Archive for October, 2010

Anat R. Admati, Peter M. DeMarzo, Martin R. Hellwig, and Paul Pfleiderer, August 2010, Rock Center for Corporate Governance at Stanford University Working Paper No. 86, Stanford Graduate School of Business Research Paper No. 2065.

• Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive (Research Paper)

• For more Related Academic Contributions see here.

Abstract

We examine the pervasive view that “equity is expensive,” which leads to claims that high capital requirements are costly and would affect credit markets adversely. We find that arguments made to support this view are either fallacious, irrelevant, or very weak. For example, the return on equity contains a risk premium that must go down if banks have more equity. It is thus incorrect to assume that the required return on equity remains fixed as capital requirements increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that
subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive. Any desirable public subsidies to banks’ activities should be given directly and not in ways that encourage leverage. Finally, suggestions that high leverage serves a necessary disciplining role are based on inadequate theory lacking empirical support.

We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, taking deposits and issuing money-like securities. To the contrary, better capitalized banks suffer fewer
distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal, and, except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks.

Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy.

Research by

Anat R. Admati
George G.C. Parker Professor of Finance and Economics
Stanford Graduate School of Business

Peter M. DeMarzo
Mizuho Financial Group Professor of Finance
Stanford Graduate School of Business

Martin F. Hellwig
Max Planck Institute for Research on Collective Goods
Department of Economics, University of Bonn

Paul Pfleiderer
C.O.G. Miller Distinguished Professor of Finance
Stanford Graduate School of Business

IRRC Institute and Stanford’s Rock Center Submit Report to SEC That Raises Questions About Fundamental Underpinnings of Corporate Governance

Corporate and Bankruptcy Laws Lag Behind Market Reality With Regard to Shareholder/Creditor Ability to Vote and Exert Influence Despite Having No Economic Interest; Potentially Damaging Implications for Companies and Markets

A report commissioned by the Investor Responsibility Research Center Institute (IRRC) and conducted by the Rock Center for Corporate Governance at Stanford University raises concerns that the financial markets’ ability to divorce economic interests from ownership rights – via derivatives and other means – has outpaced the existing corporate governance and bankruptcy legal framework. The report provides an analysis of the decoupling phenomenon – also known as “empty voting” – that occurs when shareholder voting rights substantially exceed economic interest in a company.

“Concept Release on the U.S. Proxy System”

The report, “Identifying The Legal Contours Of The Separation Of Economic Rights And Voting Rights In Publicly Held Corporations,” was submitted today to the Securities and Exchange Commission (SEC) as part of the agency’s request for comments (“Concept Release on the U.S. Proxy System”) to examine aspects of the proxy system including ways empty voting can occur, its nature, extent, and effects on shareowner voting and the proxy process.

Joseph A. Grundfest, former SEC Commissioner and co-director of Stanford University’s Rock Center for Corporate Governance said, “The study’s findings raise important questions about the very foundations on which corporate governance is based. Modern financial markets make it very easy for sophisticated shareholders to cast important votes in corporate elections even if they have no financial exposure to the company’s stock price performance.” Grundfest added, “It’s a bit like voting in a country’s election even though you are no longer a citizen. Yet, we have no clear idea about how frequently this problem arises or its actual implications for corporate governance.”

“Ironically, we just enacted a massive reform of the financial system. The underlying presumption, however, was that economic and ownership interests are inseparable. We know this is not true,” said Jon Lukomnik, IRRC Institute program director. He added, “We commissioned the report because we are increasingly concerned that the fundamental philosophic basis of corporate governance – that the owners of the company who can determine its fundamental fate are incented to want it to thrive – is eroding. As worrisome, if those who control ownership rights can be incentivized towards value destruction rather than value creation, it is only a matter of time until the real economy is affected due to a large-scale impact on corporations. Our study suggests that the law, unfortunately, has not kept pace with financial market reality.”

The key research findings in the report include:

• The potential for and reality of decoupling transactions that can generate empty or negative voting can present significant challenges to existing shareowner and creditor governance practices.
• Existing disclosure provisions in federal securities law and federal bankruptcy law assume that the economic rights and voting rights associated with share or debt ownership are inseparable. Because these rights may be freely decoupled, existing law fails to provide necessary transparency as to the existence of hedging transactions that can affect the economic rights and voting incentives of shareholders and creditors. This, in turn, can mean that others, including regulators, corporate directors, other shareowners and creditors, are made on a less than informed basis.
• It is unclear that disclosure alone is sufficient to address the problems that can be created by empty and/or negative voting. Policy makers may therefore wish to consider substantive measures that might address the rights of shareowners or creditors to cast votes without regard to their participation in decoupling transactions that can give rise to empty or negative voting.

