Securities Mosaic® Blogwatch
May 21, 2019
Directors’ Ties to Non-CEO Executives: Information Advantage or Entrenchment?
by Udi Hoitash and Anahit Mkrtchyan

Understanding factors that facilitate or inhibit boards’ ability to monitor the chief executive officer (CEO) is central to corporate governance. In a recent paper, we analyze how informal relationships between directors and non-CEO executives (hereafter, internal ties) affect board effectiveness.

This overlooked dimension of corporate boards may improve board performance by creating an alternative channel through which valuable information can flow to the board. Social ties between directors and executives may increase the likelihood of information sharing because social connections often lead to more frequent interactions and, more importantly, foster trust between the connected parties. As a result, directors with ties to non-CEO executives may have unfiltered access to firm-specific information, enabling them to verify information supplied by the CEO, gain more profound insights into the firm’s operations, ask penetrating questions, and obtain soft information about the CEO’s ability and fit with the firm. Hence, internal ties might enhance board effectiveness and ability to reign in the CEO by facilitating valuable information sharing.

Alternatively, internal ties may hurt boards’ monitoring ability if such connections are used by the CEOs to perpetuate their power in the boardroom. This prediction is consistent with prior academic research that shows that ties between independent directors and CEOs are associated with lower board monitoring leading to a reduction in firm value. If internal ties are similar to director–CEO ties, then entrenched CEOs may hire friendly directors connected to executives in order to shift board composition toward their preferences, or they can hire executives with ties to directors as favors to board members. Because directors connected to non-CEO executives could feel beholden to the CEO, they might side with the CEO’s decisions even if they are not optimal. Hence, internal ties may reduce the monitoring effectiveness of the board and promote CEO entrenchment.

To examine the impact of internal ties on board’s monitoring ability, we rely on a large sample of firms covered by the BoardEx database. We identify a director as connected if he and a non-CEO executive have worked together in the past at a different firm, or if both executive and director currently serve on the board of another firm. We document that 24 percent of firms have at least one internal tie during the years 2001 to 2015.

We start our analysis by examining factors influencing a firm’s choice to appoint connected directors. We document that firms with powerful CEOs are less likely to add directors with ties to non-CEO executives. This result indicates that powerful CEOs may resist the appointment of connected directors to limit alternative channels of information to the board. We proceed to analyze how internal ties affect boards’ decisions related to CEO turnover, acquisitions, and financial reporting.

If internal ties enable boards to have timelier and more detailed information about CEOs’ actions, decisions, and ability, then boards with such ties will be more likely to identify poorly-performing CEOs and terminate their employment faster. In contrast, if internal ties promote CEO entrenchment, then boards with internal ties will be more lenient toward CEOs, resulting in longer CEO tenures. We find that boards with connected directors are more likely to terminate CEOs for poor performance. This suggests that internal ties provide information to these boards, allowing directors to better perform their duties. Importantly, we document that the benefits of having access to firm-specific information are more valuable in firms with higher information asymmetry and when connected directors have greater influence in the boardroom.

Our analysis of acquisition decisions provides further support for the conjecture that internal ties improve board effectiveness. We find that firms with internal ties are less likely to engage in acquisitions that generate large shareholder losses and are more likely to make acquisitions that lead to large gains. These results suggest that internal ties can improve board monitoring without compromising on boards’ ability to advise CEOs.

We complete our study by examining the impact of internal ties on financial misconduct. This setting allows us to provide direct evidence on how boards’ access to position-specific information can improve board monitoring. We take advantage of the unique role played by the chief financial officer (CFO) in financial reporting and examine the propensity of firms with internal ties to engage in financial wrongdoing. We find that the presence of connections between directors and the CFO reduces the probability of class action lawsuits related to the financial reports and the likelihood of issuing earnings restatements. This result is more pronounced when the CFO is likely to be pressured into earnings manipulation by a powerful CEO.

Overall, in contrast to the extensive prior literature that documents negative effects of director–CEO ties on board monitoring, we show that connections between directors and non-CEO executives enhance board effectiveness. We attribute these results to social ties facilitating information transfer between outside directors and non-CEO executives. Our findings are particularly important in the current governance landscape where CEOs often serve as sole insiders, thereby increasing information asymmetry between boards and CEOs.

This post comes to us from professors Udi Hoitash and Anahit Mkrtchyan at Northeastern University. It is based on their recent article, “Directors’ Ties to Non-CEO Executives: Information Advantage or Entrenchment?” available here.

May 21, 2019
Global Divestment Study
by Carsten Kniephoff, Paul Hammes, Paul Murphy, Rich Mills, Ernst & Young

In their quest for greater value, C-suites across the globe face a myriad of forces affecting divestment plans—from shifting customer expectations, to technology-driven sector convergence, to ongoing shareholder pressure. Companies are streamlining operating models so that they can pivot more quickly in pursuit of new growth opportunities and stay competitive. In particular, they are using divestments to fund new investments in technology, products, markets and geographies.

This is keeping the appetite for divestments near record levels, with 81% of companies saying the desire to streamline the operating model will impact their divestment plans over the next 12 months. They continue to divest businesses no longer core to the portfolio or best left in the hands of another owner. As companies reshape their portfolios, they are building greater trust with stakeholders and mitigating pressure from activists.


But once companies decide to divest, the complex separation process requires far more preparation than sellers often expect. This year’s Global Corporate Divestment Study aims to help companies understand the critical steps to increase divestment success—from weighing the merits of different deal structures to pre-empting regulatory hurdles and addressing interdependencies across their businesses—and improve the valuation of the remaining organization.

To further drive value, sellers need to prepare for a widening pool of buyers—from private equity to cross-sector—by leveraging analytics, aligning leadership around deal perimeters and building stand-alone operating models so these buyers have confidence that the business has been properly prepared for separation.

All of these critical divestment steps can help companies accelerate their pace of transformation, reposition the remaining business for future growth and, ultimately, drive total shareholder value.

