(Editor’s note: The post below comes to us from Andriy Bodnaruk of the University of Maastricht, Massimo Massa of INSEAD, and Andrei Simonov of the Stockholm School of Economics and CEPR).

We have recently released a paper, entitled The Dark Role of Investment Banks in the Market for Corporate Control. Our paper studies M&A transactions in the US in the 20 year-period 1984 to 2003. Its focus is on transactions in which the investment bank advising the bidder in an M&A transaction also holds a stake in the shares of the target company at the time the deal was announced. In broad terms, the paper provides evidence as to (1) the extent to which investment banks advising bidders took advantage of confidential information garnered from their advisory assignments to acquire stakes in the target prior to the deal’s announcement; and (2) the extent to which the investment bank’s stake in the target compromised the financial interests of the bank’s bidder client.

We show that the presence of advisors helps to predict if a firm will be a takeover target. Conditioning on firms with similar industry and size characteristics, firms in which the advisors to the bidder hold a stake are 45 percentage points more likely to become targets, with the probability of becoming a target increasing from the unconditional sample mean of 4.2% to 6.1%. When we build the trading strategy long in the actual positions of the advising investment banks and short in the positions of the non-advisory banks, we find the strategy delivers 1.40% per month (adjusted for risk). This provides a lower bound estimate of the informational advantage that the advisory bank has relative to other sophisticated market players.

We further show that where an investment bank advising the bidder holds a stake in the target, the bidder will pay a higher premium for the target relative to deals in which the advisor holds no target stake. The target’s premium increases by 590 basis points from 30.6% to 36.5% relative to non-conflicted deals. An increase of one standard deviation in the (dollar value of the) average fraction of the target firm held by the advisor to the bidder implies a premium 310 (290) basis points higher than average. Deals involving the bidder’s advisor holding a stake in the target are more likely to succeed than other deals. Moreover, targets in these deals tend to be overvalued by more than 10% compared to deals in which the bidder’s advisor holds no target stake.

These findings suggest that advisors do take advantage of their privileged position, not only by acquiring positions in the deals on which they advise, but also by directly affecting the outcome of the deal in order to realize higher capital gains from their positions. These results provide important insights into the conflicts of interest affecting financial intermediaries that can both advise on corporate events and invest in the equity market.

The paper is available here.

Two committees of the American Accounting Association have produced detailed reports evaluating the SEC’s proposal to accept financial statements prepared in accordance with International Financial Reporting Standards (IFRS) from foreign-private issuers without reconciliation to U.S. GAAP (the SEC subsequently voted in favor of the proposal on November 15, 2007). This proposal was also discussed by Carl Olson in his November 28 post. These two papers highlight the difficult nature of this issue. Despite the common background of the members of each group and the common academic research utilized in preparing each proposal, the recommendations of the two committees are distinctly different.

The Financial Accounting Standards Committee report (available here) argues that since there is no conclusive research evidence that financial reports prepared using U.S. GAAP are better than reports prepared using IFRS, the prudent approach is to promote competition among them. This finding supports adopting the SEC’s proposal to permit foreign private issuers a choice between IFRS and U.S. GAAP.

The Financial Reporting Policy Committee report (available here) concludes that the proposed elimination of the GAAP reconciliation requirement is premature. This conclusion is based on research that finds that material reconciling items exist that are relevant to U.S. investors, that there are differences in the implementation of uniform standards and that compliance to IFRS or U.S. GAAP by foreign firms is a concern, that foreign firms benefit from greater access to capital by listing in the U.S., that U.S. investors tend to prefer U.S. GAAP, and that U.S. GAAP - IFRS harmonization might improve the functioning of the U.S. capital markets.

(Editor’s Note: The post below comes to us from Jennifer G. Hill of the University of Sydney, Australia, who is Visiting Professor at Vanderbilt Law School during Spring 2008 and 2009.)

I have recently completed a paper, entitled “The Shifting Balance of Power Between Shareholders and the Board: News Corp’s Exodus to Delaware and Other Antipodean Tales”. The paper is posted on SSRN here.

