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Corporate governance, incentive compensation and the uncorporation

Posted by Larry Ribstein on April 7, 2011

Acharya, Gabarro and Volpin’s Competition for Managers, Corporate Governance and Incentive Compensation has interesting insights and data on both corporate governance and executive compensation debates.  In the final analysis, I think it’s most interesting for what it says about the uncorporation.  Here’s the abstract: 

We propose a model in which firms use corporate governance as part of an optimal compensation scheme: better governance incentivizes managers to perform better and thus saves on the cost of providing pay for performance. However, when managerial talent is scarce, firms compete to attract better managers. This reduces an individual firm’s incentives to invest in corporate governance because managerial rents are determined by the manager’s reservation value when employed elsewhere and thus by other firms’ governance. In equilibrium, better managers end up at firms with weaker governance, and conversely, better-governed firms have lower-quality managers. Consistent with these implications, we show empirically that a firm’s executive compensation is not chosen in isolation but also depends on other firms’ governance and that better managers are matched to firms with weaker corporate governance.

Some particularly interesting points in the paper:

  • Pay-for-performance compensation is greater in firms with weaker governance, thus indicating that these are substitutes.  Another reminder of the dangers of putting on blinders when evaluating and regulating corporate governance.
  • Executive compensation depends not just on a firm’s own governance, but on the governance of the firm’s competitors of comparable size.
  • Managerial quality also depends on firm governance. When a firm gets a better CEO, the quality of its governance decreases, and vice versa,

This paper shows that corporate governance and executive compensation are much more complicated not only than regulators’ simplistic assumptions, but even than some leading theories, such as Gabaix & Landier on the effect of firm capitalization (Why Has CEO Pay Increased So Much?, 123 QJE 49 (2008)) and Hermalin & Weisbach on CEO power (Endogenously Chosen Boards of Directors and Their Monitoring of the CEO, 88 American Economic Review 96 (1998)).  The authors note that the offsetting effects of governance and managerial quality “may explain why it has proven so hard so far to find direct evidence that corporate governance increases firm performance.”

Of particular interest for my work is this final observation in the paper:

A notable exception is the link between governance and performance found in firms owned by private equity: Private equity ownership features strong corporate governance, high pay-for-performance but also significant CEO co-investment, and superior operating performance. Since private equity funds hold concentrated stakes in firms they own and manage, they internalize better (compared, for example, to dispersed shareholders) the benefits of investing in costly governance. Our model and empirical results can be viewed as providing an explanation for why there exist governance inefficiencies in firms with dispersed shareholders that concentrated private equity investors can “arbitrage” through their investments in active governance.

This is another testament to the governance implications of the uncorporation.  For explanations of these implications, see my Rise of the Uncorporation, Chapter 8, and Partnership Governance of Large Firms.

Posted in corporate governance, executive compensation, private equity, uncorporations | 2 Comments »

The counterproductive effects of SOX and Dodd-Frank

Posted by Larry Ribstein on March 22, 2011

Much significant regulation has been inflicted on the financial markets over the last decade with little regard for evidence of whether the regulation is likely to accomplish its intended purpose.  A couple of recent studies on SOX and Dodd-Frank suggest that at least some of this regulation has made things worse.

Kim and Lu, Unintended Consequences of the Independent Board Requirement on Executive Suites investigates the effect of SOX independent director requirements.  They find that the executives react to the regulation by filling executive suites with their friends, with worse results for their firms. According to the abstract:

Following enactment [of SOX], affected firms fill their executive suites with significantly higher abnormal fractions of top-executives appointed (AFTA) during the current CEO’s tenure, replacing predecessors’ appointees. * * * [T]he newly appointed executives are more connected to their CEOs through past employment. * * * Higher AFTA is associated with lower firm valuation and less profitable acquisition bids. Moreover, the regulation’s overall effect on shareholder value is negative and significant, implying that the benefits of more independent directors are overwhelmed by harmful effects of the unintended consequences.

