Faculty Bibliography

The financial crisis has generated a renewed interest in financial regulation as well as corporate governance more generally, among both academics and lawmakers. A large number of bills have been introduced in the Congress to address one or more aspects of corporate governance, including most prominently the Shareholder Bill of Rights Act of 2009 (S. 1074), introduced by New York’s Senator Charles Schumer. The following testimony of Prof. Coates takes up three broad themes: (1) the need for corporate governance of financial institutions to differ from that of other companies, (2) the general weakness of academic and scientific evidence on corporate governance topics, and (3) the general need for carefully considered moderate reforms that can be revised as evidence develops over time. The testimony reviews the state of the evidence on specific, current policy proposals, including “say on pay,” splitting the chair and CEO roles, staggered boards, and proxy access.

One hesitates to write history as it happens, or to draw policy lessons from current events. The conference took place in May 2008 - after the government-assisted takeover of Bear Stearns but before a capital market downturn fueled a system-wide liquidity crisis, with successive insolvencies at IndyMac, Fannie Mae, Freddie Mac, Lehman, AIG, WaMu, and, as I write, Citigroup. But it would be odd to comment on capital market regulation without mentioning the events of the last three months. I am first to acknowledge that anything I might have written in May would not have foreseen the crisis or linked capital market regulation to financial institutions, which in the US have been conventionally treated as discrete in discourse and institutions (e.g., U.S. Treasury 2008; Leuz and Wysocki 2008).

Many Americans are angry at banks for taking bailout money while still cutting back on lending. But the government is also to blame. For reasons that remain unclear, the Troubled Asset Relief Program has channeled aid to bank holding companies rather than banks. The Obama administration’s new Financial Stability Plan will have more influence on bank lending if it actually directs its support to banks. To see why, it’s important to understand the distinction between banks and bank holding companies. Banks take deposits and make loans to consumers and corporations. Bank holding companies own or control these banks. The big holding companies also own other businesses, including ones that execute trades both on their clients’ behalf and for themselves.

Efforts to recapitalize banks in the current crisis have to date been focused on government assistance under the TARP, rather than private investment, and on bank holding companies, rather than banks. We describe three alternative or complementary approaches designed to lower the cost of bank recapitalizations by drawing in funds from the private sector and focusing on banks: rights offerings, debt restructurings, and FDIC-assisted bridge banks. Each approach was used in dealing with problem banks in the 1990s; each can be pursued without additional legislation; and each is worth considering now. We also propose two legal changes that would assist bank recapitalization: (1) the Fed should further modestly relax its rules under the Bank Holding Company Act to eliminate the presumption of "control" by investors at the current threshold of 5%, which would permit more capital to be invested in banks by private equity and other institutional investors; and (2) Congress should consider a new statute to streamline the recapitalization of bank holding companies by moving them outside current bankruptcy laws into a new resolution regime similar to the FDIC regime currently used for banks.

Most Americans invest through mutual funds. A comparison of US tax and securities law governing mutual funds with laws governing other collective investments, in both the US and in the EU, shows: (a) the US fund industry continues to be the world leader, but now lags domestic and foreign competitors, primarily because of US tax and securities law; (b) mutual funds are taxed less favorably and regulated more extensively in the US than direct investments or other collective investments, including alternatives available only to wealthy investors; (c) the structure of US regulation - numerous proscriptive bright-line rules written nearly 70 years ago, subject to SEC exemptions - makes success of US mutual funds dependent on the resources, responsiveness and flexibility of the SEC; (d) while the high-level formal framework for mutual funds in the EU is as or more restrictive and inflexible in most respects than the Investment Company Act, competitive pressures in the EU constrain supervisors in EU countries to be more flexible in adopting implementing regulations, and EU regulators have greater resources and are more responsive than the SEC, which could achieve the same flexibility and responsiveness through exemptive orders but has been unwilling or unable to do so in a timely fashion. The paper discusses a number of reforms to improve the treatment of middle class investments, including improvements in mutual fund taxation, ways to enhance the flexibility and resources of US fund regulators, modifications of the existing ban on asymmetric advisor compensation and the exclusion of foreign funds, and unjustified disparities in the treatment of mutual funds and mutual fund substitutes.