The abstract to the paper is as follows:

The balance of power between shareholders and the board of directors is a contentious issue in current corporate law debate. It also lay at the heart of a controversy concerning the re-incorporation of News Corporation (News Corp) in Delaware. News Corp has recently been the subject of intense media attention due its successful bid to acquire Dow Jones & Company. Nonetheless, News Corp’s move to the US, which paved the way for this victory, was neither smooth nor a fait accompli. Rather, the original 2004 re-incorporation proposal prompted a revolt by a number of institutional investors, on the basis that a move to Delaware would strengthen managerial power vis-à-vis shareholder power. The institutional investors were particularly concerned about the effect of the re-incorporation on shareholder participatory rights, and the ability of the board of directors to adopt anti-takeover mechanisms, such as poison pills, which are not permissible under Australian law. It was this latter concern, which ultimately led a group of institutional investors to commence legal proceedings in the Delaware Chancery Court in UniSuper Ltd v News Corporation (2005 WL 3529317 (Del Ch)).

The News Corp re-incorporation saga highlights a number of important differences between US, UK and Australian corporate law rules relating to shareholder rights, and provides a valuable comparative law counterpoint to the recent US shareholder empowerment debate. Other recent Australian commercial developments discussed in the article show a tension between legal rules designed to enhance shareholder power, and commercial practices designed to readjust power in favor of the board of directors. These developments are interesting because they demonstrate how some Australian companies have tried to create a de facto corporate governance regime, which mimics certain aspects of Delaware law.

I have just posted on SSRN a paper that put forwards a new approach to improving the structure of executives’ equity-based pay arrangements, Hands-Off Options. The current draft is available here.

The abstract is as follows:

Despite recent reforms, public company executives can still use inside information to time their stock sales, secretly boosting their pay. They can also still inflate the stock price before selling. Such insider trading and price manipulation imposes large costs on shareholders. This paper suggests that executives’ options be cashed out according to a pre-specified, gradual schedule. These hands-off options would substantially reduce the costs associated with current equity arrangements while imposing little burden on executives.

As I am continuing to work on this paper and a number of related projects, any comments would be most welcome.

We have just posted a paper on SSRN, Opting Only In: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom, challenging one of the core positions of the contractarian approach to corporate law. Contractarians espouse an enabling approach to regulation allowing corporations to opt in or opt out and oppose a mandatory approach based on categorical rules. In their view, an enabling approach allows private ordering and enables owners and managers to derive the most efficient set of provisions, tailored to each company’s specific circumstances. This position has been reflected in attacks on legislations like SOX. Many commentators objected to its provisions because they were categorical and did not allow for private ordering.

Our study seeks to test this theory’s explanatory power in one area of corporate law. We chose a recent example of states replacing a categorical requirement with an enabling provision - waiver of liability provisions – for examination. These provisions allow companies to “opt out” of a rule that imposes liability on directors for breach of the duty of care. They may do so through the mechanism of an amendment to the articles. The amendment process requires the consent of both owners and managers, presenting conditions ripe, at least in theory, for the two groups to “bargain.”

We note first that waiver of liability provisions were authorized not in response to Van Gorkom, as is typically represented, but in response to the D&O insurance crisis occurring in the 1980s. In other words, the provisions were designed to interfere in the market for insurance. No evidence was offered, nor could we find any, indicating that this was a more efficient way of dealing with the economic uncertainties that existed at the time.

Second, we examined the waiver of liability provisions implemented by the Fortune 100 (data that we will eventually expand to the Fortune 500). Our analysis does not offer any evidence of private ordering. With one exception, all non-mutual companies in the Fortune 100 have eliminated liability for breach of the duty of care (in some states, this was done statutorily, with no company “opting out” of the no liability regime). Moreover, none of the waiver provisions reflected bargaining, with the wording of the provisions being remarkably similar. The companies in our sample waived liability to the fullest extent permitted by law.

Our analysis shows that one categorical rule favoring shareholders (liability for the breach of the duty of care) was replaced by another categorical rule favoring management (no liability for breach of the duty of care). While we do not rule out the possibility, we are not persuaded that any significant evidence demonstrating that one was more efficient than the other exists.

Our conclusion is supported by the fact that no actual bargaining occurs. Particularly where provisions are implemented by an amendment to the articles, it is management that drafts the language and only management that can initiate adoption or repeal. In other words, whatever theoretical benefit can result from the contractarian view of private ordering, it can only arise in practice if shareholders have the ability to meaningfully participate in the bargaining process. Our evidence suggests that they do not.

