Tussle over regulation of hedge funds

Should hedge funds be regulated?

The tussle over regulation of hedge funds has resulted in a number of missteps and failed attempts.

Last year, for instance, regulators tried to get a better handle on the industry by requiring them to register with the SEC and submit to random inspections. But an appeals court last year overturned the rule, saying the SEC lacked the authority to regulate hedge funds.

Firmly in the 'more regulation of hedge funds is better' camp is House Financial Services Committee Chairman and Massachussetts Democrat Barney Frank, who has called for global leaders to study the funds' effects on markets. Reuters reports on a letter written by him to President Bush: "Private equity and hedge funds have, in a short period, become owners and movers of vast pools of financial capital, with significant influence on the real economy, employment and long-term competitiveness for our companies."

Protection of the small investor is another important reason proposed to support more hedge fund regulation.

However people on the other side of the issue argue that confidentiality is essential for hedge funds to be able to maintain their superior returns in an increasingly crowded market. They also argue that the hedge fund investor, is not a 'typical' small investor - has higher net worth on average - and consequently may not need the SEC's help.

Currently, the SEC requires hedge funds to submit Form D disclosing how much it intends to raise, how much it has already raised, the names of its managers and the 10-percent beneficial owners in the fund. However, the changes the SEC is considering -- dropping the beneficial owner disclosure and requiring electronic filings -- would make it easier for hedge funds to comply. Still, it will mean that regulators and others who want to know more about who owns the funds are likely to get even less information.

A final decision is expected in early July.

Sarbanes-Oxley and Director Pay

A new study by academics at the University of Georgia and Clemson University finds that director pay has increased post-SOX. In addition, companies pay more for D&O premiums now compared to before the legislation.

But, and this is no surprise to many of us, companies are now also getting more bang for their buck from their board of directors:
* Post-SOX boards are larger and more independent
* Director workload and risk increased: audit committees meet more than twice as often post SOX as they did pre SOX
* The corporate director pool also changed post SOX: more post-SOX directors are lawyers/consultants, financial experts and retired executives and fewer are current executives.

Well, its great that directors have more financial expertise, because this older study from 2004 found that the probability of restatement is lower in companies that have independent directors with financial expertise on their boards. In the authors' words, "Our findings are consistent with the idea that independent directors with financial expertise are valuable in providing oversight of a firm's financial reporting practices."

That's not the last word on board composition and firm performance, though. Watch this space for a neat summary of studies on board composition and various aspects of corporate performance.

Institutions, govern thyselves

Earlier this month, the Stanford Investors' Forum came out with a report on best practices of fund governance in connection with Stanford University's Rock Center for Corporate Governance.
Since institutional investors are often prominent advocates for better governance in corporates, it seems only right for them to prescribe standards for their own behavior.

This WSJ article notes that prominent governance lapses at funds in recent years include:

- The Securities and Exchange Commission inquiry into New Jersey's state pension system, which is billions of dollars short in assets to cover obligations.
- TIAA-CREF's trustees resigning in 2004 after it was revealed that they had invested in a company that had done business with TIAA-CREF's independent auditor, Ernst & Young. The problems were attributed to poor judgment rather than malfeasance.
-Last year, a former trustee of the Illinois Teachers' Retirement System pleaded guilty to accepting hundreds of thousands of dollars in kickbacks from investment firms seeking to do business with the pension provider.
- In 2004, the San Diego City Employees' Retirement System projected it was $1.4 billion short of assets to cover its obligations. Subsequent investigations highlighted poor decisions by the fund's board, and some former board members face criminal charges. A fund-sponsored investigation found that former board members ignored conflicts of interest, didn't properly investigate funding proposals and failed to heed warnings by experts.

The full text of the best practices report can be found here.

Back to Blogging..

..after a hiatus once again.
My job and lifestyle made it hard for me to find time to blog. I've made some changes now, though, and I hope to be able to continue blogging.

Mutual Fund Governance

The current issue:
The SEC proposed a rule in 2004 requiring at least 75% of a mutual fund's boards to be comprised of independent directors. However a federal appeals court asked it to reconsider this rule, after which the decision has remained stalled.
Currently, the SEC is proposing a modified rule under which mutual fund boards are generally required to be headed by an independent chairperson. But if the board consists of at least 75% independent directors, and has a lead independent director, the fund will be exempt from this rule requiring an independent chairperson and may choose a chairperson.

