Across the country, public employee retirement systems are investing in companies that privatize public employee jobs. Such investments lead to reduced working hours and often job losses for current employees.  Although, in some circumstances, pension fund participants and beneficiaries may benefit from these investments, their actual economic interests might also be harmed by them, once the negative jobs impact is taken into account. But that impact is almost never taken into account. That’s because under the ascendant view of the fiduciary duty of loyalty, pension trustees owe their allegiance to the fund first, rather than to the fund’s participants and beneficiaries. Notwithstanding the fact that ERISA and state pension codes command trustees to invest, “solely in the interests of participants and beneficiaries and for the exclusive purpose of providing benefits,” the United States Department of Labor declared in 2008 that the plain text of the quoted language means that the interests of the plan come first.  Under this view, plan trustees should de facto ignore the potentially negative jobs impact of privatizing investments because that impact harms plan members, and not, purportedly, the plan itself. Thus, in the name of the duty of loyalty, the actual economic interests of plan members in plan investments are subverted to the interests of the plan itself (or, at a minimum, to an unduly constrained version of the plan’s interests that excludes lost employer and employee contributions). As a result, public pension plans make investments that harm the economic interests of their members. This turns the duty of loyalty on its head.
Posts Tagged ‘Agency costs’
The primary function of corporate governance in the United States has been to address the managerial agency cost problem that afflicts publicly traded companies with dispersed share ownership. Berle and Means threw the spotlight on this type of agency cost problem—using different nomenclature—in their famous 1932 book The Modern Corporation and Private Property. Nevertheless, it was only in the 1970s that the now ubiquitous corporate governance movement began. Why did the corporate governance movement gain momentum in the U.S. when it did? And given its belated arrival, why did it flourish during ensuing decades?
In a recent article, entitled Fact and Fiction in Corporate Law and Governance, I evaluate two broad elements of corporate governance scholarship—one conceptual and the other methodological. The conceptual element is the “contractarian” framework within which legal academics have analyzed corporate law since the 1980s. My evaluation is not aimed at the characterization of a corporation as a nexus of voluntary associations—a characterization that I think most of us share—but rather at the belief among some legal scholars that market forces lead to optimal governance arrangements within firms, and that a market dynamic leads states to compete to provide value-maximizing corporate law rules. The methodological element that I address is the use of corporate governance indices in empirical studies of corporate governance, an approach that dates back to the 1990s but that became widespread following Gompers, Ishii and Metrick’s development of the G Index in 2003.
In our paper, Determinants of Corporate Cash Policy: Insights from Private Firms, forthcoming in the Journal of Financial Economics, we exploit a database of private firms to help understand public firms’ cash policies. It is worth noting that the cash policy of private firms in itself is of great interest to financial economists due to a lack of data prior to our study. Further, the contrast between public and private firm behavior in cash management serves as cross-validation of prior research on cash policies using only public firms. We expect that the variation in agency conflicts across these two groups of firms is likely to be at least as substantial as the variation within public firms. Further, differences across these two groups of firms in financing frictions allow us to explore the relative importance of these two effects on cash levels, the speed of adjustment to target cash, and the dissipation of excess cash.
In our paper, Say Pays! Shareholder Voice and Firm Performance, which was recently made publicly available on SSRN, we estimate the effect of increasing shareholder “voice” in corporations through a new governance rule that provides shareholders with a regular vote on pay: Say on Pay. Say on Pay policy is an important governance change mandated by the Dodd-Frank Act that provides shareholders with a vote on executive pay. It is part of a general trend toward more CEO accountability and increased shareholder rights. Shareholders may use this new channel to voice their discontent regarding the link between pay and performance. This new policy is at the forefront of the debate on executive pay and its efficacy to deliver firm performance.
In our paper, Identifying the Valuation Effects and Agency Costs of Corporate Diversification: Evidence from the Geographic Diversification of U.S. Banks, forthcoming in the Review of Financial Studies, we develop and implement two new approaches for identifying the causal impact of the geographic diversification of bank holding company (BHC) assets on their market valuations. Although we provide some evidence about the factors underlying observed changes in market valuations, our major contribution is in improving identification, not in constructing better measures of scale economies, agency problems, or other factors associated with market valuations. Furthermore, although we primarily use both identification strategies to evaluate the net effect of geographic diversification on BHC valuations, they can be employed to assess an array of questions about bank behavior.
At the core of both identification strategies, we exploit the cross-state, cross-time variation in the removal of interstate bank branching prohibitions to identify an exogenous increase in geographic diversity. From the 1970s through the 1990s, individual states of the United States removed restrictions on the entry of out-of-state banks. Not only did states start deregulating in different years, but states also signed bilateral and multilateral reciprocal interstate banking agreements in a somewhat chaotic manner over time. There is enormous cross-state variation in the twenty-year process of interstate bank deregulation, which culminated in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1995.
