In our paper, Managerial Attitudes and Corporate Actions, forthcoming in the Journal of Financial Economics, we use a survey-based approach to provide new insight into the people and processes behind corporate decisions. This method allows us to address issues that traditional empirical work based on large archival data sources cannot. For example, we are able to administer psychometric personality tests, gauge risk-aversion, and measure other behavioral phenomena. Our mode of inquiry is similar to those of experimental economists (who often administer gambling experiments) and psychologists (who administer psychometric tests). As far as we are aware, no other study attempts to measure attitudes of senior management directly through personality tests to distinguish CEOs from others and U.S top level executives from non-US top level executives. We also relate CEO attributes to firm-level policies.

Our survey quantifies behavioral traits of senior executives and also harvests information related to career paths, education, and demographics. We ask these same questions of chief executives and chief financial officers, among public and private firms, and in both the US and overseas. We can thus compare traits and attitudes for US and non-US CEOs to see if there is indeed a significant difference in attitudes. We also ask questions related to standard corporate finance decisions such as leverage policy, debt maturity, and acquisition activity. This allows us to relate attitudes and managerial attributes to corporate actions. We also examine how managerial attributes such as risk-aversion and time preference relate to compensation at the firm level.

…continue reading: Managerial Attitudes and Corporate Actions

The recent financial crisis has rekindled interest in the relationship between the structure of the financial network and systemic risk. Two polar views on this relationship have been suggested in the academic literature and the policy world. The first maintains that the “incompleteness” of the financial network can be a source of instability, as individual banks are overly exposed to the liabilities of a handful of financial institutions. Thus, according to this argument, a more complete financial network, which limits the exposure of the banks to any one counterparty would be less prone to systemic failures. The second view, in stark contrast, hypothesizes that it is the highly interconnected nature of the financial system that contributes to its fragility, as it facilitates the spread of financial distress and solvency problems from one bank to the rest in an epidemic-like fashion.

In our recent NBER working paper, Systemic Risk and Stability in Financial Networks, my co-authors (Asuman Ozdaglar of MIT and Alireza Tahbaz-Salehi of Columbia Business School) and I provide a tractable theoretical framework for the study of the economic forces shaping the relationship between the structure of the financial network and systemic risk. We show that as long as the magnitude (or the number) of negative shocks is below a critical threshold, a more equal distribution of interbank obligations leads to less fragility. In particular, all else equal, the sparsely connected ring financial network (corresponding to a credit chain) is the most fragile of all configurations, whereas the highly interconnected complete financial network is the configuration least prone to contagion. In line with the observations made by Allen and Gale (2000), our results establish that, in the more complete networks, the losses of a distressed bank are passed to a larger number of counterparties, guaranteeing a more efficient use of the excess liquidity in the system in forestalling defaults.

…continue reading: Systemic Risk and Stability in Financial Networks

The Division of Risk, Strategy and Financial Innovation, or “RSFI”, was formed, in part, to integrate rigorous data analytics into the core mission of the SEC. Often referred to as the SEC’s “think tank,” RSFI consists of highly trained staff from a variety of backgrounds with a deep knowledge of the financial industry and markets. We are involved in a wide variety of projects across all Divisions and Offices within the SEC and I believe we approach regulatory issues with a uniquely broad perspective.

Because my Division has a slightly cumbersome name – which is why you might hear us colloquially called “RiskFin” (though I prefer the more inclusive and accurate “RSFI,” as you can see) – today in my remarks I thought I’d focus on one word in our magisterial title: “Risk.” Risk, particularly as relates to the financial markets, can be a capacious term, and my Division certainly touches on many of those various meanings. But we are particularly focused on developing cutting-edge ways to integrate data analysis into risk monitoring.

…continue reading: Risk Modeling at the SEC: The Accounting Quality Model

The definition of “material adverse change” plays a critical role in public company merger agreements, effectively defining the situations in which a buyer may walk away from the transaction. There is significant case law defining what is (or, much more commonly, what is not) a material adverse change, but the case law only serves to interpret the agreed definitions. The agreed definitions, in turn, are typically very vague in defining what is a material adverse change (leaving lots of scope for judges), but explicit in listing the types of changes that may not be considered in evaluating whether a material adverse change has occurred. The use of these carve-outs to limit what may be considered a material adverse change has expanded significantly in recent years — arguably to a point where it may make sense for the pendulum to start to swing back.

