth that creates and maintains full employment; the type of growth that creates affordable housing, healthcare and education for all.

The evidence is irrefutable that the pressure for short-term performance and quick stock market profits were prime factors in causing the economic crisis. Indeed, President Obama has said that compensation practices tied to short-term performance were responsible for “a reckless culture and a quarter-by-quarter mentality that in turn wrought havoc in our financial system.”

It is critical that we recognize that short-termism encourages excessive risk and diversion from the long-term planning essential to sustainable economic growth and that we use this insight to critically evaluate the entire range of corporate governance initiatives that are now on the table. There is no reason to embrace a plethora of ill-conceived federal regulation and legislation that usurps the traditional role of state law and thereby overturn the fundamental legal doctrines that have formed the bedrock of history’s most successful economic system. The engine of true economic growth will always be the informed business judgment of directors and managers, and not the hunger of short-term oriented shareholders for quick profits.

Particularly at a time of depressed stock market valuations and the resulting danger of opportunistic attacks to bust up or takeover American companies, directors and managers must remain free to invest in the future and take the long-term view, so as to ensure prosperity for future generations. To the same extent that we need to avoid legislative and regulatory actions that would undermine the ability of companies to achieve long-term growth, the courts should continue to recognize the prerogative of directors to plan for and achieve long-term value for the company and its stockholders, protected against short-termist pressure from any source and especially from the unintended consequence of proposed “reforms” (such as shareholder proxy access) that are not appropriately defined and contained. In particular, the right of a well-informed board of directors to “Just Say No” to a takeover bid remains a critical deterrent to short-termism. Under the Business Judgment Rule, directors must remain unfettered in their ability to engage in long-term planning and investment.

(Editor’s Note: This post comes to us from Moritz Schularick of the Free University of Berlin and Thomas M. Steger of ETH Zurich and CESifo.)

In our forthcoming The Review of Economics and Statistics paper: Financial Integration, Investment, and Economic Growth. Evidence from Two Eras of Financial Globalization, we turn to the economic history of the first era of financial globalization (1880-1914) for new insights into whether international financial integration boosts economic growth. We rely on models and techniques employed before in order to ensure the comparability of our results with those of previous studies, since our primary aim is to benchmark the present to the past. Economic historians have often underscored the contribution that international capital flows made to economic growth in developing countries during the “first era of globalization” – the years of the classical gold standard from 1870-1914. Yet it has not been tested econometrically for a broad cross-section of countries whether the first era of financial globalization does provide evidence that financial globalization can indeed spur growth.

We assembled the largest possible dataset for the years 1880-1914 covering 24 countries from all world regions that accounted for more than 80 percent of world output at the time. We use capital flows from the United Kingdom – the world’s leading financial centre at the time – as a proxy for the degree of financial openness of individual countries. Such detailed capital flow data are available from a recently published analysis of the geographical patterns of stock and bond issues at the London Stock Exchange (Stone, 1999). We also employ older data for foreign investment stocks (Woodruff, 1966) and net capital movements as implied by current account balances (Jones and Obstfeld, 1997) to corroborate our findings.

The new dataset allows us to show that international financial integration had a statistically significant effect on growth in the first era of global finance. We ensure the robustness of our model specification by first estimating our regressions on a dataset for 1980-2002. Using these models on our data, we find the first era of financial globalization saw a positive relationship between international financial integration and economic growth. Importantly, our study also suggests that a comparable effect cannot be found today. If financial integration contributes to economic growth today, the effect would need to be conditional on certain types of capital flows or on third factors such as the institutional framework.

We can show that before 1914 opening up to the international capital market went hand in hand with higher domestic investment. Today, changes in identical measures for financial integration are essentially uncorrelated with changes in domestic investment. Our explanation for this phenomenon focuses on the different patterns of financial globalization. The first era was marked by massive net capital flows from rich to poor economies (“development finance”). In contrast, today’s globalization is marked by high gross flows (“diversification finance”) and limited net capital transfers. In other words, in the historical period financial globalization led to long term net flows of capital from rich to poor economies. It is these net flows of capital that we suggest lead to growth.

The full paper is available for download here.

(Editors Note: This post comes to us from Charles Nathan of Latham & Watkins LLP and Rhonda Brauer of Georgeson Inc.)

Now that the SEC has issued its proposed proxy access rules and asked for comments by August 17, a critical issue for public companies is what do to in response to this SEC initiative and when. In this Proxy Access Analysis, we provide suggestions for how general counsel and corporate secretaries may begin to educate their management and boards on the issues presented by the proposed rules, evaluate the alternatives for commenting on the proposed rules and plan a course of action for their companies if proxy access is adopted for the 2010 proxy season.

