The Journal of Financial Economics has recently accepted for publication our study, Learning and the Disappearing Association between Governance and Returns. The paper, which was earlier issued as a working paper of the Program on Corporate Governance, is available here.

Our study seeks to explain a pattern that has received a great deal of attention from financial economists and capital market participants: during the period 1991-1999, stock returns were correlated with the G-Index based on twenty-four governance provisions (Gompers, Ishii, and Metrick (2003)) and the E-Index based on the six provisions that matter most (Bebchuk, Cohen, and Ferrell (2009)). We show that this correlation did not persist during the subsequent period 2000-2008. Furthermore, we provide evidence that both the identified correlation and its subsequent disappearance were due to market participants’ gradually learning to appreciate the difference between firms scoring well and poorly on the governance indices. Consistent with the learning hypothesis, we find that:

      (i) The disappearance of the governance-return correlation was associated with an increase in the attention to governance by a wide range of market participants;
      (ii) Until the beginning of the 2000s, but not subsequently, stock market reactions to earning announcements reflected the market’s being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms;
      (iii) Stock analysts were also more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms until the beginning of the 2000s but not afterwards;
      (iv) While the G-Index and E-Index could no longer generate abnormal returns in the 2000s, their negative association with Tobin’s Q and operating performance persisted; and
      (v) The existence and subsequent disappearance of the governance-return correlation cannot be fully explained by additional common risk factors suggested in the literature for augmenting the Fame-French-Carhart four-factor model.

Here is a more detailed account of our analysis:

…continue reading: Learning and the Disappearing Association between Governance and Returns

This post provides information about thirty-six precatory board declassification proposals, submitted by institutional investors represented and advised by the Harvard Law School Shareholder Rights Project (SRP), that are expected to go to a vote at annual meetings during this proxy season.

During the 2011-12 proxy season, the SRP has been representing and advising several institutional investors – Illinois State Board of Investment (ISBI) , the Los Angeles County Employees Retirement Association (LACERA), the Nathan Cummings Foundation (NCF), the North Carolina Department of State Treasurer (NCDST), and the Ohio Public Employees Retirement System (OPERS) – in connection with the submission of precatory shareholder proposals to more than eighty S&P 500 companies that have classified boards. The proposals urge repealing the classified board and moving to annual elections, which are widely viewed as corporate governance best practice.

Through active engagement with companies receiving declassification proposals, the SRP and the institutional investors working with the SRP have been able to reach negotiated outcomes with (as of today) forty-four of the companies receiving such proposals. These companies have entered into agreements committing them to bring management proposals to declassify their boards. (A partial list of companies entering into such agreements, including only companies that have already made public filings that disclose the planned management proposals, is available here.)

In many other companies receiving proposals, however, the SRP and the institutional investors working with the SRP have not been able to obtain such negotiated outcomes. In such cases, the shareholder proposals urging board declassification are expected to go, or have already gone, to a vote at 2012 the annual meeting.

Thus far, only one proposal has gone to a vote. The proposal, submitted by the Illinois State Board of Investments to the F5 Networks, Inc. (FFIV), won 77% of the votes cast.

Below is a list of thirty-six companies where shareholders are expected to vote at the 2012 annual meeting on shareholder proposals submitted by institutional investor represented and advised by the SRP. Where the proxy statement has already been issued, the date of the meeting and a link to the proxy statement are also provided. The list does not include companies where a dialogue is still ongoing. The list will be updated periodically and the most updated version is available here.

…continue reading: Thirty-Six Precatory Declassification Proposals Going to a Vote at Annual Meetings

The Harvard Law School Shareholders Rights Project (SRP) recently issued joint press releases with five institutional investors, principally state and municipal pension funds, trumpeting SRP’s representation of and advice to these investors during the 2012 proxy season in submitting proposals to more than 80 S&P 500 companies with staggered boards, urging that their boards be declassified. The SRP’s “News Alert” issued concurrently reported that 42 of the companies targeted had agreed to include management proposals in their proxy statements to declassify their boards – which reportedly represented one-third of all S&P 500 companies with staggered boards. The SRP statement “commended” those companies for what it called “their responsiveness to shareholder concerns.”

This is wrong. According to the Harvard Law School online catalog, the SRP is “a newly established clinical program” that “will provide students with the opportunity to obtain hands-on experience with shareholder rights work by assisting public pension funds in improving governance arrangements at publicly traded firms.” Students receive law school credits for involvement in the SRP. The SRP’s instructors are two members of the Law School faculty, one of whom (Professor Lucian Bebchuk) has been outspoken in pressing one point of view in the larger corporate governance debate. The SRP’s “Template Board Declassification Proposal” cites two of Professor Bebchuk’s writings, among others, in making the claim that staggered boards “could be associated with lower firm valuation and/or worse corporate decision-making.”

