Archive for September, 2009

The Economic Consequences of IPO Spinning

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday September 30, 2009 at 3:52 pm
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(Editor’s Note: This post comes to us from Xiaoding Liu and Jay Ritter of the University of Florida)

In our paper, The Economic Consequences of IPO Spinning, which was recently accepted for publication in the Review of Financial Studies, we investigate the practice of spinning using a sample of 56 companies that went public during the period 1996-2000. Spinning is the allocation by underwriters of the shares of hot initial public offerings (IPOs) to company executives in order to influence their decisions in the hiring of investment bankers and/or the pricing of their own company’s initial public offering. The term spinning refers to the fact that the shares are often immediately sold in the aftermarket, or “spun,” for a quick profit, and an IPO is termed “hot” if it is expected to jump in price as soon as it starts trading.

Despite the fact that IPO spinning is one of the four scandals associated with IPOs that have been the subject of regulatory settlements, it is the only scandal that has not yet received any systematic study due in large part to the unavailability of data. We overcome this limitation through the careful hand collection of a detailed dataset. More specifically, for our empirical analysis, we use data gathered from court cases, the media, and documents requested through the Freedom of Information Act. From these sources, we obtain data on 146 officers and directors at 56 companies that were recipients of hot initial public offering (IPO) allocations. All of these companies were taken public by Deutsche Morgan Grenfell (DMG), Credit Suisse First Boston (CSFB), and Salomon Smith Barney (SSB) during 1996-2000.

There is evidence in Securities and Exchange Commission (SEC) settlements and Congressional testimony that Piper Jaffray, Goldman Sachs, and other investment banking firms also engaged in spinning. Our empirical analysis, however, is restricted to IPOs for which DMG, CSFB, or SSB was the bookrunner. The reason that we impose this restriction is that the companies identified in press reports and settlements suffer from a selection bias, frequently containing examples of prominent executives at well-known companies. In contrast, the data for the three investment banking firms that we focus on is systematic, composed of all of the executives who were being systematically spun by CSFB as of March 21, 2000; executives who were being spun by CSFB and lived in Silicon Valley, including those being spun after March 21, 2000; or those being spun by SSB at any time during 1996-2000. For each executive that had a brokerage account with the SSB unit in charge of spinning, we have data on the allocations to each executive for 48 IPOs.

We estimate the effect of spinning on IPO underpricing and the awarding of future investment banking mandates. We find that holding everything else constant, IPOs in which the executives are being spun are 23% more underpriced (e.g., 43% vs. 20%). The average dollar value of this incremental underpricing, the incremental money left on the table, is approximately $17 million, where money left on the table is the underpricing per share multiplied by the number of shares issued. The average first-day profit received from hot IPO allocations by the executives of a company being spun is $1.3 million. The ratio of these numbers indicates that only 8% of the incremental amount of money left on the table flows back to the executives being spun. The effect of spinning on subsequent investment banking mandates relates to the literature that asks why firms do or do not switch underwriters—this literature has focused on performance dissatisfaction, graduation to a more prestigious underwriter, and analyst coverage reasons as factors that affect switching decisions. We add another reason, the co-opting of executive decision-makers, to this list. We find that companies with executives who are being spun are dramatically less likely to switch underwriters for their first seasoned equity offering. For companies not being spun, the probability of switching underwriters is 31%. For companies being spun, the probability of switching is only 6%.

Overall, our findings suggest that the spinning of executives accomplished its goal of affecting corporate decisions. More generally, this paper presents evidence on the economic consequences of an agency problem arising from the delegation of decision-making to corporate managers.

The full paper is available for download here.

Davis Polk Releases Comprehensive Review of Financial Crisis Laws

Posted by Margaret E. Tahyar, Davis Polk & Wardwell LLP, on Tuesday September 29, 2009 at 9:25 am
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Editor’s Note: This post is by Margaret E. Tahyar of Davis Polk & Wardwell LLP.