Why are so many companies divesting?

The intent to divest remains at record levels—84% of companies plan to divest within the next two years, consistent with last year’s record of 87%. Despite uncertainty from tariffs, a trade war, desynchronized growth and geopolitical concerns, the market offers sellers a resilient yet competitive environment.

Streamlining operating models for better agility and sharper focus

Faced with evolving sector landscapes, businesses are continuously evaluating their growth strategies and competition. They are more rigorous in portfolio management—two-thirds (66%) of companies say they review their portfolios at least every six months, according to the latest EY Capital Confidence Barometer survey—and they continue to actively dispose of underinvested assets best left in the hands of another owner. This disciplined approach to portfolio management is working. More companies are divesting for strategic reasons as opposed to because of a failure in the business: companies that cite a unit’s weak competitive advantage as a driver in their latest divestment fell significantly to 69% from 85%.

The result is a streamlined operating model that gives companies the ability to quickly execute on their capital agendas. Eighty-one percent of companies say streamlining the operating model will factor into their divestment plans over the next 12 months, while two-thirds (67%) say this was a factor behind their most recent divestments.

The importance of portfolio reviews is further evidenced in the deconglomeration trend of the last several years, sparked in part by shareholder activism. Many companies have become increasingly complex by operating in several disparate, yet intertwined, businesses. This complexity, while often resulting in some cost savings, has come at a price. In addition to hampering agility, this conglomerate model often negatively affects market valuation. Various academic studies indicate large conglomerates often operate at a 5%–15% discount
relative to the sum of their parts.

Companies that divest may redeploy proceeds in growth areas to improve shareholder value. Sixty percent of companies reinvested proceeds from their last divestment in new products, markets and geographies. Honeywell completed two spin-offs in 2018 representing US$7.5 billion in revenue. When the divestitures were announced, CEO Darius Adamczyk commented that he was “excited” about M&A in its four businesses, and the company has made acquisitions since.

Technology accelerates the pace of transformation

Companies must continually reformulate their capital agendas and go-forward strategies relative to their competition, particularly in light of technology-driven changes in consumer habits and supply chain. Seventy percent expect more large-scale transformational divestments within the next 12 months, up from 50% in 2018. At the same time, companies are making acquisitions that allow them to add new capabilities, such as IBM’s purchase of open source software and technology distributor Red Hat.

Sector convergence prompts divestment

Further, 70% say sector convergence is more likely to drive their own divestment decisions, as they focus on innovation in the face of new competition from companies outside of their traditional sectors. With technology often being the catalyst of this convergence, many companies have redefined their business strategies around a narrower set of priorities and are determining the capital investments required to support technology for future growth.

Recent examples of these technology and cross-sector transformations include Philips shedding its lighting business to reposition for new technological growth in health care and GE refashioning its business through divestitures to focus on growing its footprint in renewable energy as well as its technology-driven power and aviation businesses.

Technology-driven divestments increase

Separately, 80% of companies expect the number of technology-driven divestments to rise in the next 12 months, compared with 66% in 2018. These plans may also support the capital requirements to fund new technology investments. Further, companies that say changes in the technology landscape are directly influencing their divestment plans are more than seven times as likely as their counterparts to secure a higher price for the business sold. This may be because these companies have their eyes on the market and their portfolios, and are more prepared to address the impact technology has on their operating model.

Geopolitical shifts: a constant variable in the divestment equation

Despite uncertainty within the global markets, whether driven by tariffs or trading costs, companies must continue to diligently review their portfolios. The current US administration has raised the stakes over global trade, while Brexit in the UK, the rise of populist governments in Europe and the ongoing debate over immigration add to complexity when making strategic portfolio decisions.

Companies appear to have grown more accustomed to this uncertainty over the past year: 51% of companies, compared with 62% in 2018, say that macroeconomic and geopolitical triggers will play into divestment decisions next year. Still, these factors must be weighed in the financial forecasts of companies operating in affected markets.

Almost three-quarters (74%) of companies expect these geopolitical shifts to push operating costs higher, while 69% wonder whether they can depend on existing cross-border trade agreements to remain in force. They will have to factor these rising costs into their divestment strategy and timing. Whether these factors can otherwise be addressed through vendor negotiations, price increases or cost reductions may factor into whether a company decides to divest a unit that is affected by tariffs, trade disputes or geopolitical uncertainty. One company recently entered into an earn-out agreement relative to tariffs. Knowing it is still too early to predict the full ongoing impact of tariffs, but considering its commitment to selling the business, the company took the risk of whether the earn-out will potentially pay off relative to the strategies implemented prior to the closing of the sale.

Active portfolio management tempers opportunistic divestments

Through more active portfolio management, companies have sharpened their focus on agility and improved their ability to respond to new opportunities both inside and outside of their sector. They have become better at identifying assets ripe for divestment and are starting to prepare their assets to maximize the potential for success when receiving an unsolicited bid. To capture full value, opportunistic divestors need a solid understanding of their earnings power, net assets and working capital, both historically and projected. It is no longer enough to focus on pro forma historical performance. Sellers have to understand and credibly portray—using analytics and sophisticated tools—the drivers of forecasted performance for potential buyers.

Opportunisitic divestments by the numbers

65% of those reporting an opportunistic divestment say they had already started considering a sale and therefore completed some level of preparation when the unsolicited bid was made. They were also four times more likely than their counterparts to meet or exceed their expectations for both price and timing in the divestment, demonstrating that preparation for a possible divestment as a result of portfolio reviews pays off when the asset is divested.

72% of companies opened their opportunistic divestment process up to at least one other buyer to create competitive tension and validate the price offered. Companies can maximize value by taking the appropriate steps in the best interest of shareholders.

46% of sellers describe their last divestment as opportunistic, down from 71% in 2018. While every business may be for sale in whole or in part, active portfolio management may mean that companies have fewer assets remaining that they are willing to part with, even if a buyer appears.