The good news is that markets to some extent ride to the rescue:

Importantly, affected firms facing strong product market competition do not increase AFTA. Strong external pressure for good governance from the product market seems to preclude the unintended consequence, demonstrating the merits of market-based solutions for better governance.

This suggests that the market would have done a better job on governance if the regulators had simply left them alone, at least in terms of independent director regulation. 

The authors explain why, in theory, we should expect exactly what occurred:

Board independence is but one of many facets of a firm’s governance structure. When regulation imposes a quota on one area of governance, it may have spillover effects on other less regulated areas of governance. The purpose of this paper is to identify spillover effects of the independent board requirement and ask: What are the effects of the regulation on shareholder value and what circumstances allow the spillover effects to take place?* * *

We explain these results with the Hermalin and Weisbach (1998) model, which shows in the absence of regulation, board independence is endogenously determined by a bargaining process between CEOs and boards, leading to an outcome where CEOs with greater bargaining power (due to their perceived superior managerial talent) have less independent boards. The quota on the percentage of independent directors nullifies the bargaining outcome for firms without independent boards, reducing their CEO influence over the board below what they bargained for. To recoup the loss of influence, these CEOs may attempt to increase their influence in their executive suites by replacing top-executives appointed by their predecessors with more of their own men–“circling the wagons” against more independent directors by assembling a more closely aligned and loyal team of top-executives. CEOs affected by the regulation will be more effective in making these personnel decisions and meet less resistance from the board because of their relatively strong bargaining positions, which according to the Hermalin and Weisbach model, is witnessed by the greater proportion of dependent directors prior to the regulation.

Martin, Trends in Financial Reporting: Shareholder Rights as a Poor Solution to Financial Reporting Abuses, studies the effect of shareholder rights provisions of Dodd-Frank. According to the abstract, it finds  

a general positive relation between stronger shareholder rights and accruals-based earnings management. Even when coupled with other reforms such as the Sarbanes-Oxley Act of 2002, this general positive relation may persist. These results provide evidence consistent with the inability of stronger shareholder rights to reduce earnings manipulation and actually provide evidence to the contrary. For those who propose shareholder rights as a solution to reduce irregularities in financial reporting, this paper should at a minimum cause pause and hopefully redirect regulatory and legislative efforts to more effective tools.

Martin theorizes that where shareholders are stronger managers have stronger incentives to manipulate earnings to keep them happy.

From the conclusion:

At a minimum, this paper provides additional evidence that manager discretion in financial reporting is complex, with many confounding incentives simultaneously in operation, with some in competition with one another. Therefore it is important for researchers to continue to explore better ways to identify and empirically document the factors that affect financial reporting decisions.

The lesson from both these papers is that corporate governance is a more complex mechanisms than the regulators thought. 

Of course even more conscientious regulators than the ones who enacted SOX and Dodd-Frank in a regulatory panic (see Romano on SOX) can’t predict all the potential effects of their laws.  That’s why they need to be more modest and recognize the need for regulatory competition (like the state competition that used to prevail in corporate governance) or at least sunset and opt-out provisions for federal regulation.  See Butler and Ribstein and Ribstein.

Posted in corporate governance, financial regulation | 2 Comments »

Unconscionability for corporate law

Posted by Larry Ribstein on February 17, 2011

So you thought unconscionability was for furniture stores?  Larry Cunningham has news for you:

This Article explains why and how traditional contract law’s theory of unconscionability should be used to create a modicum of judicial scrutiny to strike obnoxious pay contracts and preserve legitimate ones. Under this proposal, pay contracts that are the product of managerial domination of the process and formed on terms massively favoring the executive will be stricken. This will follow direct shareholder lawsuits in state courts where the contract is made or performed and applying that state’s contract law. This new legal theory circumvents today’s dead-end route, where pay contracts are always upheld in derivative shareholder lawsuits applying corporate law that sets no meaningful limits on executive pay. This proposal creates new but modest pressure from sister states on Delaware to take greater responsibility for the effects its production of corporate law has nationally.