It has been my privilege to support my partners as the editor of Davis Polk’s recently issued Financial Crisis Manual, which has been written by 21 Davis Polk partners and counsel working in a collaborative team that is the hallmark of our firm culture. The Manual is a comprehensive review of financial crisis laws as they apply to US financial institutions. Written for anyone who wants to understand the flurry of new legislation and other rulemaking that has occurred at a dizzying speed over the last year and a half, it covers the major Federal Reserve programs, Treasury’s capital investments and warrants, the FDIC’s debt guarantees, the public-private investment program, the enforcement landscape and executive compensation. It is also meant to be, through the hyperlinks in each Chapter, a reference work gathering in one place the scattered primary sources of financial crisis laws, regulations and contracts.

As practicing lawyers, we leave to others the tasks of analyzing the causes of the crisis and assessing the government’s responses to it. That said, the political and social context in which financial crisis rulemaking occurred resulted in regulations with characteristics that affect the way lawyers interpret the law and provide advice to clients. According to one commentary, this system “married transactional practice to administrative law.” Here are a few observations about the characteristics of US financial crisis laws.

…continue reading: Davis Polk Releases Comprehensive Review of Financial Crisis Laws

Sharp Increase in Shareholder Votes Opposing Director Nominees

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Tuesday September 29, 2009 at 9:19 am
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(Editor’s Note: This post comes to us from Scott Fenn of Proxy Governance Inc.)

Recent data compiled by PROXY Governance, Inc. show a significant increase in the percentage of director nominees who received high percentages of shareholder votes cast in opposition in director elections during the 2009 proxy season. Although the vast majority of director nominees continue to be elected with little opposition, for companies with director election results available through August 2009, 9.8 percent of unopposed director nominees had at least 20 percent of shares voted against them or withheld, up from 5.5 percent in 2008. This trend was apparent at other threshold levels as well, with the percentage of directors having at least 40 percent of shares voted in opposition doubling from 1.0 percent in 2008 to 2.1 percent in 2009, and the percentage of directors failing to attain majority support tripling from 0.2 percent in 2008 to 0.6 percent in 2009. (See Table 1)

Table 1.
Percentage of Directors Receiving
High Percentages of Votes in Opposition
(2007 – 2009)

2007 2008 2009 [1]
20%+ opposition vote 4.8 % 5.5 % 9.8 %
30%+ opposition vote 2.2 % 2.5 % 5.0 %
40%+ opposition vote 0.8 % 1.0 % 2.1 %
Majority opposition vote 0.2 % 0.2 % 0.6 %
[1] Based on 2,441 meetings held with voting results available through
Aug. 31, 2009. Results for 2007 and 2008 are for full calendar year.

While declines in stock prices and the financial crisis no doubt played a role in the apparent increase in shareholder discontent with directors during 2009, compensation and corporate governance concerns also appear to have been primary drivers behind the increasing number of shares voted in opposition to directors. Of all director nominees who had more than 20 percent of shares withheld or voted against them in board elections, more than 57 percent served on compensation committees. Governance concerns – ranging from ignoring a majority vote on a shareholder proposal to adopting or renewing a poison pill without shareholder approval – also appear to have played a role in the high opposition votes at many companies.

Despite fewer organized “Vote No” campaigns against directors in 2009 – where a group of shareholders mount a public campaign to oust specific directors – at least 84 directors at 48 companies failed to attain majority support from shareholders through August 2009 at more than 2,400 companies where director voting results were available. Most of these 48 companies still use plurality voting, so the practical impact on most of the directors will be limited. Southwestern Energy Co., Pride International Inc., Cablevision Systems Corp., Pulte Homes Inc., Southwest Airlines Co., Massey Energy Co. and Kansas City Southern were among the larger companies where at least one director failed to achieve a majority vote. A list of the 48 companies where such votes have occurred so far in 2009 is shown in Table 2.