I have just released a working paper on the measurement of shareholder protection around the world, entitled “’Law and Finance’ Revisited” and available on SSRN here. The abstract is as follows:

The “Antidirector Rights Index” from La Porta et al.’s “Law and Finance” (1998) has been used as a measure of shareholder protection in almost 100 published studies. With articles by legal scholars questioning the accuracy of index values for several countries, I undertake a systematic study to verify these values for 46 countries with the help of local lawyers. My emphasis is on accuracy of the data; I do not change the original variable definitions. The study leads to a substantial revision: 33 of the 46 observations need to be corrected, and the correlation of corrected and original values is only .53. With accurate values, the well-known results of La Porta et al. (1997, 1998) no longer hold: accurate index values are neither distributed with significant differences between Common and Civil Law countries nor correlated with stock market size and ownership dispersion. All of the many results derived with the index will have to be revisited.

(NB: This paper is a revision of Spamann (2006).

By way of background, the cited article “Law and Finance” by La Porta, Lopez-de-Silanes, and Vishny (1998) started an entire literature of the same name. I have recently described the current state of this literature on this blog here.

Lawdragon magazine presented its third annual list of the “500 Leading Lawyers in America,” and the list includes eight individuals who are affiliated with the Harvard Law School Program on Corporate Governance and/or the Harvard Law School Corporate Governance Blog.

The 500 Leading Lawyers list includes professor Lucian Bebchuk (Harvard Law School), who serves as director of the Program, as well as four members of the Program’s advisory board: Peter Atkins (Skadden, Arps, Slate, Meagher & Flom), Theodore Mirvis (Wachtell, Lipton, Rosen & Katz), James Morphy (Sullivan & Cromwell), and Eileen Nugent (Skadden, Arps, Slate, Meagher & Flom).

In addition, the 500 Leading Lawyers list includes three guest contributors of the Blog: Jay Eisenhofer (Grant & Eisenhofer), Mark Morton (Potter, Anderson & Corroon), and Charles Nathan (Latham & Watkins).

Lawdragon’s list includes attorneys from private practice, in-house counsel, law professors, judges, government attorneys, and public interest lawyers. Lawdragon bases its selection of the leading lawyers through a combination of online balloting and independent research. Lawdragon’s announcement appears here.

On February 14, the SEC Advisory Committee on Improvements to Financial Reporting presented its interim report to the Securities and Exchange Commission. The report includes 12 developed proposals, conceptual approaches representing the Committee’s initial views on matters, and currently identified matters for further consideration. The key themes of the report are the following: increasing emphasis on the investor perspective in the financial reporting system; consolidating the process of setting and interpreting accounting standards; promoting the design of more uniform and principles-based accounting standards; creating a disciplined framework for the increased use of professional judgment; and taking steps to coordinate Generally Accepted Accounting Principles (GAAP) in the US with International Financial Reporting Standards (IFRS).

Formed by the SEC in July 2007, the Committee was tasked to examine the US financial reporting system and to recommend changes to increase the usefulness of financial information to investors, while reducing the financial reporting system’s complexity. The Committee’s final report is some months away. The Committee includes representatives from the Financial Accounting Standards Board and the Public Company Accounting Oversight Board.

The interim report is available here.

I’ve been giving some thought to the dust up last year between Marty Lipton and other governance experts as to whether Pfizer’s initiative of having several of its independent directors meet with its largest institutional investors represented a landmark in the decline of director-centric corporate governance, and have also been thinking about what we mean when we talk about director-centric vs. shareholder-centric governance. The working text of a talk I gave on the subject last week at the Corporate Governance Center at the University of Tennessee in Knoxville, at the invitation of Joe Carcello and Joan Heminway, is available here. I plan to do some more work on this and turn it into an article later this year. In the meantime, I’d greatly appreciate comments.