For those outraged by lopsided corporate executive compensation, this Article offers an appealing new legal theory of contractual unconscionability to police them. Those who see no or few problems with contemporary pay arrangements, or who are outraged by federal regulatory schemes like the Dodd-Frank Act, will welcome how this proposal is narrowly tailored using common law to address the most obnoxious cases.

The article, among other things, would take the executive pay issue out of the internal affairs doctrine and put it into the morass of general choice of law rules for contracts (footnotes omitted):

[B]ecause they are not matters of internal affairs, they would be governed by the law of the state having the greatest interest.  Managers could name Delaware as the choice of law by contract and maintain Delaware’s quasi-monopoly that insulates the devices from judicial scrutiny. Yet contractual choice-of-law clauses are but one factor relevant to determining what law governs a contract.

To be sure, says Cunningham,

investors may recoil at the prospect of gadfly fellow shareholders challenging corporate pay contracts.

But he sees this as

a way to restore a modicum of external pressure on the State of Delaware, the leading promulgator of corporate law for national use. * * * [T]he practical reality is that the competition has ended, and Delaware faces no such pressure today.

There is, of course, a substantial literature questioning the Bebchuk-Fried-Walker conclusion on which this proposal is based that executive pay is out of whack.  And another substantial literature on whether or not the market for corporate law is out of whack.  But let’s put those questions aside and play along with the premises of the proposal.  Consider the consequences: 

  • Under this proposal, an executive, having negotiated her pay with a corporate board, would have no way of knowing whether, at some point, the pay might be challenged under standards to be named later in some state (her residence state, the corporation’s main place of doing business, somewhere else?) at the instigation of a lawyer seeking to extort a payment from the company. 
  • Executives would retain whatever power they supposedly had over the corporation in negotiating their contract to negotiate protection from or payment for this litigation risk.  Shareholders, of course, would pay.
  • Firms would surely find some way to deal with this new rule.  Would the result be better than the system we have now of entrusting the decision to directors?

I guess you could say I’m not convinced. I prefer to take this article as an interesting thought-experiment on why regulation of corporate pay is misguided.

Posted in contracts, corporate governance, executive compensation, Jurisdictional competition | 4 Comments »

More on the First Amendment and proxy access

Posted by Larry Ribstein on January 21, 2011

The ramifications of the Supreme Court’s decision in Citizens United promise to play out for quite awhile, particularly including its effect on corporate governance. For example, will corporate decision-making that produces corporate speech be exempt from the First Amendment?  And how does the First Amendment apply to securities law limitations on what corporations can say to their shareholders and the markets?   I discuss these issues in my recently posted The First Amendment and Corporate Governance.

An important battleground for these issues is the challenge by the Chamber of Commerce and the Business Roundtable of the SEC’s Rule 14a-11, which forces corporations to give certain large shareholders access to the corporate proxy materials for purpose of nominating directors.  I discussed the COC/BRT brief a few weeks ago. Now we have the SEC brief.

The SEC argues that the rule survives a First Amendment challenge because it affects only the firm’s “internal communications,” and that strict First Amendment scrutiny does not apply because this is securities disclosure regulation and commercial speech.

My paper linked above suggests, among other things, that Citizens United may have obliterated the commercial speech doctrine.  For what it’s worth, I’m skeptical that 14a-11 would even meet the lower scrutiny standard for commercial speech. 

In general, my article discusses two possible theories the Court might apply.  Some would argue that the Court will permit government to protect the expressive rights of shareholders from abuse by corporate agents and majority shareholders.  For reasons discussed at length in the article, I think that’s unlikely. It think it’s more likely the Court will stress listeners’ rights to hear what corporations have to say. Here’s an excerpt from the article relating to the 14a-11 issue[footnotes omitted]:

An important pre-Citizens United case on corporate governance speech is Pacific Gas & Electric Co. v. Public Utilities Commission, where the Court struck down under the First Amendment a law compelling speech by a corporation in the form of mandatory inserts in its power bills. Justice Stevens, the Citizens United dissenter, also dissented in PGE, comparing the regulation at issue to the SEC’s shareholder proposal rule, which also requires corporations to distribute statements to its shareholders in connection with corporate elections.  The majority rejected the analogy because the shareholder proposal rule does “not limit the range of information that the corporation may contribute to the public debate” and because proxy regulation governs managers’ use of corporate property. 