How it affects mutual funds now:
It has been documented that most mutual funds now do have at least 75% independent directors on their boards. As such, the new rule may not make a significant difference to most mutual funds.

How valid is the rule:
This study among many others, has documented a fact that may be intuitive to some, but is an important observation all the same: funds with independent boards not only perform better, but also are more likely to replace underperforming managers when they do not perform well.
So the rule is backed by some solid justification.
And so what if most funds are already compliant: all that it means is that the cost of compliance is low ! So mutual funds are not going to add their voices to all those companies out there complaining about the cost of SOX!

Governance of charitable institutions

The WSJ had this great article about the Wall Watchers, an organization founded by Howard Leonard which monitors the uses of donations to religious organizations.
Another organization that does important work along these lines is the Better Business Bureau's Wise Giving Alliance. On their website, they have a set of comprehensive guidelines that seek "to ensure that the volunteer board is active, independent and free of self-dealing".
They include:
1. A board of directors that provides adequate oversight of the charity's operations and its staff.
2. A board of directors with a minimum of five voting members.
3. A minimum of three evenly spaced meetings per year of the full governing body with a majority in attendance, with face-to-face participation.
4. Not more than one or 10% (whichever is greater) directly or indirectly compensated person(s) serving as voting member(s) of the board. Compensated members shall not serve as the board's chair or treasurer.

Buy-side vs. Sell-side

A look at what this common Wall Street terminology means:

TheStreet.com says:
" Sell-side firms are what people traditionally think of when looking for Wall Street jobs. These firms underwrite securities and advise on mergers and acquisitions through their corporate finance divisions. Their sales and trading divisions make secondary markets in a variety of securities, including stocks, bonds, currencies, swaps, commodities and derivatives. Analysts in research divisions make both macro (overall investment strategy) and micro (company-specific) recommendations.

Buy-side firms generally manage portfolios on behalf of clients. They include insurance companies like Aetna, investment management firms like Wellington Management, mutual fund companies like Fidelity and hedge funds like Moore Capital."

A clearer definition (I think) is this: the key is to think of basic financial instruments (stocks, bonds and the like). Buy-side firms (such as mutual funds) invest in these financial instruments. Sell-side firms sell these - for example, investment banks may underwrite a company's IPO, or help to sell the company's shares to the public (and take a cut).

Though the definition seems clear-cut, its not always this simple.
Where do commercial banks stand (they take deposits and issue loans)? They invest the deposits by buying securities - so buy-side? Or maybe - because they issue bank loans, a form of financing- sell-side? Officially, they're on the buy side.
Insurance companies sell what might be called a financial instrument, but they fall on the buy-side because they invest the policies they collect in securities. Investment bankers who broker M&A deals are on the sell-side, regardless of whether they represent the company that's being taken over (sell-side?) or the raider company (the one that's looking to 'buy').

Finance, Economics, and Peace

Congratulations to the pioneering 'microfinance' practitioner, Bangladeshi Dr. Muhammad Yunus, for winning the Nobel Peace Prize on Friday. Dr. Yunus is a PhD in Economics and won the prize for his founding of Grameen Bank, which lends to small entrepreneurs at reasonable rates of interest in order to finance their small businesses.
Certainly he has taken important steps towards helping the poorest people to become self-sufficient and to prevent their being taken advantage of by unscrupulous money lenders.

But the Peace Prize?

At first glance, it is hard to equate philanthropic work or finance innovation with an award for peace. The peace prize after all has historically been awarded to international figures who try to broker peace between warring factions:
The Intl. Atomic Energy Agency last year, and previously activist for women's issues and refugees Shirin Ebadi, the United Nations and Doctors Without Borders.

To make matters more dubious in my eyes, the Nobel Committee specifically introduced the Islam motif in their award speech with the statement "Here we see a Muslim influencing the rest of the world" (presumably they also meant "in a positive way").
In my view the introduction of this religious theme into what should be a nonsectarian recognition of the greatest human effort to promote peace was quite unnecessary. More so when one realizes that Grameen Bank does not have particular claims to Islam - in fact, its basic premise, lending with interest, is completely at odds with the first principles of Islamic finance. (Islamic finance forbids lenders from charging interest).