…continue reading: Harvard’s Shareholder Rights Project is Wrong

Over the past two weeks, Lucian Bebchuk and René Stulz engaged in an online debate on the question: Has Executive Compensation Contributed to the Financial Crisis? Bebchuk supported a “yes” answer, and Stulz argued for a “no” answer. The debate, which was hosted by the World Bank’s All about Finance blog, was followed by a poll in which readers cast their votes. The votes are now in, and 79.9% of the votes were cast in support of the position supported by Bebchuk.

The opening statements by Bebchuk and Stulz are available here and here. The second-round responses by Bebchuk and Stulz are available here and here. The results of the readers’ poll are available here.

In his opening statement, René Stulz relies on the results of the Fahlenbrach-Stulz study (FS study) to reject the view that executive compensation has contributed to the financial crisis. Stulz argues that the evidence in his study is “inconsistent with the view that banks performed poorly because CEOs had poor incentives.” However, as explained below, the FS study does not provide a good basis for rejecting the poor incentives view.

The FS study attempts to test the “poor incentives” hypothesis by examining whether banks whose CEOs had larger equity holdings performed better during the crisis. Failing to find such an association – and indeed finding that such banks performed worse – the FS study rejects the poor incentives hypothesis. But the poor incentives view does not attribute poor risk-taking incentives to relatively low equity holdings, and the analysis in the FS study does not supply an adequate test of this view.

As I explained in my opening statement, the poor incentives view does not regard large equity holdings as the way to ensure good risk-taking incentives and does not view poor incentives as rooted in insufficient equity holdings. Rather, as I explained, poor incentives have resulted from (i) design of equity compensation (as well as bonus compensation) that rewarded executives even for short-term results that were subsequently reversed, and (ii) linking executive payoffs only to payoffs for shareholders and not also to payoffs for other contributors of capital to financial firms (such as bondholders).

…continue reading: Executive Pay and the Financial Crisis: A Response to René Stulz

Yes, there is a good basis for concern that executive pay arrangements have contributed to excessive risk-taking during the run-up to the financial crisis. To be sure, other factors were clearly at work: the environment within which firms operated grew riskier due to asset bubbles generated by macro policies and global factors, and regulatory constraints on risk-taking and capital requirements were too lax. As financial economists generally recognize, however, for any given environment and outside constraints, the performance and risk choices of firms depend substantially on the incentives of firms’ executives. Unfortunately, rather than provide incentives to avoid excessive risk-taking, the design of pay arrangements in financial firms encouraged such risk-taking.

Of course, despite incentives to take excessive risks, some executives might have avoided doing so due to professional integrity, reputational concerns, or fiduciary duty norms. And some executives taking excessive risks might have done so due to their under-estimation of the risks taken. But economics and finance teach us that incentives often matter. Thus, to the extent that pay arrangements provided significant incentives to take excessive risks, the possibility that such incentives in fact contributed materially to the excessive risks taken in the run-up to the crisis should be seriously considered.

In fact, pay arrangements did provide substantial incentives for excessive risk-taking. Under the standard design of pay arrangements, executives were fully exposed to the upside of risks taken but enjoyed substantial insulation from part of the downside of such risks. As a result, executives had incentives to increase risk-taking beyond optimal levels.

…continue reading: Executive Pay and the Financial Crisis

A recent issue of the Review of Financial Studies featured (as lead article) our study “Self-Fulfilling Credit Market Freezes.” This paper develops a model of a self-fulfilling credit market freezes and uses it to study alternative governmental responses to such a crisis.

We study an economy in which operating firms are interdependent, with their success depending on the ability of other operating firms to obtain financing. In such an economy, an inefficient credit market freeze may arise in which banks abstain from lending to operating firms with good projects because of their self-fulfilling expectations that other banks will not be making such loans. Our model enables us to study the effectiveness of alternative measures for getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of interest rate cuts, infusion of capital into banks, direct lending to operating firms by the government, and the provision of government capital or guarantees to finance or encourage privately-managed lending.

Our analysis provides a framework for analyzing the standard and nonstandard instruments used by authorities during the financial crisis of 2008-2009. This framework, we hope, can be useful for authorities making choices in the face of financial crises in the future. Our analysis also provides testable implications for – and can guide empirical work on – how firms, banks, and economies can be expected to be affected by shocks to the banking system.

We now turn to describing our analysis in a bit more detail: An important aspect of the economic crisis of 2008-2009 has been the contraction or “freezing” of credit to nonfinancial firms. During the crisis, financial firms have displayed considerable reluctance to extend loans to nonfinancial firms (as well as households). Some observers attributed the reluctance of financial firms to lend to irrational fear, while others attributed it to a rational assessment of the fundamentals of the economy, which can be expected to reduce the number of operating firms with good projects worthy of financing.

We analyze in this paper another factor that may contribute to the contraction of credit in such circumstances. In particular, we show how coordination failure among financial institutions can lead to inefficient “credit markets freeze” equilibria. In such equilibria, financial institutions rationally avoid lending to nonfinancial firms (operating firms) that have projects that would be worthy if banks did not withdraw from the lending market en masse. They do so out of self-fulfilling fear, validated in equilibrium, that other financial institutions would withhold loans and that operating companies would not be able to succeed in an environment in which other operating firms fail to obtain financing.