The report is a comprehensive review that identifies the different manifestations of the decoupling issue in the corporate governance, securities regulation, and bankruptcy arenas. More specifically, it summarizes 19 research studies; analyzes relevant provisions of federal securities law; critiques policy-relevant proposals; discussed the Dodd-Frank Act reporting swap contracts; considers opportunities within SEC’s “Proxy Plumbing;” catalogues implications of decoupling and of empty or negative voting in the context of the federal bankruptcy process; and summarizes several key judicial opinions indicating in growing concerns in litigated transactions.

The full report is available here: Final decoupling report for SEC It also is included in the IRRC sponsored Social Science Research Network Corporate Governance Network at http://www.ssrn.com/cgn/index.html.

About IRRC Institute

The IRRC Institute is a not-for-profit organization headquartered in New York, N.Y. Its mission is to provide thought leadership at the intersection of corporate responsibility and the informational needs of investors. More information is available at www.irrcinstitute.org.

Contacts

IRRC Institute
Kelly Kenneally, 202-256-1445
kelly@irrcinstitute.org
or
For Rock Center:
Judith Romero, 650-723-2232
judith.romero@stanford.edu

How To Tell When A CEO Is Lying (text and audio coverage)
NPR Interview with Professor David F. Larcker and Phd. candidate Anastasia Zakolyukina, 10-18-2010
“I think since the Garden of Eden we’ve been trying to figure this out — who’s lying and who’s not lying,” says David Larcker, a professor of accounting at Stanford’s Graduate School of Business. Opaque Books, Huge Frauds…”

Detecting Deceptive Discussions in Conference Calls
Rock Center Working Paper, July, 2010

Related:

Is That CEO Telling the Truth?
Stanford GSB News, August 2010

How do you tell if CEOs are not being truthful during quarterly earnings conference calls? Stanford Graduate School of Business researchers have developed a model to analyze the words and phrases used during these calls and found some specific speech patterns that give clues.

STANFORD GRADUATE SCHOOL OF BUSINESS—How do you tell if CEOs are not being truthful during quarterly earnings conference calls? Stanford Graduate School of Business researchers have developed a model to analyze the words and phrases used during these calls and found some specific speech patterns that give clues.

After studying Q&A sections of transcripts of hundreds of calls with CEOs and CFOs, the researchers then looked to see whether financial statements being discussed were substantially restated at some point after the call. If they were restated, Professor David Larcker and Anastasia Zakolyukina, a PhD student at the school, reasoned that the executive had been less than candid in describing their firm’s quarterly figures.

Larcker, the James Irvin Miller Professor of Accounting and senior faculty of the Stanford Rock Center for Corporate Governance, and Zakolyukina developed a model to analyze words and phrases used based on prior deception detection research conducted by psychologists and linguists. CEOs who were hiding information were less likely to say “I” and more likely to use impersonal pronouns and references to general knowledge such as “you know.” They also expressed more extreme positive emotions (“fantastic” as opposed to “good”), used fewer extreme negative emotions, and fewer certainty and hesitation words. They were less likely to refer to shareholders value.

Results from their model are 4% to 6% better than a random guess. Yet the authors offered some cautions about their work. “First, we are not completely certain that the CEO and/or CFO know about the manipulation when they answer questions during the conference call,” they wrote. They also cautioned the words they studied might not be “completely appropriate for capturing business communication.” But they said, the results were strong enough to warrant additional research.

Closer Look Series: Topics, Issues and Controversies in Corporate Governance, No. CGRP-11, By David F. Larcker, James Irvin Miller Professor of Accounting, Director of Stanford Graduate School of Business Corporate Governance Research Program And Brian Tayan, MBA ’03, Stanford GSB;, Date: 10-11-2010

• Pledge (and Hedge) Allegiance to the Company (PDF)

Companies include equity in a compensation package to align the interests of management with those of shareholders. It is not uncommon for an executive who has been employed at a company for many years to accumulate a substantial dollar ownership position in the company. With a concentration of wealth in a single financial asset, the executive may want to limit his or her exposure by hedging a portion of the position through financial instruments or pledging shares as collateral for a loan.

While there are many reasons why a board may want to allow an executive to hedge or pledge an equity ownership position, there are also many reasons why this may be a cause for concern. We examine these issues in detail.

Can boards explain why they do or do not allow executive hedging? If an executive has hedged the equity position, why does the board continue to grant new equity and not cash?