Berkshire Hathaway Vice Chairman Charlie Munger is well known as the partner of CEO Warren Buffett and also for his advocacy of “multi-disciplinary thinking”—the application of fundamental concepts from across various academic disciplines to solve complex real-world problems. One problem that Munger has addressed over the years is the optimal system of corporate governance. How should an organization be structured to encourage ethical behavior among organizational participants and motivate decision-making in the best interest of shareholders? His solution is unconventional by the standards of governance today and somewhat at odds with regulatory guidelines. However, the insights that Munger provides represent a contrast to current “best practices” and suggest the potential for alternative solutions to improve corporate performance and executive behavior. In our paper, Corporate Governance According to Charles T. Munger, which was recently made publicly available on SSRN, we examine this solution in greater detail.
Posts Tagged ‘David Larcker’
Recent events suggest that shareholders pay attention to matters involving the personal lives of CEOs and take this information into account when making investment decisions. In our paper, Separation Anxiety: The Impact of CEO Divorce on Shareholders, which was recently made publicly available on SSRN, we examine the impact that CEO divorce can have on a corporation.
There are at least three potential ways in which a CEO divorce might impact a corporation and its shareholders. The first is loss of control or influence. A CEO with a significant ownership stake in a company might be forced to sell or transfer a portion of this stake to satisfy the terms of a divorce settlement. This can reduce the influence that he or she has over the organization and impact decisions regarding corporate strategy, asset ownership, and board composition. Shareholder reaction to loss of control will vary, depending on the view that investors have of CEO performance and governance quality. If they view performance and governance quality favorably, they will react negatively to the news; if they view management as entrenched or a poor steward of assets, they will react positively. Shareholder reaction will also depend in part on what happens to divested shares, including whether they are transferred to the spouse, sold in a block to a third-party, or dispersed in the general market. Each of these can shape the future governance of a firm.
There has been a recent surge in research that seeks to understand the sources of variation in tax avoidance (e.g., Shevlin and Shackelford, 2001; Shevlin, 2007; Hanlon and Heitzman, 2010). The benefits of tax avoidance can be economically large (e.g., Scholes et al., 2009) and tax avoidance can be a relatively inexpensive source of financing (e.g., Armstrong et al., 2012). However, aggressive tax avoidance may be accompanied by substantial observable (e.g., fines and legal fees) and unobservable (e.g., excess risk and loss of corporate reputation) costs. Although understanding the factors that influence managers’ tax avoidance decisions is an important research question that has broad public policy implications, relatively little is known about why some firms appear to be more tax aggressive than others.
In our paper, Corporate Governance, Incentives, and Tax Avoidance, which was recently made publicly available on SSRN, we examine whether variation in firms’ corporate governance mechanisms explains differences in their level of tax avoidance. We view tax avoidance as one of many investment opportunities that is available to managers. Similar to other investment decisions, managers have personal incentives to engage in a certain amount of tax avoidance that may not be in the best interest of shareholders, thereby giving rise to an agency problem. From the perspective of the firm’s shareholders, unresolved agency problems with respect to tax avoidance can manifest as either “too little” or “too much” tax avoidance. As with other agency problems, certain corporate governance mechanisms can mitigate agency problems with respect to tax avoidance.
A large body of prior literature examines the relation between managerial equity incentives and financial misreporting but reports mixed results. This literature argues that a manager whose wealth is more sensitive to changes in stock price has a greater incentive to misreport. However, if managers are risk-averse and misreporting increases both equity values and equity risk, managers face a risk/return tradeoff when making a misreporting decision. In this case, the sensitivity of the manager’s wealth to changes in stock price, or portfolio delta, will have two countervailing incentive effects: a positive “reward effect” and a negative “risk effect.” In contrast, the sensitivity of the manager’s equity portfolio to changes in risk, or portfolio vega, will have an unambiguously positive incentive effect. Accordingly, when managers are risk-averse, it is important to jointly consider both portfolio delta and portfolio vega when assessing the relation between equity incentives and misreporting.
In our paper, The Relation Between Equity Incentives and Misreporting: The Role of Risk-Taking Incentives, forthcoming in the Journal of Financial Economics, we show that jointly considering both portfolio delta and portfolio vega substantially alters inferences reported in the literature. Specifically, we find inferences in studies reporting either a positive relation or no relation between portfolio delta and misreporting are not robust to controlling for vega.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) imposed a requirement that public companies allow shareholders the opportunity to cast an advisory vote on executive compensation (typically annually). This requirement is commonly referred to as say-on-pay (SOP). Shareholders that disagree with a firm’s executive compensation program can cast anon-binding (or precatory) vote “against” the management compensation program disclosed in the proxy statement for the annual shareholder meeting. Presumably firms with a substantial proportion of negative votes will make appropriate changes to their compensation program.
In the paper, The Economic Consequences of Proxy Advisor Say-on-Pay Voting Policies, which was recently made publicly available on SSRN, my co-authors (Allan McCall of Stanford University and Gaizka Ormazabal of the University of Navarra) and I examine the changes that boards of directors make in anticipation of the initial SOP votes and the shareholder reaction to those changes. Since the SOP vote is advisory, boards are under no obligation to make changes pursuant to its outcome. A board may simply wait to see the outcome of the vote before deciding whether changes to compensation programs are warranted. However, if a board anticipates substantial opposition to its executive compensation program and believes that this opposition is costly to shareholders (e.g., because it invites derivative lawsuits, negative press, regulatory scrutiny, or distracts executives and employees), it might rationally take preemptive actions to decrease the probability of receiving negative votes. In such a setting, the board of directors will be interested in anticipating whether institutional investors (who hold the majority of outstanding shares) will vote for or against a SOP proposal.