Table 2.
Companies Where At Least One Director Nominee
Failed to Achieve Majority Support in 2009

ACI WORLDWIDE INC
ADVANCED ANALOGIC TECH
ANIXTER INTL INC
ASSOCIATED ESTATES RLTY CORP
ASSURANT INC
CABLEVISION SYS CORP -CL A
CATALYST HEALTH SOLUTIONS
CHECKPOINT SYSTEMS INC
CIRCOR INTL INC
COGNEX CORP
COMPUTER PROGRAMS & SYSTEMS
DIGI INTERNATIONAL INC
DOLLAR TREE INC
ESSEX PROPERTY TRUST
FIRST MERCURY FINANCIAL CORP
FIRSTENERGY CORP
HEALTHCARE SERVICES GROUP
HMS HOLDINGS CORP
INTERLINE BRANDS INC
KANSAS CITY SOUTHERN
LAYNE CHRISTENSEN CO
LIFEPOINT HOSPITALS INC
MARINER ENERGY INC
MASSEY ENERGY CO
MEDNAX INC.
MENTOR GRAPHICS CORP
NATCO GROUP INC
NBTY INC
NV ENERGY INC
PLEXUS CORP
PRIDE INTERNATIONAL INC
PULTE HOMES INC
RED ROBIN GOURMET BURGERS
SKYWEST INC
SOUTHWEST AIRLINES
SOUTHWESTERN ENERGY CO
SPSS INC
SWIFT ENERGY CO
SYNIVERSE HOLDINGS INC
TENNANT CO
TETRA TECHNOLOGIES INC/DE
THORATEC CORP
TRIQUINT SEMICONDUCTOR INC
UNITED ONLINE INC
UNITED THERAPEUTICS CORP
VALUECLICK INC
ZAPATA CORP
ZOLL MEDICAL CORP

High profile “Vote No” campaigns aimed at unseating directors at financial firms such as Bank of America Corp. and Citigroup Inc. had mixed results – while the directors targeted in such campaigns were re-elected, several targeted directors at Bank of America later resigned, including the bank’s lead director.

The level of opposition to director candidates is likely to increase further next year as a number of existing and proposed regulatory changes related to proxy voting in director elections come into play. Beginning in 2010, under a rule change adopted by the New York Stock Exchange and approved by the Securities and Exchange Commission, discretionary voting by brokers of shares where they have not received voting instructions from shareowners will no longer be allowed in director elections. Because uninstructed broker votes can account for up to 20 percent of the vote at many companies, and are routinely voted with management’s recommendations, the new rule could result in many more directors failing to achieve majority support. For example, out of the universe of more than 2,400 companies, 284 director nominees were elected with less than 60 percent support of the shares cast and 473 nominees were elected with less than 65 percent support of the shares cast. Many of these directors might not have received majority support without the benefit of broker discretionary votes.

In addition to the impact of the rule change on broker discretionary voting, various bills are pending in Congress that would mandate annual elections for all directors and/or a majority voting system for all companies in uncontested elections. Annual elections would put many more directors up to a shareholder vote each year, potentially resulting in a greater total number of directors failing to achieve majority votes. Legislation mandating majority voting, while it might not impact the number of votes in opposition to directors, would certainly change the impact of those votes. Finally, the SEC has proposed a proxy access rule granting large shareholders access to the corporate proxy for purposes of nominating directors which, if implemented, could also have a significant impact on the director election process.

The Momentum For Reform Must Be Maintained

Posted by Lord Adair Turner, Chairman, United Kingdom Financial Services Authority, on Monday September 28, 2009 at 9:32 am
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(Editor’s Note: The post below by Lord Adair Turner is a transcript of his remarks at London’s City Banquet, on September 22, 2009.)

It’s a year and four days since Callum McCarthy spoke here on his second last day as Chairman of the FSA. I know he always received a warm welcome here and I am grateful, Lord Mayor, for your kind words, given that I now seem to be regarded as somewhat of a heretic in certain quarters of the City.  Heretics used to be burned at Smithfield, not far from here, so perhaps I should have been worried coming here. But I will not be recanting this evening. I will try, however, to be socially useful by addressing head on the complexities involved in distinguishing the benefits of a vibrant financial sector from the problems of excess and instability.

