Diversified Shareholders Research Articles

Prosocial Antitrust

Antitrust law is at the center of today’s public debate. It has even emerged as a rare unifying force, with bipartisan promises to combat the concentration of economic power, starting with breaking up Big Tech. Meanwhile, the business and investment community is grappling with mounting systematic risks arising from the pandemic, climate change, income inequality, and racial injustice. Unexpectedly, the largest asset managers in the world find themselves on the front lines of these battles. Due to the rise of index investing, these “universal owners” manage portfolios that are so large and diversified, their holdings mirror the entire economy. Their diversification protects them against idiosyncratic risk, but greatly exposes them to these systematic risks.The universal owners are keenly aware of their exposure to these systematic risks. They are turning to their portfolio companies and increasing demands on directors and managers to “serve a social purpose” and reduce their negative externalities. Public-regarding pronouncements from CEOs of Wall Street’s biggest firms ring hollow to many shareholder primacy loyalists. But the skeptics are missing the economic logic underlying this paradigm shift—diversified shareholders do not want companies to externalize their negative impacts onto the rest of the investors’ portfolios. Many companies are rising to the challenge and making bold commitments. However, many are recognizing that, to satisfy pervasive social and environmental challenges, they must collaborate with their competitors. This Article reveals that current antitrust law is a barrier to this collaboration and offers a policy proposal for aligning antitrust law with the demands upon the prosocial corporation. The COVID-19 pandemic has taught us that we are all interconnected. Climate change will continue to deepen that understanding. The problems we face are difficult, but they are not insurmountable. To solve them, we must value collaboration at least as much as we value competition.

Regulating Risk by 'Strengthening Corporate Governance'

This paper, presented at the “Regulating Risk” symposium at the University of Connecticut School of Law, April 16, 2010, briefly reviews the connection between risk and corporate governance, then examines the “strengthening corporate governance” provisions of Subtitle G of the Restoring American Financial Stability Act of 2010 (also known as the “Dodd Bill”). The corporate governance provisions, covering majority voting for director elections, proxy access, and the separation of the roles of CEO and chairman of the board, seem likely to have one of two possible effects. On the one hand, the provisions may be pernicious, in that they further enhance shareholder power without a clear justification for increased shareholder power, and more particularly without a justification for shareholder power as a risk management device. Indeed, the Dodd Bill’s corporate governance provisions may work at cross-purposes to the risk management intent of the remainder of the Dodd Bill: the corporate governance provisions operate under the assumption that enhanced shareholder power will result in better monitoring of managerial behavior, which presumably will help to prevent future crisis, but both theory and evidence suggests that diversified shareholders generally prefer companies to take risks that other constituencies (including taxpayers) would not prefer. On the other hand, the Dodd Bill may have very little effect on investor behavior or risk management. Increases in shareholder power over the past years (fundamentally the result of increased federal regulation) have made management more responsive to - and in some cases probably overly responsive to - shareholder concerns over agency costs. Indeed, some of the proposed reforms already have been or were likely to have been put in place at most public companies. If private ordering is already working, what is the point of imposing strict governance constructs across the market as a whole, especially when most of the affected firms are victims of, rather than contributors to, the Financial Crisis‘

R&D or R vs. D? Firm Innovation Strategy and Equity Ownership

We analyze a unique dataset that separately reports research and development expenditures for a large panel of public and private firms. We establish new empirical facts about how equity ownership status relates to innovation strategy and then compare these facts to equilibrium outcomes predicted by theory. We find public firms have greater research intensity than private firms, inconsistent with theories predicting an equilibrium wherein private firms conduct relatively more exploratory innovation. We also find public firms invest more intensely in innovation of all sorts. These results suggest more innovative firms select into public status, which relaxes financing constraints and provides a more diversified shareholder base more tolerant of high idiosyncratic risk. Reconciling several seemingly conflicting results in prior research, we find private equity held firms, though equally innovative as other private firms, skew their strategies toward development and away from research.

Why do auditors fail? What might work? What won’t?

