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.

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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.

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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.

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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.

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Corporate disclosure is widely seen as an unambiguous good. In our paper, Information Disclosure and Corporate Governance, forthcoming in the Journal of Finance, we show that this view is, at best, incomplete. Greater disclosure tends to raise executive compensation and can create additional or exacerbate existing agency problems. Hence, even ignoring the direct costs of disclosure (e.g., meeting stricter accounting rules, maintaining better records, etc.), there could well be a limit on the optimal level of disclosure.

The model used to study disclosure reflects fairly general organizational issues. A principal desires information that will improve her decision making (e.g., whether or not to fire the agent, tender her shares, move capital from the firm, adjust the agent’s compensation scheme, etc.). In many situations, the agent prefers the status quo to change imposed by the principal (e.g., he prefers employment to possibly being dismissed). Hence, better information is view asymmetrically by the parties: It benefits the principal, but harms the agent. If the principal did not need to compensate the agent for this harm and if she could prevent the agent from capturing, through the bargaining process, any of the surplus this better information creates, the principal would desire maximal disclosure. In reality, however, she will need to compensate the agent and she will lose some of the surplus to him. These effects can be strong enough to cause the principal to optimally choose less than maximal disclosure.

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In our paper, Concentrating on Governance, forthcoming in the Journal of Finance, we develop a unified account of the costs and benefits of external governance and explore the economic determinants of the resulting trade-offs for shareholder value. The importance of corporate governance is broadly recognized, but there is a great deal of disagreement on whether existing governance mechanisms ultimately benefit or hurt shareholders. Our novel perspective explains shareholder governance trade-offs, why they arise, and how they vary across firms and industries.

The classical agency view is that it is costly for shareholders to yield power to managers because managers pursue private benefits of control whenever their jobs are protected from takeovers or shareholder initiatives. A challenge to the agency view comes from the alternative bargaining view, which suggests that it is in the interest of shareholders to yield power to managers, a popular argument among M&A lawyers and practitioners.

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The extent of agency problems in publicly traded firms and the need for reform of executive compensation remain the subject of active debate. In the paper, Agency Problems in Public Firms: Evidence from Corporate Jets in Leveraged Buyouts, recently made available on SSRN, I bring new evidence to this debate by measuring a particular kind of firm behavior where there is potential for managerial abuse—the use of corporate jets.

Motivated by a large literature that finds improvements in efficiency and performance when firms are purchased by a private equity (PE) fund in a leveraged buyout (LBO), I use novel data to compare the fleets of jets operated by publicly traded and privately held firms. In the cross-section of firms from 2008, I find that PE-owned firms average about 40% smaller jet fleets than publicly traded firms, even after controlling for firm size, industry, and location in a variety of flexible ways. One could still worry, however, that these cross-sectional differences do not represent a causal effect of PE ownership due to omitted variables or other factors. Thus, I also measure changes in jet fleets within firms that are taken from public to private by a PE fund in an LBO between 1992 and 2007, and I find fleet reductions of a similar magnitude. Of course, the selection of firms into PE-ownership is not random, and I discuss assumptions under which these comparisons across and within firms provide estimates of lower and upper bounds on the average treatment effect of taking a firm from public to private in an LBO.

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The Program on Corporate Governance recently issued our study, Golden Parachutes and the Wealth of Shareholders.

Golden parachutes have attracted much debate and substantial attention from investors and public officials for more than two decades, and the Dodd-Frank Act recently mandated a shareholder vote on any future adoption of a golden parachute by public firms. Our study uses IRRC data for the period 1990-2006 to provide a comprehensive analysis of the relationship that golden parachutes have both with the evolution of firm value over time and with shareholder opportunities to obtain acquisition premiums. We find that golden parachutes are associated with increased likelihood of either receiving an acquisition offer or being acquired, a lower premium in the event of an acquisition, and higher (unconditional) expected acquisition premiums. Tracking the evolution of firm value over time in firms adopting GPs, we find that firms adopting a GP have a lower industry-adjusted Tobin’s Q already in the IRRC volume preceding the adoption, but that their value continues to decline during the inter-volume period of adoption and continues to erode subsequently. A similar pattern is displayed by an analysis of abnormal stock returns prior to the adoption of GPs, during the inter-volume period of adoption, and subsequently.

Here in some more detail is what our study, which is available here, does:

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CEO compensation typically includes both performance sensitive and performance insensitive components. This pay structure can be readily rationalized in a contracting setting (e.g., Holmstrom (1982)). Performance sensitive payments link a manager’s value enhancing actions to his wealth thereby aligning his incentives with those of the firm. These payments are risky, however, and in contracts with a risk averse manager risk sharing motives give rise to a role for the performance insensitive component. Compensation structure has a direct impact on manager objectives and it is natural to expect it to affect a manager’s choice of firm risk and, consequently, the dynamics of the firm’s security prices. Aspects of these linkages have been explored empirically, but the structural modeling of the impact of CEO pay on risk choice, capital structure, and the pricing of financial securities remains relatively unexplored.

In our paper, Leverage Choice and Credit Spread when Managers Risk Shift, forthcoming in the Journal of Finance, we demonstrate the relevance of the agency costs of Jensen and Meckling (1976) for structural models of leverage choice and credit spreads. Assuming a realistic compensation structure for risk-averse managers, consisting of cash and stock, we show that managers will optimally choose to lever the firm and that their resulting pay will be convex in the firm’s terminal liquidating pre-tax payout. This convexity induces asset substitution, leading to riskier payouts and higher credit spreads than predicted by the prior literature. We also demonstrate that optimal leverage choice is the result of a balance between tax benefits and the utility cost of ex-post risk shifting. Our work thus highlights that operating behavior induced by compensation terms can be of first-order importance for understanding debt levels and credit spreads.

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In our paper, Executive Compensation and the Maturity Structure of Corporate Debt, which was recently accepted for publication in the Journal of Finance, we investigate the role of short-term debt in reducing agency costs of debt arising from executive incentive contracts. Specifically, we examine the effect of the two portfolio sensitivities on the maturity structure of corporate debt. In addition, we analyze the effect of debt maturity on the relation between portfolio sensitivities and bond yields.

We study the causal link between CEO incentive compensation and corporate debt maturity using a sample of 6,825 firm-year observations during the 14-year period from 1992 to 2005. We employ alternative definitions of short-term debt, follow Core and Guay’s (2002) method for estimating option sensitivities, and then apply several empirical methodologies (e.g., pooled OLS and GMM simultaneous equation estimation, fixed-effect regressions, change-invariables regressions) and an alternative new debt issuance sample to analyze the predicted relations.

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