There is a limited amount of time for dealing with proxy access, given the August 17 deadline for SEC comments and the SEC’s apparent intent to promulgate final proxy access rules by the end of November so that they can be effective for the 2010 proxy season. As a result, general counsel and corporate secretaries should be reviewing their board and governance committee meeting schedules now to be sure that there is ample time to educate their management and boards and to take any actions deemed appropriate by their boards, with sufficient flexibility to accommodate the SEC’s proxy access rule-making calendar as it develops.

…continue reading: Responding to the SEC Proxy Access Rule Proposal

This post is by my colleagues Mark Schonfeld, John Sturc, Barry Goldsmith, Eric Creizman, Jennifer Colgan Halter, Akita St. Clair, Ladan Stewart and Matthew Estabrook.

Without question, the first six months of 2009 have been a period of sharply increased enforcement activity at the Securities and Exchange Commission. The financial crisis, the new administration, new SEC leadership, increased funding and the focus of Congress and the media have all combined to encourage heightened government scrutiny. And even though it has only been a few months since a new Chairman took office, already there are tangible signs that the SEC has taken a more aggressive enforcement posture. In this alert, we review the changes the new SEC leadership has instituted and is considering, the observable impact of the new administration on enforcement activity and significant cases in key areas that reflect the agency’s evolving enforcement program.

I. Overview of Changes

A. The Backdrop

The events of 2008 led directly to the current enforcement agenda. The collapse of the subprime mortgage market, the ensuing credit crisis, the demise of several major investment banks and, perhaps most of all, the Madoff case led to a loss of confidence in the agency’s ability to protect investors. This loss of confidence was manifested in Congressional hearings and an intensified media spotlight. At the same time, the SEC’s Inspector General has issued a number of reports critical of the agency, and Congress intensified pressure on the SEC and Department of Justice to bring cases in the wake of the financial crisis. At a March hearing of the Senate Judiciary Committee on the law enforcement response to the financial crisis, Senator Patrick J. Leahy declared, “I want to see prosecutions…. I want to see people go to jail.”

…continue reading: A Mid-Year Review of SEC Enforcement in 2009

(Editor’s Note: This post comes from Mei Feng of the Katz Graduate School of Business, University of Pittsburgh, Jeffrey D. Gramlich of the University of Southern Maine School of Business and Copenhagen Business School, and Sanjay Gupta of the Eli Broad College of Business, Michigan State University.)

We investigate the use, determinants, and earnings effects of special purpose vehicles. Based on a proxy of SPV activity that can be applied to a broad cross-section of firms over time, we find a two-and-a-half fold monotonic increase in the percentage of firms using at least one SPV during the eight-year period from 1997 through 2004. Tobit regressions of the determinants of SPV use show that SPV activity increases with financial reporting incentives and economic and tax motivations, but strong corporate governance tends to mitigate their use. In addition, the evidence is consistent with SPVs arranged for financial reporting purposes being associated with earnings management, whereas the same does not appear to be the case for SPVs set up mainly for economic, tax, and other reasons.

Using a sample of 6,473 firms from 1997 to 2004, we obtain 22,604 firm-year observations for which the requisite data are available. SPV use appears highest among industry groups that tend to be leasing-activity intensive, such as trading, real estate, and construction, traditionally viewed as one of the main activities involving SPV use. We also find relatively high SPV use in banking and telecommunications, consistent with these industries providing new avenues for SPV use during the 1990s, such as the securitization of financial assets and broadband capacity.

With respect to investigating the determinants of SPV use, Tobit regression results show that SPV activity is increasing in financial reporting incentives and economic motivations, but strong corporate governance mitigates SPV use. Specifically, we find that SPV use is positively related to: (1) leverage, (2) CEO bonus compensation, (3) availability of funds, and (4) demand for tax benefits, but decreasing in board independence and independent directors’ stockholdings. These results are robust to a variety of sensitivity tests, including the use of other model specifications besides Tobit (e.g., logit and OLS), different sample selection criteria, and alternative definitions of the dependent and independent variables. In terms of economic magnitude, inter-quartile increases in leverage, availability of funds, intangible assets, and board independence result in changes in expected SPVs of 1.31, -0.36, 1.05, and -1.04, respectively. These effects are quite large given that more than 70 percent of our sample observations have zero or one SPV. Also, SPV use is increasing in firm size, consistent with larger firms having greater technical expertise to handle the complexity of structured financing arrangements.