Does a Director Qua Director Have Standing to Sue Derivatively? No, so said the Delaware Supreme Court yesterday in Schoon v. Smith. The Supreme Court affirmed the Court of Chancery’s little-noticed ruling last year that dismissed a derivative claim brought by a director against the company’s other directors, including its controlling stockholder. The plaintiff-director, who was not a stockholder of the company, charged his fellow directors with, among other things, breach of fiduciary duty and unjust enrichment. The court held that, notwithstanding the equitable origins of derivative suits, the issue of director standing today is best left to the legislature. “Although the Delaware General Assembly has the prerogative to confer standing upon directors by statute,” the court wrote, “it has not chosen to do so.” Rejecting the American Law Institute Principles that give individual directors standing to sue on behalf of their corporations, the court continued that, “[b]ecause a stockholder derivative action is available to redress any breach of fiduciary duty, we decline to extend the doctrine of equitable standing to allow a director to bring a similar action.” The court concluded, however, by leaving itself a little room to permit directors to bring derivative suits, but only where the failure to do so would result in a “complete failure of justice”—a seemingly high standard.

As a practical matter, the decision is unlikely to have much significance because most directors are also stockholders. But the decision is still significant and may draw criticism with respect to its implications for corporate governance and director duties. In particular, the court noted that the concept of being an “independent director” does not mandate “a duty to sue on behalf of the corporation.”

The opinion is available here.

(Editor’s Note: The post below comes to us from Peter Moon of Universities Superannuation Scheme, Phil Spathis of the Australia Council of Super Investors, and Keith Johnson of Reinhart Institutional Investor Services.)

Verizon, Par Pharmaceutical and Aflac became the first US companies over the last year to adopt policies requiring an advisory vote of shareholders on company executive compensation practices. A network of over 70 institutional and individual investors lead by AFSCME and Walden Asset Management announced in January that adoption of this ’say on pay’ policy is expected to be put on proxies at more than 90 US companies this year. With majority shareholder votes having been cast for similar resolutions at seven companies during 2007, say on pay will be one of the hottest issues in the upcoming US proxy season. In their article, Global Investors Laud Shareholder Votes on Executive Compensation, Peter Moon from the $65 billion Universities Superannuation Scheme pension fund in Britain, Phil Spathis from the $200 billion Australia Council of Super Investors and Keith Johnson from the University of Wisconsin Law School’s International Corporate Governance Initiative describe the impact that say on pay has had in other markets and discuss the benefits it could produce for both companies and shareholders in the United States.

On Monday February 4, HLS Professor John C. Coates IV delivered his inaugural lecture “On Being a Corporate Lawyer” on the occasion of his appointment as the John F. Cogan, Jr. Professor of Law and Economics.

Coates’ lecture surveyed recent trends in corporate law practice—the field, he said, which continues to draw the majority of graduates of top schools. He noted that the leading corporate law firms have remained relatively stable and free from the kind of volatility seen in the investment banking sector over the past several decades, citing major banks that have vanished or been displaced. But, he said, some important changes are nevertheless on the way. Among them:

Click here for a webcast of this event.

CVS Caremark and I have reached an agreement under which the company adopted a by-law provision limiting the adoption of poison pills. The adopted by-law is based on a shareholder proposal to amend the company’s by-laws that I submitted for the company’s upcoming annual meeting. Following the agreement that the company and I reached, the company’s board adopted the new by-law earlier this week, and I withdrew my shareholder proposal. The amended by-laws of CVS, including the new section 8 of Article VI, were filed yesterday and are available here.

Under the new by-law provision, any extension of a poison pill plan not ratified by the shareholders must be approved by at least 75% of the members of the board of directors, and a pill not so extended will expire one year after its adoption or last such extension.

My shareholder proposal and the by-law adopted by CVS are based on a model by-law that was the subject of litigation and a court decision in the CA case, which led CA to abandon its attempt to exclude my proposal from the corporate ballot. An article about the litigation and my model by-law is available here.

CVS is the third company to adopt a by-law provision based on this model by-law. The adoption by CVS was preceded by an adoption by Disney, which adopted a version of my proposal after the proposal won 57% of the votes in Disney’s annual meeting, as well as an adoption by Bristol-Myers Squibb.

I commend the board of CVS for its adoption of the pill-limiting by-law. I hope that boards of other public companies will follow the example set by the boards of CVS, Disney, and Bristol-Myers and adopt similar by-law provisions.

