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Abstract: We investigate the relative importance of the twenty-four provisions followed by the Investor Responsibility Research Center (IRRC) and included in the Gompers, Ishii, and Metrick governance index (Gompers, Ishii, and Metrick 2003). We put forward an entrenchment index based on six provisions: staggered boards, limits to shareholder bylaw amendments, poison pills, golden parachutes, and supermajority requirements for mergers and charter amendments. We find that increases in the index level are monotonically associated with economically significant reductions in firm valuation as well as large negative abnormal returns during the 1990-2003 period. The other eighteen IRRC provisions not in our entrenchment index were uncorrelated with either reduced firm valuation or negative abnormal returns.
G30, G34, K22
Abstract: We investigate which provisions, among a set of twenty-four governance provisions followed by the Investor Responsibility Research Center (IRRC), are correlated with firm value and stockholder returns. Based on this analysis, we put forward an entrenchment index based on six provisions - four constitutional provisions that prevent a majority of shareholders from having their way (staggered boards, limits to shareholder bylaw amendments, supermajority requirements for mergers, and supermajority requirements for charter amendments), and two takeover readiness provisions that boards put in place to be ready for a hostile takeover (poison pills and golden parachutes). We find that increases in the level of this index are monotonically associated with economically significant reductions in firm valuation, as measured by Tobin's Q. We present suggestive evidence that the entrenching provisions cause lower firm valuation. We also find that firms with higher levels of the entrenchment index were associated with large negative abnormal returns during the 1990-2003 period. Moreover, examining all sub-periods of two or more years within this period, we find that a strategy of buying low entrenchment firms and selling short high entrenchment firms out-performs the market in most such periods and does not under-perform the market even in a single sub-period. Finally, we find that the provisions in our entrenchment index fully drive the correlation, identified by prior work, that the IRRC provisions in the aggregate have with reduced firm value and lower stock returns during the 1990s; we do not find any evidence that the other eighteen IRRC provisions are negatively correlated with either firm value or stock returns during the 1990-2003 period.
Data on the entrenchment index for the period 1990-2007, and a list of over seventy-five studies using our entrenchment index, is available for downloading at Lucian Bebchuk's home page.
Corporate governance, agency costs, boards, directors, takeovers, tender offers, mergers and acquisitions, proxy fights, defensive tactics, entrenchment, anti-takeover provisions, staggered boards, corporate charters, corporate bylaws, golden parachutes, poison pills
Abstract: This paper reconsiders the basic allocation of power between boards and shareholders in publicly traded companies with dispersed ownership. U.S. corporate law has long precluded shareholders from initiating any changes in the company's basic governance arrangements. I show, and support with empirical evidence, that shareholders' existing power to replace directors is insufficient to secure the adoption of value-increasing governance arrangements that management disfavors. I put forward an alternative regime that would allow shareholders to initiate and adopt rules-of-the-game decisions to change the company's charter or state of incorporation. Providing shareholders with such power would improve over time to improve all corporate governance arrangements, largely by inducing management to initiate value-increasing changes and without shareholders' having to exercise their power to intervene.
Furthermore, I argue that, as part of their power to amend governance arrangements, shareholders should be able to adopt provisions that give them additional power to intervene, down the road, in specific business decisions. Power to intervene in game-ending decisions (to merge, sell all assets, or dissolve) could address management's bias in favor of the company's continued existence. Power to intervene in scaling-down decisions (to make cash or in-kind distributions) could address management's tendency to retain excessive funds and engage in empire-building. Shareholders' ability to adopt, when necessary, provisions that give themselves additional power to intervene could thus produce benefits in many companies.
A regime with shareholder power to intervene, I show, would address governance problems that have long troubled legal scholars and financial economists. These benefits would result mainly from inducing management to act in ways that better serve shareholder interests and without shareholders' having to exercise their power to intervene. I also discus how such a regime could best be designed to address concerns that supporters of management insulation could raise; for example, to allay such concerns, shareholder-initiated changes in governance arrangements could be adopted only if they enjoy shareholder support in two consecutive annual meetings.
Finally, examining a wide range of possible objections, I conclude that they do not provide a good basis for opposing the proposed increase in shareholder power.
corporate governance, shareholders, managers, directors, boards, stakeholders, agency costs, mergers, takeovers, acquisitions, proxy contests, corporate charters, charter amendments, state competition, dividends, distributions, free cash-flow, empire-building, myopia, short-termism, corporate reform
Abstract: This paper critiques the proposed emergency legislation for spending $700 billion on purchasing financial firms' troubled assets to address the 2008 financial crisis. It also puts forward a superior alternative for advancing the two goals of the proposed legislation - restoring stability to the financial markets and protecting taxpayers.
I show that the proposed legislation can be redesigned to limit greatly the cost to taxpayers while doing much better in terms of restoring stability to the financial markets. The proposed redesign is based on four interrelated elements:
* No overpaying for troubled assets: The Treasury's authority to purchase troubled assets should be limited to doing so at fair market value.
* Addressing undercapitalization problems directly: Because the purchase of troubled assets at fair market value may leave financial firms severely under-capitalized, the Treasury's authority should be expanded to allow purchasing, again at fair market value, new securities issued by financial institutions in need of additional capital.
* Market-based discipline: to ensure that purchases are made at fair market value, the Treasury should conduct them through multi-buyer competitive processes with appropriate incentives. * Inducing infusion of private capital: to further expand the capital available to the financial sector, and to reduce the use of public funds for this purpose, financial firms should be required or induced to raise capital through right offerings to their existing shareholders.
Compared with the Treasury's proposed legislation, the alternative proposal put forward in this paper would provide a far better way to use taxpayers' funds to address the financial crisis.
The approach of buying troubled assets through privately managed and competing funds put forward in this paper, which was subsequently followed by the Treasury in its March 2009 plan for buying troubled assets, is further developed in "How to Make TARP II Work," a February 2009 discussion paper available at http://ssrn.com/abstract=1341939
The proposal for using competing private funds for buying trouble assets put forward in this paper is further developed in How To Make TARP II Work (Harvard Law & Econ. Discussion Paper No. 626, 2009), available at http://papers.ssrn.com/abstract =1341939, and in “Buying Troubled Assets, Yale Journal on Regulation, 2009, available at http://papers.ssrn.com/abstract =1392808.
Financial crisis, bailout, subprime mortgages, creditor run
Abstract: This Paper provides an overview of the main theoretical elements and empirical underpinnings of a 'managerial power' approach to executive compensation. Under this approach, the design of executive compensation is viewed not only as an instrument for addressing the agency problem between managers and shareholders but also as part of the agency problem itself. Boards of publicly traded companies with dispersed ownership, we argue, cannot be expected to bargain at arm's length with managers. As a result, managers wield substantial influence over their own pay arrangements, and they have an interest in reducing the saliency of the amount of their pay and the extent to which that pay is de-coupled from managers' performance. We show that the managerial power approach can explain many features of the executive compensation landscape, including ones that many researchers have long viewed as puzzling. Among other things, we discuss option plan design, executive loans, retirement benefits, payments to departing executives, the use of compensation consultants, and the observed relationship between CEO power and pay. We also explain how managerial influence might lead to substantially inefficient arrangements that produce weak or even perverse incentives.
M14, corporate governance, managers, shareholders, boards, directors, executive compensation, stock options, principal-agent problem, agency costs, rent extraction, golden parachutes, executive loans, compensation consultants, expensing
Abstract: This paper provides an overview of the main theoretical elements and empirical underpinnings of a 'managerial power' approach to executive compensation. Under this approach, the design of executive compensation is viewed not only as an instrument for addressing the agency problem between managers and shareholders but also as part of the agency problem itself. Boards of publicly traded companies with dispersed ownership, we argue, cannot be expected to bargain at arm's length with managers. As a result, managers wield substantial influence over their own pay arrangements, and they have an interest in reducing the saliency of the amount of their pay and the extent to which that pay is de-coupled from managers' performance. We show that the managerial power approach can explain many features of the executive compensation landscape, including ones that many researchers have long viewed as puzzling. Among other things, we discuss option plan design, stealth compensation, executive loans, payments to departing executives, retirement benefits, the use of compensation consultants, and the observed relationship between CEO power and pay. We also explain how managerial influence might lead to substantially inefficient arrangements that produce weak or even perverse incentives.
Abstract: This paper provides an overview of the main theoretical elements and empirical underpinnings of a managerial power approach to executive compensation. Under this approach, the design of executive compensation is viewed not only as an instrument for addressing the agency problem between managers and shareholders but also as part of the agency problem itself. Boards of publicly traded companies with dispersed ownership, we argue, cannot be expected to bargain at arm's length with managers. As a result, managers wield substantial influence over their own pay arrangements, and they have an interest in reducing the saliency of the amount of their pay and the extent to which that pay is de-coupled from managers' performance. We show that the managerial power approach can explain many features of the executive compensation landscape, including ones that many researchers have long viewed as puzzling. Among other things, we discuss option plan design, stealth compensation, executive loans, payments to departing executives, retirement benefits, the use of compensation consultants, and the observed relationship between CEO power and pay. We also explain how managerial influence might lead to substantially inefficient arrangements that produce weak or even perverse incentives.
Abstract: In a recent book, Pay without Performance: The Unfulfilled Promise of executive Compensation, we critique existing executive pay arrangements and the corporate governance processes producing them, and put forward proposals for improving both executive pay and corporate governance. This paper provides an overview of the main elements of our critique and proposals. We show that, under current legal arrangements, boards cannot be expected to contract at arm's length with the executives whose pay they set. We discuss how managers' influence can explain many features of the executive compensation landscape, including ones that researchers subscribing to the arm's length contracting view have long viewed as puzzling. We also explain how managerial influence can lead to inefficient arrangements that generate weak or even perverse incentives, as well as to arrangements that make the amount and performance-insensitivity of pay less transparent. Finally, we outline our proposals for improving the transparency of executive pay, the connection between pay and performance, and the accountability of corporate boards.
Keywords: Corporate governance, managers, shareholders, boards, directors, executive compensation, stock options, principal-agent problem, agency costs, rent extraction, disclosure, stealth compensation, compensation consultants, camouflage.
Abstract: Corporate structures differ among the advanced economies of the world. We contribute to an understanding of these differences by developing a theory of the path dependence of corporate structure. The corporate structures that an economy has at any point in time depend in part on those that it had at earlier times. Two sources of path dependence--structure driven and rule driven--are identified and analyzed. First, the corporate structures of an economy depend on the structures with which the economy started. Initial ownership structures have such an effect because they affect the identity of the structure that would be efficient for any given company and because they can give some parties both incentives and power to impede changes in them. Second, corporate rules, which affect ownership structures, will themselves depend on the corporate structures with which the economy started. Initial ownership structures can affect both the identity of the rules that would be efficient and the interest group politics that can determine which rules would actually be chosen. Our theory of path dependence sheds light on why the advanced economies, despite pressures to converge, vary in their ownership structures. It also provides a basis for why some important differences might persist.
Abstract: This Paper develops an account of the role and significance of managerial power and rent extraction in executive compensation. Under the optimal contracting approach to executive compensation, which has dominated academic research on the subject, pay arrangements are set by a board of directors that aims to maximize shareholder value. In contrast, the managerial power approach suggests that boards do not operate at arm's length in devising executive compensation arrangements; rather, executives have power to influence their own pay, and they use that power to extract rents. Furthermore, the desire to camouflage rent extraction might lead to the use of inefficient pay arrangements that provide suboptimal incentives and thereby hurt shareholder value. The authors show that the processes that produce compensation arrangements, and the various market forces and constraints that act on these processes, leave managers with considerable power to shape their own pay arrangements. Examining the large body of empirical work on executive compensation, the authors show that managerial power and the desire to camouflage rents can explain significant features of the executive compensation landscape, including ones that have long been viewed as puzzling or problematic from the optimal contracting perspective. The authors conclude that the role managerial power plays in the design of executive compensation is significant and should be taken into account in any examination of executive pay arrangements or of corporate governance generally.
Corporate governance, managers, shareholders, directors, boards, executive compensation, stock options, private benefits of control, principal-agent problem, agency costs, rent extraction, golden parachutes, accounting, FASB rules, disclosure, camouflage
Abstract: This paper develops an account of the role and significance of managerial power and rent extraction in executive compensation. Under the optimal contracting approach to executive compensation, which has dominated academic re-search on the subject, pay arrangements are set by a board of directors that aims to maximize shareholder value. In contrast, the managerial power approach suggests that boards do not operate at arm's length in devising executive compensation arrangements; rather, executives have power to influence their own pay, and they use that power to extract rents. Furthermore, the desire to camouflage rent extraction might lead to the use of inefficient pay arrangements that provide suboptimal incentives and thereby hurt shareholder value. The authors show that the processes that produce compensation arrangements, and the various market forces and constraints that act on these processes, leave managers with considerable power to shape their own pay arrangements. Examining the large body of empirical work on executive compensation, the authors show that managerial power and the desire to camouflage rents can explain significant features of the executive compensation landscape, including ones that have long been viewed as puzzling or problematic from the optimal contracting perspective. The authors conclude that the role managerial power plays in the design of executive compensation is significant and should be taken into account in any examination of executive pay arrangements or of corporate governance generally.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Abstract: This paper develops an account of the role and significance of managerial power and rent extraction in executive compensation. Under the optimal contracting approach to executive compensation, which has dominated academic research on the subject, pay arrangements are set by a board of directors that aims to maximize shareholder value. In contrast, the managerial power approach suggests that boards do not operate at arm's length in devising executive compensation arrangements; rather, executives have power to influence their own pay, and they use that power to extract rents. Furthermore, the desire to camouflage rent extraction might lead to the use of inefficient pay arrangements that provide suboptimal incentives and thereby hurt shareholder value. The authors show that the processes that produce compensation arrangements, and the various market forces and constraints that act on these processes, leave managers with considerable power to shape their own pay arrangements. Examining the large body of empirical work on executive compensation, the authors show that managerial power and the desire to camouflage rents can explain significant features of the executive compensation landscape, including ones that have long been viewed as puzzling or problematic from the optimal contracting perspective. The authors conclude that the role managerial power plays in the design of executive compensation is significant and should be taken into account in any examination of executive pay arrangements or of corporate governance generally.
corporate governance, managers, shareholders, directors, boards, executive compensation, stock options, private benefits of control, principal-agent problem, agency costs, rent extraction, golden parachutes, accounting, FASB rules, disclosure, camouflage, insider trading, indexed options, vesting
Abstract: This paper analyzes how asymmetric information affects which corporate governance arrangements firms choose when they go public. It is shown that such asymmetry might lead firms to adopting - through the design of securities and corporate charters - corporate governance arrangements that are known to be inefficient both by public investors and by those taking firms public. When assets with higher value produce opportunities for higher private benefits of control, asymmetric information about the asset value of firms going public will lead some or all such firms to offer a sub-optimal level of investor protection. The results can help explain why charter provisions cannot be relied on to provide optimal investor protection in countries with poor investor protection, why companies going public in the US commonly include substantial antitakeover provisions in their charters, and why companies rarely restrict self-dealing or the taking of corporate opportunities more than is done by the corporate laws of their country. The analysis also identifies a potentially beneficial role that mandatory legal rules might play in the corporate area.
adverse selection, asymmetric information, corporate governance, investor protection, security design, private benefits of control, agency costs, expropriation, minority shareholders, IPO, going public, corporate charter, contractual freedom, private ordering, takeovers, antitakeover provisions, self-dealing
Abstract: The power of shareholders to replace the board is a central element in the accepted theory of the modern public corporation with dispersed ownership. This power, however, is largely a myth. I document in this paper that the incidence of electoral challenges during the 1996-2005 decade was very low. After presenting this evidence, the paper analyzes why electoral challenges to directors are so rare, and then makes the case for arrangements that would provide shareholders with a viable power to remove directors. Under the proposed default arrangements, companies will have, at least every two years, elections with shareholder access to the corporate ballot, reimbursement of campaign expenses for candidates who receive a sufficiently significant number of votes (for example, one-third of the votes cast), and the opportunity to replace all the directors; companies will also have secret ballot and majority voting in all directors elections. Furthermore, opting out of default election arrangements through shareholder-approved bylaws should be facilitated, but boards should be constrained from adopting without shareholder approval bylaws that make director removal more difficult. Finally, I examine a wide range of possible objections to the proposed reform of corporate elections, and I conclude that they do not undermine the case for such a reform. The paper, which is based on the Raben Lecture in Corporate Law at Yale and the Uri and Caroline Bauer Lecture at Cardozo, is scheduled to appear in May 2007 in the Virginia Law Review together with responses to it by Martin Lipton and William Savitt, Jonathan Macey, John Olson, Lynn Stout, and E. Norman Veasey.
Corporate governance, directors, boards, shareholders, shareholder rights, shareholder voting, shareholder franchise, corporate elections, corporate ballot, proxy fights, proxy contests, access to the ballot, staggered boards, confidential voting, majority voting, bylaws, entrenchment, myopia
Abstract: This book provides a detailed account of how structural flaws in corporate governance have enabled managers to influence their own pay and produced widespread distortions in pay arrangements. The book also examines how these flaws and distortions can best be addressed.
Part I of the book (titled The Official View and its Limits) critically examines the arm's length contracting view, which underlies much of the academic research on executive compensation as well as the law's approach to it. We show that boards have not been operating at arm's length from the executives whose pay they set. While recent reforms can improve matters, they cannot be expected to eliminate significant deviations from arm's length contracting. We also show that the constraints imposed by market forces and shareholders' power to intervene are not tight enough to prevent such deviations.
Part II of the book (titled Power and Pay) shows how an understanding of the role of managerial power can help explain executive compensation practices. We provide a framework for assessing whether pay arrangements are a product of managerial influence. We discuss managers' interest in camouflaging the amount and the performance-insensitivity of their pay. Applying our framework, we discuss how managerial influence can help explain, among other things, the evidence on the relationship between managerial pay and managerial power; the use of retirement benefits and other compensation arrangements to provide stealth compensation; and the ability of departing managers to obtain more than their contractual entitlement.