With respect to examining SPVs’ role in earnings management, we use the Tobit regression results to parse the number of SPVs for each firm-year into those predicted by financial reporting motivations, those predicted by economic considerations, and those predicted by other variables. We then investigate the relation between these predicted SPV components and two measures of earnings management – discretionary accruals and frequency of small profits or losses. We hypothesize that SPVs arranged for financial reporting reasons are likely to be positively associated with earnings management measures, whereas we do not expect a similar relation for SPVs arranged for other reasons. Our evidence based on both univariate and regression tests is consistent with this hypothesis. The economic magnitude of this association appears to be substantial. For example, when the number of predicted SPVs for financial reporting purposes increases by one, on average the probability that a firm reports a small gain instead of a small loss increases by 18 percent.

The full paper is available for download here.

In an article entitled “Responding to Unsolicited Takeover Offers,” my partner Frederick H. Alexander provides an overview of the issues a board may consider in evaluating a company’s governance profile given the potential increase in unsolicited offers in the current market environment. The article explains that despite the downturn in M&A activity during the past two years, current market conditions make some companies vulnerable to unsolicited bids. Indeed, hostile bids accounted for 47% of the M&A transactions in the first two months of 2009, compared with 24% in 2008 and 7% in 2004. Against this backdrop, the article discusses forms that unsolicited acquisition offers may take as well as the considerations and constraints relevant to directors in determining their responses.

The article also provides the following checklist of critical issues that directors should consider to avoid becoming the target of a harmful takeover offer attempt and determine the most appropriate course of action should the company be approached by an unsolicited bidder.

Assemble a solid team of experts. Operating in the M&A market has traditionally required a wide range of expertise that the board may not have internally. The need for skills and preparedness is only accentuated by the challenges of the current economic and financial environment. In particular, directors should ensure they have ready access to in-house and outside legal and financial advice as well as experts in investor relations and proxy solicitation.

Understand shareholder base and intentions. Board members and senior executives should have a full understanding of shareholders’ intentions, as they may be critical both from a preventive standpoint and in determining the right defensive strategy. Stock surveillance firms and proxy solicitors may help the corporation actively monitor the larger investors as well as those who engage in large accumulations of stock or extraordinary trading patterns. The company should also consider investigating groups of investors or other possible (undisclosed) voting arrangements to determine whether a bidder is acting alone or has the support of others.

Maintain proactive external relations. Credibility with institutions, analysts and proxy advisors may be crucial in responding to unsolicited bids, so it is important to maintain good lines of communication. Investor relations teams, in particular, can help corporate leaders identify key shareholder allies and nurture those relationships, for example, by regularly informing them—in compliance with Regulation FD and insider trading rules—on new business decisions affecting strategy and long-term shareholder value as well as the financial metrics and valuations on which those decisions were based. Similarly, a proactive outreach to governance analysts and proxy advisors is essential to communicate and persuade on the rationale for adopting defensive devices that could otherwise become the subject of public criticism.

Review certificate of incorporation and bylaws. A board should review charter and bylaw provisions for the purpose of assessing the strength of the corporation’s general defensive profile. Structural and procedural defenses should be updated so that they reflect legal developments and, when possible, best practices. In doing so, directors should be mindful of the following considerations.

Some defensive actions (e.g., classified board structures or disabling action by written consent) can only be adopted bilaterally through a board resolution and subsequent shareholder approval. Others, such as bylaw provisions and poison pills, may be adopted unilaterally by the directors, but may be helpful only if already in place when the company receives the unsolicited bid.

• If the decision is to depart from governance standards that are widely supported by proxy advisory firms and influential shareholder groups, the reasons why directors believe doing so is in the shareholders’ best interests should be clearly articulated.

• Many legal advisors recommend that the company should consider addressing instances of undisclosed derivative/hedging positions (such as cash-settled swaps) and the vulnerability resulting from depressed stock valuations. A bylaw requiring that the advance notice of shareholder proposals or nominations be accompanied by more detailed disclosure of all equity (including synthetic and temporary) holdings as well as a poison pill of limited duration may help to achieve these goals.

Develop coherent procedures and a unified response. The board of directors should be comfortable that the company has ad hoc internal communication and reporting procedures to deal effectively with the threats of a hostile takeover. Most important, any evidence of a potential bidder should be promptly escalated to the top (at a minimum, the chairman of the board, the governance committee chair, and the CEO should be informed) so that it receives the appropriate level of attention. For the purpose of developing an actionable response plan, board members should seek the close collaboration of senior management, albeit while remaining mindful of potential conflicts of interest.