34% of companies say they are not confident they would be able to accurately value their businesses were they to receive an unsolicited bid today, underscoring the need to regularly conduct portfolio reviews with an eye toward the value of a business to different types of potential buyers.

When opportunistic divestments present themselves, success is by no means guaranteed. Unplanned divestments are four times less likely than planned divestments to achieve expectations on price and improve the valuation of the remaining company.

With a more active approach to portfolio management, companies can begin to prepare a compelling value story for an increasingly diversified pool of buyers. This is an essential step in closing the widening price gap between buyers and sellers.

How can you maximize value from the next wave of buyers?

In a volatile marketplace driven by high valuation expectations, sector convergence and an abundance of capital—both private equity and corporate—who will be your next buyer? How will you anticipate the needs of different buyers and maintain competitive tension? What tools do you need in your negotiation playbook?

Expect wider price gaps

The price gap between what buyers and sellers expect has risen sharply over the past year. Sellers of quality businesses often value assets through a combination of improvements and projected earnings power, while buyers are inclined to calibrate against historical earnings to discount for short-term or unquantified risks while balancing their desire to stay in the deal process.

Two-thirds (67%) of sellers say the price gap between what they expect to receive for an asset and what buyers are willing to pay is greater than 20%. In 2018, only a quarter noted such a significant gap. Now, more than ever, it is critical for sellers of quality businesses to build a credible value story with supporting data and start the related preparation early to achieve their desired valuation.

High purchase prices and the fluency with which PE can close a deal are highly positive factors that increase the value of the deal. They are efficient deal makers with the ability to align the loose ends of a deal and keep a diligent check on execution.
—Director of Mergers & Acquisitions at a technology business in the UK

Leverage the power of private equity

Appealing to private equity buyers sometimes requires significant time and effort, but these bidders can also bring sharper focus on value, increased competition and potentially higher multiples to the sales process.

Unlike corporate buyers, PE may not necessarily have a portfolio company in which to integrate the business being sold. In the absence of synergies, sellers may find PE diligence demands to be more granular, and therefore time-consuming. Seventyfour percent of sellers say the increased amount of time for PE diligence requests was a challenge. But fulfilling these exacting requirements during negotiations can support a faster closing once the deal is signed. Forty-nine percent of sellers say that PE’s involvement in the divestment led to a reduced time to close. Reasons for a faster closing may be that PE firms require fewer regulatory disclosures; they may already have expertise relative to a particular business based on ownership experience with an existing portfolio company; or their clarity relative to the exit strategy and related time sensitivity speeds up the process. There are other benefits, too: 38% say working with a PE buyer led to an increase in purchase price.

Sellers should take the following steps to maximize PE participation in a competitive process:

  • Build a compelling picture of the asset as a stand-alone business: one quarter of PE firms say a well-thought-out stand-alone case and related cost model are key to keeping them in the sales process. Sellers may need greater flexibility in financial reporting systems as a first step in developing an accurate picture.
  • Keep an eye on operational performance: missed forecasts concern potential buyers, particularly if the business misses forecasted performance outlined in marketing materials. More than a third (39%) of private equity bidders cite this as the most likely reason they would drop their price or walk away.
  • Help PE “see” the exit strategy: the nature and timing of an exit is of ultimate focus to PE. Sellers should articulate their perspective around potential monetization strategies early in the process.
  • Be prepared to generate granular data: half of PE firms say access to granular data was a key factor in their decision about whether to stay in an auction process. The seller may need to have historical and projected information down to transactional and SKU-level detail, often monthly, and for as many as 10 years.
  • Tell a consistent story about financial forecasts, growth opportunities, capital requirements, the management team and the overall business going forward. These are focus areas to PE as they drive the financial and operational business models as well as the exit strategy.

Keeping PE engaged in the process can be vital to a successful deal. For example, a fifth of businesses say their last divestment ultimately lost value because they failed to maintain competitive tension throughout the deal process. Not articulating a clear value story, lack of adequate preparation for diligence requests and not fully understanding the buyer pool’s requirements (e.g., operational, regulatory, financing) can contribute to the loss of bidders in the sales process.


Case study: Stress test through a buyer’s lens

One global consumer company preparing to divest used analytics to test revenue forecasts relative to customer churn and product pricing. While the company was confident in its revenue projections among top-tier customers, analytics revealed how price increases had impacted the bottom tier of customers, driving 40% of gross profit. This lower-tier customer base was turning over on average
every three years and therefore needed to be continually replaced—clearly a risk to potential buyers. In uncovering this issue early, the company was able to illustrate its success in managing such turnover given the overall market potential.

Use analytics in the sales process

When faced with widening interest from more diverse buyer pools—from PE to cross-sector corporates—sellers may benefit by leveraging analytics in the negotiation process. Advanced analytics can produce greater insight for buyers on the historical and future performance of a business while allowing sellers to tailor and strengthen their value story for different buyers. Only 39% of sellers say they used analytics during buyer negotiations, but 52% say it’s a step they should have taken. In doing so, sellers and buyers alike can avoid surprises leading to loss of value or cause the deal to fail.

Further, companies that use analytics in negotiations are three times more likely to achieve a higher sales price and increase valuation in the remaining business, as well as to close the deal faster, than those that do not. Additionally, use of analytics during negotiations can reduce the workload of the management team by anticipating buyer’s questions before they arise. This success can be attributed to providing buyers with the appropriate level of granular data that both satisfies their diligence requests and supports the value story. Also, use of analytics minimizes surprises and avoids additional time spent on negotiations relative to matters the company should have been aware of at the start of diligence.

Tools to support the negotiation playbook


Divestment tools can help sellers save time and make more informed decisions during the negotiation process by streamlining access to data across business functions. These specialized deal tools can be loaded with commingled financial and operational information. Then, using specified parameters, sellers can isolate transactions and information specific to the business being divested. This becomes the basis not only for generating financial statements and financial analytics to support diligence, but mapping fixed assets, intangibles, SKUs, inventory, vendors, customers and employees to support operational separation. Companies then have better insights on the deal perimeter impact to working capital, legal entities, operations, supply chain, HR and tax. Even more importantly, sellers will have a better, faster understanding of how the slightest change in perimeter may impact the target financial forecasts across the business.