It has been traditional for adverse effects attributable to changes in general economic conditions to be excluded in considering whether a material adverse effect has occurred, such that e.g., a loss of sales attributable to the great recession, no matter how severe, would not give buyer the right to terminate a merger agreement. This carve-out from the material adverse change definition can be grouped with others, such as carve-outs for downturns in the target industry, changes in law or accounting policies, acts of war, etc. — all of which shift to buyer the risks associated with the environment in which the target operates. What is notable is that over the last several years, not only has the percentage of deals that shift these “environmental” risks to buyer increased significantly, but MAC carve-outs that shift to buyer the risk of the deal, and (anecdotally at least) even the risk of running the business, have also increased markedly.

…continue reading: Runaway MAC Carve-outs

In our paper, Accounting and Litigation Risk: Evidence from Directors’ & Officers’ Insurance Pricing, forthcoming in the Review of Accounting Studies, we study whether and how financial reporting concerns and traditional measures of corporate governance are priced by insurers that sell Directors’ and Officers’ (D&O) insurance to public firms. As D&O insurers typically assume the liabilities arising from shareholder litigation, the insurance premiums they charge for D&O coverage reflect their assessment of a company’s litigation risk.

Estimation of ex-ante litigation risk has always been a challenge for empirical research. Past studies employ ex-post lawsuits to derive an ex-ante measure of litigation risk. In such studies, a litigation risk prediction model is first estimated with the dependent variable being whether the firm got sued ex-post. The predicted values of the probability of getting sued are then used as ex-ante measures of litigation risk in an empirical model. Such measures ignore lawsuits filed in other jurisdictions and also cannot distinguish between frivolous and serious lawsuits. We employ a market-based measure of ex-ante litigation risk; that is, the D&O liability insurance premium, which incorporates the ex-ante expectation of both the likelihood of lawsuits and the magnitude of damages. In the U.S., public firms routinely purchase D&O insurance coverage for their directors and officers for reimbursement of defense costs and settlements arising from shareholder litigation. Most shareholder litigation is settled within policy limits, with the D&O insurers primarily footing the bill. Therefore, we expect the D&O insurers to price financial reporting risk and corporate governance risk efficiently in order to compensate for their expected payout obligations in the case of lawsuits.

…continue reading: Accounting and Litigation Risk

Executive Summary

At most U.S. firms, ownership is dispersedly-­held and voting power is proportionate to capital at risk. At a minority of firms, however, a significant amount of the vote is controlled by one party through a sizeable ownership stake or, alternately, through a multiclass capital structure created specifically to allow voting power to be disproportionate to capital commitment. These controlling parties often include company founders and/or insiders whose interests may or may not conflict with those of unaffiliated shareholders.

The issue of control has received much attention since the initial public offerings of LinkedIn Corp., Zynga Inc., Groupon Inc., and Facebook Inc. While these firms were taken public amid great fanfare and high expectations, the results have been mixed. As of Aug. 31, 2012, the market price of LinkedIn Corp. had risen over 138 percent from its Sept. 16, 2011, initial public offering but Zynga Inc., Groupon Inc., and Facebook Inc. had fallen 72.0 percent, 79.3 percent, and 52.5 percent, respectively, from their IPO prices. A common feature of these firms is a capital structure that allows founders to control a majority of the voting stock while holding a comparatively small portion of their firm’s economic value.

Supporters of these structures claim that control of a firm’s voting power enables management to govern with minimal outside interference and focus on long-term business growth, ultimately delivering shareholders higher returns in exchange for control rights. Detractors, however, claim that control mechanisms misalign interest between affiliated and external shareholders and allow insiders to operate without the normal accountability mechanisms. This study attempts to contribute to that debate by examining the prevalence, characteristics, and relative performance of controlled companies listed on exchanges in the United States.