Auditing failures and scandals have become commonplace. In response, reformers (including the Kingman Review in the U.K. and a recent report of the U.K.’s Competition and Market Authority) have proposed a variety of remedies, including prophylactic bans on auditors providing consulting services to their clients in the belief that this will minimize the conflicts of interest that produce auditing failures. Although useful, such reforms are already in place to a considerable degree and may have reached the point of diminishing returns. Moreover, this strategy does not address the deeper problem that clients (or their managements) may not want aggressive auditing, but rather prefer a deferential and perfunctory audit. If so, auditors will realize that they are marketing a ‘commodity’ service and cannot successfully compete based on their quality of services. Rationally, they would respond to such a market by seeking to adopt a cost-minimization strategy, competing by reducing the cost of their services and not investing in new technology or higher-priced personnel.What could change this pattern? Gatekeepers, including auditors, serve investors, but are hired by corporate management. To induce gatekeepers to better serve investors, one needs to reduce the ‘agency costs’ surrounding this relationship by making gatekeepers more accountable to investors. This might be accomplished through litigation (as happens to some degree in the U.S.), but the U.K. and Europe have rules that discourage collective litigation. Thus, a more feasible approach would be to give investors greater ability to select and remove the auditor. This paper proposes a two part strategy to this end: (1) public ‘grading’ of the auditor by the audit regulator in an easily comparable fashion (and with a mandatory grading curve), and (2) enabling a minority of the shareholders (hypothetically, 10%) to propose a replacement auditor for a shareholder vote. It further argues that both activist shareholders and diversified shareholders might support such a strategy and undertake it under different circumstances. Absent such a focus on agency costs, however, reformers are likely only re-arranging the deck chairs on the Titanic.

Tax and Corporate Governance: The Influence of Tax on Managerial Agency Costs

This chapter of the Oxford Handbook on Corporate Law and Governance canvasses a broad range of ways that tax influences managerial agency costs, focusing especially on the United States. In doing so, this chapter has two goals. The first is to help corporate law experts target managerial agency costs more effectively. The analysis here flags when tax is likely to exacerbate agency costs, and when it is likely to mitigate them. Armed with this information, corporate law experts have a better sense of how vigorous a contractual or corporate law response they need. In some cases, a change in the tax law may also be justified. This chapter’s second goal, then, is to enhance our understanding of tax rules, shedding light on a set of welfare effects that are important but understudied. After all, tax policy is more likely to enhance welfare if policymakers weigh all possible welfare effects, including managerial agency costs. Overall, the U.S. tax system’s record in influencing agency costs is not encouraging. After all, a tax system’s priority is not to reduce agency costs, but to raise revenue efficiently and fairly. Government tax experts do not usually have the expertise or motivation to tackle corporate governance problems. Tax also is a poor fit because it typically applies mandatorily and uniformly, while responses to agency cost should be molded to the context. For example, promoting stock options or leverage will be valuable in some settings, but disastrous in others. There also are political hurdles to be overcome. Accordingly, when tax rules target agency costs, the results often are poorly tailored or even counterproductive. Even so, the effects are not all bad. On the positive side of the ledger, U.S. tax rules encourage performance-based pay, albeit in blunt ways. In addition, by taxing intercompany dividends, the U.S. keeps block-holders in one firm from indirectly controlling other firms. U.S. tax rules also encourage leverage, which usually (but not always) mitigates managerial agency costs. Likewise, some tax rules favor long-term ownership, which can motivate shareholders to monitor management more carefully. The need to disclose financial information on a corporate tax return can also discipline management. Discouraging the use of offshore accounts and off-balance sheet entities can keep managers from cheating shareholders, as well as the fisc. On the other side of the ledger, U.S. tax rules can be a reason (or excuse) for flawed pay. Managers also can use tax as a pretext to retain earnings, and also to oppose takeovers that put their jobs at risk. Tax also can be invoked to justify “empire building” acquisitions as well as hedging, each of which appeals more to undiversified managers than to diversified shareholders. U.S. tax rules also encourage firms to incorporate offshore or to use pass-through entities, even though these steps can weaken shareholders’ corporate law rights.

Why Do Auditors Fail? What Might Work? What Won't?

Auditing failures and scandals have become commonplace. In response, reformers (including the Kingman Review in the U.K and a recent report of the U.K.’s Competition and Market Authority) have proposed a variety of remedies, including prophylactic bans on auditors providing consulting services to their clients in the belief that this will minimize the conflicts of interest that produce auditing failures. Although useful, such reforms are already in place to a considerable degree and may have reached the point of diminishing returns. Moreover, this strategy does not address the deeper problem that clients (or their managements) may not want aggressive auditing, but rather prefer a deferential and perfunctory audit. If so, auditors will realize that they are marketing a “commodity” service and cannot successfully compete based on their quality of services. Rationally, they would respond to such a market by seeking to adopt a cost-minimization strategy, competing by reducing the cost of their services and not investing in new technology or higher-priced personnel. What could change this pattern? Gatekeepers, including auditors, serve investors, but are hired by corporate management. To induce gatekeepers to better serve investors, one needs to reduce the “agency costs” surrounding this relationship by making gatekeepers more accountable to investors. This might be accomplished through litigation (as happens to some degree in the U.S.), but the U.K. and Europe have rules that discourage collective litigation. Thus, a more feasible approach would be to give investors greater ability to select and remove the auditor. This paper proposes a two part strategy to this end: (1) public “grading” of the auditor by the audit regulator in an easily comparable fashion (and with a mandatory grading curve), and (2) enabling a minority of the shareholders (hypothetically, 10%) to propose a replacement auditor for a shareholder vote. It further argues that both activist shareholders and diversified shareholders might support such a strategy and undertake it under different circumstances. Absent such a focus on agency costs, however, reformers are likely only re-arranging the deck chairs on the Titanic.