For example, a multinational automation company was forced to divest parts of a business during an acquisition process. Without having time to complete full diligence on the assets, a small yet strategic and high-value part of the business had been included in the deal perimeter. The seller realized this late in the process and wanted it removed. However, the bidders knew their market, saw the importance of this business and wanted it left in the perimeter. In the end, it was removed and the deal value dropped, with time and money lost, as well as delays to the sales process.

Build value through stand-alone operating models

In carve-outs, buyers may recognize greater value by presenting a stand-alone operating model. In fact, sellers that present a business as a stand-alone are twice as likely to achieve a higher price and complete their deal faster than those electing not to do so. Buyers have confidence in the operating model and know that the business has been properly prepared for sale, with a comprehensive separation plan. Further, significant time is saved post-signing by not having to take these steps, long ago completed. This is critical to PE—51% of PE buyers say it’s required for them to stay in a purchase process for corporate assets—as they often do not have the infrastructure or personnel to support a stand-alone business unless there is a match with an existing portfolio company.

The benefits also extend to sellers by:

  • Enabling them to easily understand the impact of potential deal perimeter changes in “real time”—to make the business more attractive to a buyer
  • Assisting with TSAs, one-time costs and stranded cost remediation, which impacts the deal model for both the buyer and seller
  • Serving as key input into and aligning with the standalone cost model that drives deal economics
  • Building the foundation for the seller’s separation planning and the buyer’s integration planning, both of which will be greatly accelerated
  • Allowing for proper planning relative to capitalization and regulatory requirements, which avoids delayed or deferred closings

Align on deal perimeter

Companies often ask us, “The deal perimeter simply reflects the business — why are we spending so much time on this?” The business to be divested is often defined differently by executives and functions within the organization. Too often, deal models are prepared utilizing historically generated system data that contains improperly allocated costs, excludes certain costs and does not reflect the business to be ultimately transferred. Accordingly, alignment on the deal perimeter across all functional areas, with a clear line of site to the deal model for each buyer, is critical.

Leadership alignment around the deal perimeter — across RemainCo and DivestCo — is essential, but this is a challenge for 63% of companies. One common deal perimeter issue for sellers is deciding on the disposition of commingled manufacturing and production facilities. For example, one life sciences company was looking to carve out a business that shared manufacturing facilities with other businesses in the portfolio. The seller’s supply chain leaders pushed to remove the divested business from all commingled locations around the globe to pursue new growth opportunities. Buyers immediately recognized this as costly and highly disruptive to the business, thereby eroding value and requiring lengthy negotiations to reach a compromise. Sellers can improve alignment in deal perimeters by involving leadership early in the portfolio management process with the right data to inform decision-making.

Case study: Don’t miss out on hidden gems


A US-based service provider sold a series of comparable businesses across the globe. A performance analysis of these initial carve-outs uncovered two steps the company failed to take in the sales process to help support a higher deal price. In their next divestment, they addressed the analysis by delivering buyers a detailed separation plan and providing a vendor due diligence report. As a result, they increased the EBITDA multiple by 17%.


Leading practices in the negotiation process

  • Articulate and support the value story: ensure product pipeline and business strategy supports revenue growth projections. Develop a target operating model that identifies potential cost and revenue synergies available from combining the asset to be divested with the businesses of potential buyers as well as other value creation opportunities, such as changes to the country go-to-market strategy.
  • Involve leadership teams: bring the management of the business into the process at an early stage to increase divestment success. Seek their views on potential buyers, upsides that can be incorporated into the forecast and value story, risks likely to be discovered during diligence and how to deal with them, the likely go-forward operating model and how to anticipate buyer concerns. Consider “boot camps” that include executives and experienced deal professionals from outside the organization that have “been there and done that” to prepare management for successful meetings with buyers.
  • Communicate the tax upsides: evaluate how different divestment structures impact the business value from the buyer perspective and factor this into negotiations. Clearly identify and specify tax assets already available or triggered upon the divestment to allow the buyer to evaluate impact on the financial model and cash taxes.
  • Demonstrate deal flexibility: understand how different deal structures and perimeters may appeal to different buyers and consider dual tracking if necessary.
  • Share analytics and necessary diligence materials: make sufficient diligence materials available to prospective buyers who may otherwise identify opportunities to pay less.
  • Develop a negotiation matrix: evaluate each key point in the negotiation process, its impact on the remaining organization and stakeholder value, and also determine “how far you are willing to go.”

The complete publication is available for download here.

May 21, 2019
SEC Guidance on Auditor Independence
by Andrew Fuchs, Charles Smith, Skadden

In remarks made in December 2018, the Securities and Exchange Commission’s (SEC) Chief Accountant Wesley Bricker reaffirmed that auditor independence remains one of the SEC’s areas of focus. Consultations with the SEC about specific auditor independence questions influence the staff’s recommendations to the commission regarding updating or expanding the independence rules and existing staff guidance, Bricker said. Indeed, the SEC is currently considering amendments to those rules related to certain lending relationships as a result of these consultation trends.

Despite the SEC’s affirmation of the importance of these consultations in identifying emerging and recurring auditor independence issues, the SEC does not make its specific guidance on individual consultations publicly available. It is important for public company audit committees to understand these limitations in this complex area. There also is an opportunity for the SEC to improve its process by making its specific guidance public.