If raising the quality of life for the poorest sections of the world is a basis for awarding the Peace Prize (and I'm not disagreeing, certainly it is a worthwhile effort that should be recognized, and certainly it does not fit into any of the other Nobel categories)- and Doctors Without Borders, an organization I have immense awe for, could certainly fit under this head - perhaps Bill and Melinda Gates should be contenders. Their Foundation, which is probably the largest of its kind in the world, especially after the recent additions by Warren Buffett, contributing the equivalent of many small countries' fortunes annually to various charitable causes.
In comparison with what they do for the world's underpriveleged, Muhammad Yunus is merely a businessman and economist who started a bank with an innovative lending policy.

"How does corporate governance even matter?" The bottom line..

Suppose the CFO or CEO of a company asks you the above question.
Forget value judgements and moral righteousness.
How would you convince the CFO/CEO that good corporate governance is worth the cost?

The carrots:

1. Corporate governance affects bond ratings
Bhojraj and Sengupta as well as Ashbaugh, Collins and LaFond have made arguments to that effect.

2. And therefore affects cost of capital
See above; as well as Gompers Ishii and Metrick's paper entitled Corporate Governance and the Cost of Equity Capital.

3. Corporate governance affects share price

4. Institutional investors' demand for a stock may depend on governance

5. Better compensation structure may result from stronger governance
Davila and Penalva found that stronger corporate governance is associated with higher proportion of equity in a CEO’s compensation package.

6. Governance may directly affect firm performance
Brown and Caylor found that seven of the metrics utilized by Institutional Shareholder Services (ISS), principally those related to director performance and senior management stock options, had an effect on firm performance. Bebchuk Cohen and Ferrell find that the entrenchment index (developed from six ISS corporate governance variables) improves firm performance.

And the stick:

5. Poor corporate governance can result in executives' employment termination

More on these individual issues (and more links to papers and findings) coming up.

Out of hibernation

Hello readers!
I am back after some prodding by my faithful readers and friends, after a long hiatus.
My bad. No excuses.
Much has happened in the corporate governance news in the meantime. The options backdating issue has snowballed into a scandal of epic proportions. The resultant spotlight has brought various other governance lapses of companies to public view, prominent among which is the H-P directors snafu that resulted in the resignation of chairperson Patricia Dunn. Executive pay continues to be a concern.
Your opinions on these and other events are, as always, welcome.
And mine, as before, will be forthcoming.

Securities litigation: top ten settlements

Ten largest settlements in securities class action lawsuits: (in millions)

Rank Issuer Settlement amount Percentage of Valuation
1 Enron $7,160.50 21.12%
2 WorldCom $6,156.30 18.16%
3 Cendant $3,528.00 10.41%
4 AOL Time Warner $2,500.00 7.37%
5 Nortel Networks $2,473.60 7.30%
6 Royal Ahold $1,091.00 3.22%
7 IPO Allocation Lit. $1,000.00 2.95%
8 McKesson HBOC $960.00 2.83%
9 Lucent Technologies $673.40 2.19%
10 Bristol-Myers Squibb $574.00 1.69%
All other large settlements $7,786.50 22.97%

Source: Stanford Securities Class Action Database jointly maintained by Cornerstone Research.

Freddie vs. Fannie

I was asked the other day (by a rather nice person) what the difference was between Freddie Mac and Fannie Mae. I didn't know. Hence this post (after some googling, of course).

This article from the Real Estate department at Texas A&M says:

At first, the two agencies took somewhat distinctive positions within the secondary mortgage market, buying different types of loans and issuing different types of securities. Today, however, there is little difference in the way the two operate or raise funds. Fannie Mae is perceived as more governmental than Freddie Mac, possibly because it is a more vocal advocate of its public mission.

I actually interviewed for an economist position with Freddie Mac before I took up my current position. They have a good research team (and excellent benefits!), but the job profile with its concentration in economics (not finance and certainly not corporate finance) wasn't such a fit with my research interests.

Fannie Mae and the Wiki: Or, Am I being picky?

Check out Fannie Mae's Wikipedia entry. After describing what Fannie Mae does (a good description if you're not quite sure) it goes on to say:

Fannie Mae is a consistently profitable corporation. While it receives no direct government funding or backing, it has certain looser restrictions placed on its activities than normal financial institutions. For example, it is allowed to sell mortgage backed securities with half the capital backing them up than is required by other financial institutions. Critics, including Alan Greenspan, say that this is only allowed because investors seem to think that there is a hidden, or implied, guarantee to the bonds that Fannie Mae sells ([2]). Although the company describes them as having no guarantee, nevertheless the vast majority of investors believe that the Government would prevent them from defaulting on their debt, and so buy bonds at very low interest rates as compared to others having like risk.

