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Pat CoxFormer President of the European Parliament

Richard Bruton, T.D.Minister for Jobs, Enterprise and Innovation

Video Message Michel Barnier

European Commissioner for Internal Markets & Services

Ugo BassiDirector for Capital and Companies, DG Internal Market & Services,

European Commission

Panel Discussion European Commission’s Action Plan on Company Law and Corporate Governance

Pat Cox ChairFormer President of the European Parliament

Chris HodgeHead of Corporate Governance, UK Financial Reporting Council

Paul HaranChairman, UCD, Michael Smurfit Graduate School of Business and Director of Glanbia

Professor Niamh BrennanProfessor of Management, UCD

Dr. Thomas B. CourtneyArthur Cox, Dublin

Ugo BassiDirector for Capital and Companies, DG Internal Market & Services, European Commission

Coffee Break

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Pat CoxFormer President of the European Parliament

ECGI SessionShort-termism, the impact of financial markets and the UK Kay Review

Jörgen HolmquistChairChairman of the European Corporate Governance Institute, former Director General, DG Internal Market & Services, European Commission

Professor Patrick BoltonProfessor of Business, Columbia Business School

Professor Alex EdmansAssistant Professor of Finance, The Wharton School, University of Pennsylvania

Short-termist Financial Markets and Corporate Governance Challenges

Professor Patrick BoltonProfessor of Business, Columbia Business School

Short-termism in one Cartoon

“Yes, the planet got destroyed, But for a beautiful moment in time we created a lot of value for shareholders.”

Financial Markets are Structurally Short-termist

Why?• One reason is that Financial Markets are incomplete• Stock prices reflect present discounted valuations of incomplete cash-

flow streams• A key omitted impact on future cash-flows: climate risk• At some point in the near future the world will have to price

Greenhouse Gas Emissions and the price will be steep• Where is carbon pricing risk reflected in current cash-flow projections?

The Long-Term Value of ESG Factors

ESG: Environmental, social and corporate governance• Eccles, Ioannou and Serafeim (2011): Compare a matched sample of

180 companies and find that

• Companies that have adopted ESG policies have higher long-run stock market and accounting performance.

• Major obstacle in the short run: lack of standardized measures of ESG (“integrated accounting”)

The Long-Term Value of ESG Factors

The Long-Term Value of ESG Factors

ESG Factors: Google word search trends

Short-termist Financial Markets:

Extrapolation Bias and

Excess Volatility

Extrapolation Bias and Excess Volatility

Excess Volatility

• Jeremy Grantham, Co-Founder and Chief Investment Strategist, Grantham, Mayo, Van Otterloo (GMO):

“we are 19 times more volatile than the clairvoyant series—19 times more volatile than is justified by the underlying stable data to a long-term holder. This is not impressive. This is not efficient. I have spent 30 years being extremely irritated listening to the intellectual torturing of logic to explain that it is in fact a rational market. ”

Excess Volatility

Kay Report:

We question the exaggerated faith which market commentators place in the efficient market hypothesis; the theory represents a poor basis for either regulation or investment

Excess Volatility

• How is it possible to be so inefficiently short-termist?

• Forecasting methods: Fuster, Hebert and Laibson (2011) -> robust short-term forecasting => too little correction for long-run mean-reversion (too few lags)

• Extrapolation bias: (Barberis, Shleifer and Vishny 1998, Hirshleifer and Yu, 2012) DSGE models with extrapolative expectations explain better key stylized facts about asset prices and macroeconomic variables than existing rational models

Short-termism

• Limits to Arbitrage: (Dow and Gorton 1995, Shleifer and Vishny 1997, Abreu and Brunnermeier 2003)

• Speculation: Differences of opinion + short sales constraints (Scheinkman and Xiong 2003, Bolton, Scheinkman and Xiong, 2006) =>

Stock Price = fundamental value + speculative option value

Shorter holding periods in the USThe average holding period has been decreasing for 45 years:

Average Holding Period for a stock on the NYSE (in years)

Source: NYSE overview statistics

Years

UK and Europe…Average Holding Period for a stock on the FTSE

(years)

19

66

19

69

19

72

19

75

19

78

19

81

19

84

19

87

19

90

19

93

19

96

19

99

20

02

20

05

0123456789

Source: London Stock Exchange Source: World Federation of Exchanges

Average Holding Period in other major stock exchanges (in years)