The SEC has repeatedly emphasized that “maintaining the independence of auditors is crucial to the credibility of financial reporting.” As such, auditors and audit committees constantly—both before and during an engagement—must be vigilant against impairment of their independence and devote substantial resources to verifying and maintaining that independence. The potential consequences to an issuer of violating auditor independence standards are severe. Violations may render previously filed financial statements noncompliant with the Securities Exchange Act of 1934 and related SEC rules, or they could adversely affect the timely filing of financial statements. A violation also could require the issuer to retain a new, fully independent auditor to re-audit the financial statements, which not only would be expensive and distracting, but could again lead to a failure to timely file financial statements. For an auditor, the consequences may be equally grave. The auditor may face regulatory penalties, loss of the engagement, remediation expenses and reputational harm.

The SEC, Public Company Accounting Oversight Board, American Institute of Certified Public Accountants and state accounting boards all maintain and enforce independence rules, but the SEC is the principal enforcer of auditor independence for public companies. According to SEC rules, the general standard of auditor independence is that it is impaired if a reasonable, fully informed investor would conclude that the auditor is not capable of exercising objective and impartial judgment on all issues encompassed within the audit engagement. Beyond this, the auditor independence standards are found in a patchwork of SEC rules, guidance documents, enforcement orders and speeches. Few of these have been updated recently—most date to circa 2000. As a result, analyses of independence questions are often based on the application to specific facts of general principles and guidance, much like common law, rather than detailed regulations.

Although many independence issues are straightforward, others are more nuanced and difficult, due to the size and complexity of both the audit firm and the issuer. Often in these situations, which are complex and fact-specific, specific guidance does not exist. For example, an issuer may have its own auditor, while a separate firm audits a partially owned, remote subsidiary. The issuer’s audit firm may have provided a negligible amount of bookkeeping services to the remote subsidiary, but the remote subsidiary’s separate auditor is independent of the issuer and remote subsidiary. The issuer and its auditor need to determine whether the issuer’s auditor’s independence has been compromised as a result of the provision of the bookkeeping services, but cannot find directly applicable rules or published guidance that allows them to understand the SEC’s position with similar fact patterns.

The SEC understands that “auditor independence matters often involve unique and complex fact patterns,” and because the SEC warns that its rules are for “general guidance only,” it encourages issuers and audit firms to consult with its Office of the Chief Accountant (OCA) on auditor independence questions. According to a detailed written policy on such consultations, OCA accepts written correspondence on a particular question, after which OCA schedules a preliminary conference call between it, the issuer and the auditor. Once OCA reaches a conclusion, it communicates its view by phone to the issuer. At that point, if it so desires, the issuer may prepare and send a letter to OCA describing the issuer’s understanding of the staff’s position.

This process is valuable for the parties involved in a specific inquiry, and issuers and auditors routinely take advantage of it. But it is designed to develop no guidance that can be accessed, let alone relied on, by others who seek to understand and apply the rules. Indeed, in describing its consultation process, OCA states that it will “consider how OCA has previously addressed similar accounting or auditing issues to see if a precedent has been set for the issue at hand or if there is a past decision to which the current issue may be analogized.” The SEC intentionally does not make this rich source of information about auditor independence issues publicly available. This is somewhat of a reversal of prior practice, as the SEC previously published certain of these questions and OCA’s responses (with the disclaimer that the responses represent the view of OCA and not the commission). The SEC last updated a publicly available document containing these questions and answers on December 13, 2011. It may be that it has since determined that OCA’s guidance is so fact-specific that making it available as precedent would lead to misinterpretations and undue reliance.

In our experience, auditors and audit committees would benefit from more sources of guidance and clarification of the SEC’s positions when conducting difficult analyses. OCA’s procedure and the reasons underlying it highlight how difficult independence issues can be for auditors and audit committees to analyze and resolve. In particular, as Bricker, the chief accountant, explained in December 2018, the SEC receives and analyzes questions with recurring fact patterns. Disclosing the SEC’s view of those situations would help those striving to comply with independence requirements.

As part of its efforts to improve its guidance, the SEC should take a fresh look at making its specific guidance publicly available. For example, state licensing boards in a variety of professions, such as boards of ethics or attorney disciplinary commissions, publish Q&A documents to assist practitioners in analyzing similarly highly fact-bound questions. It strikes us as a relatively sound way for the SEC to enhance its guidance on auditor independence.

May 21, 2019
Share Buybacks Under Fire
by Lizanne Thomas, Lyle Ganske, Robert Profusek, Jones Day

Stock buybacks reached record levels in recent years, fueled in part by the 2017 tax cuts, shareholder activism, and record low borrowing costs. S&P 500 companies repurchased a record $770 billion in shares in 2018, and forecasts for 2019 are even higher, with companies expected to repurchase $940 billion—using almost a third of the aggregate $3 trillion in cash reflected on the balance sheets of the S&P 500.

Stock buybacks have, however, been sharply criticized of late and have been ensnared in the bitter partisanship in Washington. For example, Senators Schumer and Sanders penned an op-ed in The New York Times outlining a plan to limit buybacks to companies that pay workers at least $15 an hour and provide paid sick time. Others have advocated for restrictions on executives’ abilities to sell their shares following a buyback announcement or to require additional disclosure about the board’s reasons for choosing a share repurchase. Are these criticisms justified, or have buybacks been targeted unfairly?

One of the chief arguments against buybacks is that companies that repurchase shares are using capital for a short-term purpose—returning cash to shareholders—at the expense of long-term goals.

One of the chief arguments against buybacks is that companies that repurchase shares are using capital for a short-term purpose—returning cash to shareholders—at the expense of long-term goals, such as R&D, capital improvement, and worker training. In fact, some companies have used this “short-termism” argument to resist demands by shareholder activists to implement substantial returns of capital.


Capital allocation decisions are, however, far more complicated than many buyback critics admit. In certain circumstances, particularly when interest rates are low and/or the company has a cash surplus, a company’s investment in its own shares may be the most efficient near-term use of capital for the company and its shareholders. Cash returned to shareholders can be reinvested in companies with different growth profiles or capital needs, efficiently allocating capital across the economy. Moreover, there is no compelling evidence that share repurchases ultimately result in decreased cap ex spending or negatively impact long-term growth, as for most companies dividends and other returns of capital are but one component of a company’s overall capital allocation strategy.