Reforming the Securities Class Action: An Essay on Deterrence and its Implementation

The securities class action cannot be justified in terms of compensation, but only in terms of deterrence. Currently, the damages recovered through private enforcement dwarf the financial penalties levied by public enforcement. Yet, the evidence is clear that corporate officers and insiders rarely contribute to securities class action settlements, with the settlement funds coming instead from the corporation and its insurers. As a result, the cost of such actions in the aggregate falls on largely diversified shareholders. Such a system is akin to punishing the victims of burglary for their negligence in suffering a burglary and does little to deter corporate officials who have private motives for engaging in securities fraud. The present structure of securities class actions benefits a trio of interest groups - corporate officials, plaintiff's attorneys, and insurers - but not shareholders. To reform the securities class action and give it a true deterrent orientation, this article proposes a variety of steps - none requiring legislation or the reversal of well-established precedents - to shift the costs of the securities class action to the culpable. These steps proceed from the twin premises that (1) the settlement of a securities class action is a conflict of interest transaction requiring independent directors to exercise oversight over the allocation process, and (2) enterprise liability is an ineffective approach for misconduct that is privately motivated and easily concealed. To incentivize private enforcers, a basic change in the judicial approach to attorney's fees is proposed.

Bank Bonus Pay as a Risk Sharing Contract

We show that banker bonuses cannot be understood exclusively as incentive contracts, but also incorporate a significant risk sharing dimension between bank shareholders and bank employees. This contrasts with the conventional view whereby diversified shareholders fully insure risk averse employees. However, financial frictions imply that shareholder value is concave in a bank's cash reserves---making shareholders effectively risk averse. The optimal contract between shareholders and employees then involves some degree of risk sharing. Using extensive payroll data on 1.26 million bank employee years in the Austrian, German, and Swiss banking sectors, we show that the structure of bonus pay within and across banks is compatible with an economically significant risk sharing motive, but difficult to rationalize based on incentive theories of bonus pay only.

The Shareholder Base Hypothesis of Stock Return Volatility: Empirical Evidence

AbstractWe use Swedish ownership data to explore whether a large and diversified shareholder base leads to lower volatility by improving the information content of stock prices. We find that volatility increases in the number of shareholders with respect to both the number of relatively large shareholders and the fraction of shares held by investors with stakes below 0.1%. Volatility is also positively related to the number of institutional owners but negatively related to the number of large and underdiversified institutional owners. Foreign investors have no impact. Our results suggest that a large shareholder base does not lower volatility.

Large Shareholder Portfolio Diversification and Corporate Voluntary Disclosures

This study, using a recently available dataset that tracks investors’ equity holdings across countries, investigates the relation between the degree of large shareholders’ acquisition of equity in multiple firms (i.e., portfolio diversification) and corporate voluntary disclosures. While large shareholders are traditionally viewed as investors with sufficient resources to acquire costly private information, we posit that shareholders with more diversified portfolios have greater reliance on public disclosures owing to resource constraints. Hence, we expect these shareholders to have a stronger demand for voluntary disclosures as a less costly alternative information source. Consistent with this prediction, we find that large shareholder portfolio diversification relates positively to voluntary disclosures as measured by the incidence and the frequency of management forecasts, conference calls, analyst/investor days, and product-related announcements. Corroborating our main analysis, we document a negative impact of portfolio diversification on voluntary disclosures when the firms providing the disclosures constitute a significant portion of large shareholders’ investment portfolios. We also find that the positive relation between large shareholder portfolio diversification and voluntary disclosure is more pronounced when the firm is located in a country with a lower quality labor market. In addition, we find that firms cater to diversified large shareholders’ public information reliance by providing disclosures that elicit a stronger stock market reaction, indicating the high information content of these disclosures. Overall, our findings suggest that diversified portfolio holdings incentivize large shareholders to place greater reliance on public information and that managers respond through providing high-quality voluntary disclosures.