Part III of the book (titled Decoupling Pay from Performance) examines how managerial influence has operated to reduce the performance-sensitivity of executive pay. Among other things, we examine the structure of non-equity compensation, the design of conventional option plans, the use of restricted stock grants, and managers' freedom to unload options and shares.
Part IV of the book (titled Going Forward) discusses how executive compensation - and corporate governance more generally - can be improved. We examine the extent to which pay arrangements can be improved by adopting board process rules, imposing shareholder approval requirements, and making pay more transparent. We conclude that problems with compensation arrangements cannot be fully addressed without ensuring that directors focus on shareholder interests and operate at arm's length from the executives whose compensation they set. To achieve this result, we argue, it is not sufficient to make directors independent of executives as recent reforms has sought to do; it is also necessary to make directors dependent on shareholders by changing the legal arrangements that insulate boards from shareholders.
The preface and introduction are available to download at the bottom of this page. Also available for downloading from SSRN are three papers on which the book partly draws:
- Lucian Bebchuk and Jesse Fried, "Stealth Compensation via Retirement Benefits," http://ssrn.com/abstract=583861
- Lucian Bebchuk and Jesse Fried, "Executive Compensation as an Agency Problem," Journal of Economic Perspectives, Vol. 17, pp. 71-92, 2003, http://ssrn.com/abstract=364220
- Lucian Bebchuk, Jesse Fried, and David Walker, "Managerial Power and Rent Extraction in the Design of Executive Compensation," University of Chicago Law Review, Vol. 69, pp. 751-846, 2002, http://ssrn.com/abstract=316590
Corporate governance, managers, executives, shareholders, boards, directors, executive compensation, principal-agent problem, pay for performance, agency costs, stock options, rents, camouflage
Abstract: This paper evaluates the primary mechanisms for changing management or obtaining control in publicly traded corporations with dispersed ownership. Specifically, we analyze and compare three mechanisms: (1) proxy fights (voting only); (2) takeover bids (buying shares only); and (3) a combination of proxy fights and takeover bids in which shareholders vote on acquisition offers. We first show how proxy fights unaccompanied by an acquisition offer suffer from substantial shortcomings that limit the use of such contests in practice. We then argue that combining voting with acquisition offers is superior not only to proxy fights alone but also to takeover bids alone. Finally, we show that, when acquisition offers are in the form of cash or the acquirer's existing securities, voting shareholders can infer from the pre-vote market trading which outcome would be best in light of all the available public information. Our analysis has implications for the ongoing debates in the US over poison pills and in Europe over the new EEC directive on takeovers.
Corporate governance, corporate control, takeovers, proxy contests, mergers and acquisitions
Abstract: This paper examines both empirically and theoretically the growth of US executive pay during the period 1993-2003. During this period, pay has grown much beyond the increase that could be explained by changes in firm size, performance, and industry classification. Had the relationship of compensation to size, performance, and industry classification remained the same in 2003 as it was in 1993, mean compensation in 2003 would have been only about half of its actual size. During the 1993-2003 period, equity-based compensation has increased considerably in both new-economy and old-economy firms, but this growth has not been accompanied by a substitution effect, i.e. a reduction in non-equity compensation. The aggregate compensation paid by public companies to their top-five executives during the considered period added up to about $350 billion, and the ratio of this aggregate top-five compensation to the aggregate earnings of these firms increased from 5 per cent in 1993-5 to about 10 per cent in 2001-3. After presenting evidence about the growth of pay, we discuss alternative explanations for it. We examine how this growth could be explained under either the arm`s-length bargaining model of executive compensation or the managerial-power model. Among other things, we discuss the relevance of the parallel rise in market capitalizations and in the use of equity-based compensation.
Abstract: This paper examines both empirically and theoretically the growth of U.S. executive pay during the period 1993-2003. During this period, pay has grown much beyond the increase that could be explained by changes in firm size, performance and industry classification. Had the relationship of compensation to size, performance and industry classification remained the same in 2003 as it was in 1993, mean compensation in 2003 would have been only about half of its actual size. During the 1993-2003 period, equity-based compensation has increased considerably in both new economy and old economy firms, but this growth has not been accompanied by a substitution effect, i.e., a reduction in non-equity compensation. The aggregate compensation paid by public companies to their top-five executives during the considered period added up to about $350 billion, and the ratio of this aggregate top-five compensation to the aggregate earnings of these firms increased from 5% in 1993-1995 to about 10% in 2001-2003. After presenting evidence about the growth of pay, we discuss alternative explanations for it. We examine how this growth could be explained under either the arm's length bargaining model of executive compensation or the managerial power model. Among other things, we discuss the relevance of the parallel rise in market capitalizations and in the use of equity-based compensation.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Abstract: This paper examines both empirically and theoretically the growth of U.S. executive pay during the period 1993-2003. During this period, pay has grown much beyond the increase that could be explained by changes in firm size, performance and industry classification. Had the relationship of compensation to size, performance and industry classification remained the same in 2003 as it was in 1993, mean compensation in 2003 would have been only about half of its actual size. During the 1993-2003 period, equity-based compensation has increased considerably in both new economy and old economy firms, but this growth has not been accompanied by a substitution effect, i.e., a reduction in non-equity compensation. The aggregate compensation paid by public companies to their top-five executives during the considered period added up to about $350 billion, and the ratio of this aggregate top-five compensation to the aggregate earnings of these firms increased from 5% in 1993-1995 to about 10% in 2001-2003. After presenting evidence about the growth of pay, we discuss alternative explanations for it. We examine how this growth could be explained under either the arm's length bargaining model of executive compensation or the managerial power model. Among other things, we discuss the relevance of the parallel rise in market capitalizations and in the use of equity-based compensation.
The figures and tables from this paper are available for downloading at Lucian Bebchuk's home page.
executive compensation, equity-based compensation, cash compensation, growth of compensation, managerial power
Abstract: This paper examines common arrangements for separating control from cash flow rights: stock pyramids, cross-ownership structures, and dual class equity structures. We describe the ways in which such arrangements enable a controlling shareholder or group to maintain a complete lock on the control of a company while holding less than a majority of the cash flow rights associated with its equity. Next, we analyze the consequences and agency costs of these arrangements. In particular, we show that they have the potential to create very large agency costscosts that are an order of magnitude larger than those associated with controlling shareholders who hold a majority of the cash flow rights in their companies. The agency costs of these structures, we suggest, are also likely to exceed the agency costs of attending highly leveraged capital structures. Finally, we put forward an agenda for research concerning structures separating control from cash flow rights.
Pyramids, dual-class, cross-ownership, cash flow nights, votes, agency costs, corporate governance, law and finance
Abstract: This paper seeks to make three contributions to understanding how banks’ executive pay has produced incentives for excessive risk-taking and how such pay should be reformed. First, although there is now wide recognition that pay packages focused excessively on short-term results, we analyze a separate and critical distortion that has received little attention. Equity-based awards, coupled with the capital structure of banks, tie executives’ compensation to a highly levered bet on the value of banks’ assets. Because bank executives expect to share in any gains that might flow to common shareholders, but are insulated from losses that the realization of risks could impose on preferred shareholders, bondholders, depositors, and taxpayers, executives have incentives to give insufficient weight to the downside of risky strategies. Second, we show that corporate governance reforms aimed at aligning the design of executive pay arrangements with the interests of banks’ common shareholders — such as advisory shareholder votes on compensation arrangements, use of restricted stock awards, and increased director oversight and independence — cannot eliminate the identified problem. In fact, the interests of common shareholders could be served by more risk-taking than is socially desirable. Accordingly, while such measures could eliminate risk-taking that is excessive even from shareholders’ point of view, they cannot be expected to prevent risk-taking that serves shareholders but is socially excessive. Third, we develop a case for using regulation of banks’ executive pay as an important element of financial regulation. We provide a normative foundation for such pay regulation, analyze how regulators should monitor and regulate bankers’ pay, and show how pay regulation can complement and reinforce the traditional forms of financial regulation.
executive compensation, banks, financial regulation, financial firms, financial crisis, TARP, restricted shares, options, moral hazard, risk-taking, prudential regulation, say on pay, compensation committees
Abstract: This paper is a case study of Fannie Mae's executive compensation arrangements during the period 2000-2004. We identify and analyze four problems with these arrangements:
- First, by richly rewarding executives for reporting higher earnings, without requiring return of the compensation if earnings turned out to be misstated, Fannie Mae's arrangement provided perverse incentives to inflate earnings.
- Second, Fannie Mae's arrangements provided soft landings to executives who were pushed out by the board for failure; expectation of such outcome adversely affected ex ante incentives.
- Third, even if the executives had retired after years of unblemished service, the value of their retirement packages would have been largely unrelated to their own performance.
- Fourth, both when promising retirement payments to executives and when making theses payments, Fannie Mae's disclosures obscured rather than made transparent the total values of the executives' retirement packages.
Because many other companies have practices similar to Fannie Mae's, our case study highlights some general problems with existing pay practices and the need for reform.
Executive compensation, agency problems, pay for performance, nonperformance pay, performance pay, soft landing, golden goodbyes, camouflage, misreporting, restatement, earning manipulation, incentives
Abstract: We study the relation between corporate governance and opportunistic timing of CEO option grants via backdating or otherwise. Our methodology focuses on how grant date prices rank within the price distribution of the grant month. During 1996-2005, about 12% of firms provided one or more lucky grant -- defined as grants given at the lowest price of the month -- due to opportunistic timing. Lucky grants were more likely when the board did not have a majority of independent directors and/or the CEO had longer tenure -- factors associated with increased influence of the CEO on pay-setting. We find no evidence that gains from manipulated grants served as a substitute for compensation paid through other sources; total reported compensation from such sources was higher in firms providing lucky grants. Finally, opportunistic timing has been widespread throughout the economy, with a significant presence in each of the economy`s twelve (Fama-French) industries.
Abstract: We study the relation between corporate governance and opportunistic timing of CEO option grants. Investigating the incidence of lucky grants - defined as grants given at the lowest price of the month - we estimate that about 1,150 lucky grants resulted from opportunistic timing, and that 12% of firms provided one or more lucky grant due to opportunistic timing during the period 1996-2005. We find no evidence that opportunistically timed grants served as a substitute for other forms of compensation; indeed, total reported compensation from other sources was higher (relative to peer companies) in firms providing lucky grants. For any given CEO with two or more grants, grants were more likely to be lucky when they took place in months in which the potential payoffs from opportunistic timing were relatively high. Grants were also more likely when the company did not have a majority of independent directors on the board and/or the CEO had longer tenure, both factors that are associated with increased influence of the CEO on pay-setting and board decision-making. Luck was persistent, with a CEO's chance of getting a lucky grant increasing when a preceding grant was lucky as well. Finally, we find that opportunistic timing was present in each of the economy's 12 (Fama-French) industries, and we do not find evidence that it was significantly driven by industry norms and culture.
The analysis of this paper was subsequently combined with that of our companion paper “Lucky Directors,” http://ssrn.com/abstract=952239, and the combined and further developed analysis will be published in the Journal of Finance under the title “Lucky CEOs and Lucky Directors.” The combined paper is available on SSRN at: http://ssrn.com/abstract=1405316
Executive compensation, corporate governance, options, backdating, spring-loading, inside information, CEO, independent directors
Abstract: This article contains the edited transcript of a forum on personal liability of directors held at Harvard Law School in November 2005. Eleven panelists offer their diverse views and perspectives on this subject. The participants in the panel, which is moderated by Lucian Bebchuk, are: Joseph Bachelder, Roel Campos, Byron Georgiou, Alan Hevesi, William Lerach, Robert Mendelsohn, Robert Monks, Toby Myerson, John Olson, Leo Strine, Jr., and John Wilcox.
delaware, journal, corporate, law, transcript, personal liability, directors, Harvard Law, Corporate governance, directors, boards, shareholders, shareholder suits, liability, plaintiffs lawyers, derivative suits, securities litigation, D&O insurance
Abstract: This paper develops a rent-protection theory of corporate ownership structure - and in particular, of the choice between concentrated and dispersed ownership of corporate shares and votes. The paper analyzes the decision of a company's initial owner whether to maintain a lock on control when the company goes public. This decision is shown to be very much influenced by the size that private benefits of control are expected to have. Most importantly, when private benefits of control are large - and when control is thus valuable enough - leaving control up for grabs would attract attempts by rivals to grab control and thereby capture these private benefits; in such circumstances, to preclude a control grab, the initial owner might elect to maintain a lock on control. Furthermore, when private benefits of control are large, maintaining a lock on control would enable the company's initial shareholders to capture a larger fraction of the surplus from value-producing transfers of control. Both results suggest that, in countries in which private benefits of control are large, publicly traded companies will tend to have a controlling shareholder. It is also shown that separation of cash flow rights and voting rights will tend to be used in conjunction with a controlling shareholder structure but not with a dispersed ownership structure. Finally, the paper analyzes why companies might make control partially contestable, as many US companies currently do by adopting antitakeover arrangements. The results of the paper are consistent with the available evidence, can explain the observed patterns of corporate ownership, and yield testable predictions for future empirical work. The analysis also implies that a corporate law system that effectively limits private benefits of control can produce more efficient choices of ownership structure.
Abstract: This paper develops a rent-protection theory of corporate ownership structure--and in particular, of the choice between concentrated and dispersed ownership of corporate shares and votes. The paper analyzes the decision of a company's initial owner whether to maintain a lock on control when the company goes public. This decision is shown to be very much influenced by the size that private benefits of control are expected to have. Most importantly, when private benefits of control are large--and when control is thus valuable enough--leaving control up for grabs would attract attempts by rivals to grab control and thereby capture these private benefits; in such circumstances, to preclude a control grab, the initial owner might elect to maintain a lock on control. Furthermore, when private benefits of control are large, maintaining a lock on control would enable the company's initial shareholders to capture a larger fraction of the surplus from value-producing transfers of control. Both results suggest that, in countries in which private benefits of control are large, publicly traded companies will tend to have a controlling shareholder. It is also shown that separation of cash flow rights and voting rights will tend to be used in conjunction with a controlling shareholder structure but not with a dispersed ownership structure. Finally, the paper analyzes why companies might make control partially contestable, as many US companies currently do by adopting antitakeover arrangements. The results of the paper are consistent with the available evidence, can explain the observed patterns of corporate ownership, and yield testable predictions for future empirical work. The analysis also has policy implications and, in particular, identifies an important benefit that arises from having a corporate law system that effectively limits private benefits of control.
Abstract: U.S. corporate law has long denied shareholders the power to make rules-of-the-game decisions - that is, decisions to change the company's charter or state of incorporation. In an article published last year, The Case for Increasing Shareholder Power, I advocated providing shareholders with power to make rules-of-the-game decisions. A forthcoming exchange in the Harvard law Review will feature responses by Professor Stephen Bainbridge and Vice-Chancellor Leo Strine taking issue with my proposal. This paper, which was written for this exchange, responds to Bainbridge and Strine as well as further develops my arguments for increasing shareholder power. I discuss the significant costs arising from boards control over rules-of-the-game decisions during the often long life of public companies. Discussing the objections raised by critics, I show that giving shareholders power to make rules-of-the-game decisions would be consistent with centralized management in public companies; would not be made unnecessary by reforms in corporate elections; and should not dismissed on the grounds that it would already be offered by corporate charters or state law rules if it were beneficial. I also address concerns arising from the shortcomings of institutional investors. I conclude that there is a strong case for a serious reexamination of boards' control over the rules of the game. Stephen Bainbridge's response is available at: http://ssrn.com/abstract=808584 Leo Strine's response is available on SSRN at: http://ssrn.com/abstract=883720 The earlier article to which Bainbridge and Strine respond is available at: http://ssrn.com/abstract=631344
corporate governance, shareholders, managers, directors, boards, centralized management, corporate law, agency costs, corporate charters, charter amendments, incorporation, state competition, IPO, proxy contests, corporate reform
Abstract: This paper develops a model of the causes and consequences of misreporting of corporate performance. Misreporting in our model covers all actions, whether legal or illegal, that enable managers of firms with low value to make statements that mimic those made by firms with high value. We show that even managers who cannot sell their shares in the short-term might misreport in order to improve the terms under which their company would be able to raise capital for new projects or acquisitions. When managers may sell some of their holdings in the short-term, incentives to misreport and the incidence of misreporting increase to an extent that depends on what fraction of their holdings managers may sell and on whether they can sell without the market knowing about it. Investments in misreporting have real economic costs and distort financing and investment decisions, with firms that misreport raising too much equity and firms that do not misreport raising too little. A lax accounting and legal environment increases the incidence of misreporting and consequently the distortions in capital allocation. Our analysis provides many testable predictions concerning the times, industries, and types of firms where misreporting is likely to occur. The analysis also has implications for corporate governance and executive compensation.
Asymmetric information, acquisitions, corporate governance, disclosure, myopia, short-termism, executive compensation, stock options, insider trading, accounting, financial statements, earnings management, auditor, financial reporting
Abstract: This article argues that effective staggered boards (ESBs) provide a powerful antitakeover defense, more powerful than is commonly recognized. We develop a theoretical account of how ESBs impede hostile bids by forcing bidders both to wait at least one year to gain control and to win two elections far apart in time rather than a one-time referendum on their offer. We then test our theory using a new data set of hostile bids during 1996-2000. We find that in this period:
1) Not a single hostile bidder won a ballot box victory against an ESB; 2) An ESB nearly doubled the odds of remaining independent for an average target in our data set; 3) Shareholders of targets that remained independent were made worse off compared with accepting the bid; 4) ESBs did not provide significant countervailing benefits in terms of increased premiums to offset the costs of remaining independent; 5) Overall, during 1996-2000, ESBs reduced the returns to shareholders of hostile bid targets on the order of 8-10%; and 6) Most ESBs were adopted before the developments in takeover jurisprudence that made ESBs.