To say a lot has changed in the year since Callum stood before you is inadequate.  Callum’s speech came a few days after Lehman’s collapse, but before we understood the full consequences.  When I became Chairman two days later, I didn’t know I would spend my first three weeks at the FSA amidst the biggest financial crisis for at least 70 years.

Today the world looks much less scary than it did then.  The financial system is no longer fragile: growth is returning in many countries, confidence to many markets.  I say that with some trepidation because, of course, there may be setbacks and unexpected events.  But it is important to recognise the positives: a bias to over-cautious pessimism in official statements can be as harmful as a bias to unjustified optimism.

The banking system is stable. House prices have fallen much less than anticipated. The big emerging economies have proved far more robust than we feared.  The Bank of England mid-point forecast suggests fairly robust UK growth over the next three years.

But even if that is the case – even indeed if the path of growth, unemployment and housing prices turns out to be better than current expectation – we must not forget what occurred last autumn.   This was the worst crisis for 70 years – indeed potentially it could have been the worst in the history of market capitalism.  Real disaster – a new Great Depression – was only averted by quite exceptional policy measures.  Despite these measures major economic harm has occurred. Hundreds of thousands of British people are newly unemployed; tens of thousands have lost houses to repossession; and British citizens will be burdened for many years with either higher taxes or cuts in public services – because of an economic crisis whose origins lay in the financial system, a crisis cooked up in trading rooms where not just a few but many people earned annual bonuses equal to a lifetime’s earnings of some of those now  suffering the consequences.  We cannot go back to business as usual and accept the risk that a similar crisis occurs again in ten or 20 years’ time.

We need radical change.  Regulators must design radically changed regulations and supervisory approaches, but we also need to challenge our entire past philosophy of regulation.

And parts of the financial services industries need to reflect deeply on their role in the economy, and to recommit to a focus on their essential social and economic functions, if they are to regain public trust.

…continue reading: The Momentum For Reform Must Be Maintained

Stapled Finance

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday September 28, 2009 at 9:28 am
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(Editor’s Note: This post comes to us from Paul Povel of the University of Houston, and Rajdeep Singh of the University of Minnesota.)

In our recently accepted Journal of Finance paper, Stapled Finance, we investigate the relatively new, but now quite common occurrence of a loan commitment that is “stapled” onto an offering memorandum by the investment bank advising the seller in an M&A transaction. Stapled finance provides for credit at pre-specified terms to whoever wins the bidding contest for the asset or firm that is being put up for sale; but the winner is under no obligation to accept the loan offer.

We show that arranging stapled finance affects the bidding itself, by making it more competitive. We show that an appropriately designed stapled finance package increases the expected price that will be paid to the seller. Three characteristics are crucial for this to be beneficial for the seller. First, the stapled finance offer is optional: the winning bidder has the right, but not the obligation, to accept a loan whose terms have been fixed before the takeover contest started. Second, the stapled finance is a non-recourse claim, i.e., the debt is supported only by the target’s assets and cash flow, not by the other assets and operations that the winning bidder owns. Third, there are bidders who plan to hold the target as a portfolio company, i.e., who do not plan to integrate it into their other operations if they win. Our arguments do not rely on financial constraints of any sort; stapled finance is accepted by bidders for strategic reasons, even if they have sufficient internal or outside funds to pay for an acquisition.

In addition, we show that if the stapled finance package is designed optimally, then the investment bank providing it expects not to break even. The reason is that stapled finance is optional, so it is accepted only if the terms are attractive to the bidder—and therefore unattractive to the lender. This suggests that stapled finance that benefits the seller can be arranged only if it is possible to compensate the investment bank for its expected loss, for example with an up-front fee, or by retaining it for other fee-based services. It also suggests that stapled finance loans that investment banks and other financial institutions retained on their balance sheets should perform worse than buyout loans that were negotiated independently.

