Corporate Governance

The Center’s research agenda will be anchored by issues in corporate governance that have received extensive attention in the wake of the two landmark episodes of the decade – corporate scandals and the recent financial meltdown. At the heart of these episodes are lack of accountability, poor disclosure, misaligned incentives, and severe regulatory gaps. These are issues at the interface of finance and public policy, and at the interface of Wall Street and Main Street. These are issues that the Center will help remedy.

Finance Professor Michael Faulkender discusses executive compensation on PBS Newshour

Policy Briefs

The Rise of Equity-Based Compensation: The Bright and The Dark
by Lemma Senbet
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Prepared for the 25th anniversary of Institutional Shareholders Services (ISS) Corporate Governance Compendium.

“Over the last twenty five years we have witnessed (a) extensive debate on excessive pay, (b) the advent of 162 (m), (c) financial excesses, and (d) crisis of epic proportions. Equity-based compensation, particularly stock option compensation, has been central to these issues. This leads me to conclude there is one aspect of corporate governance that has become the unifying link for these issues, namely the rise of equity-based compensation, and I consider this as the most significant development over the last twenty-five years.” Read all 25 selected papers

Conference Addresses

ISS and The Future of Corporate Governance

The Weinberg Center for Corporate Governance at the Lerner College of Business and Economics, University of Delaware, held the panel discussion “ISS and The Future of Corporate Governance” on November 17, 2011, part of the Seminar in Corporate Governance. This discussion was moderated by Charles M. Elson, Edgar S. Woolard, Jr., Chair in Corporate Governance. CFP Director Lemma Senbet was one of eleven panel members to participate in this discussion.

Executive Compensation In a Public Domain
by Lemma Senbet
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Watch an excerpt of his address

Professor Lemma Senbet, Director of the Center for Financial Policy, addressed the 72nd International Atlantic Economic Conference in Washington, D.C. on October 22, 2011.  This distinguished speech covered imbalances and excesses in executive compensation, discussed the two generations of reforms (SOX and Dodd-Frank) and made the case for incentivized regulation.

Executive Compensation and Public Policy
by Lemma Senbet
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A keynote address for the Triple Crown Conference, Newark, NJ, April 30, 2010
Professor Senbet explores the role of executive compensation in the economic crisis and comments on various policy reforms.

Statements and Commentary

Discussion of Cost-Benefit Analysis in SEC Rulemaking
by Albert S. (Pete) Kyle
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On April 16, 2012 at Columbia University’s Law and Economics of Capital Markets Fellows Workshop, Professor Kyle discussed the cost-benefit analysis of SEC rulemaking. As a framework for his presentation, Professor Kyle examined the six recommendations of the SEC’s Office of Inspector General study on the topic and offered his opinion of each recommendation.

Response to Interagency Notice of Proposed Rulemaking: Incentive-Based Compensation Arrangement 
by Ethan Cohen-Cole, Michael Faulkender, Nagpurnanand Prabhala, Lemma Senbet and Haluk Ünal
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On May 3, 2011, five CFP faculty associates sent a letter to several agencies responding to the Notice of Proposed Rulemaking (NPR): Incentive-Based Compensation Arrangement. The letter comments on the definition of covered institutions, incentive-based compensation, required reports, deferral arrangements, executive compensation, and personal hedging strategies of executives. The faculty associates provide recommendations that they feel will further strengthen the objective of this Interagency NPR, which is “to strengthen the incentive compensation practices at covered institutions by better aligning employee rewards with longer-term institutional objectives.”

Financial Economists Roundtable (FER) Statement of the Financial Economists Roundtable on Reforming the OTC Derivatives Markets
by Chester S. Spatt, Darrell Duffie and Albert S. (Pete) Kyle
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Research Track Lead Pete Kyle and CFP Academic Fellow Chester Spatt authored this FER statement released on June 29, 2010, a result of a discussion at FER's annual meeting on July 18-20, 2009 at Skamania Lodge in the Columbia River Gorge. Professors Kyle and Spatt, along with CFP Director Lemma Senbet, are members of The Financial Economists Roundtable, a group of senior financial economists, who have made significant contributions to the finance literature and seek to apply their knowledge to current policy debates.  