In view of these findings, we argue that courts should not permit managers of a target with an ESB to continue maintaining a pill after they lose one election conducted over an acquisition offer. This approach, we suggest, would best implement the basic proportionality principles underlying takeover doctrine.
The Stanford Law Review is planning to publish a symposium with responses and reactions to this article. Participants will include Steve Bainbridge (UCLA), Mark Gordon (Wachtell, Lipton), Patrick McGurn (Institutional Shareholder Services), Lynn Stout (UCLA), and Leo Strine (Delaware Chancery Court). We are now in the process of writing for the symposium a paper that will respond to these five commentators and will further develop our analysis of staggered boards. Accordingly, comments or reactions on the article would be most welcome.
Takeover, mergers and acquisitions, tender offers, takeover bids, defensive tactics, staggered boards, poison pills
Abstract: This Paper develops a model of the competition among states in providing corporate law rules. The analysis provides a full characterization of the equilibrium in this market. Competition among states is shown to produce optimal rules with respect to issues that do not have a substantial effect on managers' private benefits but not with respect to issues (such as takeover regulation) that substantially affect these private benefits. We analyse why a dominant state such as Delaware can emerge, the prices that the dominant state will set and the profits it will make. We also analyse the roles played by legal infrastructure, network externalities, and the rules governing incorporations. The results of the model are consistent with, and can explain, existing empirical evidence; they also indicate that the performance of state competition cannot be evaluated on the basis of how incorporation in Delaware in the prevailing market equilibrium affects shareholder wealth.
Network externalities, private benefits of control, Delaware, regulatory competition, shareholders, corporate law
Abstract: This paper develops a model of the competition among states in providing corporate law rules. The analysis provides a full characterization of the equilibrium in this market. Competition among states is shown to produce optimal rules with respect to issues that do not have a substantial effect on managers' private benefits but not with respect to issues (such as takeover regulation) that substantially affect these private benefits. We analyze why a Dominant state such as Delaware can emerge, the prices that the dominant state will set and the profits it will make. We also analyze the roles played by legal infrastructure, network externalities, and the rules governing incorporations. The results of the model are consistent with, and can explain, existing empirical evidence; they also indicate that the performance of state competition cannot be evaluated on the basis of how incorporation in Delaware in the prevailing market equilibrium affects shareholder wealth.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Abstract: This paper develops a model of the competition among states in providing corporate law rules. The analysis provides a full characterization of the equilibrium in this market. Competition among states is shown to produce optimal rules with respect to issues that do not have a substantial effect on managers' private benefits but not with respect to issues (such as takeover regulation) that substantially affect these private benefits. We analyze why a dominant state such as Delaware can emerge, the prices that the dominant state will set and the profits it will make. The results of the model are consistent with, and can explain, existing empirical evidence. Finally, the analysis highlights the importance of the rules governing reincorporation and the potential benefits of giving shareholders the power to make reincorporation decisions.
corporate law, managers, shareholders, regulatory competition, Delaware, private benefits of control, network externalities
Abstract: This paper empirically investigates the decisions of publicly traded firms where to incorporate. We study the features of states that make them attractive to incorporating firms and the characteristics of firms that determine whether they incorporate in or out of their state of location. We find that states that offer stronger antitakeover protections are substantially more successful both in retaining in-state firms and in attracting out-of-state incorporations. We estimate that, compared with adopting no antitakeover statutes, adopting all standard antitakeover statutes enabled the states that adopted them to more than double the percentage of local firms that incorporated in-state (from 23% to 49%). Indeed, the incorporation market has not even penalized the three states that passed two extreme antitakeover statutes that have been widely viewed as detrimental to shareholders. We also find that there is commonly a big difference between a state's ability to attract incorporations from firms located in and out of the state, and we investigate several possible explanations for this home-state advantage. Finally, we find that Delaware's dominance is greater than has been recognized and can be expected to increase further in the future. Our findings have significant implications for corporate governance, regulatory competition, and takeover law.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Abstract: This paper empirically investigates the decisions of publicly traded firms where to incorporate. We study the features of states that make them attractive to incorporating firms and the characteristics of firms that determine whether they incorporate in or out of their state of location. We find that states that offer stronger antitakeover protections are substantially more successful both in retaining in-state firms and in attracting out-of-state incorporations. We estimate that, compared with adopting no antitakeover statutes, adopting all standard antitakeover statutes enabled the states that adopted them to more than double the percentage of local firms that incorporated in-state (from 23% to 49%). Indeed, we find no evidence that the incorporation market has even penalized the three states that passed antitakeover statutes widely viewed as detrimental to shareholders. We also find that there is commonly a big difference between a state's ability to attract incorporations from firms located in and out of the state, and we investigate several possible explanations for this home-state advantage. Our findings have significant implications for corporate governance, regulatory competition, and takeover law.
The data on which this paper is based is available for downloading at Lucian Bebchuk's home page.
Delaware, incorporation, corporate governance, regulatory competition, managers, shareholders, takeovers, antitakeover statutes, antitakeover defenses, home bias
Abstract: Treasury Secretary Geithner announced a plan, which the Treasury is willing to finance with up to $1 trillion of public funds, to partner with private capital to buy banks' troubled assets. The Treasury has not yet settled on the plan's design, and its announcement has encountered substantial skepticism as to whether an effective plan for a public-private partnership in buying troubled assets can be worked out. This paper argues that, yes, it can. The paper also analyzes how the plan should be designed to contribute most to restarting the market for troubled assets at the least cost to taxpayers.
The government's plan should focus on establishing a significant number of competing funds that will be privately managed and dedicated to buying troubled assets - not on creating one, large public-private aggregator bank. Establishing competing funds, I show, is necessary both to securing a well-functioning market for troubled assets and to keeping costs to taxpayers at a minimum.
Each new fund will be partly financed with private capital, with the rest coming (say, in the form of non-recourse debt financing) from the government's Investment Fund planned by the Treasury. One important element of the proposed design is a competitive process in which private managers seeking to establish a fund participating in the program will submit bids as to what fraction of the fund's capital will be funded privately. The government will set the fraction of each participating fund's capital that must be financed with private money at the highest level that, given the received bids, will still enable establishing new funds with aggregate capital equal to the program's target level. Overall, I show that the proposed design will leverage private capital to the fullest extent possible and will provide the most effective and least costly mechanism for restarting the market for troubled assets.
The paper builds on and develops the proposal for using privately managed funds for buying troubled assets I first put forward in A Plan for Addressing the Financial Crisis (Harvard Law & Econ. Discussion Paper No. 620, 2009), available at http://papers.ssrn.com/abstract =1273241. The analysis of this proposal is further developed in “Buying Troubled Assets, Yale Journal on Regulation, 2009, available at http://papers.ssrn.com/abstract =1392808.
Troubled assets, Bailout, Financial Crisis, Banks, Financial Stability
Abstract: This paper investigates empirically how the value of publicly traded firms is overall affected by arrangements protecting management from removal. A majority of U.S. public companies have staggered boards that substantially insulate the board from removal via a hostile takeover or a proxy contest. We find that staggered boards are associated with an economically significant reduction in firm value (as measured by Tobin's Q). We also find evidence consistent with staggered boards' bringing about, and not merely reflecting, a lower firm value. Finally, the correlation with reduced firm value is stronger for staggered boards established in the corporate charter (which shareholders cannot amend) than for staggered boards established in the company's bylaws (which can be amended by shareholders).
Abstract: This paper investigates empirically how the value of publicly traded firms is affected by arrangements that protect management from removal. Staggered boards, which a majority of U.S. public companies have, substantially insulate boards from removal in either a hostile takeover or a proxy contest. We find that staggered boards are associated with an economically meaningful reduction in firm value (as measured by Tobin's Q). We also provide suggestive evidence that staggered boards bring about, and not merely reflect, an economically significant reduction in firm value. Finally, the correlation with reduced firm value is stronger for staggered boards that are established in the corporate charter (which shareholders cannot amend) than for staggered boards established in the company's bylaws (which shareholders can amend).
Corporate governance, Tobin's Q, firm value, agency costs, boards, directors, takeovers, tender offers, mergers and acquisitions, proxy fights, defensive tactics, antitakeover provisions, staggered boards, poison pills
Abstract: We investigate the relationship between CEO centrality - the relative importance of the CEO within the top executive team in terms of ability, contribution, or power - and the value and behavior of public firms. Our proxy for CEO centrality is the fraction of the top-five compensation captured by the CEO. We find that CEO centrality is negatively associated with firm value (as measured by industry-adjusted Tobin's Q). Greater CEO centrality is also correlated with (i) lower (industry-adjusted) accounting profitability, (ii) lower stock returns accompanying acquisitions announced by the firm and higher likelihood of a negative stock return accompanying such announcements, (iii) higher odds of the CEO's receiving a 'lucky' option grant at the lowest price of the month, (iv) greater tendency to reward the CEO for luck in the form of positive industry-wide shocks, (v) lower likelihood of CEO turnover controlling for performance, and (vi) lower firm-specific variability of stock returns over time. Overall, our results indicate that differences in CEO centrality are an aspect of firm management and governance that deserves the attention of researchers.
Abstract: We investigate the relationship between CEO centrality - the relative importance of the CEO within the top executive team in terms of ability, contribution, or power - and the value, performance and behavior of public firms. Our proxy for CEO centrality is the fraction of the aggregate compensation of the top-five executive team captured by the CEO. We find that CEO centrality is negatively associated with firm value (as measured by industry-adjusted Tobin's Q). This result is robust to controlling for all standard controls in Q regressions as well as additional controls such as CEO tenure, whether the CEO is a founder or a large owner, and whether the company's top-five aggregate compensation is high or low relative to peer companies. CEO centrality also has a rich set of relations with firms' behavior and performance. In particular, CEO centrality is correlated with (i) lower (industry-adjusted) accounting profitability, (ii) lower stock returns accompanying acquisitions announced by the firm and higher likelihood of a negative stock return accompanying such announcements, (iii) higher odds of the CEO's receiving a "lucky" option grant at the lowest price of the month, (iv) greater tendency to reward the CEO for luck due to positive industry-wide shocks, (v) lower performance sensitivity of CEO turnover, and (vi) lower firm-specific variability of stock returns over time.
Executive compensation, corporate governance, CEOs, executives, options, equity-based compensation, non-equity compensation, Tobin's Q, firm entrenchment, CEO turnover, independent directors, CEO chair, acquisitions, CEO turnover, pay for luck., variability of returns, pay distribution, internal pay
Abstract: This paper analyzes an important form of "stealth compensation" provided to managers of public companies. We show how boards have been able to camouflage large amount of executive compensation through the use of retirement benefits and payments. Our study highlights the significant role that camouflage and stealth compensation play in the design of compensation arrangements. Our study also highlights the significance of whether information about compensation arrangements is not merely publicly available but also communicated in a way that is transparent and accessible to outsiders.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Abstract: This Article analyzes an important form of stealth compensation provided to managers of public companies. We show how boards have been able to camouflage large amounts of executive compensation through the use of retirement benefits and payments. Our study illustrates the significant role that camouflage and stealth compensation play in the design of compensation arrangements. It also highlights the importance of having information about compensation arrangements not only publicly available but also communicated in a way that is transparent and accessible to outsiders.
To improve the transparency of executives' retirement payments and benefits, we propose several changes in current disclosure requirements. Among other things, firms should be required to report to investors each year the dollar value of all the retirement benefits to which their executives become entitled. For example, firms should disclose to investors the annual buildup in the actuarial value of executives' retirement plans, as well as the tax savings reaped by executives at the company's expense through the use of deferred compensation arrangements. Firms should also disclose to investors each year the present value of all the retirement benefits their top executives have accumulated.
Executive compensation, pay for performance, agency costs, rent extraction, stealth compensation, camouflage, retirement benefits, deferred compensation, executive pensions, perks
Abstract: We study the extent to which decisions to expand firm size are associated with increases in subsequent CEO compensation. Controlling for past stock performance, we find a positive correlation between CEO compensation and the CEO's past decisions to increase firm size. This correlation is economically meaningful; for example, other things being equal, CEOs who in the preceding three years were in the top quartile in terms of expanding by increasing the number of shares outstanding receive compensation that is higher by one-third than the compensation of CEOs belonging to the bottom quartile. We also find that stock returns are correlated with subsequent CEO pay only to the extent that they contribute to expanding firm size; only the component of past stock returns not distributed as dividends is correlated with subsequent CEO pay. Finally, we find an asymmetry between increases and decreases in size: while increases in firm size are followed by higher CEO pay, decreases in firm size are not followed by reduction in such pay. The association we find between CEOs' compensation and firm-expanding decisions undertaken earlier during their service could provide CEOs with incentives to expand firm size.
Abstract: We study the extent to which decisions to expand firm size are associated with increases in subsequent CEO compensation. Investigating a broad universe of firm-expansion choices, we find, controlling for performance and firm characteristics, a positive and economically meaningful correlation between CEO compensation and the CEO's past decisions to increase firm size. We demonstrate that the identified correlation is not driven by large corporate acquisitions, and that it remains significant and economically meaningful when firms making large acquisitions during the relevant period are excluded. We further find an asymmetry between size increases and decreases: while size increases are positively correlated with subsequent CEO pay, size decreases are not negatively correlated with subsequent CEO pay. The identified association between expansion decisions and subsequent CEO pay is relevant for assessing CEO incentives with respect to a broad range of choices made by firms.
executive compensation, firm size, acquisitions, distributions, repurchases, stock issuance, empire-building, sales growth, pay for performance, options
Abstract: Researchers and shareholder advisers have devoted much attention to developing metrics for assessing the governance of public companies around the world. These important and influential efforts, we argue, suffer from a basic shortcoming. The impact of many key governance arrangements depends considerably on companies’ ownership structure: measures that protect outside investors in a company without a controlling shareholder are often irrelevant or even harmful when it comes to investor protection in companies with a controlling shareholder, and vice versa. Consequently, governance metrics that purport to apply to companies regardless of ownership structure are bound to miss the mark with respect to one or both types of firms. In particular, we show that the influential metrics used extensively by scholars and shareholder advisers to assess governance arrangements around the world—the Corporate Governance Quotient (CGQ), the Anti-Director Rights Index, and the Anti-Self-Dealing Index—are inadequate for this purpose.
We argue that, going forward, the quest for global governance standards should be replaced by an effort to develop and implement separate methodologies for assessing governance in companies with and without a controlling shareholder. We also identify the key features that these separate methodologies should include, and discuss how to apply such methodologies in either country-level or firm-level comparisons. Our analysis has wide-ranging implications for corporate-governance research and practice.
Corporate governance, investor protection, agency costs, law and finance, governance indices, global standards, best practices, controlling shareholders, CGQ, anti-director index, anti-self-dealing index.
Abstract: The development of U.S. state takeover law in the past three decades has produced considerable and quite possibly excessive protection for incumbent managers from hostile takeovers. Although the shortcomings of state takeover law have been widely recognized, there has been little support for federal intervention because of the concern that such intervention might produce even worse takeover arrangements. This paper puts forward a novel form of federal intervention in the regulation of takeovers that would address these shortcomings without raising such a concern. Rather than mandating particular substantive takeover arrangements, this form of federal intervention would focus on increasing shareholder choice. Choice-enhancing' federal intervention would consist of two elements: (i) an optional body of substantive federal takeover law which shareholders would be able to opt into (or out of) and (ii) a mandatory process rule that would provide shareholders the right to initiate and adopt, regardless of managers' wishes, proposals for opting into (or out of) the federal takeover law. We argue that such a federal role in takeover law cannot harm and would likely improve the regulation of takeovers. Moreover, by showing how federal law can be used to improve regulatory competition in the provision of takeover law rather than preempt it, our analysis lays the groundwork for a more general reconsideration of regulatory competition in the corporate law area.
Abstract: The paper puts forward a new approach to two corporate subjects that have been intensively debated in the last three decades, the regulation of takeovers and state competition in the production of corporate law. During this period, U.S. state takeover law has produced considerable and quite possibly excessive protection for incumbent managers from hostile takeovers. Although the shortcomings of state takeover law have been widely recognized, there has been little support for federal intervention because of the concern that such intervention might produce even worse takeover arrangements. This paper, however, identifies a form of federal intervention in the regulation of takeovers "choice-enhancing" intervention that would address these shortcomings without raising such a concern.
"Choice-enhancing" federal intervention would consist of two elements: (i) an optional body of substantive federal takeover law which shareholders would be able to opt into (or out of) and (ii) a mandatory process rule that would provide shareholders the right to initiate and adopt, regardless of managers' wishes, proposals for opting into (or out of) the federal takeover law. An alternative version of choice-enhancing intervention would provide a federal law requiring states to allow shareholders to initiate and approve opting out of anti-takeover arrangements provided by the state's law. We argue that such a federal role in takeover law cannot harm and would likely improve the regulation of takeovers. Moreover, by showing how federal law can be used to improve regulatory competition in the provision of takeover law rather than preempt it, our analysis lays the groundwork for a more general reconsideration of regulatory competition in the corporate law.
Takeovers, mergers and acquisitions, corporate governance, regulatory competition
Abstract: While prior empirical work and much public attention have focused on the opportunistic timing of executives' grants, we provide in this paper evidence that outside directors' option grants have also been favorably timed to an extent that cannot be fully explained by sheer luck. Examining events in which public firms granted options to outside directors during 1996-2005, we find that 9% were lucky grant events falling on days with a stock price equal to a monthly low. We estimate that about 800 lucky grant events owed their status to opportunistic timing, and that about 460 firms and 1400 outside directors were associated with grant events produced by such timing. There is evidence that the opportunistic timing of director grant events has been to a substantial extent the product of backdating and not merely spring-loading based on private information. We find that directors' luck has been correlated with executives' luck. Furthermore, grant events were more likely to be lucky when the firm had more entrenching provisions protecting insiders from the risk of removal, as well as when the board did not have a majority of independent directors.