Being a fairly recent creation, stapled finance has not yet entered the academic mainstream, and therefore there is little existing empirical research. However, the institutional details about stapled finance are consistent with our results. In our paper, we discuss (informal) explanations for the popularity of stapled finance that practitioners provide, and how our results differ from predictions that follow from those explanations.

The full paper is available for download here.

Proposed Rules regarding Ratings Agencies and Flash Orders

Posted by Mary L. Schapiro, Chairman, U.S. Securities and Exchange Commission, on Sunday September 27, 2009 at 11:45 am
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(Editor’s Note: This post includes the transcripts of Chairman Schapiro’s statements on nationally recognized statistical rating organizations and flash orders at the SEC’s recent Open Meeting.  The statements of each of the other Commissioners on the two subjects are available here.)

Nationally Recognized Statistical Rating Organizations

Today we are considering a series of proposal that would significantly bolster the regulatory framework around nationally recognized statistical rating organizations, or “NRSROs.”

We are also considering a recommendation to propose a ban on the practice of flashing marketable orders. Flash orders provide a momentary head-start in the trading arena that can produce inequities in the markets and create disincentives to display quotes.

We begin with the credit rating recommendations. In 2006, the Credit Rating Agency Reform Act gave the Commission the exclusive authority over rating agency registration and qualifications. In the three years since, the Commission has undertaken several rulemaking initiatives. But as I have said previously, more needs to be done.

So, today we will consider six items that are intended to create a stronger, more robust regulatory framework. In particular, these proposals would improve the quality of ratings by requiring greater disclosure, fostering competition, helping to address conflicts of interest, shedding light on rating shopping, and promoting accountability.

These proposals are needed because investors often consider ratings when evaluating whether to purchase or sell a particular security. That reliance did not serve them well over the last several years and it is incumbent upon us to do all that we can to improve the reliability and integrity of the ratings process and give investors the appropriate context for evaluating whether ratings deserve their trust.

Collectively, the changes and concepts being adopted, proposed and considered today would benefit investors in many ways:

  • They would promote greater accountability by requiring compliance officers to file annual reports with the Commission.
  • They would foster competition by enabling unsolicited ratings for structured finance products.
  • They would decrease the level of undue reliance on the nationally recognized statistical rating organizations by beginning the process of removing references to NRSRO ratings in certain existing rules. It is time that we started this process to systematically minimize the use of ratings in the SEC’s rules and, while I know, there is much to do in this regard, I am pleased that we are taking these steps today.
  • And finally, they would empower investors to make more informed decisions by helping to expose rating shopping and potential revenue-linked conflicts.

…continue reading: Proposed Rules regarding Ratings Agencies and Flash Orders

SEC Proposes Rule to Prohibit Pay-to-Play Practices

Posted by Charles M. Nathan, Latham & Watkins LLP, on Saturday September 26, 2009 at 11:51 am
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(Editor’s Note: This post is based on a client memorandum by Kathleen Walsh, Andrea Schwartzman and Matthew Chase of Latham & Watkins LLP.)

On August 3, 2009, the US Securities and Exchange Commission (the SEC) released a proposed rule under the Investment Advisers Act of 1940 (the Advisers Act) aimed at preventing “pay to play” practices by investment advisers that seek investment advisory business — including investment commitments in private equity funds — from state and local government entities.  As described in the proposing release, pay to play practices “may take a variety of forms, including an adviser’s direct contributions to government officials, an adviser’s solicitation of third parties to make contributions or payments to government officials or political parties in the State or locality where the adviser seeks to provide services, or an adviser’s payments to third parties to solicit (or as a condition for obtaining) government business.”  Referencing a number of enforcement proceedings in the area, the proposing release further states that “it has become increasingly clear that pay to play is a significant problem in the management of public funds by investment advisers.”