The PGE distinction makes some sense in terms of Citizens United’s shareholder expression rationale.  Under that reasoning it is arguably acceptable to regulate speech within the corporation in order to protect shareholders’ control of corporate resources.  This would seem to be an even more important consideration post-Citizens United, given corporations’ new freedom to spend their resources on political speech.  On the other hand, PGE‘s fine distinction between proxy and other types of corporate speech would not square with Citizens United‘s broad listener-based rationale.  Thus, corporate governance, and specifically proxy regulation, may be a significant battleground for Citizens United’s shareholder protection rationale for regulating corporate speech.

This reasoning is particularly relevant to the SEC’s new Rule 14a-11 providing that large, long-term shareholders (i.e., those who have held a three percent interest for three years) may use the corporation’s proxy materials to nominate directors. It has been argued that the PGE distinction between billing inserts and shareholder proposals would not apply to this rule because it affects the speech of shareholders such as hedge funds and not just corporate officials.[citing the COC/BRT brief].

The shareholder expression argument seems to support PGE’s internal-external speech distinction.  In order to ensure that corporate speech reflects shareholders’ views — that is, to protect against internal distortion — the First Amendment arguably authorizes not only direct regulation of authorization of corporate speech, such as via the proposed Shareholder Protection Act, but regulation of corporate governance processes that might affect control over corporate speech, such as Rule 14a-11. 

On the other hand, the analysis comes out differently under Citizens United’s listeners’ right rationale.  As corporate activities are more regulated and therefore seek to play an increasing role in public discourse, their internal governance debates increasingly relate to political debates occurring outside the corporation.  This suggests a direct conflict between the shareholder protection rationale, which seeks to regulate internal governance because of its effect on public debate, and the special need for First Amendment protection of speech related to that debate. 

A further quandary in applying the shareholder protection rationale of regulating corporate speech concerns the question of which shareholders.  This is raised directly by Rule 14a-11, which as noted above favors certain large long-term shareholders.  Larger shareholders may favor rent-seeking actions that inflict deadweight losses on shareholders by seeking to transfer wealth among the firms in their broadly diversified portfolios. On the other hand, smaller, diversified shareholders, who own substantial amounts of large corporations’ shares, would favor actions that benefit their whole portfolios and not costly wealth transfers between individual firms in those portfolios. 

Citizens United’s listeners’ rights rationale raises additional questions concerning the constitutionality of other securities law provisions constraining truthful speech, particularly including prohibition of speech in unregistered public offerings under the Securities Act of 1933 and Regulation FD which penalizes selective disclosure of material information to securities analysts. These examples suggest that securities regulation may come under broad constitutional scrutiny following Citizens United.

The bottom line, as the ACLU’s Joel Gora said today in a WSJ op-ed celebrating the first anniversary of CU, comes down to this:  “Either the politicians and the government get to decide how much political speech there will be and what form it will take, or the people and the groups they organize get to make that call. But hasn’t the First Amendment already made that choice?” Yes.

Here’s  an earlier post on the constitutionality of Regulation FD. With respect to 1933 Act disclosures, see my post on the Bulldog Investors case. And for a general analysis of all these issues, see my article with Butler, Corporate Governance Speech and the First Amendment, 43 U. Kan. L. Rev. 163 (1994).

Posted in corporate governance, First amendment, securities regulation | 2 Comments »

Agents Prosecuting Agents

Posted by Larry Ribstein on January 12, 2011

I’ve been blogging over the years quite a bit about a problem I call “criminalizing agency costs,” which is a piece of the general problem of over-criminalization.  In fact, this problem was a big reason for my getting started in blogging almost seven years ago.