Regardless of whether a financial advisor is an “investment advisor” or a “broker” or neither under federal securities laws, the advisor might be an agent of the client under the common law of agency. If so, then as a matter of state law the advisor is a fiduciary who will be subject to liability for breach of any of several fiduciary duties to the client. In a recent paper sponsored by Federated Investors that is available for download here, I examine the fiduciary obligations of financial advisors who are agents under the common law of agency. The paper draws on earlier work on the economic structure of fiduciary law.
The debate about whether to impose a harmonized federal fiduciary standard of conduct on investment advisors and brokers notwithstanding, a financial advisor who is an agent under state agency law is subject to fiduciary duties of loyalty, care, and a host of subsidiary rules that reinforce and give meaning to the broad standards of loyalty and care as applied to specific circumstances. In the event of the advisor’s breach of duty, the client will be entitled to an election among remedies that include compensatory damages to offset losses incurred or to make up gains forgone owing to the breach; disgorgement by the advisor of any profit accruing from the breach or compensation paid by the client; or punitive damages. A financial advisor who ignores the possibility of fiduciary status under state agency law acts at his peril.
In our paper, Are Mutual Funds Active Voters?, which was recently made publicly available on SSRN, we document that mutual funds vary significantly in how they fulfill their fiduciary duty to vote their shares in shareholders’ interests. Approximately 25% of mutual funds vote with ISS on nearly all company agenda items throughout our five-year sample period. However, many other mutual funds disagree frequently with ISS, particularly on contentious votes. We find that certain types of funds are more likely to find it optimal to incur the costs of evaluating the necessary information to independently assess the items up for vote. For example, large funds and funds from top 5 families can spread the costs over a wider asset base, and low turnover funds are more likely to own the stocks long enough to realize the valuation effects of the vote outcome and any consequent changes in company governance. We would thus expect such funds to be more likely to actively vote. A summary measure of fund activism, which is based on six fund characteristics, highlights the extent to which variation in funds’ costs and benefits of actively voting translates into dramatically different voting patterns. Across a sample of contentious compensation and governance votes, we find that passive funds follow ISS in 86% of the compensation and 77% of the governance votes, compared to analogous rates of only 15% and 19% among actively voting funds. Similarly, across a sample of contentious director votes, passive funds are approximately three times more likely than active funds to follow ISS.
In the paper, Campaign Contributions and Governmental Financial Management: Evidence from State Bond Pricing, which was recently made publicly available on SSRN, I study campaign-finance agency costs related to pricing in the $2.9 trillion state and local government bond market. By selecting a contributing underwriter directly, the government could incur significant costs with respect to government bond underpricing. There is no comparable impact when an underwriter is chosen through an auction. Through the use of a control function approach, I show that the decision to select a contributing underwriter is endogenous to first-day returns. When underpricing is expected, the government’s propensity to choose a contributing underwriter decreases as expected underpricing increases. This evidence supports the idea that there are significant agency costs associated with campaign contributions and the evidence remains robust after a battery of checks.
This paper’s results lend support to the political agency cost model. Consistent with the common assertion that the election is the primary disciplining mechanism for political executives in a political agency cost model (Besley, 2006), the likelihood that a contributing underwriter is chosen is decreasing in the closeness to the next election. Consistent with the idea that laws can discipline politicians directly and through taxpayer monitoring, the likelihood that the government does not choose an auction to select an underwriter is decreasing in the quality of conflict-of-interest laws and freedom-of-information laws; the likelihood that the government chooses a contributing underwriter is decreasing in the quality of freedom-of-information laws.
In the paper, Agency Costs in the Era of Economic Crisis – The Enhanced Connection between CEO Compensation and Corporate Cash Holdings, which was recently made publicly available on SSRN, I examine the evolution of the practice of cash hoarding following the Great Recession. The results suggest that managerial behavior, as evidenced by the elasticity of cash holdings as a function of total director compensation, has changed significantly in 2008 with economically meaningful implications. The effect was somewhat diminished the following year, which may be attributed to the growth and stimulus of the second half of 2009, but peaked again in 2010. In particular, I find that following the Great Recession managerial compensation has become positively correlated with the level of corporate cash holdings, suggesting that agency costs contribute to cash retention in times of financial distress.
It is possible that high managerial compensation influences the managers to be more risk averse and thus affects the managers’ decision to retain cash. Since diversified shareholders are likely to be less risk averse than the managers at times of financial crisis, when it is harder to find a comparable alternative job and the probability of complete failure increases, it may well be that the cash hoarding practice is at a suboptimal level and comes at the expense of shareholder value. Thus, the influence of the size of the managerial compensation on the manager’s risk tolerance should be taken into account when evaluating managerial pay.