I dont like to pick on Fannie Mae, but it probably this very notion of Fannie Mae being 'consistently profitable' that the company managers were reluctant to give up. And that probably explains (but does not excuse) why Fannie Mae, which experienced major losses as mortgage rates dropped, avoided recording the losses as such. Instead, they were hidden in the balance sheet under AOCI, or "accumulated other comprehensive income" and slowly amortized.

Wikipedia goes on to report the latest events (and I quote) :

In May 2006, the Office of Federal Housing Enterprise Oversight released a detailed report on the scandal, alleging Fannie Mae management fraudulently altered the company's accounting to overstate earnings to boost their personal bonuses. The report also alleges the company hired lobbyists to attempt to get Congress to investigate OFHEO and cut its budget, to hide the misdeeds. Fannie Mae agreed to pay $400 million in penalties. The company's market capitalization droped by $9 billion as a result of the scandal. As of May 2006, no criminal charges have been filed, but the investigation is ongoing.

Changes at Fannie Mae and looking back in time

MarketWatch has an interesting article about changes at Fannie Mae following "the company's foundation-shaking $10 billion accounting scandal."

" (CEO) Mudd has explained repeatedly to investors and lawmakers that he's trying to clean up Fannie, which is chartered by the government, but publicly traded.
On Thursday, Mudd told senators the company replaced its onsite auditors and has more than 300 auditors overseeing the firm's books. He said he and his management team are reorganizing Fannie's internal audit department. There's a new chief audit executive, with a direct line to the board's audit committee, he said.
The company will complete the massive restatement of earnings by year-end, Mudd said Thursday.

(But) James Lockhart, head of the Office of Federal Housing Enterprise Oversight, told lawmakers that Fannie Mae and Freddie Mac have a "very, very long way to go" to correct internal accounting control problems. Neither of the agencies, said Lockhart, is "even close to complying with Sarbanes-Oxley," referring to the corporate governance law passed in 2002. "

Fannie Mae's accounting scandal that recently came to light involves allegations of manipulation to hide massive losses in 2002 and 2003.
Take a look, then, at this article written in early 2003 that mentions Fannie Mae's high corporate governance score awarded by S&P at the time! Here's an excerpt:

Fannie Mae (ticker: FNM), the government-mandated mortgage broker, earned an overall CGS of 9.0 on a 10-point scale, reflecting "strong or very strong" corporate governance practices in all four of the areas analyzed.
..S&P Governance Services applauded the structure of Fannie Mae's board of directors, which meets the rules recently proposed by the New York Stock Exchange (NYSE). S&P also praised the board's independence.
"Our standard is to be a model 'glass box' company," said Mr. Raines (Fannie Mae CEO/Chair Franklin Raines). "And as the record shows, we are always willing to do more to keep our disclosures and corporate governance at the cutting-edge of best practices."

Oh, the irony !

Microsoft forward dated option awards... even to directors!

..and yet they didnt think to question the practice?!

Well, I suppose we should give them a break. Somebody must have raised some objections, because they abandoned the system in the late 1990s.

For those still confused about backdating vs. forward dating, here's the deal:

Say on June 1st, company X decides to give an employee stock options. Ideally, they should award the options with an exercise price thats equal to the stock price on June 1st.
The companies involved in the backdating scandal however, picked a date which had the lowest stock price in the previous quarter (or year, or month) and awarded it retrospectively on that date - say, May 4th.

Microsoft, however, after deciding to award the stock options to the employee on June 1st, goes on to wait and see for the next 30 days. Then it awarded the option with an exercise price equal to the lowest stock price in the next 30 days - say, on June 13th. Hence "forward" dating.

Whats the difference? A Microsoft spokesperson in an article today claimed that there was nothing wrong with what they did. However, lets examine the incentives at work here.
The employee at Company X was happy to receive a stock option which locked in an instant gain on the day he received it. This did not motivate him to work hard enough in the next year or so, because the locked-in gains were substantial as it is and unlikely to get much larger.