I would like to thank the law firm of Grant & Eisenhofer for its valuable legal advice and legal representation in connection with my shareholder proposals in general and the pill by-law proposals in particular. I also wish to thank Spotlight Capital Management for advising me on engagement with companies.

I posted previously here on Vice Chancellor Strine’s decision in Mercier v. Inter-Tel (Delaware), Inc., and I continue to believe that it was probably the most important decision issued by the Delaware Court of Chancery in 2007. I recently wrote an article for the Securities Litigation Report discussing Inter-Tel and explaining its potential significance. In particular, Vice Chancellor Strine’s reasonableness standard in reviewing a decision to move a stockholders meeting date — if endorsed by the Delaware Supreme Court — would provide much clarity to practitioners and boards of directors. The decision is also notable for, among other things, its discussion of the roles of ISS and arbitrageurs in influencing merger votes.

The article, which originally appeared in the November 2007 issue of the Securities Litigation Report, is available here and is being reproduced with the permission of Thomson West.

Our firm has recently released a Corporate Governance Commentary providing an overview of the recent proxy rule amendments designed to encourage the use of electronic shareholder forums (for convenience, referred to as “e-forums”). The amendments were hastily adopted at a time when most of the attention was on proxy access. While the amendments were intended to benefit both companies and shareholders, it is activist investors who may be the most significant beneficiaries.

The Commentary, entitled “A Practitioner’s Guide to Electronic Shareholder Forums“, explains how the amendments facilitate the use of e-forums, and what the potential risks and benefits to companies are. It explains that for a lot of companies, e-forums may serve as an additional channel of communication with shareholders for which the companies do not have a pressing need. For companies that do decide to construct or participate in e-forums, the companies will have to be careful that the e-forums are functionally useful and are not used for launching tirades against management. Perhaps more troubling for companies, e-forums will improve the ability of hedge funds and other activist investors to mobilize.

The full Commentary is available online here.

I have just posted a forthcoming Vanderbilt Law Review article on issuer proxy access, Proxy Access in an Era of Increasing Shareholder Power: Forget Issuer Proxy Access and Focus on E-Proxy. The current draft is posted on SSRN here.

The abstract is as follows:

The current debate over shareholder access to the issuer’s proxy for the purpose of making director nomination is both overstated in its importance and misses the serious issue in question. The Securities and Exchange Commission’s new e-proxy rules, which permit reliance on proxy materials posted on a website, should substantially reduce the production and distribution cost differences between a meaningful contest waged via issuer proxy access and a freestanding proxy solicitation. The serious question relates to the appropriate disclosure required of a shareholder nominator no matter which avenue is used. Institutional investors and other shareholder activists should focus their energies on working through the mechanics of waging short-slate proxy contests using e-proxy solicitations.

Activist institutions need to work out the disclosure package required under the existing proxy rules. Such disclosure may be tested (and refined) through litigation, but a standardized package should emerge relatively quickly that the institution could use in proxy contests without a control motive. Institutional investors need to become facile with the e-proxy model (including coordinating a practice for opting-in to web-access) and should appreciate the extent to which proxy advisory services will do much of the actual solicitation work. If institutions are unwilling to make the relatively modest investment to master the mechanics of e-proxy contest, both in their initiation as well as voting in support of them, then their role in corporate governance will necessarily be limited.

With my co-authors Reena Aggarwal (Georgetown), Isil Erel (Ohio State) and Rohan Williamson (Georgetown), I have recently completed a revision of the paper “Differences in Governance Practices between U.S. and Foreign Firms: Measurement, Causes, and Consequences.” The paper is available at SSRN. The paper is now forthcoming at The Review of Financial Studies. The paper shows that foreign firms invest less in firm-level governance and that this lower investment is associated with lower valuations.

Using the well-known definition of Shleifer and Vishny (1997), governance consists of the mechanisms which insure that minority shareholders receive an appropriate return on their investment. Governance depends both on country-level as well as firm-level mechanisms. The country-level governance mechanisms include a country’s laws, its culture and norms, and the institutions which enforce the laws. Firm-level or internal governance mechanisms are those that operate within the firm. Firm-level governance mechanisms that increase the power of minority shareholders to receive a return on their investment are costly, so that the adoption of such mechanisms by a firm is an investment. The payoffs from that investment differ across countries and across firms.