White Papers

Executive Compensation: An Overview of Research on Corporate Practices and Proposed Reforms
by Michael Faulkender, Dalida Kadyrzhanova, N. Prabhala, and Lemma Senbet
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Abstract: The 2008 financial crisis spread rapidly around the world. These landmark episodes have drawn attention to the high levels of executive compensation, and to the possibility that the structure of executive pay plans may have contributed to the post-1990s bubbles, corporate scandals, and recent financial crisis.

Working Papers

Corporate Financial Distress and Bankruptcy: A Survey
By Lemma W. Senbet and Tracy Yue Wang
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Inside Debt, Bank Default Risk and Performance during the Crisis
by Haluk Ünal
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Corporate Governance Mandates and Firm Outcomes
by CFP Academic Fellow Reena Aggarwal, Jason D. Schloetzer and Rohan Williamson
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Abstract: Regulators and stock exchanges have recently responded to perceived corporate governance failures by mandating certain governance attributes across all firms. There has been considerable debate whether this public policy approach achieves the desired goal even for firms that have the weakest governance structure and are most affected by the mandates. While SOX-related regulatory actions required all firms to adopt certain corporate governance attributes, not all firms were equally affected. This paper identifies a unique sample of firms that were more affected by the new corporate governance regulations compared with relatively less affected firms. Using a propensity-score trimmed sample, we find affected firms had significantly lower pre-regulation valuations. After affected firms adopt governance mandates, there is an increase in affected firm post-regulation firm value compared with relatively less affected firms. This relative increase for affected firms is not related to post regulation differences in investment, earnings quality, or operating performance. Rather, affected firms experience a decrease in CEO compensation and an increase in the likelihood of CEO turnover in the post-regulation period compared with relatively less affected firms. Overall, the evidence suggests that corporate governance mandates enhanced firm value and improved board monitoring of firms most affected by the regulatory action.

Systemic Risk and Network Formation in the Interbank Market
By Ethan Cohen-Cole, Eleonora Patacchini, and Yves Zenou
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Abstract: We propose a novel mechanism to facilitate understanding of systemic risk in financial markets. The literature on systemic risk has focused on two mechanisms, common shocks and domino-like sequential default. Our approach is a formal model that provides an intellectual combination of the two by looking at how shocks propagate through a network of interconnected banks. Transmission in our model is not based on default. Instead, we provide a simple microfoundation of banks’ profitability based on classic competition incentives. As competitors lending quantities change, both for closely connected ones and the whole market, banks adjust their own lending decisions as a result, generating a ‘transmission’ of shocks through the system. We provide a unique equilibrium characterization of a static model, and embed this model into a full dynamic model of network formation with n agents. Because we have an explicit characterization of equilibrium behavior, we have a tractable way to bring the model to the data. Indeed, our measures of systemic risk capture the propagation of shocks in a wide variety of contexts; that is, it can explain the pattern of behavior both in good times as well as in crisis.

Concentrating on Governance
by Dalida Kadyrzhanova and Matthew Rhodes-Kropf
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Abstract: This paper develops a novel trade-off view of corporate governance. Using a simple model that integrates agency costs and bargaining benefits of management-friendly provisions, we identify the economic determinants of the resulting trade-offs for shareholder value. Consistent with the theory, our empirical analysis shows that provisions that allow managers to delay takeovers have a significant bargaining effect and a positive relation with shareholder value in concentrated industries. By contrast, non-delay provisions have an unambiguously negative relation with value, and more so in concentrated industries. Overall, our analysis suggests that there are governance trade-offs for shareholders and industry concentration is an important determinant of their severity.