Abstract: While prior work has focused on the opportunistic timing of executives' grants, we provide in this paper evidence that outside directors' option grants have also been favorably timed to an extent that cannot be fully explained by sheer luck. Examining events in which public firms granted options to outside directors during 1996-2005, we find that 9% of director grant events were lucky grant events falling on days with a stock price equal to a monthly low. We estimate that about 800 lucky grant events owed their status to opportunistic timing, and that about 460 firms and 1400 outside directors were associated with grant events produced by such timing. Director grant events were preceded by negative abnormal returns and followed by positive abnormal returns. There is evidence that the opportunistic timing of director grant events has been to a substantial extent the product of backdating and not merely spring-loading based on private information. We find that directors' luck has been correlated with executives' luck. We also find that director grant events were more likely to be lucky when the potential gains from such luck were larger, when the firm had more entrenching provisions protecting insiders from the risk of removal, and when the board did not have a majority of independent directors.
The analysis of this paper was subsequently combined with that of our companion paper “Lucky CEOs,” http://ssrn.com/abstract=945392, and the combined and further developed analysis will be published in the Journal of Finance under the title “Lucky CEOs and Lucky Directors.” The combined paper is available on SSRN at: http://ssrn.com/abstract=1405316
Executive compensation, corporate governance, stock options, backdating, spring loading, inside information, CEO, independent directors, outside directors, entrenchment
Abstract: This paper analyzes the history of federal intervention in corporate law and draws from it lessons for the future. We show that federal intervention has generally not alternated between tightening state law restrictions on corporate insiders and relaxing them. Rather, federal law has systematically replaced state law arrangements with ones imposing tighter constraints on insiders. Without federal intervention, state law would have produced a corporate system that provides substantially weaker investor protection than the United States enjoys today. We also show that federal interventions have systematically taken advantage of additional tools (including public enforcement, criminal sanctions, gatekeeper liability, and agency-based regulations) beyond those that state law has chosen or been able to use. Overall, unless one views existing levels of investor protection as substantially excessive, past patterns suggest that state competition on its own is unlikely to produce an adequate level of investor protection. Furthermore, the recurring need for federal officials to rectify state law failures in order to provide investors with adequate protection indicates that federal lawmaking should be proactive rather than reactive. We thus recommend that, going forward, federal policymakers examine in a systematic and comprehensive fashion which corporate law areas should be federalized either because tighter restrictions on insiders are needed or because the additional tools available to federal law would be useful.
State competition, regulatory competition, Delaware regulations, incorporations, Corporate Charters, corporate law, corporate governance, securities regulations, SEC
Abstract: Because public firms are not required to disclose the monetary value of pension plans in their executive pay disclosures, financial economists have generally analyzed executive pay using figures that do not include the value of such pension plans. This paper presents evidence that omitting the value of pension benefits significantly undermines the accuracy of existing estimates of executive pay, its variability, and its sensitivity to performance companies. Studying the pension arrangements of CEOs of S&P 500, we find that the CEOs' plans had a median actuarial value of $15 million; that the ratio of the executives' pension value to the executives' total compensation (including both equity and non-equity pay) during their service as CEO had a median value of 34%; and that including pension values increased the median percentage of the executives' total compensation composed of salary-like payments during and after their service as CEO from 15% to 39%.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Abstract: This paper presents evidence of the extent to which omitting the value of pension benefits has undermined the accuracy of existing estimates of executive pay, its variability, and its sensitivity to performance.We study the pension arrangements of CEOs of S&P 500 companies that (1) are now serving and are near the retirement age; or (2) left their positions during 2003 and the first half of 2004. Roughly two-thirds of these CEO have a pension plan (or similar retirement arrangement), and our findings with respect to these CEOs are as follows:
· The executives' pension plans had a median actuarial value of $15 million. · The ratio of the executives' pension value to the executives' total compensation (including both equity and non-equity pay) during their service as CEO had a median value of 34%. · Including pension values increased the median percentage of the executives' total compensation composed of salary-like payments during and after their service as CEO from 15% to 39%.
In addition, the pension benefits in our sample varied considerably with respect to both their magnitude and their relationship to the executives' overall compensation. Our findings indicate that the standard omission of pension plan values by researchers and the media leads to:
· Significant underestimation of the magnitude of executive compensation; · Severe distortions in comparisons among executive pay packages; and · Significant overestimation of the extent to which executive pay is linked to performance.
Our analysis demonstrates that the SEC new disclosure rules, which require companies to make executive pensions transparent in ways supported by this paper, can be expected to reveal large amounts of performance-insensitive compensation via executive pensions.
Executive compensation, executive retirement benefits, executive pensions, stealth compensation, camouflage, pay for performance
Abstract: This paper analyzes how government intervention in the market for banks' troubled assets is best designed, and also uses this analysis to evaluate the public-private investment program announced by the U.S. government in March 2009. I begin by presenting the case for using government funds to restart the market for troubled assets. I then discuss the advantages of providing government capital to competing privately managed funds, a strategy I have advocated in past work, and I outline the key elements that such a plan should include.
Based on this analysis, I propose three improvements to the government's current plan:
• Introducing a competitive mechanism that would ensure that the government's subsidy to participating private parties is kept at a minimum; • Redesigning the plan to provide such private parties with incentives aligned with those of taxpayers rather than highly skewed incentives to overpay for troubled assets; and • Precluding banks that hold significant amounts of troubled assets from participating as managers or private investors in funds set up under the program.
The proposed changes would address most of the concerns that have been raised by critics of the administration's program. In particular, they would reduce costs to taxpayers, prevent excessive and unnecessary gains by private parties, and produce market prices that can be relied on for valuing assets that remain on banks' books.
The paper builds on and incorporates elements of my September 2008 and February 2009 working papers on using privately managed funds for buying troubled assets, A Plan for Addressing the Financial Crisis (Harvard Law & Econ. Discussion Paper No. 620, 2009), available at http://papers.ssrn.com/abstract =1273241, and How To Make TARP II Work (Harvard Law & Econ. Discussion Paper No. 626, 2009), available at http://papers.ssrn.com/abstract =1341939.
Troubled assets, toxic assets, public-private investment program, bailout, financial crisis, banks, financial stability, U.S. Treasury
Abstract: The SEC is now considering a proposal to require some public companies to include in their proxy materials candidates for the board nominated by shareholders. I document that incumbents do not currently face any meaningful risk of being replaced via the ballot box, and I argue that providing shareholder access would be a moderate step toward improving board accountability. Analyzing each of the objections that opponents have raised against the proposed shareholder access, I conclude that none of them provides a good basis for opposing it. Indeed, it would be desirable to supplement shareholder access with additional measures to invigorate corporate elections.
corporate governance, directors, shareholders, shareholder voting, corporate elections, proxy fights, proxy contests, proxy rules, SEC
Abstract: We model how lobbying by interest groups affects the level of investor protection. In our model, insiders in existing public companies, institutional investors (financial intermediaries), and entrepreneurs who plan to take companies public in the future, compete for influence over the politicians setting the level of investor protection. We identify conditions under which this lobbying game has an inefficiently low equilibrium level of investor protection. Factors that operate to reduce investor protection below its efficient level include the ability of corporate insiders to use the corporate assets they control to influence politicians, as well as the inability of institutional investors to capture the full value that efficient investor protection would produce for outside investors. The interest that entrepreneurs (and existing public firms) have in raising equity capital in the future reduces but does not eliminate the distortions arising from insiders' interest in extracting rents from the capital public firms already have. Our analysis generates testable predictions, and can explain existing empirical evidence, regarding the way in which investor protection varies over time and around the world.
Abstract: We model how lobbying by interest groups affects the level of investor protection. In our model, three groups - insiders in existing public companies, institutional investors (financial intermediaries), and entrepreneurs who plan to take companies public in the future - compete for influence over the politicians setting the level of investor protection. We identify conditions under which this lobbying game has an inefficiently low equilibrium level of investor protection. Factors pushing investor protection below its efficient level include the ability of corporate insiders to use the corporate assets they control to influence politicians, and the inability of institutional investors to capture the full value that efficient investor protection would produce for outside investors. The interest that entrepreneurs (and existing public firms) have in raising equity capital in the future reduces but does not eliminate the distortions arising from insiders' interest in extracting rents from the capital that public firms already possess. Our analysis generates testable predictions, and can explain existing empirical evidence, regarding the way in which investor protection varies over time and around the world.
Investor protection, corporate governance, corporate law, interest groups, political economy, law and finance, insiders, institutional investors, entrepreneurs, equity capital, agency costs, private benefits of control
Abstract: We investigate the distribution of pay in the top executive team in public companies. In particular, we study the CEO's pay slice (CPS), defined as the fraction of the aggregate top-five total compensation paid to the CEO. The level of a firm's CPS might reflect the relative centrality of the CEO in the top executive team in terms of ability, contribution to the firm, or power.
We find that CPS has been going up over the past decade. During this period, CEOs have increased their fraction of both equity-based compensation and non-equity compensation. The level of CPS is associated with various characteristics of the top team and the firm's governance arrangements. Among other things, CPS is high when the CEO has long tenure; when the CEO chairs the board; when few other executives are members of the board; and when the firm has more entrenching provisions.
High CPS is associated with lower firm value as measured by Tobin's Q. Using a simultaneous equations approach yields findings consistent with the possibility that this negative correlation is at least partly due to high CPS, or the relative CEO centrality it might reflect, bringing about a lower Tobin's Q. Consistent with the negative correlation between high CPS and Q, high CPS is associated with a less favorable market reaction, and a higher likelihood of a negative market reaction, to acquisitions announced by the firm. We also find that high CPS is associated with lower variability of stock returns over time. Overall, our results indicate that the distribution of compensation in the top executive team is an aspect of pay arrangements and corporate governance that deserves researchers' attention.
Executive compensation, corporate governance, CEOs, options, equity-based compensation, non-equity compensation, Tobin's Q, entrenchment, independent directors, board size, CEO tenure, CEO turnover, acquisitions, variability of returns, pay distribution, and internal pay equity
Abstract: Firms going public have increasingly been incorporating antitakeover provisions in their IPO charters, while shareholders of existing companies have increasingly been voting in opposition to such charter provisions. This paper identifies possible explanations for this empirical pattern. Specifically, I analyze explanations based on (1) the role of antitakeover arrangements in encouraging founders to break up their initial control blocks, (2) efficient private benefits of control, (3) agency problems among pre-IPO shareholders, (4) agency problems between pre-IPO shareholders and their IPO lawyers, (5) asymmetric information between founders and public investors about the firm's future growth prospects, and (6) bounded attention and imperfect pricing at the IPO stage.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Abstract: Firms going public have increasingly been incorporating antitakeover provisions in their IPO charters, while shareholders of existing companies have increasingly been voting in opposition to such charter provisions. This paper identifies and analyzes possible explanations for this empirical pattern. Specifically, I analyze explanations based on (1) the role of antitakeover arrangements in encouraging founders to break up their initial control blocks, (2) efficient private benefits of control, (3) agency problems among pre-IPO shareholders, (4) agency problems between pre-IPO shareholders and their IPO lawyers, (5) asymmetric information between founders and public investors about the firm's future growth prospects, and (6) bounded attention and imperfect pricing at the IPO stage.
I also discuss the policy implications of the possible explanations. Among other things, the analysis implies that researchers should not automatically infer that arrangements adopted in IPO charters are ones that enhance shareholder value. The analysis also indicates that board veto arrangements is unlikely to serve shareholders in companies with dispersed ownership and should not be chosen as a default. The analysis provides some support for limits on contractual freedom at the IPO stage. Finally, the analysis suggests that it might be desirable for corporate law to use sunset strategies, requiring that entrenching arrangements adopted by charter provisions lapse after a certain period unless renewed by a shareholder vote.
corporate governance, corporate control, takeovers, mergers and acquisitions, takeover bids, tender offers, takeover defenses, antitakeover charter provisions, staggered boards, corporate charters, IPO, mandatory rules, sunset arrangements
Abstract: This essay surveys the literature on Chapter 11. I start by discussing the objectives by which the performance of corporate reorganization rules is to be judged and then consider the fundamental problem of valuation that arises in corporate reorganization. I next turn to examine the performance of the prevailing bargaining-based approach to reorganization, both in terms of its effect on total reorganization value and in terms of its effect on the division of this value. Finally, I examine the two alternative approaches that have been put forward to the approach of existing rules -- that of auctioning the reorganized company's asset (put forward by Baird (1986) and Jensen (1991)) and that of using options to reorganize the company's ownership (put forward by Bebchuk (1988)).
Abstract: This essay surveys the literature on Chapter 11. I start by discussing the objectives by which the performance of corporate reorganization rules is to be judged and then consider the fundamental problem of valuation that arises in corporate reorganization. I next turn to examine the performance of the prevailing bargaining-based approach to reorganization, both in terms of its effect on total reorganization value and in terms of its effect on the division of this value. Finally, I examine the two alternative approaches that have been put forward to the approach of existing rules - that of auctioning the reorganized company's asset (put forward by Baird (1986) and Jensen (1991) and that of using options to reorganize the company's ownership (put forward by Bebchuk (1988)).
Abstract: In the ongoing debate on state competition over corporate charters, supporters of state competition have long claimed that the empirical evidence clearly supports their view. This paper suggests that the body of empirical evidence on which supporters of state competition have relied does not warrant this claim. The paper first demonstrates that reported findings of a positive correlation between incorporation in Delaware and increased shareholder wealth are not robust and, furthermore, do not establish causation. The paper then shows that, even if Delaware incorporation were found to cause an increase in shareholder value, this finding would not imply that state competition is working well; benefits to incorporating in the dominant state would likely exist in a race-toward-the bottom' equilibrium in which state competition provided undesirable incentives. Third, the analysis shows that empirical claims that state competition rewards moderation in the provision of antitakeover protections are not well grounded. Finally, we endorse a new approach to the empirical study of the subject that is based on analyzing the determinants of companies' choices of state of incorporation. Recent work based on this approach indicates that, contrary to the beliefs of state competition supporters, states that amass antitakeover statutes are more successful in the incorporation market.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Abstract: In the ongoing debate on state competition over corporate charters supporters of state competition have long claimed that the empirical evidence clearly supports their view. This article shows, however, that the body of empirical evidence on which supporters of state competition have relied does not warrant this claim. This empirical evidence, we argue, is in fact entirely consistent with the opposing view that state competition provides undesirable incentives with respect to corporate issues, such as takeover regulation, that substantially affect managers' private benefits.
We first show that reported findings of a positive correlation between incorporation in Delaware and increased shareholder wealth are not robust and are much more mixed and ambiguous than has been recognized. Furthermore, we argue that the presence of such causation would in any event not establish that Delaware incorporation increases value rather than simply chosen by higher value companies.
We next show that, even if Delaware incorporation were found to cause an increase in shareholder value, this finding would not imply that state competition is working well; benefits to incorporating in the dominant state would likely exist in a "race-toward-the-bottom" equilibrium in which state competition provides undesirable incentives. Finally, we show that empirical claims that state competition rewards moderation in the provision of antitakeover protections are not well grounded.
We conclude by endorsing a new approach to the empirical study of the subject that is based on analyzing the determinants of companies' choices of state of incorporation. Recent work based on this approach indicates that, contrary to the beliefs of state competition supporters, states that amass antitakeover statutes are more successful in the incorporation market.
Delaware, incorporations, corporate charters, regulatory competition, corporate governance, managers, shareholders, takeovers, antitakeover statutes
Abstract: This paper shows that "one-sided" terms in standard contracts, which deny consumers a contractual benefit that seems efficient on average, may arise in competitive markets without informational problems (other than those of courts). A one-sided term might be an efficient response to situations in which courts cannot perfectly observe all the contingencies needed for an accurate implementation of a "balanced" contractual term when firms are more concerned about their reputation, and thus less inclined to behave opportunistically, than consumers are. We develop this explanation, discuss its positive and normative implications, and compare them to those of information-based explanations for one-sided terms.
contracts, standard form contracts, contracts of adhesion, reputation, opportunism, observability
Abstract: This paper contains the edited transcripts of the Symposium on Corporate Elections held at Harvard Law School in October 2003. The symposium brought together SEC officials, CEOs, directors, institutional investors, money managers, shareholder activists, lawyers, judges, academics, and others to discuss the subject from a wide range of perspectives. The symposium included the following six sessions:
1. The Basic Pros and Cons of Shareholder Access. Martin Lipton and Steven Rosenblum, Wachtell, Lipton, Rosen & Katz, Lucian Bebchuk, Harvard Law School
2. The Board/Management Perspective. Richard Breeden, Richard C. Breeden & Co. John Castellani, The Business Roundtable James Rogers, Cinergy Inc. Ralph Whitworth, Apria Healthcare Group
3. The Perspective of Institutional Investors. Orin Kramer, Kramer Spellman Robert Pozen, Harvard Law School Michael Price, MFP Investors Sarah Teslik, Council for Institutional Investors
4. The Perspective of Shareholder Activists and Advisers. Jaime Heard, Institutional Shareholder Services Robert Monks, Lens Governance Advisors Damon Silvers, AFL-CIO John Wilcox, Georgeson Shareholders
5. Legal Problems in Designing a Shareholder Access Rule. John Coffee, Columbia Law School Joseph Grundfest, Stanford Law School Robert Todd Lang, Weil, Gotshal & Manges Charles Nathan, Latham & Watkins Leo Strine, Delaware Chancery Court
6. Concluding Remarks. Robert Clark, Harvard Law School Floyd Norris, The New York Times Harvey Goldschmid, U.S. Securities and Exchange Commission
Each session started with opening presentations by the panelists, followed by a discussion among the panelists and between the panelists and other participants in the symposium.
corporate governance, directors, shareholders, shareholder voting, corporate elections, proxy fights, proxy contests, proxy rules, corporate elections, SEC
Abstract: This Paper argues that once undistorted shareholder choice is ensured - which can be done by making it necessary for hostile bidders to win a vote of shareholder support - boards should not have veto power over takeover bids. The Paper considers all of the arguments that have been offered for board veto - including ones based on analogies to other corporate decisions, directors' superior information, bargaining by management, pressures on managers to focus on the short-run, inferences from IPO charters, interests of long-term share-holders, aggregate shareholder wealth, and protection of stakeholders. Examining these arguments both at the level of theory and in light of all available empirical evidence, the Paper concludes that none of them individually, nor all of them taken together, warrants a board veto. Finally, the Paper discusses the implications that the analysis has for judicial review of defensive tactics.