…continue reading: Self-Fulfilling Credit Market Freezes

A group of ten corporate and securities law experts submitted yesterday a rulemaking petition (the “Petition”) to the Securities and Exchange Commission. The Petition urges the Commission to develop rules to require public companies to disclose to shareholders the use of corporate resources for political activities.

The Committee on Disclosure of Corporate Political Spending, which we co-chair, is composed of ten academics whose teaching and research focus on corporate and securities law. In addition to the two of us, the members of the Committee include Bernard Black (Northwestern), John Coffee (Columbia), James Cox (Duke), Ronald Gilson (Stanford and Columbia), Jeffrey Gordon (Columbia), Henry Hansmann (Yale), Donald Langevoort (Georgetown), and Hillary Sale (Washington University in St. Louis).

The Petition proceeds as follows:

• First, the Petition explains that the Commission’s disclosure rules have evolved over time in response to changes in investor interests and needs as well as corporate practices.
• Second, the Petition presents data indicating that public investors have become increasingly interested in receiving information about corporate political spending.
• Third, the Petition explains that, in response to increased investor interest, many public companies have voluntarily adopted policies requiring disclosure of the company’s spending on politics, and these disclosure practices can provide a useful starting point for the SEC in designing disclosure rules in this area.
• Fourth, the Petition explains that disclosure of information on corporate political spending is important for the operation of corporate accountability mechanisms, including those that the Supreme Court has relied upon in its analysis of corporate political speech.
• Finally, the Petition explains that the design of disclosure rules concerning political spending would involve choices similar to those presented by the disclosure rules previously developed by the Commission, and thus that the Commission has ample experience and expertise to make these choices.

The Petition concludes that the Commission should promptly initiate a rulemaking project to make political spending by public companies more transparent to investors.

The full Petition is available here.

Several prominent members of the U.S. Senate and House of Representatives re-introduced yesterday the Shareholder Protection Act for debate. The bill would establish special corporate-governance rules for deciding when corporate resources may be spent on politics. Although it appears that the bill is unlikely to be adopted during this Congress, the approach it represents deserves consideration and support. In an article published last year in the Harvard Law Review, “Corporate Political Speech: Who Decides?,” we presented the case for such an approach. As we argued in “Corporate Political Speech,” political speech decisions are different from ordinary business decisions—and, thus, special rules are needed for deciding when a corporation may spend shareholder resources on politics.

The Shareholder Protection Act would establish a legal structure with three types of rules that apply when public companies wish to use corporate resources for political activity. These rules would require extensive disclosure, a role for independent directors, and shareholder approval.

First, the Shareholder Protection Act would require companies to disclose to shareholders each year both the amounts and recipients of the company’s spending on politics. Existing election law does not require disclosure of significant amounts of corporate spending on politics—especially contributions to intermediaries. Indeed, our article provided evidence indicating that five intermediaries who receive corporate contributions spent more than $130 million on lobbying and politics during the 2008 election cycle alone. Although the Act would mandate these disclosures by statute, the SEC currently has the authority to require disclosures of this type, and we urge the SEC to develop rules that would require that shareholders be given information on corporate political spending.

Second, the Act would require oversight of political spending by the board of directors. In our view, like other areas in which corporate law requires directors to take an active role in certain decisions—for instance, executive pay and financial audits—directors should be required to oversee corporate spending on politics. Because the interests of executives and shareholders may often diverge with respect to such spending, director oversight is especially desirable in this area. We also favor requiring directors to provide shareholders, in each year’s proxy statement, with a report explaining their choices and policies concerning the company’s spending on politics.

…continue reading: The Re-Introduction of the Shareholder Protection Act

In a letter submitted yesterday to the Securities and Exchange Commission, we provide a detailed analysis of the policy issues relevant for the Commission’s ongoing examination of changes to its rules under Section 13(d) of the Securities Exchange Act of 1934. These rules, which govern share accumulation and disclosure by blockholders, are the subject of a recent rulemaking petition submitted by Wachtell, Lipton, Rosen and Katz, which proposes that the rules be tightened.

We argue that the Commission should not view the proposed tightening as merely “technical” changes needed to modernize its Section 13(d) rules. In our view, the proposed changes should be examined in the larger context of the beneficial role that outside blockholders play in American corporate governance and the broad set of rules that apply to such blockholders.

Our analysis proceeds in five steps. First, we describe the significant empirical evidence indicating that the accumulation and holding of outside blocks in public companies benefits shareholders by making incumbent directors and managers more accountable and thereby reducing agency costs and managerial slack.

Second, we explain that tightening the rules applicable to outside blockholders can be expected to reduce the returns to blockholders and thereby reduce the incidence and size of outside blocks—and, thus, blockholders’ investments in monitoring and engagement, which in turn may result in increased agency costs and managerial slack.

…continue reading: How the SEC Should Consider Possible Changes in Section 13(d) Rules