As I mentioned a couple of months ago, I presented a paper on this at George Mason’s “Over-criminalization 2.0″ conference. Now the paper’s on SSRN:  Agents Prosecuting Agents. Here’s the abstract:

Significant questions have been raised concerning the efficiency of criminalizing agency costs and the problems of excessive prosecution of crimes committed by corporate agents. This paper provides a new perspective on these questions by analyzing them from the perspective of agency cost theory. It shows that there are close analogies between the agency costs associated with prosecutors in corporate crime cases and those of the agents being prosecuted. The important difference between the two contexts is that prosecutors are not subject to many of the standard mechanisms for dealing with corporate agency costs. An implication of this analysis is that society must decide if prosecuting corporate agents is worth incurring the agency costs of prosecutors.

It’s a simple concept:  If agency costs are a big enough deal to criminalize, we should worry about the agency costs on the prosecutors’ side as well.

Read it while it’s hot.

Posted in corporate crime, corporate governance | 4 Comments »

The First Amendment and Corporate Governance

Posted by Larry Ribstein on January 12, 2011

I have spent some time over the last year discussing the Supreme Court’s big corporate speech case, Citizens United – at Stanford and Georgia State, and in an archive full of Ideoblog posts.

Now my paper on the case, The First Amendment and Corporate Governance, is finally available on SSRN.  Here’s the abstract:

The Supreme Court’s decision in Citizens United did not end the controversy over regulating corporate speech. Although the Court broadly subjected regulation of corporate speech to the First Amendment, it did not wholly preclude regulation of corporate governance processes that produce corporate speech. The Court’s opinion therefore shifted debate concerning corporate speech from corporations’ “external” distortion of the political process to their “internal” distortion of shareholders’ self-expression. This paper shows that regulation of the corporate governance process that produces speech faces significant obstacles under the First Amendment. These include the limited efficacy of regulation of corporate governance, regulation’s potential for protecting the expressive rights of some shareholders by suppressing others, and the uncertain implications of this rationale for types of speech other than that involved in Citizens United. These problems with the corporate governance rationale for regulating corporate speech suggest that protection of shareholders’ expressive rights may be trumped by society’s interest in hearing corporate speech and the First Amendment’s central goal of preventing government censorship.

As you can see from the abstract, I have moved on from debating whether the case is rightly decided to thinking about what will happen in the post-Citizens United era, particularly regarding corporate governance regulation and commercial speech. 

I think my paper is an important addition to the discussion of Citizens United.  It struck me at the AALS Business Associations/Con Law session on Citizens United last week that a lot of law professors do not seem to have fully internalized the fact that the Supreme Court has decided to protect corporate speech.  And the law professors who are thinking about the corporate governance implications of Citizens United haven’t fully internalized the fact that the First Amendment applies to this issue.  Thus, Bebchuk & Jackson’s recent paper devotes just a few paragraphs to the constitutionality of their proposals.

So if you want the lowdown on how the constitution now applies to corporate governance, read my paper.

Posted in constitutional law, corporate governance, corporate speech | 1 Comment »

Abercrombie goes to Ohio

Posted by Larry Ribstein on December 28, 2010

Steve Davidoff has the story, and it’s an interesting exercise in corporate contracting complicated by jurisdictional choice.

Abercrombie’s proposed reincorporation is essentially a takeover defense.  Unlike Delaware, Abercrombie’s current state of incorporation, Ohio  

  • Has a business combination statute that’s triggered by a 10% acquisition rather than 15% as in Delaware.
  • Has a control share acquisition statute requiring shareholder approval of an acquisition of shares that would put the acquirer over the statutory level of control.
  • Would disenfranchise shareholders (i.e., arbs) who acquire a more than .5% block after an acquisition proposal.
  • Does not have a “Revlon rule” subjecting director decisions to sell the company to a higher scrutiny level.
  • Is Abercrombie’s home state, and therefore a friendly forum in a takeover battle.