Proposed Rule

In response, the proposed rule would prohibit an investment adviser, as well as its “covered associates” from:

(1) providing or agreeing to provide payments (broadly defined) to a third party to solicit a government entity for investment advisory business on behalf of such investment adviser;

(2) receiving compensation from government entities within two years of making a contribution to an official of the government entity; and

(3) soliciting third parties to make a political contribution to an official of a government entity to which the investment adviser is providing or seeking to provide investment advisory services. The proposed rule would also require an investment adviser to maintain detailed records relating to its covered associates and their political contributions.

…continue reading: SEC Proposes Rule to Prohibit Pay-to-Play Practices

Storm Clouds Gather over Director Elections

Posted by Francis H. Byrd, Laurel Hill Advisory Group, on Friday September 25, 2009 at 9:23 am
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(Editor’s Note: This post from Francis H. Byrd is based on an Altman Group publication titled Governance & Proxy Review Update.)

(Update:  This post has been updated below to reflect information provided in a subsequent Governance & Proxy Review Update.)

This post is by my colleagues Domenick de Robertis and Reid Pearson.

In response to the recent decision by the SEC to approve the elimination of broker discretionary voting authority on the election of directors at annual meetings after January 1, 2010, NYSE Rule 452 is front and center on the minds of many in the proxy and governance arena.

The amendment to Rule 452 will be the end of the “stuffing of the ballot box” for the election of directors that some shareholders have long complained about. The question now is to what extent will the change impact the ability of corporations to get their directors re-elected each year? In addition, what should corporations and their advisors be thinking about?

Assessing the Risk

Since the July announcement of the change, The Altman Group has completed numerous analyses for corporate issuers projecting the voting impact from the amended NYSE Rule 452. We will share our findings in the next issue of the Governance & Proxy Review and answer some practical questions that a company should consider in preparing for what is likely to be the toughest proxy season in history.

Strategies to Consider When Counteracting the Loss in Broker Voting

Historical statistics show that approximately 25 to 35 percent of the retail shareholder base will respond by voting without being prompted. The variance in response rates is tied to a number of factors, such as stock price (higher apathy with lower priced stocks) and the distribution of shareholdings (are there a lot of odd-lot holders, for example).

As we pointed out in our comment letters to the SEC, (Comment Letter – March 27, 2009) (Comment Letter – May 23, 2007) (Comment Letter – July 14, 2006) small-cap issuers are likely to bear the brunt of the burden placed on Corporate America by this change. Any issuer with a heavy retail base is likely to incur additional solicitation costs. There is no magic bullet for getting retail holders to vote. Issuers will need to consider the costs, necessity and effectiveness of follow-up mailings and phone solicitation to unvoted holders.

…continue reading: Storm Clouds Gather over Director Elections

Auditor Liability and Client Acceptance Decisions

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday September 25, 2009 at 9:22 am
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(Editor’s note: This post comes to us from Volker Laux and Paul Newman of the University of Texas at Austin.)

The audit profession has long argued that excessively burdensome legal liability imposed on auditors hinders capital formation by increasing the likelihood that audit firms will reject potential clients, particularly high risk firms, leaving such firms with limited access to capital markets. However, in equilibrium, a change in the legal environment will also have an impact on the audit fee, as the entrepreneur can compensate the auditor for the increased risk since it allows him to raise capital from investors at lower cost. Thus, the equilibrium implications of increased auditor liability on client rejection rates are not as obvious as implied by the audit profession’s arguments. In our forthcoming Accounting Review paper entitled Auditor Liability and Client Acceptance Decisions, we examine the implications of the legal liability environment for the auditor’s decision to accept or reject risky clients, the level of audit quality (given acceptance), and the level of the audit fee, in a setting where the auditor spends costly resources to evaluate the prospective client prior to making the acceptance decision.