Another criticism of buybacks is that they unfairly enhance executive pay. Of course, share repurchases boost earnings per share, and may increase share prices, at least in the short-term. When incentive compensation packages are based in part on those metrics, critics may claim that buybacks are unfairly enriching executives. It is our sense, however, that these criticisms based on the purported impact of buybacks on employee pay are misguided.

While they sometimes are opportunistic, buybacks are part of a company’s overall capital allocation policy in most cases, and compensation targets are set with this in mind. Moreover, buybacks generally have a positive impact on share prices which, of course, benefits all shareholders, not just executives or employees. Finally, some of the legislative efforts to regulate and improve transparency about buybacks identify a problem that has already been solved—the SEC’s current disclosure requirements already cover all that is needed.

A related point, however, is how the buyback boom should affect executive compensation decisions on a more basic level. The overall trend to align shareholder and management interests has resulted in very substantial increases in the percentage of top management (and even directors) being made in the form of equity rather than cash.

However, in an era in which stock buybacks are substantial and consistent, it at least raises the question whether it makes sense for companies to pay employees in equity when they are buying back stock—and have been for years. Companies with large-scale repurchase programs may consider whether general changes to compensation practices are warranted—such as more sharply targeting the people in the equity pool, putting hold requirements on stock awards, adopting (or readopting) vesting restrictions and using ­phantom equity, which on the whole, are practices that are otherwise becoming less prevalent.

As with most governance issues, there is no one-size-fits-all approach here. Moreover, the decision of how to best allocate capital is, of course, squarely within the purview of the board. Although buybacks may have a short-term impact, that is precisely the kind of investment decision the board is expected to make—how to allocate the company’s capital among short- and long-term uses and opportunistic or strategic goals.

In our view, severely restricting repurchases—or limiting them to companies that have adopted specific employment practices—may be an inapt, or even pernicious, way to address concerns relating to share buybacks and may have an unintended impact on the economy as a whole, and Congress has more important topics on which to focus than this.

Two Key Takeaways


  • Corporate share buybacks remain at record high levels, although they have been sharply criticized and have spurred possible federal legislation curbing their use.
  • Capital allocation decisions—including the return of capital to shareholders through dividends or repurchase programs—are squarely within the purview of the board of directors. Directors should, however, be sensitive to the criticisms lodged against share buybacks when designing and implementing a repurchase program.
May 21, 2019
The Specter of the Giant Three
by Lucian Bebchuk, Scott Hirst

We recently posted on SSRN our study The Specter of the Giant Three. The study will be published in a Boston University Law Review symposium issue on institutional investors.

Our study examines the substantial and continuing growth of the so-called “Big Three” index fund managers—BlackRock, Vanguard, and State Street Global Advisors. We show that there is a real prospect that the Big Three will grow into the “Giant Three,” and that they will come to dominate shareholder voting in most significant public companies.

Our new study is part of a larger, ongoing project on stewardship by index funds and other institutional investors in which we have been engaged. This study complements our earlier study of index fund stewardship, Index Funds and the Future of Corporate Governance: Theory, Evidence and Policy, forthcoming later this year in the Columbia Law Review. That study of index fund stewardship builds, in turn, on the analytical framework put forward in our 2017 article with Alma Cohen, The Agency Problems of Institutional Investors.

We begin by analyzing the drivers of the rise of the Big Three, including the structural factors that are leading to the heavy concentration of the index funds sector. We then provide empirical evidence about the past growth and current status of the Big Three, and their likely growth into the Giant Three. We extrapolate from past trends to estimate the future growth of the Big Three. We estimate that the Big Three could well cast as much as 40% of the votes in S&P 500 companies within two decades. We argue that policymakers and others must recognize—and must take seriously—the prospect of a Giant Three scenario. The plausibility of this scenario exacerbates concerns about the problems with index fund incentives that we identify and document in our earlier work.

A more detailed overview of our analysis follows:


In Part I of our study, we analyze three key drivers that underlie the steady and persistent growth of the Big Three. The nature of these drivers means that the Big Three are likely to continue to grow. First, we discuss the factors that have led to the tenfold growth of institutional investor ownership over the past six decades. Second, we document the steady increase in the proportion of the assets managed by investment managers that are allocated to index funds. Third, we analyze three factors that lead to the heavy concentration of the index fund sector: scale economies, the liquidity benefits offered by exchange-traded funds (“ETFs”) with large assets, and the ability of dominant index fund managers to compete quickly with new products introduced by rivals. These factors are likely to facilitate the continued dominance of the Big Three.

In Part II, we present our empirical analysis of the past growth of the Big Three, their current status as major shareholders of U.S. companies, and their likely future growth. Our empirical analysis focuses on the companies in the S&P 500 and Russell 3000 indices, which represent 73% and 91% (respectively) of the total market capitalization of listed U.S. companies as of December 31, 2017.

We start with the past growth and current status of the Big Three. Among other things, we document that:

  • Over the last decade, more than 80% of all assets flowing into investment funds have gone to the Big Three, and the proportion of total funds flowing to the Big Three has been rising through the second half of the decade;
  • The average combined stake in S&P 500 companies held by the Big Three essentially quadrupled over the past two decades, from 5.2% in 1998 to 20.5% in 2017;
  • Over the past decade, the number of positions in S&P 500 companies in which the Big Three hold 5% or more of the company’s equity has increased more than five-fold, with each of BlackRock and Vanguard now holding positions of 5% or more of the shares of almost all of the companies in the S&P 500;
  • Following two decades of growth, the Big Three now collectively hold an average stake of more than 20% of S&P 500 companies; and
  • Because the Big Three generally vote all of their shares, whereas many of the non-Big-Three shareholders of those companies do not, shares held by the Big Three represented an average of about 25% of the shares voted in director elections at S&P 500 companies in 2018.