The U.S. is recognized to have extremely high financial and economic development, to have strong investor protection, and to protect property rights well. Consequently, we would expect the internal governance of firms in the U.S. to come as close as possible to what the optimal internal governance of a firm would be in a foreign country if it were not constrained by weaker institutions and lower development than in the U.S. The internal governance of firms in the U.S. therefore provides a benchmark that can be used to evaluate the impact of different institutions and different development from the U.S. on governance choices and, through these choices, on firm value.

On theoretical grounds, it is not clear whether the characteristics of the U.S. make firm-level investment in governance mechanisms that increase the power of minority shareholders more or less advantageous for U.S. firms relative to firms from countries which do not have the same high level of development and investor protection. One possibility is that foreign firms would invest less in firm-level governance if they were in the U.S. because firm-level governance and country-level investor protection are substitutes. An alternative possibility is that investment in firm-level governance is less productive in countries with poor economic development and weak investor protection than it is in the U.S., implying that firm-level governance and investor protection are complements.

We find strong evidence that foreign firms invest less in internal governance mechanisms that increase the power of minority shareholders than comparable U.S. firms do. In other words, investment in firm-level governance is higher when a country becomes more economically and financially developed and better protects investor rights. Further, to the extent that institutional and development weaknesses reduce a foreign firm’s investment in corporate governance compared to a U.S. firm, we would expect the value of the foreign firm to be lower. As expected, we find that the value of foreign firms is negatively related to the magnitude of their governance investment shortfall relative to U.S. firms.

To conduct our investigation, we need information about firm-level corporate governance attributes that increase the power of minority shareholders for a large number of firms across a large number of countries and we would like individual governance attributes to be assessed similarly across all these firms. We use the corporate governance attributes recorded by Institutional Shareholder Services (ISS). By doing so, we can analyze 44 common governance attributes for 2,234 non-U.S. firms and 5,296 U.S. firms covering 23 developed countries. We create a governance index making sure that the governance attributes included are relevant both for U.S. firms and foreign firms. We call it the GOV Index.

To evaluate the governance a foreign firm would have if it were in the U.S., we use a propensity score matching method in order to match each foreign firm with a comparable U.S. firm. We then show that foreign firms generally have a lower GOV index, so that they give less power to minority shareholders, than if they were U.S. firms. We define the governance gap to be the difference between the governance index of a foreign firm and the governance index of a comparable U.S. firm. A firm with a positive governance gap has a higher value of the GOV index than its matching U.S. firm. Only 12.7% of foreign firms have a positive governance gap. Strikingly, 86.1% of these firms come from Canada and the U.K., so that firms from countries with similar investor protection as in the U.S. are the ones that are the most likely to invest more in governance than comparable U.S. firms. Such a result is inconsistent with the hypothesis that investor protection and internal governance mechanisms are substitutes.

Having compared the governance of foreign and U.S. firms, we turn to the question of whether the governance gap helps explain a firm’s valuation. We find that the value of foreign firms is increasing in their GOV index. More importantly, perhaps, the lower the GOV index of a foreign firm compared to its matching U.S. firm, the lower the value of that foreign firm. We find that this result holds controlling for firm characteristics known to affect q and controlling for the endogeneity of the choice of governance mechanisms.

If firm-level governance is more costly for foreign firms than for U.S. firms, we expect that the foreign firms comparable to the U.S. firms that benefit the most from investing in internal governance will find it optimal to invest less in governance than matching U.S. firms do and will suffer a loss of value as a result. We can therefore use regression analysis to investigate whether a foreign firm’s q is negatively related to the governance index value it would have in the U.S. We find that this is the case. Such a coefficient is not subject to an endogeneity bias because we are measuring the governance of a U.S. firm and the valuation of a foreign firm.

In addition to investigating the value relevance of differences in the aggregate governance index between foreign firms and comparable U.S. firms, we also consider the value relevance of specific governance provisions. We focus on provisions that have attracted considerable attention in the literature and among policymakers. We find that firms that have an independent board, auditors that are ratified annually, and an audit committee comprised solely of outsiders, have a higher value when their U.S. matching firm has these governance attributes. In contrast, neither board size nor separation of the chairman and CEO functions are value relevant.