Product diversification and bank performance: Does ownership structure matter?

Using detailed data on control chains of 710 European commercial banks, we test whether the presence of some categories of controlling shareholders affects product diversification performance. We find that when banks have no controlling shareholder or have only family and state shareholders activity diversification yields diseconomies. However, as long as the control chain involves banking institutions, institutional investors, industrial companies or any other combination of these shareholder categories, banks benefit from diversification economies: they display higher profitability, lower earnings volatility and lower default risk. This is potentially because such categories of shareholders bring additional skills to manage diverse activities. A further exploration shows that such mitigating roles are greater for domestic and diversified shareholders. Our findings provide insights on why banks suffer from greater activity diversification and have several policy implications.

We Have a Consensus on Fraud on the Market - And It's Wrong

Recent scholarship overwhelmingly contends that the fraud on the market securities class action has neither deterrent nor compensatory effect and should be cut back or even abandoned entirely. This scholarship largely focuses on two critiques: circularity, which holds that shareholder class action claimants are suing themselves, making compensation impossible; and diversification, which holds that fraud constitutes a diversifiable risk, such that diversified shareholders both gain and lose from fraud in equal measure and hence are not negatively impacted. These critiques are arguably the most important and widely-used theoretical development of the last two decades in securities law, and enjoy a broad consensus. Unfortunately, these critiques are wrong. After tracing the evolution of these critiques, this paper demonstrates economically that, despite widespread acceptance, none of the principal claims of these critiques are correct. In particular: fraud on the market does indeed compensate defrauded purchasers despite circularity (under certain conditions, perfectly); and diversified investors do have expected losses from fraud and have incentives to undertake deadweight precaution costs. Further, the fraud on the market remedy deters both precaution costs and, under certain conditions, fraud itself. The critiques are fundamentally flawed, the academic consensus on fraud on the market is incorrect, and the panoply of reform proposals based on these critiques is without foundation. These critiques have fueled a trend of cutbacks and ongoing existential challenges to fraud on the market (as in Halliburton) that, in light of these results, should be rethought.

CEO Risk Incentives and Real Earnings Management

<p>Previous research shows that companies use option compensation to motivate managers to accept risk (Jensen & Meckling, 1976). Indeed, risk adverse CEOs are likely to accept less risk than that accepted by diversified shareholders (Fama & French, 1992). Nonetheless, not all risks produce the expected benefits and risk has an intrinsic cost, such as potential large losses, that cannot be eliminated. Therefore, given CEO risk incentives, real earnings management can be viewed as a mechanism used to avoid the undesirable consequences of risk on reported earnings. However, engaging in real earnings management requires cutting investments, such as R&D, that have a well-documented association with firm’s future risk profile (Comin & Philippon, 2005). As a consequence, the use of real earnings management by CEOs with high-risk incentives as a tool for mitigating the intrinsic costs of risk is an empirical question that we tackle in this paper. Using a sample of quarterly observations from US firms over the period 2003-2010, and an instrumental variable approach to overcome endogeneity concerns, we show that CEOs with high risk-related incentives engage less in real activity manipulations that encompass cutting discretionary expenditures than do executives with low incentives. These findings are consistent with the idea that CEOs incentivized on risk avoid engaging in real management activities that can decrease firm’s future risk profile.</p>

The effect of shareholders' combination on risk taking of the companies listed in Tehran Stock Exchange

Risk-taking measurement of the companies is highly significant in making economic decisions. The diverse combination of large shareholders enables them to prevent the controlling shareholders from focusing on the low-risk projects. Large shareholders can analyse the inherent risks of each project better and make action in accepting or rejecting the projects such that enhances the company performance. Here, we want to study the relationship between the shareholders' combination and their risk-taking in Tehran Stock Exchange (TSE) market through 2009-2013. In fact, the relationship between presence, quantity and voting rights of the diversified large shareholders and controlling ones were studied by the corporate performance, which is measured by three variables, including ROA, market value (Q Tobin ratio) and share returns. To test the hypotheses, the multi-variable regression model is utilised. The research results indicate that there is a positive and significant relationship between the shareholders' combination and operational criteria.

Ownership Structure, Voting, and Risk

We analyze the determinants of a firm's ownership structure when decisions over risk are taken by majority vote of risk-averse shareholders. We show that when a fraction of small, diversified shareholders abstains from voting, mid-sized blockholders may emerge to mitigate the conflict of interests between one large shareholder, who prefers less risky investments, and these small, non-voting shareholders. The paper offers a novel explanation for the puzzling observation that many firms have multiple blockholders. The paper develops numerous empirical implications, for example on the link between ownership structure and risk choices and on the relative size of blocks.