Corporate governance, corporate control, takeovers, mergers and acquisitions, takeover bids, tender offers, takeover defences
Abstract: This paper argues that once undistorted shareholder choice is ensured -- which can be done by making it necessary for hostile bidders to win a vote of shareholder support -- boards should not have veto power over takeover bids. The paper considers all of the arguments that have been offered for board veto -- including ones based on analogies to other corporate decisions, directors' superior information, bargaining by management, pressures on managers to focus on the short-run, inferences from IPO charters, interests of long-term shareholders, aggregate shareholder wealth, and protection of stakeholders. Examining these arguments both at the level of theory and in light of all available empirical evidence, the paper concludes that none of them individually, nor all of them taken together, warrants a board veto. Finally, the paper discusses the implications that the analysis has for judicial review of defensive tactics.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Abstract: This paper argues that once undistorted shareholder choice is ensured - which can be done by making it necessary for hostile bidders to win a vote of shareholder support - boards should not have veto power over takeover bids. The paper considers all of the arguments that have been offered for board veto - including ones based on analogies to other corporate decisions, directors' superior information, bargaining by management, pressures on managers to focus on the short-run, inferences from IPO charters, interests of long-term shareholders, aggregate shareholder wealth, and protection of stakeholders. Examining these arguments both at the level of theory and in light of all available empirical evidence, the paper concludes that none of them individually, nor all of them taken together, warrants a board veto. Finally, the paper discusses the implications that the analysis has for judicial review of defensive tactics.
corporate governance, corporate control, takeovers, mergers and acquisitions, takeover bids, tender offers, takeover defenses
Abstract: This paper develops and defends our earlier analysis of the powerful antitakeover force of staggered boards. We reply to five responses to our work, by Stephen Bainbridge, Mark Gordon, Patrick McGurn, Leo Strine, and Lynn Stout, which are to be published in a Stanford Law Review Symposium. We present new empirical evidence that extends our earlier findings, confirms our conclusions, and demonstrates that the alternative theories put forward by some commentators do not adequately explain the evidence. Among other things, we find that having a majority of independent directors does not address the concern that defensive tactics might be abused. We also find that effective staggered boards do not appear to have a significant beneficial effect on premia in negotiated transactions. Finally, we show that, unlike our approach, the approach that our critics advocate for Delaware takeover jurisprudence to follow is both inconsistent with its established principles and takes an extreme position in the overall debate on takeover defenses. Our analysis and new findings further strengthen the case for limiting the ability of incumbents armed with a staggered board to continue saying no after losing an election conducted over an acquisition offer.
Our earlier study, Lucian Bebchuk, John Coates IV and Guhan Subramanian, "The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy," 54 Stanford Law Review 887-951 (2002), is available on the SSRN site at http://ssrn.com/abstract=304388.
Takeover, mergers and acquisitions, tender offers, takeover bids, defensive tactics, staggered boards, poison pills, premia, independent directors
Abstract: This article defends, and further develops, our earlier work on regulatory competition and takeover law. We have argued that competition for corporate charters provides incentives to states to protect incumbent managers from hostile takeovers, and that the empirical evidence is consistent with this account. To improve the performance of regulatory competition, we have put forward the possibility of choice-enhancing federal intervention; such intervention would expand shareholder choice, and encourage states to become more attentive to shareholder interests, without imposing any mandatory arrangements. Replying to Jonathan Macey's response to our work in this issue of the Business Lawyer, we show that none of his claims weakens our analysis.
The earlier work which we defend and develop in this paper is "A New Approach to Takeover Law and Regulatory Competition," 87 Virginia Law Review 111-164 (2001). In a related piece ("Federal Intervention to Enhance Shareholder Choice," 87 Virginia Law Review 993-1006 (2001)), we reply to a critique of our work by Steve Choi and Andrew Guzman.
Delaware, incorporations, corporate charters, regulatory competition, corporate governance, managers, shareholders, takeovers
Abstract: In many business bankruptcies in which the firm is to be preserved as a going concern, one of the most difficult and important problems is that of valuing the assets that serve as collateral for secured creditors. Valuing a secured creditor's collateral is needed to determine the amount of the creditor's secured claim, which in turn affects the payout that must be made to the creditor. Such valuation has generally been believed to require either litigation or bargaining among the parties, which in turn give rise to uncertainty, delay, and deviations from parties' entitlements. This paper puts forward a new approach to valuing collateral that involves neither bargaining nor litigation. Under this approach, a market-based mechanism would determine the value of collateral in such a way that no participant in the bankruptcy would have a basis for complaining that secured creditors are either over- or under-compensated. Our approach would considerably improve the performance of business bankruptcy and could constitute an important element of any proposal for bankruptcy reform.
bankruptcy, insolvency, secured debt, security interest, collateral, valuation, bankruptcy reform
Abstract: Fairness opinions are a regular feature of every major corporate transaction. We analyze the conflict of interest problems that afflict fairness opinions and the extent to which courts should give weight to such opinions.
Investment bankers, fairness opinions, takeovers, freezeouts, corporate governance, conflict of interest, professionals
Abstract: The agents to whom shareholders delegate the management of corporate affairs may transfer value from shareholders to themselves through a variety of mechanisms, such as self-dealing, insider trading, and taking of corporate opportunities. A common view in the law and economics literature is that such value diversion does not ultimately produce a reduction in shareholder wealth, since value diversion simply substitutes for alternative forms of compensation that would otherwise be paid to managers. We question this view within its own analytical framework by studying, in a principal-agent model, the effects of allowing value diversion on managerial compensation and effort. We suggest that the standard law and economics view of value diversion overlooks a significant cost of such behavior. Many common modes of compensation can provide managers with incentives to enhance shareholder value; replacing such compensation would reduce these incentives. As a result, even if the consequences of a rule permitting value diversion can be fully taken into account in settling managerial compensation, such a rule might still produce a reduction in shareholder wealth -- and would not do so only if value diversion would have some countervailing positive effects (a possibility which our model considers) that are sufficiently significant in size.
Abstract: The agents to whom shareholders delegate the management of corporate affairs may transfer value from shareholders to themselves through a variety of mechanisms, such as self-dealing, insider trading, and taking of corporate opportunities. A common view in the law and economics literature is that such value diversion does not ultimately produce a reduction in shareholder wealth, since value diversion simply substitutes for alternative forms of compensation that would otherwise be paid to managers. We question this view within its own analytical framework by studying, in a principal-agent model, the effects of allowing value diversion on managerial compensation and effort. We suggest that the standard law and economics view of value diversion overlooks a significant cost of such behavior. Many common modes of compensation can provide managers with incentives to enhance shareholder value; replacing such compensation would reduce these incentives. As a result, even if the consequences of a rule permitting value diversion can be fully taken into account in setting managerial compensation, such a rule might still produce a reduction in shareholder wealth--and would not do so only if value diversion would have some countervailing positive effects (a possibility which our model considers) that are sufficiently significant in size.
Abstract: This paper revisits the proposal to use options in corporate bankruptcy that was put forward in Bebchuk (1988). According to the proposed procedure, corporate bankruptcy should be implemented through the distribution to participants of appropriately designed options. The paper starts by discussing the goals that should guide the design of bankruptcy procedures. The paper then explains how the options procedure can improve both ex post efficiency and ex ante efficiency. The paper offers a refined version of the procedure, and it also responds to questions that have been raised regarding the execution and desirability of the procedure. The paper concludes by explaining the relationship between the options approach to corporate bankruptcy and the Black-Scholes characterization of all corporate securities as options.
Bankruptcy, reorganization, options
Abstract: During contractual negotiations, parties often make (reliance) expenditures that would increase the surplus should a contract be made. This paper analyzes decisions to invest in pre-contractual reliance under alternative legal regimes. Investments in reliance will be socially suboptimal in the absence of any pre-contractual liability -- and will be socially excessive under strict liability for all reliance expenditures. Given the results for these polar cases, we focus on exploring how 'intermediate' liability rules could be best designed to induce efficient reliance decisions. One of our results indicates that the case for liability is shown to be stronger when a party retracts from terms that it has proposed or from preliminary understandings reached by the parties. Our results have implications, which we discuss, for various contract doctrines and debates. Finally, we show that pre-contractual liability does not necessarily have an overall adverse effect on parties' decisions to enter into contractual negotiations.
Abstract: During contractual negotiation, parties often make (reliance) expenditures that would increase the surplus should a contract be made. This paper analyzes decisions to invest in pre-contractual reliance under alternative legal regimes. Investments in reliance will be socially suboptimal in the absence of any pre-contractual liability - and will be socially excessive under strict liability for all reliance expenditures. Given the results for these polar cases, we focus on exploring how "intermediate" liability rules could be best designed to induce efficient reliance decisions. One of our results indicates that the case for liability is shown to be stronger when a party retracts from terms that it has proposed or from preliminary understandings reached by the parties. Our results have implications, which we discuss, for various contract doctrines and debates. Finally, we show that pre-contractual liability does not necessarily have an overall adverse effect on parties' decisions to enter into contractual negotiations.
Contracts, bargaining, negotiations, reliance
Abstract: During contractual negotiations, but before entering a contract, parties might make (reliance) expenditures that would increase the surplus should a contract be made but would be fully or partially wasted otherwise. This paper develops a model for analyzing parties' decisions to invest in pre-contractual reliance under alternative legal regimes. Whereas parties' investments in reliance will be socially suboptimal in the absence of any pre-contractual liability, they will be socially excessive under a regime of strict liability for all reliance expenditures. Given the results for the two polar cases, the analysis explores how "intermediate" liability rules could be designed to induce optimal reliance decisions, considers what information courts would need to implement such rules, and discusses implications for the doctrines governing pre-contractual liability. The case for liability is shown to be stronger when a party retracts from a preliminary understanding or from terms that it has proposed. Finally, the analysis shows that pre-contractual liability does not necessarily have an adverse overall effect on parties' decisions to enter into contractual negotiations.
Contracts, Negotiations, Reliance
Abstract: This piece provides the brief submitted to the Delaware Chancery Court by plaintiff in the case of Bebchuk vs. CA, Inc. The case concerns the attempt by CA to exclude from the corporate ballot a stockholder proposal to adopt a proposed bylaw concerning the use of poison pills on grounds that it would be invalid under Delaware law. Under the proposed bylaw, a board would not be able to maintain a pill indefinitely without periodic determination than doing so would serve shareholders. The brief explains why, in contrast to the claims made by CA, the proposed bylaw would neither violate any of the provisions of the Delaware corporate code nor impedes directors' fulfillment of their fiduciary duties. Although the court decided that the case was not sufficiently ripe for a ruling on the validity of the proposed bylaw, the court's decision rejected CA's arguments that the bylaw is clearly invalid.
Takeovers, takeover defenses, poison pill, bylaws, charter, fiduciary duties, corporate governance, agency costs, directors, shareholders, Delaware
Abstract: A basic question for the design of bankruptcy law concerns whether value should be divided in accordance with absolute priority. Research done in the past decade has suggested that deviations from absolute priority have beneficial ex ante effects. In contrast, this Paper shows that ex post deviations from absolute priority also have negative effects on ex ante decisions taken by shareholders. Such deviations aggravate the moral hazard problem with respect to project choice increasing the equityholders' incentive to favor risky projects as well as with respect to borrowing and dividend decisions.
Bankruptcy, Chapter 11, corporate reorganizations, workouts, absolute priority, moral hazard, asset dilution, claim dilution
Abstract: A basic question for the design of bankruptcy law concerns whether value should be divided in accordance with absolute priority. Research done in the past decade has suggested that deviations from absolute priority have beneficial ex ante effects. In contrast, this paper shows that ex post deviations from absolute priority also have negative effects on ex ante decisions taken by shareholders. Such deviations aggravate the moral hazard problem with respect to project choice - increasing the equityholders' incentive to favor risky projects - as well as with respect to borrowing and dividend decisions.
Abstract: Beginning with Calabresi's and Melamed's seminal article, economic analysis of property rights and liability rules has been largely done from an ex post perspective, taking as given the presence of the parties involved and their payoffs. This paper analyzes how such allocation of entitlements affects ex ante investments and actions. Even when ex post bargaining is easy, the ex post allocation of entitlements, by affecting the distribution of ex post value, can have significant efficiency effects ex ante. By identifying the ex ante effects of alternative rules, the analysis provides a framework for determining allocations of entitlement that would perform best from the perspective of ex ante efficiency.
externalities, property rights, liability rules, ex ante investments, regulation
Abstract: In a corporate freeze-out, the controller is required to compensate minority shareholders for the no-freezeout value of their shares that are taken from them. This paper seeks to highlight the difficulties involved in determining this no-freezeout value when, as is often the case, the controller has private information. In particular, the analysis shows that the pre-freezeout market price of minority shares cannot be used as a proxy for the no-freezeout value that these shares would have in the absence of a freeze-out. It is shown that, under a regime in which frozen out minority shareholders receive a compensation equal to the pre-freezeout market price, the pre-freezeout market price will be set at a level below the expected no-freezeout value of minority shares. The reason for this is a "lemons effect" that arises when a controller uses her private information in deciding whether to effect a freeze-out. By showing how controllers are able to use their private information to effect freeze-outs at terms favorable to them, this paper demonstrates that freeze-outs can become a significant source for private benefits of control.
Corporate freezeouts, minority shareholders, private benefits of control, expropriation, agency costs, appraisal
Abstract: Public corporations live in a dynamic and ever-changing business environment. This Paper examines how courts and legislators should choose default arrangements in the corporate area to address new circumstances. We show that the interests of the shareholders of existing companies would not be served by adopting those default arrangements that public officials view as most likely to be value enhancing. Because any charter amendment requires the board's initiative, opting out of an inefficient default arrangement is much more likely to occur when management disfavors the arrangement than management supports it. We develop a "reversible defaults" approach that takes into account this asymmetry. When public officials must choose between two or more default arrangements and face significant uncertainty as to which one would best serve shareholders, they should err in favour of the arrangement that is less favorable to managers. Such an approach, we show, would make it most likely that companies would be ultimately governed by the arrangement that would maximize shareholder value. Evaluating some of the main choices that state corporate law has made in the past two decades in light of our proposed approach, we endorse some but question others. The arrangements we examine include those developed with respect to director liability, state anti-takeover statutes, and the range of permitted defensive tactics.
Shareholders, managers, directors, default rules, interpretation, takeovers, anti-takeover statutes, poison pill, staggered boards
Abstract: Public corporations live in a dynamic and ever-changing business environment. This paper examines how courts and legislators should choose default arrangements in the corporate area to address new circumstances. We show that the interests of the shareholders of existing companies would not be served by adopting those defaults arrangements that public officials view as most likely to be value-enhancing. Because any charter amendment requires the board's initiative, opting out of an inefficient default arrangement is much more likely to occur when management disfavors the arrangement than management supports it. We develop a 'reversible defaults' approach that takes into account this asymmetry. When public officials must choose between two or more default arrangements and face significant uncertainty as to which one would best serve shareholders, they should err in favor of the arrangement that is less favorable to managers. Such an approach, we show, would make it most likely that companies would be ultimately governed by the arrangement that would maximize shareholder value. Evaluating some of the main choices that state corporate law has made in the past two decades in light of our proposed approach, we endorse some but question others. The arrangements we examine include those developed with respect to director liability, state antitakeover statutes, and the range of permitted defensive tactics.
Abstract: Public corporations live in a dynamic and ever-changing business environment. This paper examines how courts and legislators should choose default arrangements in the corporate area to address new circumstances. We show that the interests of the shareholders of existing companies would not be served by adopting those defaults arrangements that public officials view as most likely to be value-enhancing. Because any charter amendment requires the board's initiative, opting out of an inefficient default arrangement is much more likely to occur when management disfavors the arrangement than management supports it. We develop a "reversible defaults" approach that takes into account this asymmetry. When public officials must choose between two or more default arrangements and face significant uncertainty as to which one would best serve shareholders, they should err in favor of the arrangement that is less favorable to managers. Such an approach, we show, would make it most likely that companies would be ultimately governed by the arrangement that would maximize shareholder value. Evaluating some of the main choices that state corporate law has made in the past two decades in light of our proposed approach, we endorse some but question others. The arrangements we examine include those developed with respect to director liability, the regulation of takeover bidders, and the range of permitted defensive tactics.
Shareholders, managers, directors, default rules, interpretation, takeovers, antitakeover statutes, poison pill, and staggered boards
Abstract: The paper identifies problems with the ordered breakup of Microsoft that seem to have been completely overlooked by the government, the judge, and the commentators. The breakup order prohibits Bill Gates and other large Microsoft shareholders from owning shares in both of the companies that would result from the separation. Given this prohibition, we show, dividing the securities in the resultant companies among the shareholders is not as straightforward as the government has suggested. Any method of distributing the securities that would comply with this mandate would either (i) impose a significant financial penalty on Microsoft's large shareholders that is not contemplated by the order, or (ii) create a risk of a substantial transfer of value between Microsoft's shareholders. In addition to identifying the difficulties and costs involved in the two distribution methods that would comply with the cross-shareholding prohibition, we examine how the breakup order could be refined to reduce these difficulties and costs. The problems that we identify should be addressed if a breakup is ultimately to be pursued and should be taken into account in making the basic decision of whether to break up Microsoft at all.