The centrality of the CEO is reflected in the empirical literature linking CEO turnover to poor firm performance. However, less is known about the institutional and personal correlates of CEO turnover. In this study, we find two CEO characteristics interact with turnover: tenure and ownership. We interpret our results as indicating that CEOs of S&P 500 firms divide into two groups with different tenure patterns – “owners” (who have large personal shareholdings) and “managers” (who have smaller holdings). The tenure of manager-CEOs (as opposed to owner-CEOs) exhibits a term structure loosely similar to the one produced by the tenure process at academic institutions. Turnover significantly depends on firm performance during a CEO’s first four years on the job. In particular, external turnover by sale of the firm peaks a year 4 during a CEO tenure. By contrast, external turnover peaks at years 5 – 6, and plateaus at relatively high levels until year 9 of tenure. These term effects are strongest for relatively young CEOs. We also find that forced exit, retirement, and deals covary rather than substitute for one another as modes of CEO turnover. However, forced exits and deals both relate to poor performance by the firm on different metrics. Our evidence suggests that most internal turnover, particularly after a CEO’s first five years, is unrelated to firm performance.

Since 1960 the mutual fund industry has grown from 160 funds and $18 billion in assets under management to over 8,000 funds with $10.4 trillion in assets. Yet critics - including Yale Chief Investment Officer David Swensen, Vanguard founder Jack Bogle, and New York Governor Eliot Spitzer - call for more fund regulation, claiming that competition has not protected investors from excessive fees. Starting in 2003, the number of class action suits against fund advisors increased sharply, and, consistent with critics' views, some courts have excluded or treated skeptically evidence of competition and comparable fees of other funds. Skepticism about fund competition dates to the 1960s, when the SEC accepted the view that market forces fail to constrain advisory fees, in part because fund boards rarely fire advisors. In this article, we show that economic theory, empirical evidence, and careful analysis of the laws and institutions that shape mutual funds refute this view. Fund critics overlook the most salient characteristic of a mutual fund: redeemable shares. While boards rarely fire advisors, fund investors may fire advisors at any time by redeeming shares and switching into other investments. Industry concentration is low, new entry is common, barriers to entry are low, and empirical studies - including new evidence presented in this article - show higher advisory fees significantly reduce fund market shares, and so constrain fees. Fund performance is consistent with competition exerting a strong disciplinary force on funds and fees. Our findings lead us to reject the critics' views in favor of the legal framework established by §36(b) of the Investment Company Act and the lead case interpreting that law (the Gartenberg decision), while suggesting Gartenberg is best interpreted to allow the introduction of evidence regarding competition between funds.

In this paper, I draw on economic theory of ownership structure; empirical research on ownership, value and takeovers; and comparisons to US law to argue that the proposed break through rule (BTR) is not clearly better than the status quo, from either a political perspective, or an economic perspective, with implications for any directive on takeover bids (DTB). The good (a step toward an integrated EU capital market) cannot wait on the perfect (ideal takeover rules), but neither should it be pursued without regard for the difference between the two. This suggests that if the BTR is adopted, it should be kept flexible with a mixture of regulatory tools - sunsets, opt-outs, and industry-based exemptions - that reflect the fact that regulation will inevitably be both imperfect and difficult to modify once adopted. The best rationale for the BTR - that many ownership structures in EU reflect historic national market structures and may increasingly impede achievement of economies via cross-border mergers - would be better addressed by rules requiring control of such firms be made contestable on a periodic rather than a continual basis.

In recent work, we presented evidence indicating that staggered boards have adverse effects on target shareholders. John Wilcox, the Vice-Chair of Georgeson, recently published a critique of our work, urging shareholders to support staggered boards. We respond in this article to Wilcox's critique and explain why it does not weaken in any way our analysis of staggered boards. The study criticized by Wilcox, "The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy," 54 Stanford Law Review 887-951 (2002), is available at http://ssrn.com/abstract=304388. In a separate reply, "The Powerful Antitakeover Force of Staggered Boards: Further Findings and a Reply to Symposium Participants," 55 Stanford Law Review 885-917 (2002), which is available at http://ssrn.com/abstract=360840, we respond to several other responses to our original study and present additional evidence that confirms its conclusions.

This paper develops and defends our earlier analysis of the powerful antitakeover force of staggered boards. We reply to five responses to our work, by Stephen Bainbridge, Mark Gordon, Patrick McGurn, Leo Strine, and Lynn Stout, which are to be published in a Stanford Law Review Symposium. We present new empirical evidence that extends our earlier findings, confirms our conclusions, and demonstrates that the alternative theories put forward by some commentators do not adequately explain the evidence. Among other things, we find that having a majority of independent directors does not address the concern that defensive tactics might be abused. We also find that effective staggered boards do not appear to have a significant beneficial effect on premia in negotiated transactions. Finally, we show that, unlike our approach, the approach that our critics advocate for Delaware takeover jurisprudence to follow is both inconsistent with its established principles and takes an extreme position in the overall debate on takeover defenses. Our analysis and new findings further strengthen the case for limiting the ability of incumbents armed with a staggered board to continue saying no after losing an election conducted over an acquisition offer.

