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.

…continue reading: The Relation between Equity Incentives and Misreporting

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.

…continue reading: The Economic Consequences of Proxy Advisor Say-on-Pay Voting Policies

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.

…continue reading: Ten Myths of “Say on Pay”

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.

…continue reading: The Efficacy of Shareholder Voting

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.

…continue reading: The Influence of Proxy Advisory Firm Voting Recommendations

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.

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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.

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Brian Tayan and I recently co-authored a book, titled Corporate Governance Matters, which takes an organizational perspective, rather than a legal perspective, on the important topic of modern corporate governance. Our purpose is to examine the choices that organizations can make in designing governance systems and the impact those choices have on executive decision-making and the organization’s performance. The book relies on an extensive body of professional and scholarly research, and aims to correct misconceptions and cut through the considerable rhetoric surrounding corporate governance. We hope the book provides a framework that enables practitioners to make sound decisions that are well supported by careful research.

Our book covers a wide range of topics regarding corporate governance. These include a discussion of the environment in which the organization competes to understand how various forces influence the mechanisms it adopts to discourage self-interested behavior by management. In addition, we spend considerable time examining the board of directors, including the structure, processes, and operations of the board, along with the board’s functional responsibilities, such as oversight and risk management, succession planning, compensation, accounting and audits, and the consideration of mergers and acquisitions. We also examine the role of the institutional investor to understand how diverse shareholder groups and third-party proxy advisory firms influence governance choices. The book also includes an assessment of commercial and academic governance ratings systems.

Many of the conclusions of the book are phrased in the negative. While the lack of positive correlations may disappoint some, this has important implications for the current debate on governance and your evaluation of the types of governance systems that organizations might require. Some of the central lessons we draw in the book including the following:

…continue reading: Corporate Governance Matters: Lessons for Practitioners

In our paper, Proxy Advisory Firms and Stock Option Exchanges: The Case of Institutional Shareholder Services, which was recently made publicly available on SSRN, we examine the role of proxy advisors in the specific context of stock option exchanges, where firms replace underwater stock options with new awards of options, restricted stock and/or cash. We restrict our investigation to this specific transaction because it is a relatively simple, one-time transaction where the set of design choices are well defined and can be collected from SEC filings. In addition, the precise criteria used by Institutional Shareholder Services (ISS) in making the voting recommendation are known, and we can observe the degree to which an option exchange follows or deviates from their criteria. Finally, there is considerable variation across the firms in the structure of their exchange programs and the influence of ISS on proxy voting outcomes. This enables us to examine the performance implications of plan design choices and the role of ISS in these transactions.

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In the paper, The Market Reaction to Corporate Governance Regulation, which was recently made publicly available on SSRN, we investigate the market reaction to recent legislative and regulatory actions pertaining to corporate governance. The managerial power view of governance suggests that executive pay, the existing process of proxy access, and various governance provisions (e.g., staggered boards and CEO-chairman duality) are associated with managerial rent extraction. This perspective predicts that broad government actions that reduce executive pay, increase proxy access, and ban such governance provisions are value enhancing. In contrast, another view of governance suggests that observed governance choices are the result of value-maximizing contracts between shareholders and management. This perspective predicts that broad government actions that regulate such governance choices are value destroying.

…continue reading: The Market Reaction to Corporate Governance Regulation