Valuation, Microsoft, breakup, spin-off
Abstract: This paper identifies problems with the ordered breakup of Microsoft that seem to have been completely overlooked by the government, the judge, and the commentators. The breakup order prohibits Bill Gates and other large Microsoft shareholders from owning shares in both of the companies that would result from the separation. Given this prohibition, we show, dividing the securities in the resultant companies among the shareholders is not as straightforward as the government has suggested. Any method of distributing the securities that would comply with this mandate would either (i) impose a significant financial penalty on Microsoft's large shareholders that is not contemplated by the order, or (ii) create a risk of a substantial transfer of value between Microsoft's shareholders. In addition to identifying the difficulties and costs involved in the two distribution methods that would comply with the cross-shareholding prohibition, we examine how the breakup order could be refined to reduce these difficulties and costs. The problems that we identify should be addressed if a breakup is ultimately to be pursued and should be taken into account in making the basic decision of whether to break up Microsoft at all.
Abstract: The modern approach to corporate reorganizations begins in a curious place. Everywhere else in corporate law, we focus on those who control the firm and on when others should be able to go to court and reverse their decisions. With respect to corporate reorganizations, however, we ignore these questions and instead focus on priority rights. Our lodestar is the real estate foreclosure. A real estate foreclosure is an actual sale of a physical asset, and the proceeds of the sale are distributed to old creditors and shareholders according to nonbankruptcy priorities. A reorganization is also a sale, albeit a hypothetical one, and the proceeds of the sale (usually in the form of new claims against the reorganized firm) are again distributed to the old creditors and shareholders. Hence, nonbankruptcy priorities should be respected here as well. According to this conventional wisdom, the primary challenge in the law of corporate reorganizations lies in devising a process that allows us to respect priority rights when there is not an actual foreclosure with competing bids.
In this paper, we show that this conventional understanding of corporate reorganizations is wrong. It might seem that the primary question when all cannot be paid in full is who gets what, but this question is in the first instance merely distributional. It concerns only the size of the slices, not the size of the pie. Rational investors are indifferent to the priority they enjoy in bad states as long they enjoy a competitive risk-adjusted return on their investment. Hence, the central focus of corporate reorganizations should not be upon priority rights. Instead, as in corporate law generally, it should remain upon how the firm's assets are used and who controls them. Investors care intensely about ensuring that control of a firm's assets resides in able hands in good times; they care even more in bad times. When a firm is in financial distress, a large part of its value can be lost in a short period of time.
The starting place for corporate reorganization scholarship since the 1930s -- the real estate foreclosure -- ignores the question of control. Real estate foreclosure turns tangible assets into cash. With such a sale, there is no need to decide whether to liquidate the firm or to replace the current managers. These decisions can be entrusted to the new buyer. The only question is the distribution of cash among old creditors and shareholders. By contrast, in a reorganization that might last months or years, we must ask whether to continue the firm, how to identify those who will run it, and how to monitor them. About these questions, the real estate foreclosure analogy has nothing to say.
Moreover, the foreclosure analogy leads to a method of allocating rights among old investors in the new entity that is affirmatively suspect. This distributional scheme-the absolute priority rule- demands that shareholders of insolvent firms be wiped out in the event of a reorganization. This rule exists uncomfortably with a persistent and pervasive feature of the capital structures of all but the largest, publicly held firms. In smaller firms, there is a near identity between shareholder and manager.
The value of such firms as going concerns depends upon the firm-specific human capital of its manager. To be sure, if the firm lacks any value as a going concern, it should be liquidated. In such a case, there is an actual sale and nonbankruptcy priorities should be respected. But a significant number of firms have value as going concerns, and this value can be preserved only if the current manager remains in place and continues to hold the equity of the firm. When such a firm is kept as a going concern, a deal must be struck with the current manager one way or another. The dynamics of these renegotiations are such that the absolute priority rule likely has no effect on the share of the firm the manager enjoys after the reorganization, nor does it change her incentives beforehand. In short, modern scholars of corporate reorganizations have asked the wrong question and then offered an answer that is very likely irrelevant.
In this Essay, we reexamine the foundations of corporate reorganizations. More in harmony with the modern understanding of corporate law, our approach does not begin with the real estate foreclosure and does not assume the centrality of the absolute priority rule. With respect to small firms or firms in less developed capital markets, we show that the question of whether to shut down the firm is of central importance. The challenge of the law of corporate reorganizations should be one of ensuring that this decision is in the hands of someone well equipped to make it.
The thesis put forward in this Essay is straightforward. When the managers and shareholders cannot be easily separated, control rights should lie in the hands of someone whose loyalties are aligned with the creditors, but the reorganization itself should not affect the value of the managers' equity interest. These principles are not new, but rather forgotten. Although they barely made a toehold in the academic literature of the time, 10 the early law of corporate reorganizations in this country adopted these principles in an environment in which it seems likely that they vindicated the creditors' bargain. Hence, it is this body of law to which we turn first.
Abstract: In a recent article, we have put forward a new approach to takeover law and regulatory competition. We proposed a 'choice-enhancing' federal intervention that would provide: (i) an optional body of substantive federal takeover law which shareholders would be able to opt into (or out of) and which would be more hospitable than existing state takeover law, and (ii) a mandatory process rule that would provide shareholders the right to initiate and adopt, regardless of managers' wishes, proposals for option into (or out of) the federal takeover law. In this Paper, we respond to critics of our proposal, and we further develop the case for it.
Takeover law, regulatory competition, federal takeover, state takeover, shareholder
Abstract: In a recent article, we have put forward a new approach to takeover law and regulatory competition. We proposed a "choice-enhancing" federal intervention that would provide: (i) an optional body of substantive federal takeover law which shareholders would be able to opt into (or out of) and which would be more hospitable than existing state takeover law, and (ii) a mandatory process rule that would provide shareholders the right to initiate and adopt, regardless of managers' wishes, proposals for option into (or out of) the federal takeover law. In this paper, we respond to a critique of our proposal by Professors Stephen Choi and Andrew Guzman, and we further develop the case for choice-enhancing intervention.
Abstract: We study the relation between opportunistic timing of option grants and corporate governance, focusing on at-the-money “lucky” grants awarded at the lowest price of the grant month. We find that both CEO and independent directors received an abnormally high number of lucky grants, and that opportunistic timing of director grants was not merely a by-product of their coinciding with executive grants or of firms’ routinely timing all grants. Lucky grants to CEOs and directors are associated with higher CEO compensation from other sources, and are correlated with a lack of majority of independent directors on the board, no independent compensation committee with an outside blockholder, or a long-serving CEO. For any given firm, the odds of a lucky grant increased when the payoffs from luck were high and when a preceding grant was lucky.
Executive compensation, corporate governance, options, backdating, timing, spring-loading, inside information, CEO, independent directors
Abstract: This paper integrates and further develops the analysis of two discussion papers we circulated earlier, “Lucky CEOs” and “Lucky Directors.” We study the relation between opportunistic timing of option grants and corporate governance, focusing on at-the-money “lucky” grants awarded at the lowest price of the grant month. We find that both CEO and independent directors received an abnormally high number of lucky grants, and that opportunistic timing of director grants was not merely a by-product of their coinciding with executive grants or of firms’ routinely timing all grants. Lucky grants to CEOs and directors are associated with higher CEO compensation from other sources, and are correlated with a lack of majority of independent directors on the board, no independent compensation committee with an outside blockholder, or a long-serving CEO. For any given firm, the odds of a lucky grant increased when the payoffs from luck were high and when a preceding grant was lucky. Lucky CEOs is available on SSRN at: http://papers.ssrn.com/abstract =945392 Lucky Directors is available on SSRN at: http://papers.ssrn.com/abstract =952239
Abstract: This paper develops a framework for analyzing transactions that transfer a company's controlling block from an existing controller to a new controller. This framework is used to compare the market rule, which is followed in the United States, with the equal opportunity rule, which prevails in some other countries. The market rule is superior to the equal opportunity rule in facilitating efficient transfers of control but inferior to it in discouraging inefficient transfers. Conditions under which one of the two rules is overall superior are identified; for example, the market rule is superior if existing and new controllers draw their characteristics from the same distributions. Finally, the rules' effects on surplus division are analyzed and this examination reveals a rationale for mandatory rules.
Corporate control, sale of control, control blocks, large shareholders, mergers and acquisitions, private benefit of control, minority shareholders
Abstract: In recent work, we presented evidence indicating that staggered boards have adverse effects on target shareholders. John Wilcox, the Vice-Chair of Georgeson, recently published a critique of our work, urging shareholders to support staggered boards. We respond in this article to Wilcox's critique and explain why it does not weaken in any way our analysis of staggered boards.
The study criticized by Wilcox, "The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy," 54 Stanford Law Review 887-951 (2002), is available at http://ssrn.com/abstract=304388. In a separate reply, "The Powerful Antitakeover Force of Staggered Boards: Further Findings and a Reply to Symposium Participants," 55 Stanford Law Review 885-917 (2002), which is available at http://ssrn.com/abstract=360840, we respond to several other responses to our original study and present additional evidence that confirms its conclusions.
Abstract: This paper develops a model of a self-fulfilling credit market freeze and uses it to study alternative governmental responses to such a crisis. We study an economy in which operating (nonfinancial) firms are interdependent, with their success depending on the ability of other operating firms to obtain financing. In such an economy, we show, inefficient credit market freeze may arise in which banks abstain from lending to operating firms with good projects because (and only because) of their (self-fulfilling) expectations that other banks will not be lending. We show how inefficient credit freeze equilibria may result from the arrival of information about fundamentals or a negative shock to the banking system's capitalization. While such equilibria result from the arrival of information about fundamentals, they do represent a "coordination failure:" banks' separate and fully rational decisions produce an outcome that would have been avoided had they been able to choose a coordinated action.
Our model enables us to study the effectiveness of alternative measures for getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of (1) interest rate cuts, (2) infusion of capital into financial firms, (3) infusion of capital under terms that commit financial firms receiving it to use it to extend loans, (4) direct lending to operating firms by the government, and (5) lending to operating firms by funds owned by the government and managed by private agents compensated with a share of the profits generated by the fund. Throughout, we discuss the implications of our analysis for understanding and responding to the credit crisis of 2008.
A detailed discussion of the implementation and institutional design of alternative forms of government intervention to produce a credit thaw is provided in Bebchuk, "Unfreezing Credit Markets," available at: http://papers.ssrn.com/abstract=1315436
Credit freeze, credit crunch, credit thaw, self-fulfilling crisis, run on the economy, global game, coordination failure, bank capital, lending, strategic complementarities
Abstract: This paper analyzes the effects of the legal rules governing transnational bankruptcies. We compare a regime of territoriality' -- in which assets are adjudicated by the jurisdiction in which they are located at the time of the bankruptcy -- with a regime of universality are adjudicated in a single jurisdiction. Territoriality is shown to generate a distortion in investment patterns that might lead to an inefficient allocation of capital across countries. We also analyze who gains and who loses from territoriality, explain why countries engage in it even though it reduces global welfare, and identify what can be done to achieve universality.
Abstract: This paper analyzes the effects of the legal rules governing transnational bankruptcies. We compare a regime of "territoriality" - in which assets are adjudicated by the jurisdiction in which they are located at the time of the bankruptcy - with a regime of "universality," in which all assets are adjudicated in a single jurisdiction. Territoriality is shown to generate a distortion in investment patterns that might lead to an inefficient allocation of capital across countries. We also analyze who gains and who loses from territoriality, explain why countries engage in it even though it reduces global welfare, and identify what can be done to achieve universality.
Abstract: The long-standing and central debate on state competition in corporate law has been largely premised on a widely held belief that, whether the race is toward the top or the bottom, states vigorously "race" in seeking to attract incorporations. In this paper, we argue that this belief is in fact incorrect and that the competitive threat to Delaware's dominant position in the incorporation market is quite weak. We discuss evidence that Delaware's position in this market is far more dominant and secure than has been previously recognized. We then analyze the structural features of the incorporation market that can explain this state of affairs. The weak-competition account that we put forward casts substantial doubt on the extent to which state competition can be relied on - even on the most favorable view of it - to produce optimal corporate rules. This account strengthens the case for some form of federal intervention; at the minimum, it would be desirable for federal law to invigorate competition by permitting shareholders to initiate and approve reincorporations and by providing a federal incorporation option.
Delaware, Incorporation, Corporate Charters, Corporate Governance, Regulatory Competition, Managers, Shareholders, Takeovers, Barriers to entry, Network Externalities, Federalism
Abstract: This paper examines the specific features of the shareholder access rule recently proposed by the Securities and Exchange Commission. I suggest that, even accepting the Commission's generally cautious approach and its desire to limit shareholder access to cases where the need for it is evident, the restrictions included in the rule proposal are excessive and should be relaxed. In particular, I identify several changes in these restrictions that would contribute to attaining the policy goals that the proposed rule seeks to serve.
corporate governance, directors, shareholders, shareholder voting, corporate ballot, corporate elections, proxy fights, proxy contests, proxy rules, SEC.
Abstract: Corporate law scholars have long debated whether state competition for corporate charters is a "race for the bottom" or a "race for the top." This paper offers an analysis of the dynamics and performance of state charter competition. I show how the presence of managerial opportunism and externalities may lead states to adopt undesirable corporate law rules. The analysis identifies the various issues with respect to which state competition is likely to fail, and he advocates an expansion of federal regulation to govern all of these issues. I also connect the state competition question with the question of contractual freedom in corporate law and argue that many scholars should reconsider their inconsistent views regarding these two questions. Finally, I conclude by addressing potential objections to the expansion of federal corporate regulation.
Delaware, state competition, federalism, race to the top, race to the bottom, corporate governance, corporate law, agency costs, managerial opportunism, private benefits of control, takeovers
Abstract: In an earlier work, we analyzed how the legal rules governing contractual liability affect the transfer of information between the parties to the contract. In particular, we showed how limitations on contractual liability might lead high valuation buyers to reveal their valuation of performance, and we identified the circumstances under which such limitations on liability are and are not socially desirable. In an article forthcoming in the Stanford Law Review, Barry Adler develops a critique of our analysis, as well as that of Ayres and Gertner, who independently argued that contractual rules can beneficially facilitate information transfers. We reconsider here the subject of contractual liability and the revelation of information and respond to Adler's critique. We find Adler's model to be a natural extension of ours rather than a departure from it. Our reexamination leads to the conclusion that the informational effects that our work analyzed are important to take into account in designing contract rules.
Abstract: In an earlier work, we analyzed how the legal rules governing contractual liability affect the transfer of information between the parties to the contract. In particular, we showed how limitations on contractual liability might lead high valuation buyers to reveal their valuation of performance, and we identified the circumstances under which such limitations on liability are and are not socially desirable. In an article forthcoming in the Stanford Law Review, Barry Adler develops a critique of our analysis, as well as of that of Ayres and Gertner, who independently argued that contractual rules can beneficially facilitate information transfers. We reconsider here the subject of contractual liability and the revelation of information and respond to Adler's critique. We find Adler's model to be a natural extension of ours rather than a departure from it. Our reexamination leads to the conclusion that the informational effects that our work analyzed are important to take into account in designing contract rules.
Abstract: According to the contract law principle established in the famous nineteenth century English case of Hadley v. Baxendale, and followed ever since in the common law world, liability for a breach of contract is limited to losses "arising...according to the usual course of things," or that may be reasonably supposed "to have been in the contemplation of both parties, at the time they made the contract...." Using a formal model, we attempt in this paper to analyze systematically the effects and the efficiency of this limitation on contract damages. We study two alternative rules: the limited liability rule of Hadley, and an unlimited liability rule. Our analysis focuses on the effects of the alternative rules on two types of decisions: buyers' decisions about communicating their valuations of performance to sellers; and sellers' decisions about their level of precautions to reduce the likelihood of nonperformance. We identify the efficient behavior of buyers and sellers. We then compare this efficient behavior with the decisions that buyers and sellers in fact make under the limited and unlimited liability rules. This analysis enables us to provide a full characterization of the conditions under which each of the rules induces, or fails to induce, efficient behavior, as well as the conditions under which each of the rules is superior to the other.
contracts, breach, damages, precautions, information, communication
Abstract: According to the contract law principle established in the famous nineteenth century English case of Hadley v. Baxendale, and followed ever since in the common law world, liability for a breach of contract is limited to losses "arising...according to the usual course of things," or that may be reasonable supposed "to have been in the contemplation of both parties, at the time they made the contract,..." Using a formal model, we attempt in this paper to analyze systematically the effects and the efficiency of this limitation on contract damages. We study two alternative rules: the limited liability rule of Hadley, and an unlimited liability rule. Our analysis focuses on the effects of the alternative rules: the limited liability rule of Hadley, and an unlimited liability rule. Our analysis focuses on the effects of the alternative rules on two types of decisions: buyers' decisions about communicating their valuations of performance to sellers; and sellers' decisions about their level of precautions to reduce the likelihood of nonperformance. We identify the efficient behavior of buyers and sellers. We then compare this efficient behavior with the decisions that buyers and sellers in fact make under the limited and unlimited liability rules. This analysis enables us to provide a full characterization of the conditions under which each of the rules induces, or fails to induce, efficient behavior, as well as the conditions under which each of the rules is superior to the other.
Abstract: Whenever the use of an asset by one party imposes an externality on another party's use of an asset, entitlements must be allocated. Does an upstream firm have a right to use a river's water or does a downstream firm have a right not to have the water used? And if the downstream firm is to be protected, should the protection come in the form of a property right or a liability rule? This paper focuses on how the allocation of entitlements affects ex ante investments and actions. Even when ex post bargaining is easy, the ex post allocation of entitlements, by affecting the distribution of ex post value, can have significant efficiency effects ex ante. By identifying the ex ante effects of alternative rules, the analysis provides a framework for determining allocations of entitlement that would perform best from the perspective of ex ante efficiency. As far as ex ante effects are concerned, liability rules are not generally superior to property rights. The analysis has implications for a broad range of legal and policy questions.
