Posts Tagged ‘Equity-based compensation’

A Theory of Debt Maturity

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Tuesday January 14, 2014 at 9:23 am
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Editor’s Note: The following post comes to us from Douglas Diamond, Professor of Finance at the
 University of Chicago Booth School of Business, and Zhiguo He of the
 Department of Finance at the University of Chicago Booth School of Business.

In our paper, A Theory of Debt Maturity: The Long and Short of Debt Overhang, forthcoming in the Journal of Finance, we study the effects of the debt maturity on current and future real investment decisions of an owner of equity (or a manager who is compensated by equity). Our analysis is based on debt overhang first analyzed by Myers (1977), who points out that outstanding debt may distort the firm’s investment incentives downward. A reduced incentive to undertake profitable investments when decision makers seek to maximize equity value is referred to as a problem of “debt overhang,” because part of the return from a current new investment goes to make existing debt more valuable.

Myers (1977) suggests a possible solution of short-term debt to the debt overhang problem. In part, this extends the idea that if all debt matures before the investment opportunity, then the firm without debt in place can make the investment decision as if an all-equity firm. Hence, following this logic, debt that matures soon—although after relevant investment decisions, as opposed to before—should have reduced overhang.

…continue reading: A Theory of Debt Maturity

ISS Releases 2014 Voting Policies

Editor’s Note: David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz specializing in the areas of mergers and acquisitions and complex securities transactions. This post is based on a Wachtell Lipton memorandum by Mr. Katz, Trevor S. Norwitz, David E. Kahan, Sabastian V. Niles, and S. Iliana Ongun.

Institutional Shareholder Services Inc. (ISS) recently published its 2014 Corporate Governance Policy Updates, which would apply to annual meetings beginning in February 2014. ISS updated relatively few of its policies this year, but the changes largely represent a more measured, company-specific approach to corporate governance practices, which reflects a move by ISS to avoid “one-size-fits-all” policies and recommendations. ISS also announced a new consultation and comment period concerning potential policy changes applicable to the 2015 proxy season or beyond with respect to director tenure, director independence, independent chair shareholder proposals, equity-based compensation plans and auditor ratification.

2014 Policy Updates

Board Response to Majority Supported Shareholder Proposals. As announced last year, ISS evaluates a company’s response to shareholder proposals that receive a majority of shares cast in considering “withhold” recommendations against the full board, committee members or individual directors. With respect to such majority supported shareholder proposals, ISS will now make vote recommendations on director elections on a case-by-case basis and will no longer require boards to fully implement majority supported shareholder proposals in all cases. Instead, ISS will consider mitigating factors in cases involving less than full implementation, including the board’s articulated rationale for its response and level of implementation (with consideration of such rationales being a new factor not previously considered by ISS), disclosed shareholder outreach efforts by the board in the wake of the vote, the level of support and opposition for the proposal, actions taken, and the continuation of the underlying issue as a voting item on the ballot (as either shareholder or management proposals).

…continue reading: ISS Releases 2014 Voting Policies

Determinants and Performance of Equity Deferral Choices by Outside Directors

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday November 18, 2013 at 9:35 am
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Editor’s Note: The following post comes to us from Christopher Ittner, Professor of Accounting at the University of Pennsylvania; and Francesca Franco and Oktay Urcan, both of the Accounting Area at the London Business School.

In our paper, Determinants and Trading Performance of Equity Deferral Choices by Corporate Outside Directors, which was recently made publicly available on SSRN, we investigate the determinants and trading performance of outside directors’ “equity deferrals,” which represent the choice to convert part or all of the current cash compensation into deferred company stock. Director equity deferrals are interesting for two reasons. First, by deferring, the directors give up a sure amount of cash today for firm stock with an uncertain future value, while at the same time substantially increasing the proportion of their compensation that is tied to future firm performance. Second, the equity deferrals can become a form of insider trading, because directors can use these options as a tax-advantaged alternative to open-market purchases of the firm’s stock.