This situation illustrates how jurisdictional choice makes contractual what would otherwise seem to be mandatory takeover rules.

Is it a problem that Abercrombie is changing the original statutory “bargain” based on Delaware incorporation its shareholders may have relied on?  Steve notes that Abercrombie proposed the reincorporation after the announcement of buyouts for competitors J. Crew and Jo-Ann Stores which may have put Abercrombie in play. 

It would be interesting to do an event study on Abercrombie shares. I wonder if they (1) took a hit from reducing the probability of a bid; (2) got a boost because any takeover will be after an auction and possibly at a higher price; (3) got a boost because the move communicates information about the likelihood of a bid; (4) didn’t move because a reincorporation was already priced in; or (5) didn’t move because the shareholders still  have to vote on the reincorporation, and proxy advisors may weigh in against it.

Finally, was there adequate disclosure to shareholders about the reason for and implications of the move?  Does it matter if there were enough sophisticated or well-advised institutional shareholders to help ensure an informed vote?

The bottom line is that the Law Market is a significant part of the transactional environment.

Posted in corporate governance, Jurisdictional competition, takeovers | Comments Off

The securities laws and the First Amendment

Posted by Larry Ribstein on December 28, 2010

Attorney John Olson has posted a discussion and copy of a brief for the Chamber of Commerce and the Business Roundtable challenging the SEC’s recent proxy access rule, Rule 14a-11.  That’s the rule that requires corporations to include in their proxy materials candidates for director election nominated by 3%/3-year shareholders.  (Here’s my discussion of some issues regarding the rule).

The brief claims the rule is ill-considered.  One argument particularly caught my attention:

By forcing public companies to carry campaign speech of certain activist investors, the Commission violated the First Amendment.

The brief relies primarily on Pac. Gas & Elec. Co. v. Pub. Util. Comm’n, 475 U.S. 1 (1986) which, as the brief notes

invalidated a state regulatory order that required a utility to carry the message of a third party in its customer billing envelope. 475 U.S. at 13 (plurality opinion). The third-party “[a]ccess” to the billing envelope was “limited to persons or groups . . . who disagree[d] with [the utility’s] views . . . and who oppose[d] [the utility] in” certain proceedings before the agency. Id. Applying strict scrutiny, the plurality concluded that the agency’s access requirement impermissibly burdened the utility’s “right to be free from government restrictions that abridge its own rights in order to ‘enhance the relative voice’ of its opponents.” Id. at 14.

The brief says the lower standard of scrutiny applicable to commercial speech (Cent. Hudson Gas & Elec. Corp. v. Public Serv. Comm’n of New York, 447 U.S. 557, 564 (1980)) is inappropriate in this case

because a company’s proxy materials do not merely “propose a commercial transaction,” id. at 409, and Rule 14a-11 would fail for the reasons stated here even under the “commercial speech” standard.

The brief argues that the proxy access rules fail the compelling interest standard.  They restrict free speech by forcing force firms to fund opposition candidates and to respond to the opposition. They reject less restrictive ways to achieve the government’s purpose, including relying solely on the amendment to Rule 14a-8(i)(8) and deferring to state law.  

PGE attempted to distinguish the billing insert in that case from the SEC’s shareholder proposal rules on the grounds that management lacked interest in corporate property, the shareholder proposal rule involves “speech by a corporation to itself,” and the rule “do[es] not limit the range of information that the corporation may contribute to the public debate.” The brief argues those distinctions don’t apply to 14a-11 because that rule gives rights to individual institutional shareholders and may operate to trump opposition even by a majority of the shareholders.

I’m not sure I agree with the brief’s attempted distinction of PGE.  In any event, there’s a more direct route to the First Amendment not discussed in the brief:  Citizens United. The majority opinion in that case noted that “[t]he First Amendment protects speech and speaker, and the ideas that flow from each” and that “[t]he First Amendment does not permit Congress to make these categorical distinctions based on the corporate identity of the speaker and the content of the political speech.” The opinion’s breadth suggests the CU majority would be impatient with details like whether the corporation was talking to itself and whether the managers own corporate property.

