Speech by SEC Staff:
This speech was prepared for presentation at the e-learning forum of the National Investor Relations Institute on December 12, 2006. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
1. IntroductionIt’s a great pleasure to speak this afternoon at the e-learning forum of the National Investor Relations Institute. Of course, investor relations professionals are at the front lines of many important issues in corporate finance. They represent firms in addressing questions of concern to shareholders. In this sense investor relations professionals are in the cross-hairs of important conflicts between the preferences of senior management and those of the investment community and individual investors. I’d like to pursue this theme as part of my broader discussion of specific disclosure issues and the nature and rights of shareholdings. At the onset of my remarks I should emphasize, that of course, the views and perspectives that I am expressing today are my own and not those of the Commission or my colleagues on the staff of the Securities and Exchange Commission.
2. Agency Theory
My own background is as an academic economist—I have been a professor for several decades and I am currently serving as the Commission’s Chief Economist. By our training economists have tremendous respect for the power of markets to produce efficient outcomes; indeed, a version of that idea goes back to Adam Smith more than two centuries ago and in modern parlance is called the fundamental theorem of welfare economics. From that perspective the evolution of thinking among financial economists about the decisions of corporate leadership is striking. In the 1970s the market-oriented perspective was dominant. At the same time, a “theory of agency” was emerging to highlight the disparity between the incentives of agents who are delegated decision-making authority from those of the underlying principals on whose behalf they are acting.1 Since the 1980s economists have found this a work-horse framework for understanding the broad theme of conflict of interest and the nature of fiduciary responsibility that cuts beyond the management of the corporation itself to the problems of managing fiduciary relationships more generally. These issues are at the core of many of the types of issues that securities regulators have been facing in recent years in the context of corporate decision-making, investment management and the regulation of trading. Over the years, the economics of contracts—and its companion notion of agency costs—have emerged to complement the understanding of markets as a source of discipline that we ascribe to Adam Smith.
In the context of corporate decision-making, decisions about the form and level of compensation have received considerable attention by both investors and regulators because the nature of the incentive conflict is so direct in compensation setting, despite various safeguards, and the empirical facts are so striking to those in the investor class. The options backdating scandal reflects only the most recent manifestation of these concerns. In Washington one often hears the views of “business,” which in some situations may be consistent with those of shareholders as a group—but in other cases, these simply reflect management trying to give its own viewpoint a more respectable cast.
I’d like to focus a bit on various elements of the compensation issue because the nature of the agency conflict is arguably the starkest in this context. Shareholders can intuitively understand the nature of the conflict and the actions of some management groups have not provided a lot of comfort that the interests of investors are being protected. All of these reasons may be suggestive as to why disclosure issues in this domain have received a lot of attention in recent years, through strengthening of both executive compensation disclosure and employee stock option expensing requirements.
3. Disclosure IssuesThe debate about option expensing had occurred in Washington, D.C. over an extended period of time and on many levels. Some critics of option expensing had suggested that options were not an operating cost to the firm because they were not a cash cost, but of course they represent an important component of the cost to some types of companies of securing the services of its workforce. To not expense the costs would mean that regulators would treat in a fundamentally different manner diverse forms of compensation and the companies that selected those forms. Yet most observers would agree that accounting policy should endeavor to set a level playing field and to be neutral among different modes of compensation.
Others challenged the applicability of conventional traded option pricing models to this debate. But financial theory is powerful because it does not suggest a one-size fits all approach—instead it is built upon basic economic principles such as consumer--investors preferring more to less, the application of which adapts to the specific structure of the cash flows being valued. To the extent that alternative parametric valuation models may be used to describe a given set of circumstances in practice, it is important to calibrate the model one selects in a reasonable fashion in order to select the required model inputs. Based upon FAS123(R) adopted by the Financial Accounting Standards Board, options expensing should reflect the cost to the company of the option grants. Satisfying this underlying measurement objective is crucial for proper estimates for the expense of employee stock option grants rather than an objective of minimizing the costs of the grants to the company within a very broad performance criterion.
While the concept of options expensing and more specifically its proposed implementation were controversial, I think that the recent options backdating scandal sheds more light on aspects of the expensing controversy. At the onset of our discussion I should note that the empirical evidence is quite strong along various dimensions suggesting that stock prices tended to decline prior to the grant issuances and rise right afterwards and that the recipients tended to be extremely lucky in obtaining particularly low exercise prices for the issuance of the option grants. The empirical evidence in this domain also suggests that the option grants reflect timing not just firm-specific price movements, but market-wide movements. The latter seems implausible to most financial economists unless the grants reflected knowledge of post-grant price movements. Perhaps more directly, the patterns are greatly reduced after the implementation of the Sarbanes-Oxley requirement that the grants be disclosed within two days when the opportunity to back date is limited and these patterns are very correlated with the lag between the claimed option grant date and the actual reporting date and the opportunity to back date.2 In a front page article the Wall Street Journal today described a study by one of the SEC’s economists pointing to the backdating of option exercises.3
While from an economist’s perspective I view the purpose of option compensation as trying to align the employee’s incentives for stock performance with those of the shareholders, backdating leads to a form of compensation that is effectively very different from what was disclosed. More generally, it leads to questions as to whether much of the conflict and controversy about options expensing had its roots in the self-interest of management.