In the paper, Ten Myths of “Say on Pay”, my co-authors (Allan McCall, Gaizka Ormazabal, and Brian Tayan) and I review many widely held misconceptions regarding the shareholder voting practice called “say on pay.” “Say on pay” is a prominent issue today, given its unique position at the intersection of executive compensation and shareholder democracy—two topics which themselves are of deep interest to investors, stakeholder, regulators, and the media. Despite this interest, several misconceptions have developed which continue to be commonly accepted. Fortunately, academics have devoted considerable effort studying “say on pay,” shareholder democracy, and executive compensation. As a result, a lengthy empirical record exists against which “say on pay” can be examined. Our intention is to review “say on pay” in light of the scientific evidence so that practitioners have a better understanding of the limits and consequences of granting shareholders the right to vote on executive compensation.
In the paper, The Efficacy of Shareholder Voting: Evidence from Equity Compensation Plans, which was recently made publicly available on SSRN, my co-authors (Christopher Armstrong of the University of Pennsylvania and Ian Gow of Harvard Business School) and I examine the efficacy of shareholder voting in effecting changes in corporate policy. We focus on the effects of shareholder voting on equity-based compensation plans on firms’ executive compensation policies for two reasons. First, equity compensation plans are widespread and require shareholder approval, making votes on these plans the most common subject of shareholder voting after director elections and auditor ratification. Second, equity compensation proposals attract much higher levels of shareholder disapproval than most other company-sponsored proposals that are put to shareholder vote (e.g., director elections and auditor ratification nearly always receive in excess of 90% shareholder support), making them a more powerful setting for empirical analysis.
Of the 619 management-sponsored proposals rejected by shareholders between 2001 and 2010, 183 (30%) related to equity compensation plans. For the 2,659 management-sponsored proposals where Institutional Shareholder Services (ISS), a leading proxy advisory firm, recommended a vote against the proposal, 1,719 (65%) related to equity compensation plans. Moreover, ISS recommended against 27% of the 6,270 equity compensation plans considered between 2001 and 2010. Although only 2% of equity compensation proposals fail to receive the required level of shareholder support, this is substantially larger than the 0.07% failure rate for director elections, which have received considerably greater attention in recent research on shareholder voting and executive compensation.
This report examines current evidence regarding the influence of third-party proxy advisory firms’ voting recommendations on shareholder proposal voting outcomes, particularly say-on-pay votes. It also presents the findings of a study, conducted by The Conference Board, NASDAQ, and the Rock Center for Corporate Governance at Stanford University, which shows that proxy advisory firms have a substantial impact on the design of executive compensation programs. However, the impact of those firms on governance quality and shareholder value is still unknown.
A growing body of evidence demonstrates the influential role that third-party proxy advisory firms play in affecting the voting outcome of proposals made to shareholders in the annual proxy, particularly say-on-pay votes, which became mandatory for most public companies in 2011. There is less evidence, however, to establish the extent to which companies respond to this influence by changing the size and structure of executive compensation plans to conform to proxy advisor voting polices. A recent study conducted by The Conference Board, NASDAQ, and the Rock Center for Corporate Governance at Stanford University found that proxy advisory firms have a substantial impact on the design of executive compensation programs.
Considerable accounting and finance research has attempted to identify whether reported financial statements have been manipulated by executives. Most of these classification models are developed using accounting and financial market explanatory variables. Despite extensive prior work, the ability of these models to identify accounting manipulations is modest. In the paper, Detecting Deceptive Discussions in Conference Calls, forthcoming in the Journal of Accounting Research, we take a different approach to detecting financial statement manipulations by analyzing linguistic features present in CEO and CFO narratives during quarterly earnings conference calls. Based on prior theoretical and empirical research from psychology and linguistics on deception detection, we select the word categories that theoretically should be able to detect deceptive behavior by executives. We use these linguistic features to develop classification models for a very large sample of quarterly conference call transcripts.
A novel feature of our methodology is that we know whether the financial statements related to each conference call were restated in subsequent time periods. Because the CEO and CFO are likely to know that financial statements have been manipulated, we are able to reasonably identify which executive discussions are actually “deceptive”. Thus, we can estimate a linguistic-based model for detecting deception and test the out-of-sample performance of this classification method.
In the paper, Corporate Governance and the Information Content of Insider Trades, forthcoming in the Journal of Accounting Research, we examine the impact of the firm’s internal control process – specifically, actions taken by the general counsel (GC) – on addressing one specific governance issue, namely mitigating the level of informed trade. In order to investigate the effectiveness of the governance provisions in the insider trade policy (ITP) at mitigating informed trade, we examine the trades made by Section 16 insiders where we know the precise terms of the firm’s ITP. It is illegal for insiders to trade while in possession of material nonpublic information (Securities and Exchange Acts of 1933 and 1934; Insider Trading Sanctions Act of 1984 (ITSA); Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA)). However, prior research finds that insiders do appear to place, and profit from, trades based on superior information (e.g., Aboody and Lev, 2000; Ke et al. 2003; Piotroski and Roulstone, 2005; Huddart et al., 2007; Ravina and Sapienza, 2010). Building on these studies, we test the effectiveness of governance provisions in the ITP by examining whether such provisions are associated with (decreased) insider trading profits and the ability of insiders’ trades to predict future operating performance.