Key findings of the study include:

…continue reading: Controlled Companies in the S&P 1500: Performance and Risk Review

In our forthcoming American Economic Review paper, Innovation and Institutional Ownership, we examine the incentives to innovate at the firm level by studying the relationship between innovation and institutional ownership. Innovation is the main engine of growth. But what determines a firm’s ability to innovate? Innovating requires taking risk and forgoing current returns in the hope of future ones. Furthermore, while any type of financing is plagued by moral hazard and adverse selection, the financing of innovation is probably the most vulnerable to these problems (Arrow, 1962) since the information that needs to be conveyed is hard to communicate to outsiders. This paper is an attempt at analyzing the corporate governance of innovation and more specifically the role of institutional owners in fostering (or hindering) innovation.

While the ability to diversify risk across a large mass of investors makes publicly traded companies the ideal locus for innovation, managerial agency problems might undermine the innovation effort of these companies. In publicly traded companies, the pressure for quarterly results may induce a short-term focus (Porter, 1992). And the increased risk of managerial turnover (Kaplan and Minton, 2008) might dissuade risk-averse senior managers from this activity. Finally, innovation requires effort and “lazy” managers might not exert enough of it. Hence, it is especially important to study the governance of innovation in publicly traded companies, which account for a large share of the private investments in research and development (R&D).

…continue reading: Innovation and Institutional Ownership

The role of executive compensation as a possible cause of the recent financial crisis has attracted significant attention from the public, policy makers, and researchers. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd Frank Act), which was signed into law on July 21, 2010, requires the regulatory agencies to prohibit the incentive-based compensation practices that encourage inappropriate risk-taking activities at financial institutions.

One question that emerged from this attention and the subsequent legislative action is whether there is a relation between executive compensation and excessive risk taking at banks. An extensive body of research examines the relation between risk taking and the inside equity (stock options and firm equity) holdings of the chief executive officer (CEO). In our paper “Inside Debt, Bank Default Risk and Performance during the Crisis,” which was recently made publicly available on SSRN, rather than focus on inside equity, we instead study inside debt (pension benefits and deferred compensation). In particular, we investigate whether the bank holding companies (BHCs) that compensate their CEOs with higher inside debt relative to inside equity, the inside debt ratio, had a lower risk of default and better performance during the most recent financial crisis. Furthermore, we explore whether the inside debt ratio has more power to explain the default risk and the performance in BHCs than the measures based on inside equity.

…continue reading: Inside Debt, Bank Default Risk, and Performance during the Crisis

In my paper, Hedge Funds and Risk-Decoupling — The Empty Voting Problem in the European Union, I address the implications of negative risk-decoupling, otherwise known as empty voting, for corporate governance and corporate finance, and I develop suggestions for a regulatory response. These suggestions are framed for the European context, but the underlying policy considerations may prove useful for other regulators worldwide, including the SEC.

Empty voting is a popular strategy amongst hedge funds and other activist investors. In short, it is the attempt to decouple the economic risk from the share’s ownership position, retaining in particular the voting right without risk. This paper uses three perspectives to analyze the problems created by such negative risk-decoupling: an agency costs approach, an analysis of information costs, and a perspective from corporate finance. It shows how risk-decoupling is a type of market behavior that creates significant costs for market participants, in particular existing shareholders and potential investors. Risk-decoupling strategies create both agency and information costs for investors. Furthermore, they generate challenges for traditional categories of corporate finance, aiming to extract the “best of both worlds”, debt and equity.

…continue reading: Hedge Funds and Risk-Decoupling — The Empty Voting Problem in the EU

Risk allocation provisions (RAPs) are an important part of M&A contracts. In a new research paper, Allocating Risk Through Contract: Evidence from M&A and Policy Implications, I analyze those provisions in the contracts for a representative sample of deals for US targets, and find both wide variation but also clear patterns in when they are used and how they are designed. The patterns I observe reflect multiple economic theories: they show that RAPs are used and designed in light of the information different parties to a deal are likely to have, their incentives during and after the deal, and also transaction costs, especially the costs of enforcing contracts. Despite these patterns, the contracts also show enormous variation in how risk is allocated — and some of this residual variation correlates with the experience of deal lawyers — suggesting that some choices are better than others. Practitioners can benefit from better understanding economic theories, and academics can benefit from better understanding how varied and complex real-world contracts are.

Among the basic patterns I find are the following:

…continue reading: Allocating Risk Through Contract: Evidence from M&A and Policy Implications