By the way, the PGE plurality opinion made its attempted distinction between billing inserts and shareholder proposals in response to the dissent’s argument claiming that they were comparable and both valid.  The dissent in that case, as in Citizen’s United, was written by Justice Stevens.

I noted shortly after Citizens United, discussing an SEC interpretive guidance on global warming disclosures, that

One possible implication of Citizens United is that corporations will finally be able to challenge excessive restrictions not only on their clearly political speech, but also on speech like that covered by the SEC release. For a review of the issues here, see my article with Butler, Corporate Governance Speech and the First Amendment, 43 U. Kans. L. Rev. 163 (1994).

The article just cited seems less fanciful today than it did 16 years ago.

The commercial speech rule discussed in the Olson brief is also in play.  Distinguishing ideas under the First Amendment based on whether or not they are commercial never made much sense.  It makes even less sense now that the Court has decided to protect the speech of for-profit corporations.  As the Citizens United dissent noted, even the “political” speech of such firms is essentially transactional, which would  make it “commercial,” but nevertheless protected.

Even if the Court retains some distinction between commercial and other speech, it may reject a distinction for corporate governance speech, particularly in the wake of Citizens United. After all, if corporations are to be full-fledged participants in political debates, their internal discussions concerning participation in these debates also should be protected.

In short, the ramifications of Citizens United may be even broader than were initially supposed.  Speech about capitalism finally may get the same protection as, say, pornography.  And one of the first casualties of this approach may be ill-considered and unnecessary SEC restrictions on truthful speech.

Posted in constitutional law, corporate governance, First amendment, securities regulation | 4 Comments »

Lynn Stout on “criminogenic” hedge funds and insider trading

Posted by Geoffrey Manne on December 17, 2010

Lynn Stout, writing in the Harvard Business Review’s blog, claims that hedge funds are uniquely “criminogenic” environments.  (Not surprisingly, Frank Pasquale seems reflexively to approve):

My research, shows that people’s circumstances affect whether they are likely to act prosocially. And some hedge funds provided the circumstances for encouraging an antisocial behavior like not obeying the laws against insider trading, according to these investigations.

* * *

Recognizing that some hedge funds present social environments that encourage unethical behavior allows us to identify new and better ways to address the perennial problem of insider trading. For example, because traders listen to instructions from their managers and investors, insider trading would be less of a problem if those managers and investors could be given greater incentive to urge their own traders to comply with the law, perhaps by holding the managers and investors — not just the individual traders — accountable for insider trading. Similarly, because traders mimic the behavior of other traders, devoting the enforcement resources necessary to discover and remove any “bad apples” before they spoil the rest of the barrel is essential; if the current round of investigations leads to convictions, it is likely to have a substantial impact on trader behavior, at least for a while. Finally, insider trading will be easier to deter if we combat the common but mistaken perception that it is a “victimless” crime.

Rather than re-post the whole article, I’ll direct you there to see why she thinks hedge funds are so uniquely anti-social.  Then I urge you to ask yourself whether she has actually demonstrated anything of the sort.  Really what she demonstrates, if anything, is that agency costs exist.  Oh, and people learn from their peers.  Remarkable!  And this is different than . . . the rest of the world, how?  There are Jewish people in the world, a lot of them work on Wall Street, and many of them attend synagogue.  No doubt Jews mimic the behavior of other Jews.  Bernie Madoff was Jewish.  The SEC should be raiding temples all across New York, New Jersey and Connecticut!

The point is that she has no point, and directing her pointless observations toward hedge funds in particular is just silly (and/or politically expedient).  There are bad apples everywhere.  There are agency costs everywhere.  A police state could probably reduce the consequences of these problems (but don’t forget corruption (i.e., bad apples) in the government!).  The question is whether it’s worth it, and that requires a far more subtle analysis than Stout provides here.