We examine director equity deferrals using a hand-collected sample of U.S. firms that allowed outside board members to defer their cash compensation into equity between 1999 and 2003. We first focus on the factors affecting director equity deferral choices. Consistent with a certainty equivalent story, we find that directors are more likely to defer cash into equity when they receive higher cash compensation levels and when the plans offer premiums for deferrals made into equity. Deferral likelihood also increases with the size of the taxes that are deferred.

…continue reading: Determinants and Performance of Equity Deferral Choices by Outside Directors

Equity Vesting and Managerial Myopia

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday October 9, 2013 at 9:30 am
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Editor’s Note: The following post comes to us from Alex Edmans, Professor of Finance at the London Business School, Vivian Fang of the Department of Accounting at the University of Minnesota, and Katharina Lewellen of the Tuck School of Business at Dartmouth College.

In our paper, Equity Vesting and Managerial Myopia, which was recently made publicly available on SSRN, we study the link between real investment decisions and the vesting horizon of a CEO’s equity incentives. We find that research and development (“R&D”) is negatively associated with the stock price sensitivity of stock and options that vest over the course of the same year. This association continues to hold when including advertising and capital expenditure in the investment measure. Moreover, CEOs with significant newly-vesting equity are more likely to meet or beat analyst consensus forecasts by a narrow margin. However, the market recognizes such CEOs’ incentives to inflate earnings—the lower announcement returns to meet or beating earnings forecasts are decreasing in the sensitivity of vesting equity. These results provide empirical support for managerial myopia theories.

Many academics and practitioners believe that managerial myopia is a first-order problem faced by the modern firm. While the 20th century firm emphasized cost efficiency, Porter (1992) argues that “the nature of competition has changed, placing a premium on investment in increasingly complex and intangible forms,” such as innovation, employee training, and organizational development. However, the myopia theories of Stein (1988, 1989) show that managers may fail to invest due to concerns with the firm’s short-term stock price. Since the benefits of intangible investment are only visible in the long run, the immediate effect of such investment is to depress earnings and thus the current stock price. Therefore, a manager aligned with the short-term stock price may turn down valuable investment opportunities.

…continue reading: Equity Vesting and Managerial Myopia

Governance Through Threat

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday October 7, 2013 at 9:14 am
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Editor’s Note: The following post comes to us from Massimo Massa, Professor of Finance at INSEAD, Bohui Zhang of the Australian School of Business at the University of New South Wales, and Hong Zhang of the Finance Area at INSEAD.

The last decade has witnessed a renewed interest in the role of financial markets in disciplining managers. Shareholders—particularly blockholders—may induce good managerial behavior by exiting and pushing down stock prices when bad managerial actions are taken (e.g., Admati and Pfleiderer, 2009; Edmans, 2009; Edmans and Manso, 2011). In this regard, informed trading (“exit”) provides an alternative governance mechanism that shareholders can adopt in addition to the traditional “intervention” type of internal governance (e.g., Parrino et al., 2003; Chen et al., 2007; McCahery et al., 2010). Indeed, to some extent, exit and intervention offer substituting governance mechanisms that shareholders can select based on their trade-off between benefits and costs (e.g., Edmans and Manso, 2011; Edmans et al., 2013).

In our paper, Governance Through Threat: Does Short Selling Improve Internal Governance?, which was recently made publicly available on SSRN, we study how “trading-based governance” affects internal governance through the channel of short selling. Using a simple model, we argue that the threat of short-selling attacks triggered by bad managerial actions pushes existing shareholders to better control management, either through improved internal governance or via enhanced equity compensation. Thus, short-selling-based discipline mechanisms are complementary with, instead of substituting for, internal governance.