Relative Governance
by Dalida Kadyrzhanova and Kose John
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Abstract: Using data on antitakeover provisions and headquarters location for a large sample of U.S. public corporations, this paper documents robust evidence of complementarity between firm-level and local corporate governance.

Is Disclosure an Effective Cleansing Mechanism? The Dynamics of Compensation Peer Benchmarking
by Michael Faulkender and Jun Yang
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Abstract: It has become a regular practice for firms to benchmark their executive compensation against peer companies. This paper examines the dynamics of the peer benchmarking process, addressing whether the 2006 regulatory requirement of disclosing compensation peers thereby casting sunshine on the practice has mitigated firms’ behavior of benchmarking CEO compensation against a group of self-selected, highly-paid peer CEOs (Faulkender and Yang, 2010; Bizjak, Lemmon, and Nguyen, 2011). Our evidence shows the gaming of the benchmarking process has actually been exacerbated since disclosure became mandatory in 2006, calling into question the ability of mere disclosure to remedy potential abuses in determining executive compensation.

Law, Organizational Form, and Taxes: Financial Crisis and Regulating through Incentives
by Kose John, Vinay B. Nair, Lemma Senbet
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Abstract: Calls for tighter financial regulation are gathering momentum in the wake of the global financial crisis. In a setting where corporate innovation imposes positive and negative externalities, the social impact of firms in the private sector depends on the sharing rule between their owners and the society at large. We examine the role of law, regulation and institutions in altering this sharing rule. We propose a framework where the social planner puts in place a system of laws, organizational forms, and taxation within which firms optimize without invasive regulation. Since the legal regime affects the extent to which owners of firms are held responsible for the negative externalities they impose, unlimited liability may discourage innovation in strong legal regimes. Limited liability, however, might be accompanied by excessive innovation. We highlight the role of the government in altering the sharing rule due to its claim through corporate taxation and investigate the relation between law and corporate taxation. We show that the equilibrium corporate tax rates are a decreasing function of legal effectiveness in the embedding economy. We also explore the policy implications of our results for the effectiveness of the mechanisms used in the bailout of failed institutions in the current financial crisis. Finally, we highlight some stylized facts from cross-country data that support our results.

Pay for Performance? CEO Compensation and Acquirer Returns in BHCs
by Haluk Unal, Kristina Minnick, Liu Yang
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Abstract: We examine how managerial incentives affect acquisition decisions in the banking industry. We find that higher pay-for-performance sensitivity (PPS) leads to value-enhancing acquisitions. Banks whose CEOs have higher PPS have significantly better abnormal stock returns around the acquisition announcements. On average, acquirers in the High-PPS group outperform their counterparts in the Low-PPS group by 1:4% in a three-day window around the announcement. Ex ante, higher PPS helps to prevent value-destroying acquisitions, while at the same time promote value-enhancing acquisitions. The positive market reaction can be rationalized by post-merger performance. Following acquisitions, banks with higher PPS experience greater improvement in their operating performance.

Offsetting Behavior and Compensation Reform
By N. Prabhala and N. K. Chidambaran
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Abstract: Calls for regulation and reform of compensation have intensified following the2008 financial crisis, as flawed compensation is implicated as a cause of the crisis. Our study illustrates a key difficulty in implementing reform through regulation: offsetting behavior, which can entirely undo regulatory intent and even impose additional costs on shareholders. We show these effects in the context of compensation contracts, using as a laboratory the punitive disclosure requirements imposed in 1998 to deter repricing. Firms demonstrate strong offsetting behavior by squeezing out compensation through a substitute, which is paradoxically costlier for shareholders. The excess costs are best explained by a wedge between employee and firm incentive valuations and we characterize its nature. We also find offsetting behavior in broader samples of all firms with underwater options after 1998. We discuss the implications for the design of compensation design and reforms likely to be most effective in curbing compensation excesses.