Staggered boards, which a majority of public companies now have, provide a powerful antitakeover defense, stronger than is commonly recognized. They provide antitakeover protection both by (i) forcing any hostile bidder, no matter when it emerges, to wait at least one year to gain control of the board and (ii) requiring such a bidder to win two elections far apart in time rather than a one-time referendum on its offer. Using a new data set of hostile bids in the five-year period 1996-2000, we find that not a single hostile bid won a ballot box victory against an 'effective' staggered board (ESB). We also find that an ESB nearly doubled the odds of remaining independent for an average target in our data set, from 34% to 61%, halved the odds that a first bidder would be successful, from 34% to 14%, and reduced the odds of a sale to a white knight, from 32% to 25%. Furthermore, we find that the shareholders of targets that remained independent were made worse off compared with accepting the bid and that ESBs did not provide sufficient countervailing benefits in terms of increased premiums to offset the costs of remaining independent. Overall, we estimate that, in the period studied, ESBs reduced the returns of shareholders of hostile bid targets on the order of 8-10%. Finally, we show that most staggered boards were adopted before the developments in takeover doctrine that made ESBs such a potent defense. Selected by academics as one of the “top ten” articles in corporate/securities law for 2002, out of 350 articles published in that year.

Traditional law and economics scholarship predicts that no companies will adopt takeover defenses prior to IPOs, because defenses increase agency costs between shareholders and managers, and reduce IPO proceeds. In fact, data from 357 IPOs in the 1990s show that many companies adopt defenses prior to IPOs. Even more puzzling for conventional scholarship, defenses vary widely at the IPO stage. Analysis shows that more of this variation in defenses can be explained by characteristics of law firms advising owner-managers than by traditional theories about defenses. Among other findings: (1) Companies advised by larger law firms with more takeover experience adopt more defenses; (2) In 1991-92, companies with Silicon Valley lawyers adopted almost no defenses; by 1998, Silicon Valley lawyers' clients were as likely to use defenses as clients of other lawyers; (3) Companies with high-quality underwriters and venture capital backing adopt more defenses; (4) The overall rate of defense adoption increased in the 1990s. Together, these findings provide strong evidence that lawyers determine key terms in the "corporate contract," due to agency costs between owner-managers and their lawyers.

Two decades of research on poison pills and other takeover defenses does not support the belief - common among legal academics - that defenses reduce firm value. Even by their own terms, defense studies produced weak and inconsistent results, and failed to discriminate among information effects of defense adoptions. But prior studies suffer from serious, previously unrecognized design flaws: (1) pill studies assume pill adoption has an effect on takeover vulnerability and fail to recognize that nearly every firm already has a "shadow pill," making pill adoption relatively unimportant; and (2) all studies fail to account for ways defenses interact, such as the way that the shadow pill has made fair price and supermajority vote provisions unimportant. Not only do these flaws help explain the weak results of such studies, but the flaws are consistent with new evidence on bid outcomes, and recognizing them should improve future research on defenses.

Two decades of empirical research on poison pills and other takeover defenses does not support the belief - common among legal academics - that defenses reduce firm value. Even by their own terms, such studies produced weak and inconsistent results, and have not been well designed to discriminate among information effects of midstream defense adoptions. But prior studies suffer from three additional, serious, and previously unrecognized design flaws: (1) pill studies wrongly assume that pill adoption has an effect on takeover vulnerability; (2) studies of antitakeover amendments (ATAs) focus on terms made vestigial by the pill; and (3) all studies fail to account for ways defenses interact. Recognition of these flaws helps explains the weak and mixed results of such studies, and should improve future empirical research on takeover defenses.

Lockups are an increasingly important element of M&A deals in the United States. We present, for the first time, descriptive data on lockup incidence, trends, and their relationship with Delaware case law. Prior commentators have used theoretical models to argue that lockups should have little or no impact on allocational efficiency in the market for corporate control. We use data from twelve years of M&A activity in the United States to show that prior models have little predictive power in real-world transactions. We then offer a new theoretical model of lockups that includes six "buy-side" distortions: agency costs, tax effects, informational effects, switching costs, reputational effects, and endowment effects for bidders. The implications of this new model suggest that courts and corporate boards should scrutinize lockups more closely than prior commentators have advocated.