…continue reading: Governance Through Threat

Delaware Court Ruling Raises Questions About Informal NYSE Interpretations

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Saturday July 6, 2013 at 2:41 pm
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Editor’s Note: The following post comes to us from Robert Buckholz, partner and co-coordinator of the Corporate and Finance Group at Sullivan & Cromwell LLP. This post is based on a Sullivan & Cromwell publication, and is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Louisiana Municipal Police Employees Retirement System v. Bergstein [1] concerns a $120 million equity grant to the Chief Executive Officer of Simon Property Group, Inc. (“SPG”) and a related amendment to SPG’s stock incentive plan that was required to make the grant. The shareholder plaintiff alleges that the board of directors’ amendment of the plan was a breach of fiduciary duty because the plan mandated shareholder approval of amendments where required by law, regulation or applicable stock exchange rules. The defendants moved to dismiss, noting that SPG had received email confirmation from New York Stock Exchange staff that shareholder approval of the amendment was not required under NYSE rules. Ruling from the bench, Chancellor Leo E. Strine, Jr. denied SPG’s motion to dismiss, citing concerns that a staff email did not serve as a definitive interpretation of NYSE rules – particularly where, in Chancellor Stine’s view, the email to the NYSE did not adequately describe the broader circumstances.

The process SPG used is the customary one by which listed companies receive interpretations from the NYSE staff on governance matters, and Chancellor Strine’s ruling is at an early stage of the case. However, until there is more definitive guidance as to the weight that courts will give NYSE staff interpretations, listed companies should bear in mind the Chancery Court’s ruling when evaluating the weight that a court will give an NYSE email interpretation on a governance matter, particularly when evaluating whether a proposed change to an equity compensation plan would require shareholder
approval.

…continue reading: Delaware Court Ruling Raises Questions About Informal NYSE Interpretations

Downside Risk and the Design of CEO Incentives

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday June 10, 2013 at 8:56 am
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Editor’s Note: The following post comes to us from David De Angelis, Gustavo Grullon, and Sebastien Michenaud, all of the Finance Area at Rice University.

In our paper, Downside Risk and the Design of CEO Incentives: Evidence from a Natural Experiment, which was recently made publicly available on SSRN, we investigate how downside risk influences the design of CEOs’ incentives. Studying the relationship between firm risk and managerial incentives is a difficult task due to the endogenous nature of the relationship: empiricists cannot easily disentangle the effect of compensation on risk from the effect of risk on compensation (Prendergast, 2002). We address the identification challenge by exploiting a randomized natural experiment that exogenously increased downside equity risk through the relaxation of short-selling constraints. Because the removal of short-selling constraints may cause an increase – or the fear of an increase – in bear raids and market manipulation by short-sellers (Goldstein and Guembel (2008)), this increase in downside risk potentially exposes managers to losses that are beyond their control. In this scenario, CEOs may sub-optimally reduce the risk of their firms to protect their personal wealth and firm-specific human capital (Amihud and Lev (1981), May (1995)). Consistent with this view, firms and their CEOs display an acute aversion to short-sellers, and go to great lengths to fight them and reduce their influence on stock prices (Lamont (2012)). As a result, firms that maximize shareholder value should respond to an exogenous increase in short selling activity by increasing their CEOs’ risk-taking incentives to avoid sub-optimal risk reduction policies, and/or by immunizing their CEOs against the downside risk that lies outside of their control and does not reflect their performance.

…continue reading: Downside Risk and the Design of CEO Incentives

SEC Issues SOX 402 Guidance

Posted by Michael G. Oxley, Baker & Hostetler LLP, on Thursday April 18, 2013 at 9:23 am
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Editor’s Note: Michael Oxley is of counsel at Baker & Hostetler LLP, and is former Congressman and Chairman of the House Financial Services Committee. Mr. Oxley co-authored the landmark Sarbanes-Oxley Act of 2002. The following post is based on a BakerHostetler memorandum by Mr. Oxley, Andrew W. Reich, and Thomas S. Gallagher.

