Keeping Company

Kevin Lewis

March 31, 2020

Corporate Governance and Pollution Externalities of Public and Private Firms
Sophie Shive & Margaret Forster
Review of Financial Studies, March 2020, Pages 1296-1330


The number of U.S. publicly traded firms has halved in 20 years. How will this shift in ownership structure affect the economy's externalities? Using comprehensive data on greenhouse gas emissions from 2007 to 2016, we find that independent private firms are less likely to pollute and incur EPA penalties than are public firms, and we find no differences between private sponsor-backed firms and public firms, controlling for industry, time, location, and a host of firm characteristics. Within public firms, we find a negative association between emissions and mutual fund ownership and board size, suggesting that increased oversight may decrease externalities.

Executive Pay for Luck: New Evidence over the Last 20 Years
Jung Ho Choi, Brandon Gipper & Shawn Shi
Stanford Working Paper, December 2019


Pay for non-performance is among the most prominent arguments of executive rent extraction, especially Bertrand and Mullainathan's (2001) pay for luck. We revisit their finding over the last two decades, 1997 through 2016. Pay for luck presents in the first decade but declines in the second decade. This decrease is robust to different measures of luck, various industry subsamples, and the financial crisis of 2008-9. The structural break in pay for luck associates with transparency-based regulations, such as option expensing and new performance pay disclosures. These regimes plausibly enhance shareholder monitoring, which pushes compensation committees to decrease pay for luck.

Effects of an Advancing Tenure on CEO Cognitive Complexity
Lorenz Graf-Vlachy, Jonathan Bundy & Donald Hambrick
Organization Science, forthcoming


We study how the cognitive complexity of chief executive officers (CEOs) changes during their tenures. Drawing from prior theory and research, we argue that CEOs attain gradually greater role-specific knowledge, or expertise, as their tenures advance, which yields more complex thinking. Beyond examining the main effect of CEO tenure on cognitive complexity, we consider three moderators of this relationship, each of which is expected to influence the accumulation of expertise over a CEO's time in office: industry dynamism, industry jolts, and CEO positional power. We conduct our tests on a sample of 684 CEOs of public corporations. The analytic centerpiece of our study is a novel index of CEO cognitive complexity based on CEOs' language patterns in the question-and-answer portions of quarterly conference calls. As part of our extensive theory of measurement, we provide evidence of the reliability and validity of our index. Our results indicate that CEOs, in general, experience substantial increases in cognitive complexity over their time in office. Examined moderators somewhat, but modestly, alter this general trajectory, and nonlinearities are not observed. We discuss the implications of our findings.

CEOs' Outside Opportunities and Relative Performance Evaluation: Evidence from a Natural Experiment
Ke Na
Journal of Financial Economics, forthcoming


This paper examines the effect of CEOs' outside opportunities on the use of relative performance evaluation (RPE) in CEO compensation. My tests exploit the staggered rejection of the Inevitable Disclosure Doctrine (IDD) by US state courts as an exogenous increase in CEOs' outside opportunities. I find that the rejection of the IDD leads to a significant increase in the sensitivity of CEO pay to systematic performance (less RPE). This increase is more pronounced for CEOs with greater labor market mobility and industries where proprietary information is more important and not related to measures of governance quality. These results suggest that firms link CEO pay to systematic performance to retain talent and ensure participation.

Reconciling the Firm Size and Innovation Puzzle
Anne Marie Knott & Carl Vieregger
Organization Science, March-April 2020, Pages 477-488


There is a prevailing view in both the academic literature and the popular press that firms need to behave more entrepreneurially. This view is reinforced by a stylized fact in the innovation literature that research and development (R&D) productivity decreases with size. A second stylized fact in the innovation literature is that R&D investment increases with size. Taken together, these stylized facts create a puzzle of seemingly irrational behavior by large firms - they are increasing spending despite decreasing returns. There have been a number of proposals to resolve the puzzle. However, to date none of these proposals has been fully validated, so the puzzle remains. Accordingly, this paper empirically tests the proposals to see whether any resolves the puzzle. We found one proposal (use of alternative measures) was able to resolve the puzzle. When using a recent measure of firms' R&D productivity, RQ, we found that both R&D spending and R&D productivity increase with firm size. Thus, large firms seem to be acting rationally in their increasing R&D investments, as one would expect.

Monitoring the Monitor: Distracted Institutional Investors and Board Governance
Claire Liu et al.
Review of Financial Studies, forthcoming


Boards are crucial to shareholder wealth. Yet little is known about how shareholder oversight affects director incentives. Using exogenous shocks to institutional investor portfolios, we find that institutional investor distraction weakens board oversight. Distracted institutions are less likely to discipline ineffective directors with negative votes. Consequently, independent directors face weaker monitoring incentives and exhibit poor board performance; ineffective independent directors are also more frequently appointed. Moreover, we find that the adverse effects of investor distraction on various corporate governance outcomes are stronger among firms with problematic directors. Our findings suggest that institutional investor monitoring creates important director incentives to monitor.

Shareholder litigation rights and corporate acquisitions
Chune Young Chung et al.
Journal of Corporate Finance, forthcoming


We examine the effect of shareholder litigation rights on managers' acquisition decisions. Our experimental design exploits a U.S. Ninth Circuit Court of Appeals ruling on July 2, 1999 that resulted in a reduction in shareholder class actions. We find that, since the ruling, firms in Ninth Circuit states acquire larger targets. Furthermore, acquirers' returns are lower in these states, especially for those with weaker corporate governance. Further analysis shows that value destruction is the result of managers' freedom to conduct empire-building acquisitions using overvalued equity. Overall, our findings indicate the importance of shareholder litigation as an external governance mechanism.