Cremers, Pareek, and Sautner (2013)

Cremers, Pareek, and Sautner (2013)

Kay Report:

Public Equity Markets currently encourage exit (the sale of shares) over voice (the exchange of views with the company)

Short-termism

• Incentive distortion resulting from short-term performance measurement (Stein 1988, 1989, Diamond 1991, 1993 and Von Thadden 1995)

• Short term incentives and benchmarking for asset managers (mutual funds & pension funds)

(Vayanos and Woolley 2011)

Short-termism: The effects on corporate investment

Graham, Harvey and Rajgopal (2005) “More than three-fourths of the surveyed executives would give up economic

value in exchange for smooth earnings […] Many executives feel that they are choosing a lesser evil by sacrificing long-

term value to avoid short-term turmoil […] Many managers would reject a positive NPV project in order to meet the analyst

consensus estimate!” Alti and Tetlock (2013) Journal of Finance

What can be done to lessen the Short-termist pressures of Financial Markets?

Existing Long Term Incentives…

• Reduced capital gains taxes for long term (buy-and-hold) investors• Longer term executive compensation (longer vesting periods, escrow accounts

& clawback provisions) • Rewards for long-term shareholders: Extra voting rights, shares (Air Liquide),

dividends (L’Oreal)• Financial Transaction Tax• No quartely earnings guidance (Coca-Cola, IBM, Google, etc.)• … are likely not sufficient to properly align Long-term goals of firms,

managers and shareholders.

Other Solutions?

• Promote integrated financial accounting which measures ESG factors (Eccles et al. 2011)

• Loyalty Shares (Bolton and Samama, 2012)

L-Shares : The basic ideaAll shareholders are entitled to a Loyalty

Warrant

Loyalty period Exercise period

(3 years) (3 years)

The Long-term shareholders having kept their shares for three years

Warrant = 1

The Short-term shareholders having sold their shares

Warrant = Ø

Behavior of shareholders determines ownership (or not) of the warrants

Here Comes the Slow-Stock Movement (WSJ 22 March 2013)

• Henry Jackson Initiative, Towards a More Inclusive Capitalism, May 2012• World Economic Forum, Measurement, Governance and Long-term Investing, March 2012• Institutional Investor, Can Loyalty Shares Programs Help Build Long-term Value for Investors, October 2012

EU Commission Green Paper on Long-Term Financing of the European Economy, March 2013

‘Ideas have also been advanced to encourage greater long-term shareholder engagement, which could be subject to further consideration, such as analysing the possibility of options around granting increased voting rights or dividends to long-term investors.’

Conclusion

• Short-termism of Financial Markets is a major problem

• Solutions are available, but so far little has been done to respond to short-termist pressures short of delisting

• A major area in need of reform is the governance of asset management firms and the compensation of asset managers pension funds who are investing for the long-term rely too much on short-term performance benchmarks

Kay Report:

This conflict between the imperatives of the business model of asset managers, and the interests of UK business and those who invest in it, is at the heart of the problem of short-termism.

Corporate Governance and Short-Termism: Challenges and Solutions

Professor Alex EdmansAssistant Professor of Finance, The Wharton School, University of

Pennsylvania

Outline of Talk

• Executive compensation What’s right, what’s wrong, and what’s fixable Particular emphasis on short-termism

• Short-termism of shareholders• Short-termism and disclosure policy

Executive Compensation

• Many high-profile examples of inefficiency (e.g. high pay, golden parachutes, rewards for failure)

• Policymakers: “first do no harm”• Role of academic research: are the above inefficiencies limited to a few

high-profile examples, or generally true?