Building on this analysis of past growth, we then proceed to extrapolate from past trends to predict the likely growth of the Big Three in the next two decades. Assuming that past trends continue, we estimate that the share of votes that the Big Three would cast at S&P 500 companies could well reach about 34% of votes in the next decade, and about 41% of votes in two decades. Thus, if recent trends continue, the Big Three could be expected to become the “Giant Three.” In this Giant Three scenario, three investment managers would largely dominate shareholder voting in practically all significant U.S. companies that do not have a controlling shareholder.

We conclude by observing the substantial policy implications of the specter of the Giant Three. Here we build on our large-scale study of index fund stewardship, which analyzes the incentives of index fund managers and provides comprehensive empirical evidence on their stewardship activities. That study analyzes and documents the incentives of index fund managers, and especially major fund managers such as the Big Three, to be excessively deferential toward corporate managers. We argue that recognition of the Giant Three scenario increases the importance of the agency problems afflicting Big Three incentives that we have identified. Recognizing the specter of the Giant Three reinforces the importance of a serious consideration of these problems.

In addition to our own prior work, the work that is most closely related to this Article is an elegant essay, The Future of Corporate Governance Part I: The Problem of Twelve, by Professor John Coates. Although we and Coates both focus on issues arising from the growing concentration of ownership in the hands of a relatively small number of institutional investors, our works and views differ in key respects. Coates’s essay focuses on what he labels “the problem of twelve”—that is, the possibility that twelve management teams will gain “practical power over the majority of U.S. public companies.” By contrast, we focus on the possibility that a much smaller number of management teams—the Big Three—will come to dominate ownership in most public companies. In addition, this Article differs from Coates’s work in that our empirical analysis focuses on documenting the growth of the Big Three and estimating its future trajectory.

Finally, our view on the problems with the growing concentration of ownership substantially differs from that of Coates. Whereas Coates seems to be concerned that investment managers will excessively use the power that comes from their large ownership stakes, we have a very different concern—that the Giant Three will have incentives to be excessively deferential to corporate managers. Our concern is therefore that the substantial proportion of equity ownership with incentives towards deference will depress shareholder intervention overall, and will result in insufficient checks on corporate managers.

Whatever one’s view of the nature of the Giant Three problem and the concerns that it raises, the specter of the Giant Three that we document and analyze represents a major challenge. We hope that our work will highlight for researchers, market participants, and policymakers the importance of the Giant Three scenario. The specter of the Giant Three deserves close attention, and our empirical evidence and framework of analysis could inform any future consideration of this subject.

Our study is available here, and comments would be most welcome.

May 21, 2019
SEC Files Another Years Old Microcap Fraud Action
by Tom Gorman

The SEC’s focus on years old microcap fraud continues. On Friday the agency filed a years old microcap fraud manipulation action against a band of defendants who were largely recidivists. There the public had been bilked out of over $11 million in manipulations involving six issuers. Today’s microcap fraud action only involved four persons who were not recidivists and one issuer. The result was the same however – the investing public lost almost $2 million. Since the manipulation ended in 2016 there is little hope that the defrauded investors will recoup any of their lost investment. SEC v. Osegueda, Civil Action No. 2:19-cv-04348 (C.D. Cal. Filed May 20, 2019).

The Commission’s complaint names as defendants David Osegueda, Ishmail Ross, Zachary Logan and Jessica Snyder. The case centers on Green Cures & Botanical Distribution, Inc. The firm was supposedly in the cannabis and later beverage business. Neither proved profitable.

Mr. Osegueda and a partner acquired a shell which they named Green Cures in February 2014. Efforts to make a profit in the cannabis business over the next year failed. By December 2015 Defendant Osegueda, who had been joined by Mr. Ross, met with Zachary Logan who was reputed to be a stock expert. Mr. Logan was supposed use his expertise to assist in making a market for the shares of Green Cures.

Over the next eighteen months the three men deposited their shares in the firm with a broker. Those documents represented that Green Cures was not a shell company and that it was current in its submissions to OTC Link where the shares were traded. Other papers represented that Messrs. Osegueda, Ross and Logan, who collectively controlled the firm, were not affiliates of the company. Each of the representations made to the broker was false.

Over a two month period in early 2014 the four Defendants organized a promotional campaign for the stock. It included false and misleading press releases issued without the knowledge of Green Cures’ CEO – a figure head – email blasts and text messages as well as posts on Twitter and InvestorsHubcom message board.

The campaign that began in March continued until November 2016. By that point Messrs. Osegueda, Ross and Logan had sold stock and obtained proceeds of, respectively $857000, $887,000 and $164,000 based on the dramatic rise in the share price that followed the promotions. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and each subsection of 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 24472 (May 20, 2019).

FCPA Institute: On June 21 and 22, 2019, Professor Mike Koehler will conduct the FCPA Institute at the Offices of Dorsey & Whitney LLP in Minneapolis, Minnesota. The Institute provides a unique learning experience for those seeking to elevate their knowledge of the Foreign Corrupt Practices Act. Professor Koehler is one of the foremost scholars on the FCPA and conducts an interesting and most informative program. The program is live in Minneapolis and also webcast. You can obtain more information about the program and register here.

May 21, 2019
SEC’s Upcoming Roundtable: Short-/Long-Termism
by Broc Romanek

Yesterday, SEC Chair Clayton issued this statement indicating that a roundtable on short- and long-term management of companies will be forthcoming. The date & agenda are not yet know. This follows the SEC’s “request for comment” in December about the nature, content and timing of earnings releases & quarterly reports…

By the way, Chair Clayton will also host a roundtable of former SEC Chairs during the SEC’s 85th anniversary “program & dinner” coming up on June 3rd. This kind of roundtable normally would be fascinating, but I think a lot of alumni are going to that thing to catch up with each other & won’t be too interested in programming. But what do I know…

The SEC is Questioned Over Lag Bringing Volkswagen Case

Here’s the intro from this WSJ article:

A federal judge sharply questioned why securities regulators took so long to sue Volkswagen AG over its bond offerings, years after other government agencies resolved litigation over the auto maker’s diesel-cheating scandal. U.S. District Judge Charles Breyer on Friday suggested the SEC’s March 2019 lawsuit makes it look like a “carrion hawk that simply descends when everything is all over and sees what it can get from the defendant,” according to a transcript provided to The Wall Street Journal.