As many of you are aware, the SEC last summer adopted enhanced requirements for the disclosure of executive compensation. Without reviewing the specifics of the required disclosures, I wish to emphasize that I think that disclosure in this arena is particularly important in light of the direct nature of the potential incentive conflicts in compensation setting for the firm’s most senior executives. Of course, the actual impact of heightened disclosure requirements on the direction of compensation is not clear-cut. To the extent that agency issues are dominant, enhanced disclosure could reduce executive compensation. However, to the extent that the executive requires a compensating differential when his compensation is disclosed, then enhanced required disclosures can raise compensation of the effected executives. Furthermore, the disclosure of more compensation information about other firms can alter in either direction the relative bargaining power between a firm and its executives.
One other set of corporate finance issues that has been much in the news of late concerns the Commission’s implementation of Sarbanes-Oxley and especially its Section 404, which addresses material weaknesses in internal controls. The feedback in this area has been considerable—especially vis-à-vis the costs for small firms. I anticipate important developments in this context in the near term as we strive to obtain a better balance between costs and benefits.
4. Nature of Shareholdings
The final set of issues that I would like to briefly discuss concern the nature of shareholdings. Specifically, I would like to address the contrast between direct ownership on the books of the firm and indirect ownership through omnibus or street name accounts—which is a subject of strong potential interest to investor relations professionals. This is a subject of increasing attention and interest in recent years due to greater focus on various aspects of the rights and responsibilities of ownership, especially as represented by the differential taxation of actual dividends vs. dividend substitutes, the voting privilege in corporate governance, short sales, and borrowing and securities lending.
In my view a convenient way to frame some aspects of the broad issue is who controls access to the shareholder’s identity. As investor relations professionals I anticipate that you often will interact with investors—but obviously, you do not have direct access to shareholders who elect to hold shares through “street name” and omnibus accounts. To what degree can intermediaries earn rents from this information and how does the use by the shareholder of different ownership form affect our intermediaries? At this level I regard the question as an interesting one, though a somewhat abstract question about “property rights.” The ambiguity in this context arises when an investor owns shares in a firm, but elects “street-name” status through a brokerage intermediary at which the investor is a client.
In that sense at least arguably the investor is delegating to the broker-dealer the responsibility to act for him. But this delegation is not necessarily costless. In at least isolated situations, the investor’s access to the voting ballot can be impaired either because of a fail to deliver the customer’s shares or because of the loan of the customer’s shares when it is in a margin account. Of course, typically voting issues work relatively seamlessly as the value of the vote is often modest, because there is not a substantive disagreement whose outcome is uncertain and relatedly, many shareholders have little interest in exercising or asserting their voting rights. But, of course, these are not the situations which lead to substantial value for a vote. Voting issues are the subject of ongoing discussion as illustrated by the NYSE’s proposal concerning “broker votes” and the Commission’s proposal concerning electronic proxy voting.
Another example of a cost of delegating ownership through a “street name” account is the potential for receiving a “dividend substitute” rather than an actual dividend when one’s securities are being lent. This is now a substantial cost in light of the difference in tax treatment since 2003 between “ordinary dividends” that can qualify as long-term capital gains and “dividend substitutes,” which are inherently taxed as ordinary income. This identifies a tangible cost to the investor engaged in securities lending that is not necessarily compensated, particular to retail investors.
Of course, the conventional brokerage agreement requires the customer to allow his broker-dealer the right to loan his shares in return for the privileges of being able to borrow capital as well as to borrow shares from others to create short positions. As I have argued, this is an indirect cost of borrowing. It also points to an issue that as a professor of long standing, I always have found rather puzzling—why do the customers who sell stock short not receive an interest credit for substantially all the short sale proceeds that the short sale frees up. While it certainly seems quite natural that the resulting liquidity cannot be provided the customer in order to ensure sufficient collateral for contract performance, it is puzzling as to why short positions are so costly in the retail space and why competition does not force more reasonable relative pricing of long vs. short positions? This indirectly identifies one of the ways in which intermediaries benefit from particular ownership forms by clients.
I welcome your questions.
Alchian, A. and H. Demsetz, 1972, “Production, Information Costs, and Economic Organization,” American Economic Review 62, 777-795.
Bebchuk, L., Y. Grinstein and U. Peyer, 2006, “Lucky CEOs,” working paper, Harvard Law School.
Cicero, D., 2006, “Timing and Backdating of Executive Stock Option Exercises—Before and After the Sarbanes--Oxley Act,” unpublished manuscript.
Harris, M. and A. Raviv, 1979, “Optimal Incentive Contracts with Imperfect Information,” Journal of Economic Theory 20, 231-259.
Heron, R. and E. Lie, 2006, “Does Backdating Explain the Stock Price Pattern Around Executive Stock Option Grants?” Journal of Financial Economics, forthcoming.
Holmstrom, B., 1979, “Moral Hazard and Observability,” Bell Journal of Economics 10, 74-91.
Lie, E., 2005, “On the Timing of CEO Stock Option Awards,” Management Science 51, 802-812.
Jensen, M. and W. Meckling, 1976, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3, 305-360.
Maremont, M. and C. Forelle, December 12, 2006, “How Backdating Helped Executives Cut Their Taxes,” Wall Street Journal, p. A1.
Shavell, S., 1979, “Risk Sharing and Incentives in the Principal and Agent Relationship,” Bell Journal of Economics 10, 55-73
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