And all of this is because insider trading really needs to be eradicated, according to Stout:

Of course, insider trading isn’t really victimless: for every trader who reaps a gain using insider information, some investor on the other side of the trade must lose. But because the losing investor is distant and anonymous, it’s easy to mistakenly feel that insider trading isn’t really doing harm.

Actually, the reason most people feel that insider trading isn’t really doing harm is because it isn’t.

I’ll leave the synopsis of the argument to Steve Bainbridge.  On the adverse selection argument, see Stanislav Dolgopolov.  Sure, there is debate.  Empirics are hard to come by.  But the weight of the evidence and theory, especially accounting for enforcement costs (one study even seems to suggest that making insider trading illegal actually induces more insider trading to occur (and impedes M&A activity)), is decidedly against Stout’s naked assertion.  The follow on claim that, in essence, agency costs justify stepped up dawn raids at hedge funds is even more baseless.

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Posted in 10b-5, business, corporate crime, corporate governance, corporate law, disclosure regulation, financial regulation, hedge funds, insider trading, mergers & acquisitions, securities regulation | Tagged: , , , , , , , , , , | Comments Off

The obscure efficiency of empty voting

Posted by Larry Ribstein on December 17, 2010

A few years ago a new scandal emerged on the corporate scene, prompted by Hu & Black’s work on so-called “empty voting.” The supposed problem is that a hedge fund can separate voting and economic rights by borrowing, hedging or short-term trading.  The trader can vote shares in a company in which he owns a short position, and so is seemingly at odds with the other shareholders.

In the classic case, hedge fund operator Richard Perry owned stakes in both Mylan and King that were engaged in a takeover contest. Perry’s King shares would increase if Mylan bought it. He had prevented a corresponding loss in his Mylan position by arranging to transfer those shares at his purchase price. So Perry could vote Mylan for the King transaction, win in King and lose nothing in Mylan.

This scenario has sparked calls for regulation.

Now Brav & Mathews, Empty Voting and the Efficiency of Corporate Governance (discussed on the Harvard Blog), show that the situation isn’t the travesty it might appear to be:

We model corporate voting outcomes when an informed trader, such as a hedge fund, can establish separate positions in a firm’s shares and votes (“empty voting”). The positions are separated by borrowing shares on the record date, hedging economic exposure, or trading between record and voting dates. We find that the trader’s presence can improve efficiency overall despite the fact that it sometimes ends up selling to a net short position and then voting to decrease firm value. An efficiency improvement is likely if other shareholders’ votes are not highly correlated with the correct decision or if it is relatively expensive to separate votes from shares on the record date. On the other hand, empty voting will tend to decrease efficiency if it is relatively inexpensive to separate votes from shares and other shareholders are likely to vote the right way.

The hedged voter might be the “correct” one because it has more information than the outside shareholders, and because its position is consistent with that of the typical outside diversified shareholder whose portfolio is on both sides of the transaction.

Bruce Kobayashi and I were onto this several years ago in our article, Outsider Trading as an Incentive Device (discussed here), in which we note that

the Perry gambit was not pernicious, but rather a way to maximize the joint capital of the participating firms without interference from self-interested managers or undiversified shareholders. The gambit is necessary because federal takeover regulation and strong takeover defenses at the state level have reduced the leverage of outside investors like Perry in control transactions. New techniques are necessary to make speculating in control pay off, just as Milken had to perfect the use of junk bonds for a similar purpose twenty years ago. In other words, Perry can be viewed as the new Milken (or Icahn, for that matter). Vote selling and buying can be viewed as a way for the vote seller to share in the benefits from Perry’s information gathering, and for the control rights associated with the votes to flow to the person with the most reliable information and, therefore, the ability to use the rights most profitably.

In other words, the transaction is a form of regulatory arbitrage around inefficient anti-takeover devices.  Which is yet another example of why regulators need to look below the surface of transactions to the deeper financial and regulatory context.

Posted in corporate governance, securities regulation | Comments Off

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