The SEC staff for the first time issued interpretive guidance regarding Section 402 of the Sarbanes-Oxley Act of 2002 (SOX). To date, in the absence of authoritative guidance, issuers have largely steered clear of activities arguably within the ambit of SOX 402′s prohibition on personal loans to officers and directors. The staff’s new letter provides a measure of clarity regarding SOX 402′s scope.

SOX 402, codified as Section 13(k) of the Securities Exchange Act of 1934, makes it unlawful for an issuer “directly or indirectly … to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan” to any of its directors or executive officers. Violations of SOX 402 can subject issuers to civil and criminal penalties under Sections 21B and 32(a) of the Exchange Act.

…continue reading: SEC Issues SOX 402 Guidance

What Motivates Minority Acquisitions?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday March 1, 2013 at 9:26 am
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Editor’s Note: The following post comes to us from Paige Parker Ouimet of the Finance Division at the Kenan-Flagler Business School, the University of North Carolina at Chapel Hill.

What motivates minority acquisitions? We study the trade-off between minority acquisitions, involving less than 50% of the target, and majority acquisitions in the forthcoming Review of Financial Studies paper, “What Motivates Minority Acquisitions? The Trade-Offs between a Partial Equity Stake and Complete Integration.” Minority acquisitions have been shown to facilitate cooperation between two independent firms. For example, Allen and Phillips (2000) and Fee, Hadlock, and Thomas (2006) show that a minority acquisition can align the incentives of the acquirer with those of the target. However, similar benefits can also be achieved with a majority acquisition, suggesting that minority stakes are also motivated as a means to avoid certain costs associated with majority control.

Using a sample of 2,166 deals, we identify several key predictors in the choice between a minority or majority acquisition. The key insight provided in this paper is the importance of costs associated with the dilution to target managerial incentives following a majority acquisition in selecting the mode of acquisition. Evidence that firms are willing to forgo benefits to control to preserve target incentives speaks to the value of these incentives.

…continue reading: What Motivates Minority Acquisitions?

How to Prepare for Annual Meeting Litigation

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday February 7, 2013 at 9:32 am
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Editor’s Note: The following post comes to us from Regina Olshan, partner in the executive compensation and benefits practice at Skadden, Arps, Slate, Meagher & Flom LLP, and is based on a Skadden alert by Ms. Olshan, Neil Leff, Erica Schohn and Joseph Yaffe.

As the 2013 proxy season is now underway, companies should be aware of the recent wave of lawsuits alleging breaches of fiduciary duties by management and directors in connection with compensation-related decisions. These suits allege deficient disclosure with respect to compensation-related proxy proposals and seek to enjoin the company’s annual meeting until supplemental disclosures are made. They primarily target proposals to increase the amount of shares reserved for equity compensation plans and advisory votes on executive compensation (say-on-pay). There also have been a handful of suits relating to proposals seeking to amend certificates of incorporation to increase the total number of authorized shares.

More than 20 such cases were filed in 2012, and the plaintiffs’ law firm predominantly initiating these suits has announced that it is investigating nearly 40 additional companies. These cases are typically filed shortly after a company files its definitive proxy statement and make generic accusations of inadequate disclosure. Some companies concerned about potential disruption to their annual meetings have been willing to settle these claims. There have been at least six reported settlements, all involving proposals to increase the number of shares authorized under equity plans. These settlements have generally involved supplemental disclosure and payment of up to $625,000 of plaintiffs’ attorneys’ fees. Other companies have settled prior to the filing of a formal lawsuit. Although a preliminary injunction has been granted in only one of these cases, Knee v. Brocade Communications Systems, Inc., many cases in which preliminary injunctions were denied are still pending resolution regarding other relief requested by the plaintiffs, such as damages. An analysis of the claims made in filed cases to date may help companies decide whether to increase disclosure in their 2013 annual meeting proxy statements.

…continue reading: How to Prepare for Annual Meeting Litigation

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