Agency Costs of Idiosyncratic Volatility, Corporate Governance, and Investment
by Dalida Kadyrzhanova and Kose John
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Abstract: This paper identifies a fundamental conflict of interest between managers and shareholders in risk taking decisions and explores its implications for the relation between external governance mechanisms, corporate investment, and value. Using a dynamic panel GMM estimator to address endogeneity, we show that antitakeover provisions (ATPs) lead to more conservative investment decisions, including relatively less investment in R&D, more investment in PPE, and more diversifying acquisitions, and that these effects are concentrated among high idiosyncratic volatility firms - i.e., firms with agency costs of idiosyncratic risk. In addition, we find that ATPs lead to large drops in firm value, and that this negative valuation effect of ATPs is also concentrated among high idiosyncratic volatility firms - i.e., the firms for which ATP-induced conservatism is more pronounced. These results suggest that ATPs lead to excess managerial conservatism. Thus, by curbing managers’ tendency to avoid value-enhancing risks, corporate governance reforms can create value for shareholders.

Optimal CEO Incentives and Industry Dynamics
by Dalida Kadyrzhanova and Antonio Falato
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Abstract: This paper develops a competitive equilibrium model of CEO compensation and industry dynamics. CEOs make product pricing and product improvement decisions subject to shareholders compensation choices and idiosyncratic shocks to product quality. The choice of high-powered incentives optimally trades-off the benefits from expected product improvements and the associated agency costs. In market equilibrium, the interaction between CEO pay and product market decisions affects the stationary distribution of firms. We characterize a dynamic feedback effect of industry structure on CEO incentives. As a result of this effect, we predict an inverse relation between the magnitude of the performance based component of CEO pay and, (i) across industries, the degree of heterogeneity of industry structure; (ii) within industries, firm position with respect to its peers. We empirically estimate pay-performance sensitivity for a large sample of U.S. CEOs and other top executives over the 1993 to 2004 period and find strong support for our theory. Our results offer a novel product market rationale for the increased reliance of CEO pay on bonuses and stock options over the 1990s.

A Theory of Preemptive Entrenchment
by Dalida Kadyrzhanova
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Abstract: Entrenchment can benefit shareholders since aggressive managers deter rivals and, thus, make competition softer in the product market. I formalize this intuition within a simple industry equilibrium model of optimal entrenchment and test its implications empirically. The key cross-sectional prediction of the model is that industry leaders benefit most from preemptive entrenchment, since they suffer relatively larger losses in market share from facing tougher competition. I find strong support for this prediction and a number of related cross-sectional implications of my model using a large sample of U.S. public firms between 1990 and 2005 and a wide variety of entrenchment measures, such as external (antitakeover provisions, state antitakeover laws) and internal (board size and independence, institutional shareholders and pension funds) governance. In particular, I find that (i) industry leaders are more entrenched than laggards; (ii) the valuation effect of entrenchment is negative for laggards, but positive for leaders. Moreover, the link between industry leadership and the valuation effect of entrenchment is more pronounced in industries that are more concentrated, relatively less heterogeneous, and less subject to foreign competition. These findings offer a novel perspective over the debate on whether governance creates value by documenting when that is actually the case.

The Impact of Networks on CEO Turnover, Appointment, and Compensation 
by Yun Liu
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Abstract: This paper studies the influence of networks and connectedness on CEO labor market outcomes, including new CEO appointments, CEO termination, and CEO compensation. I distinguish between the pairwise specific CEO-board connectedness and the strength and structure of the CEO’s overall connectedness. I find that both types of connectedness add to traditional turnover and compensation variables in distinct and economically significant ways. Specific connectedness increases CEO entrenchment. Greater overall CEO connectedness on the employment network results in greater likelihood of CEO departure, greater turnover-performance sensitivity, and more rapid re-employment of a departed CEO. The existence of specific links between the CEO candidate and the board of directors enhances the chances of appointment in the event a company chooses to appoint an outsider as the CEO. Finally, CEOs with better overall connectedness enjoy higher total compensation. The evidence suggests that the general connectedness of a CEO in the employment network has significant and distinct economic effects beyond those of the connections between the CEO and the board in the current firm.