In particular, we consider a setting in which an entrepreneur requires capital to undertake a new project and seeks that capital through outside investors. In order to investigate the effects of the litigation environment on the probability that good-type clients get rejected, we consider three components of that environment: i) the strictness of the legal liability regime, which is interpreted as the probability that the auditor will be sued and found liable after an audit failure, ii) damage payments from the auditor to investors in case of a successful lawsuit against the auditor, and iii) other litigation costs incurred by the auditor such as criminal penalties, attorney fees, or reputation loss.

We show that under reasonable assumptions about the level of expected damage payments, an increase in any of these litigation components results in an increase in both audit quality and the equilibrium audit fee. However, when considering the probability of client rejection, it is important to carefully distinguish between the three components of the liability environment. We first show that an increase in the potential damage payments to investors leads to a reduction (not to an increase) in the client rejection rate. A higher expected damage payment implies that the entrepreneur has to offer the auditor a larger audit fee. Otherwise, the audit engagement would become less attractive to the auditor which would lead to a lower evaluation effort and hence a higher rejection rate. However, the increase in the audit fee does not involve a real cost to the entrepreneur. If investors expect a larger damage award from the auditor in case of an audit failure, investors are willing to give the entrepreneur better financing conditions. The entrepreneur in turn can use these savings to compensate the auditor for the increased liability exposure. We call this the triangle effect. Hence, a change in the damage payment has no direct effects on the evaluation effort and the rejection rate.

However, there is also an indirect effect since a larger potential damage award induces the auditor to adopt an audit of higher quality (after accepting the client) which delivers more accurate information about the investment project and hence leads to improved investment decisions. The anticipation of a better investment decision increases the value of the entrepreneur’s investment opportunity in the initial stage. Since this investment opportunity is lost if the auditor rejects the engagement, the entrepreneur is more eager to attract the auditor. To do this, the entrepreneur increases the audit fee by an amount that is larger than the increase in the auditor’s expected damage payment, which results in a higher evaluation effort and a lower rejection rate. This result is reversed if litigation frictions increase. When litigation frictions are higher, the auditor will find the engagement with the client less attractive and hence will have a weaker incentive to carefully evaluate the client, which increases the rejection rate. Of course, the client can counteract this negative effect by offering a larger audit fee, but in this case a real cost is involved because the triangle effect does not hold. As a result, the equilibrium rejection rate increases with higher litigation frictions.

Because a shift in the strength of the legal regime affects both the expected damage payments to investors as well as expected litigation frictions, a change in the legal regime involves two opposing effects. Depending on which effect is stronger, a change in the legal regime either increases or decreases the probability of client rejection. In particular, we show that the relationship between the strength of the legal liability regime and the client rejection rate is U-shaped. Our model therefore predicts that clients are less likely to be rejected in environments with moderate legal regimes compared to environments with relatively strong or relatively weak legal regimes.

The full paper is available for download here.

A Fair Deal for Taxpayer Investments

Posted by Emma Coleman Jordan, Georgetown University Law Center, on Thursday September 24, 2009 at 11:28 am
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(Editor’s Note: This post comes to us from Professor Emma Coleman Jordan of the Georgetown University Law Center, and relates to Professor Jordan’s report “A Fair Deal for Taxpayer Investments: Public Directors Are Necessary to Restore Trust and Accountability at Companies Rescued by the U.S. Government“, released by the Center for American Progress. The report was released at an event featuring Chairman Towns of the House Committee on Oversight and Government Reform, details and video of the event are available here.)

During the financial markets crash of 2008, the Treasury Department and the Federal Reserve—of necessity—improvised dramatic and aggressive solutions to rescue the financial sector from imminent collapse. A welter of creative regulatory and monetary solutions provided massive amounts of government assistance to rescue private firms from probable failure. However, the benefits of government intervention have so far largely flowed one way only—from the taxpayers to the financial sector—and there has been a marked absence of accountability or transparency associated with these government-provided benefits.