Systemic Harms and Shareholder Value

The financial crisis has demonstrated serious flaws in the corporate governance of systemically important financial firms. In particular, the Shareholder Value norm, which has guided corporate governance reform for a generation, proves to be a faulty guide for managerial action in systemically important firms. This is not only because the failure of such firms will have spillovers that defy the cost-internalization of the tort system but also because these spillovers will harm their own majoritarian shareholders. The interests of diversified shareholders fundamentally diverge from the interests of managers and other controllers because the failure of a systemically important financial firm will produce losses throughout a diversified portfolio, not just own-firm losses. Among the consequences: the business judgment rule protection that makes sense for officers and directors of a non-financial firm leads to excessive risk-taking in a systemically important financial firm. To encourage appropriate modification of the Shareholder Value norm, we propose officer and director liability rules as a complement (and substitute) to the prescriptive rules that have emerged from the financial crisis.

Shareholder diversification and bank risk-taking

Abstract Using the entire universe of Bankscope and Amadeus Top 250,000 we construct the portfolios of shareholders who hold equity stakes in publicly traded and privately held European banks for each year over the period 1999–2008. We show that about 62% of banks’ ultimate largest shareholders are diversified investors, holding on average equity investments from thirteen companies in their portfolio. We exploit this heterogeneity to investigate the impact of their portfolio diversification on bank risk-taking. Our results show that banks with more diversified shareholders undertake more risks. This relation is both statistically significant and economically sizeable. Overall, these findings contribute to the literature by studying for the first time a specific channel through which financial development, in the form of bank shareholders’ diversification, affects the banks’ risk-taking decisions.

Evidence-Based Executive Pay: Remunerating for Shareholder Value

Prevailing executive pay practices rest on fallacious assumptions about performance attribution, the nature of alignment, and the psychology of incentives, and have numerous unintended consequences that are value-destructive particularly for long term and diversified shareholders. The focus of boards, shareholders and stakeholders on technicalities within pay structures denies oxygen to more fundamental questions about the intended function and operation of remuneration. A commercial, evidence-based approach should view executive remuneration as just one among many components of talent management with pay arrangements differing according to individual and organisational circumstances.

Law, finance and innovation: the dark side of shareholder protection

Proponents of minority shareholder protection state that national legal institutions protecting small investors boost stock markets and, in turn, the long-term performance of countries. In this paper we empirically challenge this argument. We perform three-stage least squares estimation on a sample of 48 countries during 1993–2006 and find that countries with stronger shareholder protection tend to have larger market capitalisation but also lower innovative activity. We cope with stock market endogeneity and industry heterogeneity, and circumvent omitted variables bias, so that this finding is unlikely to be driven by misspecification problems. The estimation results are interpreted, arguing that stronger shareholder protection may depress rather than encourage the most valuable corporate productions, because it enables small and diversified shareholders to play opportunistic actions against undiversified stockholders, after specific investments are undertaken by the company; innovative activity, largely based on specific investing, is particularly exposed to this problem.

Corporate Governance and Executive Compensation in Financial Firms: The Case for Convertible Equity-based Pay

Unlike the failure of a nonfinancial firm, the failure of a systemically important financial firm will reduce the value of a diversified shareholder portfolio because of economy-wide reductions in expected returns and a consequent increase in systematic risk. Thus, diversified shareholders of a financial firm generally internalize systemic risk, whereas managerial shareholders and blockholders do not. This means that the governance model drawn from nonfinancial firms will not fit financial firms. Regulations that limit risk-taking by financial firms can thus provide a benefit, rather than necessarily impose a cost, for the typical diversified public shareholder. Managerial shareholding also gives rise to a particular problem of the CEO who, despite the increasing precariousness of the firm’s position, may be reluctant to pursue equity infusions or to sell the firm because of the resulting dilution of his ownership stake. This might be called the “Fuld problem.” To mitigate excessive risk-taking both in ordinary operations and as the firm approaches financial distress, this paper proposes a new compensation mechanism for senior managers: convertible equity-based pay. Upon certain external triggers––for example, a regulatory downgrade into a high-risk category, deterioration in a key financial ratio, or a significant stock price drop––such stock-based compensation should convert into subordinated debt, at a valuation discount. This will give managers an incentive to curb excessive risk-taking and, in particular, to steer the firm away from financial distress.