Abstract: In an earlier article, The Uneasy Case for the Priority of Secured Claims in Bankruptcy,' 105 Yale Law Journal 857 (1996), we suggested that the case for a full priority of secured claims in bankruptcy is an uneasy one. In this paper, we address various reactions and objections to our analysis that have been offered by subsequent work. We also further develop some of the main elements of the analysis in our earlier article with respect to both our analysis of the comparative merits of full and partial priority and our analysis of how a partial priority regime could be implemented. The analysis confirms our earlier conclusion that the case for a full priority of secured claims in bankruptcy is an uneasy one.
Abstract: In an earlier article, "The Uneasy Case for the Priority of Secured Claims in Bankruptcy" 105 Yale Law Journal 857 (1996), we suggested that the case for a full priority of secured claims in bankruptcy is an uneasy one. In this paper, we address various reactions and objections to our analysis that have been offered by subsequent work. We also further develop some of the main elements of the analysis in our earlier article with respect to both our analysis of the comparative merits of full and partial priority and our analysis of how a partial priority regime could be implemented. The analysis confirms our earlier conclusion that the case for a full priority of secured claims in bankruptcy is an uneasy one.
Secured debt, bankruptcy, reorganization, chapter 11, priority, creditors, debtors, security interests, collateral, unsecured debt, lenders, borrowers
Abstract: This article proposes a new method of dividing the reorganization pie among the participants in corporate reorganizations. This method, I argue, can address the substantial efficiency and fairness problems that afflict the existing process of division. Under the proposed method, participants will receive certain rights with respect to the reorganized company's securities; these rights will be designed so that, whatever the reorganization value is, no participant will have a basis for complaining that he is receiving less than the value to which he is entitled. Although I propose the method as a basis for law reform, I show that it also can be used under the existing reorganization rules.
Chapter 11, reorganization, bankruptcy, absolute priority, options
Abstract: Despite the large infusion of capital into the financial sector and low interest rates, the flow of financing to operating firms has failed to return to normal levels. One explanation suggested is that banks still lack confidence because they need time to adjust to the new environment. Another is that the reduced flow of credit reflects banks' rational assessment of borrowers' bleak prospects in the current economic conditions. This paper puts forward a third explanation. When the prospects of operating firms are interdependent, banks' decisions on whether to lend to a given operating firm depend on their expectations about whether other operating firms will receive financing. As a result, an inefficient credit market freeze may arise in which banks avoid lending to operating firms due to their self-fulfilling expectations that other banks will not be lending. Such an inefficient freeze may persist even when banks have ample capital and interest rates are brought down to a barely positive level.
Facing an inefficient and persistent credit freeze, I argue, the government should consider getting the economy out of it by taking upon itself the credit risks involved in providing a substantial amount of new lending to operating firms. This can be accomplished by (i) providing banks with non-recourse financing for portfolios of new loans to operating firms, or otherwise agreeing to bear part of the risks generated by such portfolios, in return for a share of the upside, or (ii) setting up government-funded, privately managed funds dedicated to making such loans. These mechanisms funds can contribute substantially, both directly and indirectly, to producing a credit thaw. A model for studying credit freezes and alternative government responses to them is developed in Bebchuk and Goldstein, Self-fulfilling Credit Market Freezes, available at: http://papers.ssrn.com/abstract=1315462
Credit freeze, credit crunch, credit thaw, financial crisis, self-fulfilling crisis, banks, financial institutions, run on the bank, coordination failure
Abstract: This paper proposes two objectives - undistorted choice and equal treatment - for the legal rules governing corporate acquisitions in general, and corporate takeovers in particular. Undistorted choice is essential to the efficient operation of the market for corporate assets and that equal treatment is suggested by both efficiency and fairness considerations. Current takeover rules, I argue, lead to distorted choice and unequal treatment. I therefore put forward a set of rules that would ensure undistorted choice and equal treatment in corporate takeovers without creating any significant efficiency costs. Although the analysis focuses on takeovers, it also considers the legal rules that should govern other methods of corporate acquisition.
takeovers, mergers and acquisitions, tender offers, takeover bids, targets, acquirers
Abstract: This paper provides a compact account of the problem of distorted choice in corporate takeovers. (A more detailed account is provided in, "Towards Undistorted Choice and Equal Treatment in Corporate Takeovers"). I analyze how the tender decisions of shareholders facing a takeover bid might be distorted. I also put forward an approach for addressing this problem, as well as analyze several alternative remedies.
Takeovers, targets, pressure, tender offers, for tender anti-takeover arrangements, anti-takeover statues, minority shares, freeze outs, bid price, voting
Abstract: In this paper, we develop a framework for analyzing the desirable legal policy towards proxy contests and apply this framework to assess the rules governing the allocation of costs in proxy contests. Proxy rules affect efficiency in three ways: they influence who will engage in proxy contests, they have an impact on who wins proxy contests, and they affect ex ante managerial behavior. Taking these effects into account, we examine how the three main dimensions of choice in the design of proxy rules - success contingency, neutrality, and the level of reimbursement - can be varied to make allocation rules more efficient. We conclude that the present rules, which provide full reimbursement to incumbents but reimburse challengers only if they gain control of the company, should be modified in three ways: to give incumbents less than full compensation and make it contingent on success, to make challenger compensation contingent on the fraction of votes received rather than on whether they gain board control, and to provide for more generous compensation to challengers in contests over matters other than the election of directors. We further argue that companies should be free to adopt rules more favorable to challengers, and less favorable to incumbents, than the standard proxy rules; however, companies should be restrained from opting for rules favoring incumbents over challengers.
corporate governance, proxy contests, proxy fights, corporate voting, corporate elections, boards, shareholders, institutional investors, shareholder activism
Abstract: This paper reexamines a longstanding principle of bankruptcy law: that secured claims are entitled to be paid in full before unsecured claims receive any payment. There is a widespread consensus among legal scholars and economists that according full priority to secured claims is desirable because it promotes economic efficiency. Our analysis, however, demonstrates that full priority actually distorts the arrangements negotiated between commercial borrowers and their creditors, producing various efficiency costs. We show that according only partial priority to secured claims could eliminate or reduce these efficiency costs - and that such an approach might well be superior to the rule of full priority. The analysis also suggests that a mandatory rule of partial priority could be effectively implemented within the framework of existing bankruptcy law, and that such an approach would be consistent with fairness and freedom of contract considerations. We therefore present two different rules of partial priority that should be considered as alternatives to full priority.
Abstract: The Business Roundtable has played a key role in the opposition to the SEC shareholder access proposal. While the strong resistance to the proposal has been thus far successful in discouraging the SEC from adopting it, this paper considers the merits of the Business Roundtable's substantive arguments in opposition to the proposal. The paper provides a detailed examination of the wide range of objections to shareholder access that the Business Roundtable put forward in its submissions to the SEC. I conclude that none of these objections provides a good basis for opposing shareholder access.
corporate governance, directors, shareholders, shareholder voting, corporate ballot, corporate elections, proxy fights, proxy contests, proxy rules, SEC, Business Roundtable
Abstract: This paper analyzes the shortcomings of using auctions for selecting lead counsel in class action cases. In contrast to what proponents of auctions suggest, the outcome of an auction is likely to diverge considerably from what an informed principal would have chosen. In particular, auctions push the percentage of recovery paid to counsel to the lowest level at which law firms would be willing to take the case. Because of the need to provide counsel with incentives to invest effort and resources, however, the class might well be better served by a higher percentage than this minimum level, and auctions might push fees to levels that are too low. The analyzed problems are ones that arise also in those types of cases for which the use of auctions should be considered according to the recent recommendations of a Task Force report.
class actions, lead counsel, attorney fees, contingent fees
Abstract: The subject of this symposium issue - based on a conference sponsored by the Columbia Law School Center for Law and Economic Studies - is contractual freedom in corporate law. The resulting debate can be usefully divided, in my view, into two debates: one concerning contractual freedom in the charter amendment stage, and one concerning contractual freedom at the initial charter. Accordingly, Part II discusses and evaluates the debate on opting out by charter amendment, and Part III does the same for the initial charter stage. In discussing contractual freedom in corporate law, both deregulators, and the first critics of their position, focused on opting out in the initial charter - the natural context for thinking about contractual freedom. THE DEBATE ON CONTRACTUAL FREEDOM AT THE INITIAL CHARTER STAGE Also, Kornhauser discusses the possibility that some shareholder-manager arrangements have externalities with respect to bondholders. If the chosen arrangement is going to be mandatory, then efficiency would be indeed served by the officials' choosing A. Because opting out of the chosen arrangement will not be possible, the officials must assume that this arrangement will govern even if the alternative arrangement is actually the efficient one. Clearly, when a corporate law issue is to be governed by a mandatory rule, the quality of that rule - and thus the selection of the institution making that rule - is of greater significance.
Corporate charters, freedom of contract, corporate governance, corporate law, corporate voting, midstream opportunism, collective action
Abstract: This Paper develops an account of the role and significance of rent extraction in executive compensation. Under the optimal contracting view of executive compensation, which has dominated academic research on the subject, pay arrangements are set by a board of directors that aims to maximize shareholder value by designing an optimal principal-agent contract. Under the alternative rent extraction view that we examine, the board does not operate at arm's length; rather, executives have power to influence their own compensation, and they use their power to extract rents. As a result, executives are paid more than is optimal for shareholders and, to camouflage the extraction of rents, executive compensation might be structured sub-optimally. The presence of rent extraction, we argue, is consistent both with the processes that produce compensation schemes and with the market forces and constraints that companies face. Examining the large body of empirical work on executive compensation, we show that the picture emerging from it is largely compatible with the rent extraction view. Indeed, rent extraction, and the desire to camouflage it, can better explain many puzzling features of compensation patterns and practices. We conclude that extraction of rents might well play a significant role in US executive compensation; and that the significant presence of rent extraction should be taken into account in any examination of the practice and regulation of corporate governance.
Executive compensation, stock options, corporate governance, private benefits of control, agency costs, rent extraction
Abstract: This paper develops an account of the role and significance of rent extraction in executive compensation. Under the optimal contracting view of executive compensation, which has dominated academic research on the subject, pay arrangements are set by a board of directors that aims to maximize shareholder value by designing an optimal principal-agent contract. Under the alternative rent extraction view that we examine, the board does not operate at arm's length; rather, executives have power to influence their own compensation, and they use their power to extract rents. As a result, executives are paid more than is optimal for shareholders and, to camouflage the extraction of rents, executive compensation might be structured sub-optimally. The presence of rent extraction, we argue, is consistent both with the processes that produce compensation schemes and with the market forces and constraints that companies face. Examining the large body of empirical work on executive compensation, we show that the picture emerging from it is largely compatible with the rent extraction view. Indeed, rent extraction, and the desire to camouflage it, can better explain many puzzling features of compensation patterns and practices. We conclude that extraction of rents might well play a significant role in U.S. executive compensation; and that the significant presence of rent extraction should be taken into account in any examination of the practice and regulation of corporate governance.
Abstract: This piece provides our amicus curiae brief in the case of American Federation of State, County & Municipal Employees Pension Plan v. American International Group, which is now under consideration by the Second Circuit Court of Appeals. In this case, a shareholder submitted a proposal to amend the company's bylaws to require the company in certain circumstances to place candidates nominated by shareholders on the company's ballot, and the company sought to exclude this proposal from the ballot. We suggest in our amicus curiae brief that companies should not be allowed to exclude form the company ballot bylaw amendments concerning corporate elections. Prohibiting companies from doing so, we argue, is required by a reasonable interpretation of the proxy rules and necessary to advance the policy goals underlying the rules. As an appendix to the brief we attach a letter to the SEC sent by forty-eight law professors including ourselves that expresses a similar position.
Corporate elections, shareholder voting, proxy contests, access to the ballot, by-laws, by-law amendments, proxy fights, proxy contests, corporate governance, agency costs
Abstract: In some cases, the law permits a party that unilaterally provides a benefit to another party to recover the estimated value of this benefit. Despite calls for expanding the set of cases to which such a restitution rule applies, the law commonly applies a mutual consent rule under which a party providing another with a benefit cannot obtain any recovery without securing the advance consent of the beneficiary to the transaction. We provide an efficiency rationale for the undesirability of broad use of the restitution rule by identifying significant adverse ex ante effects of the rule that are avoided by the consent requirement. Even assuming that courts' errors in estimating buyer benefits would be unbiased, a restitution rule would strengthen sellers' hand by providing them with a put option that they may but do not have to use. As a result, the restitution rule would encourage inefficient market entry by low-quality sellers that would not contribute to any efficient transactions but would be able to extract payments from buyers seeking to avoid an exchange with them. Furthermore, the restitution rule would discourage efficient market entry by some or all potential buyers of a good or service. Beyond the restitution rule, we extend our analysis to show that similar adverse effects can also arise from other pricing rules that provide buyers or sellers with call or put options to force an exchange at a judicially-determined price.
Abstract: In some cases, the law permits a party that unilaterally provides a benefit to another party to recover the estimated value of this benefit. Despite calls for expanding the set of cases to which such a restitution rule applies, the law commonly applies a mutual consent rule under which a party providing another with a benefit cannot obtain any recovery without securing the advance consent of the beneficiary to the transaction. We provide an efficiency rationale for the undesirability of broad use of the restitution rule by identifying significant adverse ex ante effects of the rule that are avoided by the consent requirement. Even assuming that courts' errors in estimating buyer benefits would be unbiased, a restitution rule would strengthen sellers' hand by providing them with a put option that they may but do not have to use. As a result, the restitution rule would encourage inefficient market entry by low-quality sellers that would not contribute to any efficient transactions but would be able to extract payments from buyers seeking to avoid an exchange with them. Furthermore, the restitution rule would discourage efficient market entry by some or all potential buyers of a good or service. Beyond the restitution rule, we extend our analysis to show that similar adverse effects can also arise from other "pricing" rules that provide buyers or sellers with call or put options to force an exchange at a judicially-determined price.
ownership, exchange, restitution, property rights, bargaining
Abstract: This paper takes issue with the increasingly influential view that companies should be completely free to opt out of corporate law rules by adopting appropriate charter provisions. I argue that the contractual view of the corporation, on which supporters of free opting out rely, offers substantial reasons for placing limits on opting out. The analysis focuses on opting out done by charter amendment, after a company has been formed, and highlight the differences between opting out by charter amendment and opting out in the initial charter. Analyzing the informational and collective action problems involved in the charter amendment process, I conclude that the case for placing limits on opt-out amendments is so compelling that even strong believers in free markets should recognize the need for such limits. I also provide criteria for determining the issues with respect to which, and the circumstances under which, opting out by charter amendment should be prohibited or restricted.
corporate charters, freedom of contract, corporate governance, corporate law, corporate voting, midstream opportunism, collective action
Abstract: This paper develops a sequential bargaining model of the negotiations in corporate reorganizations under Chapter 11. We identify the expected outcome of the bargaining process and examine the effects of the legal rules that shape the bargaining. We determine how much value equity holders and debt holders receive under the Chapter 11 process, and compare the value obtained by each class with the 'contractual right' of that class. We identify and analyze three reasons that the equity holders can expect to obtain some value even when the debt holders are not paid in full. Finally, we show how the features of the reorganization process and of the company filing under Chapter 11 affect the division of value, and in this way we provide several testable predictions.
Abstract: This paper develops a sequential bargaining model of the negotiations in corporate reorganizations under Chapter 11. We identify the expected outcome of the bargaining process and examine the effects of the legal rules that shape the bargaining. We determine how much value equityholders and debtholders receive under the Chapter 11 process, and compare the value obtained by each class with the "contractual right" of that class. We identify and analyze three reasons that the equityholders can expect to obtain some value even when the debtholders are not paid in full. Finally, we show how the features of the reorganization process and of the company filing under Chapter 11 affect the division of value, and in this way we provide several testable predictions.
Abstract: Under an offer of settlement' rule, a party to a lawsuit may make a special offer to settle with the other party, such that if the other party rejects this offer, then this offer (unlike an ordinary offer) becomes part of the record in the case and may affect the allocation of litigation costs. Specifically, if the parties litigate to judgment, then the allocation of litigation costs may depend on how the judgment compares with the special offer. This paper develops a model of bargaining under offer-of-settlement rules that can be used to analyze the effect that such rules have on the terms of settlement. The analysis first sets forth a general principle that identifies the settlement amount under any such rule. We then apply this principle to derive the settlement terms under the most important of these rules, and we identify a large set of seemingly different rules that produce identical settlements. Our results have both positive and normative implications.
Abstract: Under an "offer of settlement" rule, a party to a lawsuit may make a special offer to settle with the other party, such that if the other party rejects this offer, then this offer (unlike an ordinary offer) becomes part of the record in the case and may affect the allocation of litigation costs. Specifically, if the parties litigate to judgment, then the allocation of litigation costs may depend on how the judgment compares with the special offer. This paper develops a model of bargaining under offer-of settlement rules that can be used to analyze the effect that such rules have on the terms of settlement. The analysis first sets forth a general principle that identifies the settlement amount under any such rule. We then apply this principle to derive the settlement terms under the most important of these rules, and we identify a large set of seemingly different rules that produce identical settlements. Our results have both positive and normative implications.
Abstract: Negative-expected-value (NEV) suits are ones in which the expected litigation costs exceed the expected judgment. This paper offers a new explanation for the credibility and success of plaintiff with NEV suits. The explanation is based on the fact that litigation costs are generally not incurred all at once but rather over time; this divisibility of the litigation process is shown to play a crucial strategic role. The analysis identifies the conditions under which a plaintiff with an NEV suit will have a credible threat and succeed in extracting a settlement. It is demonstrated that plaintiffs have credible threats in a much wider set of cases - including in numerous small-stake cases - than has been suggested by prior economic analysis of the subject.