The employee at Microsoft, however, from June 1st onwards, was probably constantly looking for the stock price to DROP in the next 30 days (though of course he would look for the price to rise again subsequent to the 30 days). One may say that this in fact gives the employee a conflict of interest with the company!
Instead of simply being not motivated to work hard for the company (like employee X), the Microsoft guy's incentives were aligned to profit him if the company does poorly in the first 30 days !

So contrary to Microsoft's claim that they 'did nothing wrong' I would say that their actions were far more harmful to the company than the actions of all the (45 plus?) companies involved in the backdating probe.The only redeeming factor about MS being that the practice was stopped soon after it was begun in the 1990s.

Backdating companies count

I feel like I should have a counter constantly updating the number of companies that have been caught in the backdating scandal. The current hit counter is 40.

Wow. Even with this many companies (and more) that were doing it, nobody spoke up? Where are all the whistle blowers gone?

Brief hiatus

I will be out of town for the next 5 days or so with little access to the web. But I will be back and posting regularly from next week. Sorry for the interruption!

Recouping executive bonuses

GM shareholders were not the first ones to think about recouping executive performance bonuses based on falsely inflated financials (see previous post). When financials are restated, bonuses based on the wrong figures should be revised downwards and the company should recoup the excess amounts paid.

* Shareholders at another company, Kodak, tried (and failed) to make this change at their meeting last month. The Amalgamated Bank LongView Collective Investment Fund, a shareholder, wanted Kodak's board to commit to reviewing and recouping executive bonuses and other rewards in the event of an earnings restatement. However this resolution failed to pass.

* Shareholders at HP, also in May 2006, submitted (but failed to pass) a resolution seeking to allow the company to recoup bonuses after earnings restatements.

* When the Office of Federal Housing Enterprise Oversight released a report of their investigation into Fannie Mae's (suspiciously) growing earnings from 1998 until 2004, it prompted some talk about trying to recoup some of the performance-based bonuses from executives, such as former Chairman Franklin Raines. Of $90 million Raines received from the company between 1998 and 2003, $52 million was tied to earnings targets that the company hit, at least in part, by "deliberately and intentionally" manipulating its accounting, investigators concluded (story here).
But no steps have been taken as yet.


And since this blog is all about connecting academic research with real-world issues, I looked to see if there is any academic work about recovering executive pay or bonuses after restatements.
Zip. Zilch. Nothing.
Ideas, anyone?

GM shareholders initiate some changes; and an important issue comes to light

Today was the GM shareholder meeting in which shareholders voted on various resolutions.

Three of the four resolutions strongly backed by ISS(Institutional Shareholder Services, one of the big proponents of good governance)were passed. These proposals are:
- A proposal asking the company to separate the chairman and chief executive positions;
- a proposal requiring a majority vote for election of directors; and
- a proposal asking the company to provide for cumulative voting.

A fourth proposal strongly backed by ISS was not passed. This was a proposal to recoup executive compensation that may not have been correctly earned in the light of financial restatements. The proposal argues that due to financial restatements in the 2000 through 2004 period, executive compensation based on financial performance was flawed and overpaid.

This is an important issue that has been largely ignored, and also crops up in other contexts. When companies overstate their financials, and this is subsequently corrected, the company often has to pay a penalty for their poor reporting. But rarely are executive bonuses paid on the basis of the misreported high financials reimbursed.
This issue may also arise in two other situations, both when the SEC investigates improper reporting and imposes fines upon the company; and when civil litigation penalizes a company for improper litigation. In both cases, the company/shareholders pay the penalty, but executives get to keep their undue gains.

More on this issue in the next post.

What is 'Corporate Governance law' ?

From the website of law firm Weil, Gotshal and Manges, awarded the title of 'Global Corporate Governance law firm of the year' both in 2005 and 2006 by Who's Who Legal:

Weil Gotshal's Securities/Corporate Governance Litigation practice addresses the increasingly complex web of federal and state statutes, rules, common law and regulatory oversight of public and private organizations, from both the litigation and counseling perspectives.
This practice includes not only class action, "mass action," bankruptcy and other private litigation, but also civil regulatory and criminal proceedings under federal and state securities laws; shareholder derivative and other corporate/partnership governance and fiduciary duty disputes; and litigation involving complex corporate transactions.
Equally important, the other focus of this practice involves counseling issuers, boards of directors, audit committees, and other standing or special board committees and significant shareholder or securities industry constituencies, on issues involving disclosure and other securities law compliance and on issues of corporate governance (including internal investigations) and fiduciary duties under state and federal law.