Companies adopt varying takeover defenses prior to IPOs, contrary to simple agency-cost models. Variation in defenses is explained in large part by the quality of legal services provided to entrepreneurs and pre-IPO managers. Data from 320 IPOs in 1991-92 and 1998 show that companies advised by larger law firms with more takeover experience adopt more defenses. In 1991-92, companies with Silicon Valley lawyers adopted almost no defenses; by 1998, Silicon Valley lawyer clients were as likely to use defenses as other lawyers. Companies with high-quality underwriters and venture capital backing are more likely to adopt defenses, and the overall rate of defense adoption increased in the 1990s. Dual class capital structures appear to be distinct, and motivated by non-pecuniary private benefits of control. Together, these findings suggest that, except for dual class structures, defenses are generally optimal at the IPO stage, but not all clients receive that advice from their lawyers.

At the center of every management buyout or freezeout is the question, how should minority shares be valued?, and in valuing minority shares, the principal valuation question is, should value be "discounted" to reflect the non-controlling status of minority shares? Minority discounts impact both ex post deal prices and ex ante share value. For example, in the 1996 Levi Strauss buyout, a minority discount of 35% would have reduced total fair value by $1.5 billion. Yet the law governing minority discounts is unpredictable and obscure. Although the Delaware Supreme Court has rejected discounts in theory, case law analysis reveals that lower courts have (erratically) applied them in practice. While the law on fair value is thought to be mandatory, it is not. Firms and investors may contract around law regarding discounts, as with nearly all rules of corporate law (a fact that has led Bernard Black to ask whether corporate law should be characterized as "trivial"). Firms can contract around the currently unpredictable discount law by adopting fair price charter provisions, entering into buy/sell agreements, or issuing redeemable stock. These two legal facts present an economic puzzle. Parties have an incentive to contract around nonmandatory (or "default") rules that create uncertainty. Yet issuing firms have generally not contracted for a clear discount rule. In fact, firms rarely contract around unclear default rules of corporate law. Economic theory provides three compatible answers: First, the cost of contracting for a ban on discounts -- including the cost of potential signalling effects -- may exceed the benefits of such a contract. Second, firms that attempt to contract around discount rules may encounter network and innovation externalities. Third, investors may overpay for minority shares by taking Delaware law at face value, an answer that is at odds with the efficient market hypothesis but supported by the lack of adequate disclosure and commentary regarding discount law. These constraints suggest that default rules of corporate law may be far from trivial. Minority discounts raise two difficult legal policy questions. First, what should the discount rule be? I argue that a rule excluding discounts is the better rule because it appears more likely to be the efficient rule and because non-efficiency rationales for accepting discounts are weak. This conclusion is contrary to a recent proposal by Benjamin Hermalin & Alan Schwartz, who argue for using minority share market prices in setting fair value, but who are too sanguine about the ability of existing laws to adequately constrain value-reducing transactions. This conclusion is supported by evidence of actual bargains and theoretical approaches that take account of the asymmetric information confronting firms and investors in the securities markets. Excluding discounts is also more likely to reduce transaction costs. Second, should the discount rule remain nonmandatory? I argue that, in the context of initial public offerings accompanied by adequate disclosure, the rule should remain nonmandatory. In my concluding remarks, I describe the practical difficulties of separating minority discounts from control premiums, and propose a procedural rule to assist courts in doing so.

Recent scholarship by Blair & Stout has suggested that a "mediating hierarchy" version of a team production model can explain enduring features of corporate law that cannot easily be explained by agency theory. This article argues and reviews data demonstrating that "mediating hierarchy" (1) clearly does not describe a significant number of public companies, which are either manager-dominated or controlled by a single shareholder; (2) probably does not describe companies subject to the market for corporate control, which remains vigorous (notwithstanding the "poison pill"); but (3) may describe those public companies with both active "outsider" boards and a set of governance terms that delay takeovers sufficiently to dampen the effect of the market for corporate control, as well as close corporations that credibly commit to becoming such public companies. The article concludes with a review of significant, unanswered empirical questions bearing on the domain of mediating heirarchy in corporate law and on corporate governance more generally.

As the financial services industry becomes increasingly international, the more narrowly defined and historically protected national financial markets become less significant. Consequently, financial institutions must achieve a critical size in order to compete. Bank Mergers & Acquisitions analyses the major issues associated with the large wave of bank mergers and acquisitions in the 1990's. While the effects of these changes have been most pronounced in the commercial banking industry, they also have a profound impact on other financial institutions: insurance firms, investment banks, and institutional investors. Bank Mergers & Acquisitions is divided into three major sections: A general and theoretical background to the topic of bank mergers and acquisitions; the effect of bank mergers on efficiency and shareholders' wealth; and regulatory and legal issues associated with mergers of financial institutions. It brings together contributions from leading scholars and high-level practitioners in economics, finance and law.