Although a board receiving an unsolicited bid will face a number of decisions, directors ultimately choose from among three possible outcomes:

1. Sale to the bidder

2. An alternative transaction

3. Remaining independent

To fulfill their fiduciary duties of care and loyalty, directors should decide the corporation’s response to the bidder based on a thorough discussion and understanding of the implications of each alternative. This may require reassessing strategic goals in light of macroeconomic trends and industry developments as well as exploring alternative approaches to business growth.

The article is available here.

(Editor’s Note: This post comes to us from Simon Wong, Independent advisor and Adjunct Professor of Law at Northwestern University School of Law.)

As a way to contribute to the current debate on corporate governance reforms, I have written a practitioner-based article, to be published in two parts by the Global Corporate Governance Forum of the World Bank Group, examining the uses and limits of five commonly employed corporate governance instruments - transparency, independent monitoring by the board of directors, economic alignment, shareholder rights, and financial liability.

Entitled Uses and Limits of Conventional Corporate Governance Instruments: Analysis and Guidance for Reform, my article discusses how the individual instruments have worked in practice, including instances when they have failed to achieve their intended objectives and, in some cases, worsened the governance ailments that they were designed to cure. For example, the rapid growth of executive compensation persisted - and in some countries, accelerated - after the introduction of individual executive pay disclosure. In the financial sector, the shift toward a board dominated by independent directors ultimately proved to be its Achilles’ heel as weak industry knowledge meant that non-executive directors (NEDs) were unable to pick up on warning signs of imprudent risk taking by management. In addition, quarterly reporting of financial results has resulted in excessive short-termism, as management obsesses over meeting analysts’ earnings forecasts for each quarter because missing the “consensus estimates” by even one cent could pummel the share price and discredit management.

Even when these instruments have worked as intended, there are limits to their utility. For example, the structural issues that boards confront – such as potentially conflicting “watchdog” monitoring and strategy development roles, part-time status, vast information asymmetry, and boardroom group dynamics – mean that they will never be as objective and challenging of management as shareholders and others wish them to be. Likewise, there are limits to the use of economic incentives as an alignment tool, the most significant being that people are motivated by more than the prospect of financial gains. Due to free-rider problems, lack of competence (particularly for institutional investors with large portfolios), and conflicts of interest, shareholders may not be well-positioned to rigorously monitor boards and management, particularly in markets with dispersed ownership.

In this article, I also provide suggestions to improve the application of these instruments. For example, to enhance the board’s ability to understand the company’s business, its membership should comprise a substantial proportion, but not necessarily a significant majority, of independent directors. Ideally, boards should feature a diversity of perspectives, substantial formal independence, and strong company and industry knowledge.

When populating the board, it is also important to pay attention to the relative status of people in the boardroom, particularly vis-à-vis the CEO. Discussions with chairmen and direct observations of boardroom dynamics have revealed that CEOs are not always attentive to the views of non-executive directors whom they perceive to be less qualified than they are. At the same time, NEDs who are in awe of a CEO can be overly deferential to management.

On executive compensation, my recommendations include: 1) when setting the level of pay, carefully scrutinize the firms that are included in the benchmark group, 2) evaluate performance of executives through a multi-year lens and stagger payouts over several years, 3) attach performance conditions to the vesting of share awards, and 4) require executives to have “skin in the game” even after they have departed the firm.

In the area of shareholder rights, I caution policymakers – before introducing an advisory vote on remuneration (or “say on pay”) – to consider whether shareholders will devote the necessary time and develop sufficient expertise to evaluate each pay proposal on its merits, whether diverse investor views on executive pay will serve as an impediment in holding boards accountable, and whether the broader legal framework provides a sufficiently enabling environment.

My article concludes with a discussion of how policymakers should approach corporate governance reforms generally, with a view to strengthen the effectiveness of the conventional set of corporate governance instruments. Specifically, I make six suggestions: 1) calibrate reforms to fit the surrounding context, particularly ownership structure and the broader business environment; 2) assess how an instrument will influence the behavior and focus of the affected parties; 3) be prepared to take difficult decisions because the inherent complexity of certain issues means that simple solutions, while tantalizing, are unlikely to work; 4) ensure coherence of tools employed with the legal, regulatory, and tax regimes; 5) employ “carrots” – such as fast track issuance of securities and corporate governance-based stock listing tiers – as well as “sticks,” and 6) focus on values and culture.

The latest draft of my article is available here.