Level of Pay

• #250 CEO in the US earned $9m in 2008: a sixfold increase since 1980 300 times a rank-and-file employee

• But pay has fallen 40% since peak; average worker pay hasn’t fallen so fast

• Bebchuk and Fried (2004): rent extraction• Gabaix and Landier (2008): pay is for talent. It’s competitive forces

Similar “superstar” effect to footballers, movie stars Compare CEO pay not to worker pay, but contribution to firm

Level of Pay

• Certainly, some CEOs are overpaid – but a few bad apples, rather than a rotten entire cart

• Problems with regulation: One-size fits all Can be easily circumvented, e.g. $1m salary cap

• Shareholders / boards have incentives to set the optimal pay scheme. Regulation can help by Giving shareholders voice (e.g. say-on-pay legislation) Mandating disclosure: facilitates both voice and voting with your feet

What Could Be Fixed: Excessive Risk-Taking

• Pure equity compensation induces excessive risk-taking at expense of bondholders

• Edmans and Liu (2011): optimal compensation involves both debt and equity Sundaram and Yermack (2007): defined benefit pensions and deferred

compensation• Bolton, Mehran, and Shapiro (2011): tie compensation to CDS spread• AIG changed its compensation to explicitly tie executives to debt• Liikanen Commission recommended debt-based pay

What Could Be Fixed: Short-Termism

• Incentives often have short vesting periods, allowing CEOs to cash out early Countrywide CEO sold $129m of stock in 12m before 8/07 “Before the Bust, These CEOs Took Money Off the Table” (Wall Street Journal,

11/20/08) Bebchuk, Cohen and Spamann (2010): top management at Bear Stearns and

Lehman earned $1.4bn and $1bn from cash bonuses and equity sales in 2000-8

Effects of Short-Term Horizons

• Encourage bad short-term actions Johnson, Ryan, and Tian (2009): unrestricted stock linked to corporate fraud Gopalan, Milbourn, Song, and Thakor (2012): short-duration equity is associated

with earnings management• Discourage good long-term actions

Edmans, Fang, and Lewellen (2013): imminently-vesting stock and options is associated with R&D cuts

Edmans (2011): intangible investment takes several years to show up in stock prices

The Dynamic Incentive Account

• Edmans, Gabaix, Sadzik, and Sannikov (2012)• Escrow the CEO’s pay into an account, of which (say) 60% is in stock, the

remainder is in cash “Long horizon principle” – account vests gradually, including after retirement

Superior to clawbacks: prevention, not cure; runs on auto-pilot• “Constant percentage principle” – rebalance the account so that % of stock

remains 60% at all times Re-incentivizes the CEO after the stock price drops, without rewarding him for failure

• Can be implemented with deferred cash and restricted stock, without need to set up an account

Short-Term Shareholders

• View that long-term incentives will only be implemented by long-term shareholders Calls for transactions taxes, short-sales restrictions to “lock-in” investors 1980s advocacy of Japanese model

• Shareholders who are short-term and uninformed will indeed trade on short-term earnings (Bushee (1998))

• But, informed shareholders with the option to sell in the short-term can exert governance Large stakes induce information gathering Liquidity provide option to sell

Governance Through Exit

• Traditional view: shareholders govern through voice But, hard to implement in practice

• If a manager is underperforming, or boards are setting inappropriate contracts, shareholders can “vote with their feet” / follow the “Wall Street Rule” Admati and Pfleiderer (2009), Edmans (2009), Edmans and Manso (2011)

• Conditional long-termism > unconditional loyalty• Bharath, Jayaraman and Nagar (2012): liquidity improves firm value, particularly

if blockholders• Edmans, Fang, and Zur (2013): liquidity induces blockholder formation

Disclosure

• Financial crisis has precipitated calls for increased disclosure Sarbanes-Oxley Regulation Fair Disclosure

• Increased disclosure of executive compensation is indeed desirable• But, increased disclosure of earnings can induce short-termism

Kay report Google, Porsche Theory: Edmans, Heinle, and Huang (2013) Evidence: Ernstberger, Link, and Vogler (2011) on EU

Panel Discussion Reaction to ECGI Session

Professor Colin MayerChairPeter Moores Professor of Management Studies, Saïd Business School & University of Oxford

Chris HitchenChief Executive of the Railways Pension Trustee Company, Chairman of the Pensions Quality Mark & Member of the Advisory Board for the Kay Review

Myles LeeChief Executive, CRH plc

Professor Patrick BoltonProfessor of Business, Columbia Business School

Professor Alex EdmansAssistant Professor of Finance, The Wharton School, University of Pennsylvania

Jörgen HolmquistChairman of the European Corporate Governance Institute, former

Director General, DG Internal Market & Services, European Commission

Presentations will be available on

www.corpgov2013.com

Drinks ReceptionOn Third Floor

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