Litigation, suit, settlement, credibility, negative-expected-value suit, frivolous suit
Abstract: This essay focuses on negative-expected-value suits (NEV suits) -- suits in which the plaintiff would obtain a negative expected return from pursuing the suit all the way to judgment. The essay surveys the existing theories as to why, and when, plaintiffs with NEV suits can extract a positive settlement amount.
Litigation, settlement, frivolous suits, negative expected value suits.
Abstract: This Paper evaluates the primary mechanisms for changing management or obtaining control in publicly traded corporations with dispersed ownership. Specifically, we analyse and compare three mechanisms: (1) proxy fights (voting only); (2) takeover bids (buying shares only); and (3) a combination of proxy fights and takeover bids in which shareholders vote on acquisition offers. We first show how proxy fights unaccompanied by an acquisition offer suffer from substantial shortcomings that limit the use of such contests in practice. We then argue that combining voting with acquisition offers is superior not only to proxy fights alone but also to takeover bids alone. Finally, we show that, when acquisition offers are in the form of cash or the acquirer's existing securities, voting shareholders can infer from the pre-vote market trading which outcome would be best in light of all the available public information. Our analysis has implications for the ongoing debates in the US over poison pills and in Europe over the new EEC directive on takeovers.
Abstract: This paper analyzes the inefficiencies that might arise in the ownership structure chosen at the initial public offering stage. We show that, contrary to what is commonly believed, the desire of initial owners to maximize their proceeds leads them to choices that, although privately optimal, may be socially inefficient. This distortion tends to be in the direction of excessive incidence of controlling shareholder structures and excessive divestment of cash flow rights. Our analysis has far-reaching policy implications for dual class stock, stock pyramiding, sale of control rules, and public offerings of minority shares. Among its positive implications, our analysis suggests reasons for the substantial differences in the incidence of control blocks across different countries.
Abstract: Staggered boards, which a majority of public companies now have, provide a powerful antitakeover defense, stronger than is commonly recognized. They provide antitakeover protection both by (i) forcing any hostile bidder, no matter when it emerges, to wait at least one year to gain control of the board and (ii) requiring such a bidder to win two elections far apart in time rather than a one-time referendum on its offer. Using a new data set of hostile bids in the five-year period 1996-2000, we find that not a single hostile bid won a ballot box victory against an 'effective' staggered board (ESB). We also find that an ESB nearly doubled the odds of remaining independent for an average target in our data set, from 34% to 61%, halved the odds that a first bidder would be successful, from 34% to 14%, and reduced the odds of a sale to a white knight, from 32% to 25%. Furthermore, we find that the shareholders of targets that remained independent were made worse off compared with accepting the bid and that ESBs did not provide sufficient countervailing benefits in terms of increased premiums to offset the costs of remaining independent. Overall, we estimate that, in the period studied, ESBs reduced the returns of shareholders of hostile bid targets on the order of 8-10%. Finally, we show that most staggered boards were adopted before the developments in takeover doctrine that made ESBs such a potent defense.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Abstract: This paper analyzes certain important shortcomings of state competition in corporate law. In particular, we show, with respect to takeovers, states have incentives to produce rules that excessively protect incumbent managers. The development of state takeover law, we argue, is consistent with our theory. States have adopted antitakeover statutes that have little policy basis, and, more importantly, they have provided managers with a wider and more open-ended latitude to engage in defensive tactics than endorsed even by the commentators most favorable to such tactics. Furthermore, states have elected, even though they could have done otherwise, to impose antitakeover protections on shareholders, who did not appear to favor them, in a way that left shareholders with little choice or say. Finally, we conclude by pointing out that proponents of state competition cannot reconcile their views with the evolution of state takeover law---and should therefore reconsider their unqualified support of state competition.
Abstract: This paper analyzes certain important shortcomings of state competition in corporate law. In particular, we show that, with respect to takeovers, states have incentives to produce rules that excessively protect incumbent managers. The development of state takeover law, we argue, is consistent with our theory. States have adopted antitakeover statutes that have little policy basis, and, more importantly, they have provided managers with a wider and more open-ended latitude to engage in defensive tactics than endorsed even by the commentators most favorable to such tactics. Furthermore, states have elected, even though they could have done otherwise, to impose antitakeover protections on shareholders, who did not appear to favor them, in a way that left shareholders with little choice or say. Finally, we conclude by pointing out that proponents of state competition cannot reconcile their views with the evolution of state takeover law--and should therefore reconsider their unqualified support of state competition.
Abstract: In a corporate freeze-out, the controller is required to compensate minority shareholders for the no-freezeout value of their shares that are taken from them. This paper seeks to highlight the difficulties involved in determining this no-freezeout value when private information. In particular, the analysis shows that the pre-freezeout market price of minority shares cannot be used an a proxy for the no-freezeout value that these shares would have in the absence of a freeze-out. It is shown that, under a regime in which frozen out minority shareholders receive a compensation equal to the pre-freezeout market price, the pre-freezeout market price will be set a level below the expected no-freezeout value of minority shares. The reason for this is a lemons effect' that arises when a controller uses her private information in deciding whether to affect a freeze-out. By showing how controllers are able to use their private information to affect freeze-outs at terms favorable to them, this paper demonstrates that freeze-outs can become a significant source for private benefits of control.
Abstract: This paper examines common arrangements for separating control from cash flow rights: stock pyramids, cross-ownership structures, and dual class equity structures. We describe the ways in which such arrangements enable a controlling shareholder or group to maintain a complete lock on the control of a company while holding less than a majority of the cash flow rights associated with its equity. Next, we analyze the consequences and agency costs of these arrangements. In particular, we show that they have the potential to create very large agency costs - costs that are an order of magnitude larger than those associated with controlling shareholders who hold a majority of the cash flow rights in their companies. The agency costs of these structures, we suggest, are also likely to exceed the agency costs of attending highly leveraged capital structures. Finally, we put forward an agenda for research concerning structures separating control from cash flow rights.
Abstract: Focusing on takeover bids whose outcome can be predicted in advance with certainty, Grossman and Hart established the proposition, which subsequent work accepted, that successful bids must be made at or above the expected value of minority shares. This proposition provided the basis for Grossman and Hart`s identification of a free-rider problem and became a major premise for the analysis of takeovers This paper shows that this important proposition does not always hold once we drop the assumption that the only successful bids are those whose success could have been predicted with certainty In particular, it is shown that any unconditional bid that is below the expected value of minority shares but above the independent target`s per share value will succeed with a certain positive probability, that the bidder`s expected payoff from such a bid (not counting the transaction costs of making the bid) is always positive; and that bidders might elect to make such bids. These results have implications for the nature of the free-rider problem and for the operation of takeovers; in particular, it is shown that, when a raider can increase the value of a target`s assets, the raider might elect to bid even if no dilution of minority shares is possible and it holds no initial stake in the target
Abstract: This paper, which introduces the special issue on corporate governance co-sponsored by the Review of Financial Studies and the National Bureau of Economic Research (NBER), reviews and comments on the state of corporate governance research. The special issue feature seven papers on corporate governance that were presented in a meeting of the NBER‘s corporate governance project. Each of the papers represents state-of-the-art research in an important area of corporate governance research. For each of these areas, we discuss the importance of the area and the questions it focuses on, how the paper in the special issue makes a significant contribution to this area, and what we do and do not know about the area. We discuss in turn work on shareholders and shareholder activism, directors, executives and their compensation, controlling shareholders, comparative corporate governance, cross-border investments in global capital markets, and the political economy of corporate governance.
corporate governance, investor protection, shareholders, shareholder activism
Abstract: This paper studies managerial decisions about investment in long-run projects in the presence of imperfect information (the market knows less about such investments than the firm's managers) and short-term managerial objectives (the managers are concerned about the short-term stock price as well as the long-term stock price). Prior work has suggested that imperfect information and short-term managerial objectives induce managers to underinvest in long-run projects. We show that either underinvestment or overinvestment is possible, and we identify the connection between the type of informational imperfection present and the direction of the distortion. When investors cannot observe the level of investment in long-run projects, suboptimal investment will be induced. When investors can observe investment but not its productivity, however, an excessive level of investment will be induced.
Abstract: When the cost of a suit exceeds the expected judgment, will a potential plaintiff be able to extract any amount in settlement from the defendant? If so, what is the source of the plaintiff's ability to extract a settlement? This essay discusses existing theories as to why (and when) plaintiffs with negative-expected-value (NEV) suits can extract a settlement amount from the defendant. Among the theories discussed are ones that focus on informational issues and ones that focus on the way in which the parties' litigation costs are expected to be distributed over time.
Abstract: This Paper empirically investigates the decisions of US publicly traded firms on where to incorporate. We study the features of states that make them attractive to incorporating firms and the characteristics of firms that determine whether they incorporate in or out of their state of location. We find that states that offer stronger antitakeover protections are substantially more successful both in retaining in-state firms and in attracting out-of-state incorporations. We estimate that, compared with adopting no antitakeover statutes, adopting all standard antitakeover statutes enabled the states that adopted them to more than double the percentage of local firms that incorporated in-state (from 23% to 49%). Indeed, the incorporation market has not even penalized the three states that passed two extreme antitakeover statutes that have been widely viewed as detrimental to shareholders. We also find that there is commonly a big difference between a state's ability to attract incorporations from firms located in and out of the state, and we investigate several possible explanations for this home-state advantage. Finally, we find that Delaware's dominance is greater than has been recognized and can be expected to increase further in the future. Our findings have significant implications for corporate governance, regulatory competition, and takeover law.
Abstract: This paper studies certain effects of insider trading on the principal-agent problem in corporations. Specifically, we focus on insiders' choice among investment projects. Other things equal, insider trading leads insiders to choose riskier investment projects, because increased volatility of results enables insiders to make greater trading profits if they learn these results in advance of the market. This effect might or might not be beneficial, however, because insiders' risk-aversion pulls them toward a conservative investment policy. We identify and compare insiders' choices of projects with insider trading and those without such trading. We also study the optimal contract design with insider trading and without such trading, thus identifying the effects that allowing such trading has on other elements of insiders' compensation. Using these results, we identify the conditions under which insider trading increases or decreases corporate value by affecting the choice of projects with uncertain returns .
Abstract: This paper analyzes certain effects of insider trading on the principal-agent problem in corporations. Specifically, we focus on those managerial choices that confront managers with the need to decide between options that produce different corporate value but do not differ in the managerial effort involved. In the absence of insider trading, and as long as managers' salaries are positively correlated with their firms results, managers will make such choices efficiently, and consequently such choices have previously received little attention, we show that, in the presence of insider trading, managers may make such choices inefficiently. With such trading, managers night elect to have a lower corporate value -- that is, they may 'waste' corporate value -- because having such a value might enable them to make greeter trading profits. We analyze the conditions under which the problem we identify is likely to arise and the factors that determine its severity. We also identify those restrictions en insider trading that can eliminate this problem.
Abstract: In many disputes, the expected value to the plaintiff from going to trial is negative, either because the chances of winning are small or because the litigation costs are large. While such a plaintiff would not go to trial, he might sue in the hope of extracting a settlement offer: the defendant might make such an offer if he is uncertain as to whether or not the expected value to the plaintiff of going to trial is negative. This paper seeks to identify the factors that determine: (i) whether a plaintiff who does not intend to go to trial will nonetheless succeed in extracting an offer; and (ii) how much will such a plaintiff succeed in extracting.
Abstract: We show that, when plaintiffs cannot predict the outcome of litigation with certainty, neither the American rule of litigation cost allocation (under which each litigant bears its own expenses) nor the British rule (under which the losing litigant pays the attorneys' fees of the winning litigant) would induce plaintiffs to make optimal decisions to bring suit. In particular, plaintiffs may bring frivolous suits when litigation costs are sufficiently small relative to the amount at stake, and plaintiffs may not bring some meritorious suits when litigation costs are sufficiently large relative to the amount at stake. We analyze the effect of more general fee-shifting rules that are based not only upon the identity of the winning party but also on how strong the court perceives the case to be at the end of the trial -- that is, the 'margin of victory.' In particular, we explore how and when one can design such a rule to induce plaintiffs to sue if and only if they believe their cases are sufficiently strong. Our analysis suggests some considerations to guide the interpretation of Federal Rule of Civil Procedure 11.
Abstract: No abstract is available for this paper.
Abstract: This paper considers optimal enforcement when individuals may be imperfectly informed about the probability of apprehension. When individuals are perfectly informed, optimal sanctions are maximal because, as Gary Becker (1968) suggested, society can economize on enforcement resources by reducing the probability of apprehension while increasing sanctions. But when individuals imperfectly observe the probability of apprehension, it may be optimal to apply lower sanctions while expending more enforcement resources.
Abstract: This paper shows that, when plaintiffs cannot predict the outcome of litigation with certainty, neither the American rule of litigation cost allocation (under which each litigant bears its own expenses) nor the British rule (under which the losing litigant pays the attorneys' fees of the winning litigant) would induce plaintiffs to make optimal decisions to bring suit. In particular, plaintiffs may bring frivolous suits when litigation costs are sufficiently small relative to the amount at stake, and plaintiffs may not bring some meritorious suits when litigation costs are sufficiently large relative to the amount at stake. This paper analyzes the effect of more general fee-shifting rules that are based not only upon the identity of the winning party but also on how strong the court perceives the case to be at the end of the trial - that is, the "margin of victory." In particular, this paper explores how and when one can design such a rule to induce plaintiffs to sue if and only if they believe their cases are sufficiently strong. The analysis suggests some considerations to guide the interpretation of Federal Rule of Civil Procedure 11.
Abstract: This paper shows that, when plaintiffs cannot predict the outcome of litigation with certainty, neither the American rule of litigation cost allocation (under which each litigant bears its own expenses) nor the British rule (under which the losing litigant pays the attorneys' fees of the winning litigant) would induce plaintiffs to make optimal decisions to bring suit. In particular, plaintiffs may bring frivolous suits when litigation costs are sufficiently small relative to the amount at stake, and plaintiffs may not bring some meritorious suits when litigation costs are sufficiently large relative to the amount at stake. This paper analyzes the effect of more general fee-shifting rules that are based not only upon the identity of the winning party but also on how strong the court perceives the case to be at the end of the trial -- that is, the "margin of victory." In particular, this paper explores how and when one can design such a rule to induce plaintiffs to sue if and only if they believe their cases are sufficiently strong. The analysis suggests some considerations to guide the interpretation of Federal Rule of Civil Procedure 11.
Abstract: This paper analyzes certain important shortcomings of state competition in corporate law. In particular, we show that, with respect to takeovers, states have incentives to produce rules that excessively protect incumbent managers. The development of state takeover law, we argue, is consistent with our theory. States have adopted antitakeover statutes that have little policy basis, and, more importantly, they have provided managers with a wider and more open-ended latitude to engage in defensive tactics than endorsed even by the commentators most favorable to such tactics. Furthermore, states have elected, even though they could have done otherwise, to impose antitakeover protections on shareholders, who did not appear to favor them, in a way that left shareholders with little choice or say. Finally, we conclude by pointing out that proponents of state competition cannot reconcile their views with the evolution of state takeover law--and should, therefore, reconsider their unqualified support of state competition.
Abstract: We analyze situations of inadvertant rather than deliberate breach and consider the role of alternative damages remedies. Expectation damages induce excessive reliance, while reliance damages induce excessive reliance and under-efficient precaution. Overall, expectation damages are Pareto-superior to reliance damages.
Abstract: In Israel, as in a number of other economies, a few large banks have historically played a major role in the nonfinancial sector. At the end of 1995, the Israeli government appointed the Brodet Committee to examine bank investments in nonfinancial corporations. The Israeli Knesset subsequently adopted the committee's recommendations and imposed major limitations on the role of banks in the nonfinancial sector. These limitations required the two biggest Israeli banks to start selling much of their nonfinancial investments.This paper is based on the research report that we prepared for the Brodet Committee at the request of the Israeli Finance Ministry and Antitrust Authority. We explain why we recommended to the Committee that substantial limitations be imposed on bank investment in nonfinancial companies. We provide a detailed analysis of the effects that bank- conglomerate combinations have in a small economy -- such as Israel's -- that is characterized by a great deal of concentration in both the financial and nonfinancial sectors. In particular, we analyze the effects that bank-conglomerate combinations have on the safety and soundness of banks, on the decisions of the investment funds managed by banks, and on the level of competition in the economy in both the short run and the long run.
Abstract: The large economic literature on fee-shifting rules has focused on the effects that they have on the likelihood of settlement and the incentive to sue. In contrast, this paper focuses on the rules' effect on the terms of settlement. The analysis demonstrates that fee-shifting rules influence the terms of settlement, and it further identifies the effect of each of the main fee-shifting rules on settlement terms. For each such rule, the analysis examines whether the rule will make settlement terms more favorable to the plaintiff or the defendant -- and also whether the rule will move these terms closer to or further away from the expected judgement.
Abstract: When the litigation costs of a potential plaintiff exceed the expected judgment in the case, the plaintiff's threat to sue can nevertheless succeed in extracting a settlement offer if that threat is credible. This paper analyzes how the credibility of such threats is shaped by the way in which the parties' litigation costs are expected to be distributed over time. The analysis starts by demonstrating that greater divisibility of litigation costs may help -- and can never hurt -- the plaintiff's strategic position. The analysis then identifies the strategic implications of the order in which the parties must incur the bulk of their litigation costs; it is shown that, contrary to what might be initially thought, the plaintiff will be better off if the defendant's costs must largely be incurred after the plaintiff's cost. Finally, for the various possible distributions of parties' costs over time, the analysis identifies necessary and sufficient conditions for the plaintiff's threat to be credible (and, therefore, to succeed in extracting a settlement).
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