Shareholder litigation rights and capital structure decisions
Nam Nguyen, Hieu Phan & Eunju Lee
Journal of Corporate Finance, forthcoming


We exploit the staggered adoption of the universal demand (UD) laws across U.S. states, which impedes shareholder rights to initiate derivative lawsuits, as a quasi-natural experiment to examine the relation between shareholder litigation rights and firm capital structures. We find that weaker shareholder litigation rights due to the UD laws adoption lead to higher financial leverage, which enhances firm value. Furthermore, the positive relation between the UD laws adoption and financial leverage is more pronounced for firms exposed to higher shareholder litigation risk ex ante or financially constrained firms. Our evidence is consistent with lower shareholder litigation threats motivating firms to increase financial leverage.

Board Predictive Accuracy in Executive Selection Decisions: How Do Initial Board Perceptions of CEO Quality Correspond with Subsequent CEO Career Performance?
Timothy Quigley, Adam Wowak & Craig Crossland
Organization Science, forthcoming


Research examining board efficacy often focuses on oversight and monitoring, particularly as evidenced by the sensitivity of chief executive officer (CEO) compensation to prior firm performance. In this study, we adopt an alternative perspective on CEO compensation-specifically over/underpayment, or the extent to which a CEO's initial compensation is above or below prevailing market norms-that allows us to assess a board's efficacy via the accuracy of its initial CEO selection and compensation decisions. We build on and extend human capital theory to argue that boards make initial CEO compensation decisions based a range of manifestations of CEO human capital (that are both observable and unobservable to outsiders) and that initial over/underpayment represents an implicit assessment of underlying CEO quality. Using a sample of 766 CEOs, we relate initial over/underpayment to subsequent CEO career performance. Our results show that this core relationship is positively significant and economically meaningful. Thus, U.S. public company boards, as a group, do tend to be making broadly accurate initial predictions regarding the underlying capabilities of new CEO hires. This relationship is amplified in situations where board assessments of CEO human capital are more unequivocal (greater current versus prospective compensation) and when CEO human capital can be expressed most comprehensively (high managerial discretion). In supplemental analyses we show that these relationships fundamentally changed following the implementation of the Sarbanes-Oxley Act, suggesting that boards may be performing this important aspect of their governance role more effectively in recent times. We also find that our results are not symmetric-rather, they are strongest in situations where initial compensation is midrange or lower; high levels of initial overpayment are not associated with commensurate levels of career performance. Finally, we consider and account for a range of alternative explanations for our central finding.

Is Market Timing Good for Shareholders?
Ilona Babenko, Yuri Tserlukevich & Pengcheng Wan
Management Science, forthcoming


Corporations often transact in their own mispriced stock. This activity, known as equity market timing, can generate substantial profits and increase the long-term stock price. We challenge a closely related popular view that market timing always benefits firm shareholders. Opportunistic financing maneuvers by a firm can negatively affect its uninformed stock owners because of adverse selection and the change in the firm's short-term price, whereas the long-term returns do not accumulate to departing stockholders. The negative effect of market timing on stockholders increases with the share turnover. Furthermore, the effect of timing is asymmetric: shareholders prefer that the firm corrects underpricing rather than overpricing. Our theory can be used to better interpret the observed stock issuance and repurchase activities of firms.

Let's talk sooner rather than later: The strategic communication decisions of activist blockholders
Adam Aiken & Choonsik Lee
Journal of Corporate Finance, forthcoming


When starting their campaigns, activist investors face the decision of when to begin communication with the management of the target firm. We document how the choice to start communication early with management, before the 13D disclosure, fits within the campaign's overall strategy. Nearly a quarter of the activist campaigns in our sample begin with what we call open activism. More credible activists with lower costs of activism are more likely to engage with management early and this early engagement is related to their desire to see specific changes made at the target firm. Eventual actions taken by activists, such as a subsequent merger or proxy contest, as well as the long-run performance of the target, are also related to this initial communication decision. Together, our findings suggest that open activism is an important part of the activist's underlying strategy and that market participants understand this link.

Targeted by an activist hedge fund, do the lenders care?
Sandeep Dahiya, Issam Hallak & Thomas Matthys
Journal of Corporate Finance, forthcoming


Do banks worry about expropriation when an activist hedge fund targets their borrowers or are they reassured that their borrowers will perform better after such targeting? We study 1435 events during the 1996-2013 period in which an activist targeted a US corporation, to examine what happens to loan contract terms post-targeting. We present two new results. First, we show that when a firm is targeted by an activist hedge fund, the lenders of that firm charge a significantly higher rate on future loans and demand collateral more frequently than the loans made to risk- and industry-matched non-targeted firms. Second, we find that this increase in loan rate and the likelihood of collateral demand is limited only to those targets that experience a large positive announcement return when the news of an activist's involvement is first announced. We argue that higher interest rates and greater collateral requirements reflect the increased credit risk for these borrowers due, in part, to the possibility of wealth expropriation by the shareholders. Thus, we provide empirical evidence that an increase in equity value due to an activist's targeting may partially be due to wealth expropriation from creditors.


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