Taxpayer bailouts have become a central policy tool since the onset of the current economic crisis—with approximately $12 trillion dollars to date deployed to support or rescue private companies in total.2 The de facto policy of providing taxpayer support to struggling “systemically important” companies has produced an ill-defined terrain of shared governance between financial executives on the one hand and federal regulators who hold both the power of government and the power of ownership on the other.

This unusual mix of private and public power requires a more visible implementation of financial accountability to regain the trust of the American public. The American people must know that their interests as taxpayers are being safeguarded, and that as investors they can have confidence that federal intervention into the private markets is following a consistent, well-defined, and transparent process—one which follows well-established guidelines for ensuring accountability, rather than a series of ad hoc approaches. This paper argues that the best vehicle to accomplish this goal is the establishment of public directors—positions of direct representation in the boardrooms of companies that have received significant amounts of government funds and which will provide federal agencies that are the new owners and regulators with a visible structure of accountability.

The prospects for a robust prudently guided financial sector have been substantially clouded by the fact that the both the corporate governance structure and the executive leadership of the financial sector remain largely unchanged—92 percent of the management and directors of the top 17 recipients of TARP funds are still in office. The Obama administration has outlined an ambitious and sweeping plan to reform the regulatory system governing financial institutions and markets. This regulatory reform is certainly indispensable, but perhaps insufficient. The recent market crashes exposed severe deficiencies in the fiduciary obligations and public-regarding culture of financial firms. In order to prevent future crashes, we must not only seek to change how these firms are regulated, we must also seek to change the structures by which they are run. One major issue in this regard is the passivity, insularity, and narrow band of values represented by those who oversee these firms—the directors who make up the boards of the country’s largest financial institutions.

A driving force of the 2008 market collapse was the imprudent risk taking by financial sector leaders The CEO and board of directors of each company have the legal responsibility to make decisions that advance shareholder interest. In the period leading up to the crisis, the conventional wisdom among financial sector CEOs was that the high returns available from mortgage-backed securities, and the highly leveraged balance sheets and off-balance sheet transactions concentrated in exotic financial instruments were the way to maximize short-term profitability and thus advance shareholder interests. This industry-wide consensus proved to be fatally flawed.

Public directors will provide a corrective to the boards of the financial institutions that helped cause the crisis. Public directors can offer increased independence of thought and diverse perspectives among board members. Public directors should be chosen for a strong public service history, financial and corporate literacy, as well as independence from links to the financial sector. The primary aim of the public director appointments should be to diversify traditional board member profiles and to avoid replicating the disastrous pool of narrowly self-reinforcing financial sector conventional wisdom and experience that led to the crisis. As the economy heals, there are troubling signs that banks have not increased lending, and have instead resumed planning risky strategic acquisitions, and excessive compensation practices. Proportional representation by public directors can ensure that systemically-important firms that have any measure of government ownership do not relapse into the homogenous, CEO-dominated boards that were in place before the crisis.

Regulators should determine most of the details of the public directorships—after all, they have the most direct experience in trying to regulate private companies that have received public funds. But the decisions should be made with two critical principles in mind. First, the principle of proportionality should be applied to government investments in private firms. Public directors should be appointed to the boards of directors on a roughly proportional level to the amount of funding received by the rescued firm—and this should include not just purchases of company stock, but other investments and subsidies provided to help support the firm. For example, if a company receives government funding equivalent to 25 percent of its market capitalization, public directors should make up roughly 25 percent of that company’s board.

Second, because public directors should represent taxpayer interests, they should have a history of public service, and they should be chosen to provide both intellectual diversity and diversity of perspective gained from individual experience. They should also have experience and expertise from outside of the economic sector in which they serve. Diversity is necessary for good governance, as it breaks up the “groupthink” that too often characterizes corporate boards, which are typically filled by allies of management. And experiential diversity is also important for the appropriate representation of taxpayer interests. When other stakeholders—such as pension funds, unions, or hedge funds—invest major sums in corporations, they demand board representation, and their directors are picked to represent the interests and worldview of these stakeholders. Taxpayers should not be treated any differently.

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