The judge also ordered the SEC to provide a timeline on when it learned of each fact behind its case — and explain its legal reasoning behind waiting to file the suit—before he would let the case move forward.

Collecting Fines: The Challenges the SEC Faces

Here’s the intro from this WSJ article:

Wall Street watchdogs often tout the fines they levy on alleged wrongdoers. Yet much of that money is never collected. The SEC over the five years ending in 2018 took in 55% of the $20 billion in enforcement fines set through settlements or court judgments, according to agency statistics. During the prior five years, from 2009 through 2013, the SEC collected on 60% of $14.6 billion.

And in 2018, the commission collected just 28% of almost $4 billion. That rate—the lowest in a decade—was due in part to an unusual $1.7 billion settlement with the Brazilian oil company Petrobras that may never require payment to the SEC. The SEC has struggled for years to get defendants to pay more of their fines, although some are almost certain to avoid payment forever. That includes people who went to prison on related criminal charges, or people behind Ponzi schemes who spent the funds they took from defrauded investors.

Meanwhile, this study shows that the SEC’s enforcement actions against companies remain at near-record levels despite the government shutdown…

Broc Romanek

May 21, 2019
How Horizontal Shareholding Harms Our Economy—and Why Antitrust Law Can Fix It
by Einer Elhauge

In my initial Harvard Law Review article on horizontal shareholding, I showed that economic theory and two empirical studies of airline and banking markets indicated that high levels of horizontal shareholding in concentrated product markets can have anticompetitive effects. I argued that those anticompetitive effects could help explain longstanding economics puzzles, including executive compensation methods that inefficiently reward executives for industry performance, the sharp rise in the gap between corporate profits and investment, and the growing increase in economic inequality.

My claims have all been hotly contested. However, as I show in a new paper, new proofs and empirical evidence strongly confirm my economic claims. One new economic proof establishes that, if corporate managers maximize either their expected vote share or re-election odds, they will maximize a weighted average of their shareholders’ profits from all their stockholdings and thus will lessen competition the more that those shareholdings are horizontal. Another new economic proof shows that with horizontal shareholding, corporations maximize their shareholders’ interests by making executive compensation less sensitive to their own firm’s performance because that reduces competition between firms in a way that increases shareholder profits. Neither new proof requires any communication or coordination between different shareholders, between different managers, or between shareholders and managers.


These new economic proofs have been confirmed by two new cross-industry empirical studies and three new market-level studies. One cross-industry study shows that increased horizontal shareholding does make executive compensation less sensitive to their own firm’s performance, just as the economic proof predicts. The other new cross-industry study shows not only that the recent historically large gap between corporate investment and profits is mainly driven by horizontal shareholding levels in concentrated markets, but also that within any industry, the investment-profit gap is mainly driven by those firms with high horizontal shareholding levels. The three new market-level studies find that horizontal shareholding increases seed prices and both reduces and delays competitive entry into pharmaceutical markets.

I further provide new analysis rebutting various critiques of the earlier studies of airline and banking markets. While a few of these critiques are valid, addressing those valid critiques actually increases the estimated price effects. The other critiques are all mistaken. For example, some rest on endogeneity claims that are flatly contradicted by the evidence. Another critique uses purported proxies for horizontal shareholding that are actually negatively correlated with horizontal shareholding and uses market models that wrongly assume longer airline routes have lower costs. Other critiques erroneously measure horizontal shareholdings without aggregating the shares held by the same fund families, ignore actual market shares, exclude the transactions most likely to have price effects, and wrongly set many horizontal shareholding rights to zero.

Nor are the findings of anticompetitive effects undercut by a recent cross-industry study that purports to show that horizontal shareholding has no robust effect on profits or investments.  This study actually finds that large increases in ΔMHHI do increase profits. It finds no statistically significant effect from smaller increases in ΔMHHI, but that is not surprising given that even for horizontal mergers, it takes a ΔHHI of at least 200 to make anticompetitive effects likely. Further, because virtually all of the many variables used in this study depend on industry definitions that do not accurately reflect antitrust markets, all if its regressions suffer from attenuation bias that leads it to underestimate effects. All its regressions also either fail to correct and aggregate the data on horizontal shareholding levels or use control variables that create problems of multicollinearity and reverse causality.

In short, contrary to the claims of some, we do not have the sort of empirical uncertainty that justifies further delaying any enforcement actions against horizontal shareholding. Further, although some argue that the causal mechanisms or horizontal shareholder incentives to create anticompetitive effects are unproven or implausible, I debunk such claims in another recent paper, The Causal Mechanisms of Horizontal Shareholding. Moreover, my proposal is simply that antitrust agencies investigate concentrated markets with high horizontal shareholding to ascertain whether anticompetitive effects exist in those markets, so any empirical uncertainty would be resolved in enforcement actions about specific markets.

My new paper also shows that antitrust law already provides a legal remedy. Whenever horizontal shareholding has anticompetitive effects, it violates Clayton Act §7’s ban on any stock acquisitions that have anticompetitive effects. As I show, this interpretation is dictated by the legislative text, structure, and history and this legal remedy raises no insuperable administrability problems. Any horizontal shareholding that has anticompetitive effects also violates Sherman Act §1. Indeed, the very name of the legal field—antitrust law—comes from the fact that the Sherman Act aimed to prohibit certain pre-1890 trusts that were themselves horizontal shareholders in competing firms. It has thus always been the case that horizontal shareholding by a common shareholder is an agreement or combination covered by Sherman Act §1.

I further show that EU competition law can also tackle horizontal shareholding. Although EU merger control law is narrower than Clayton Act §7, EU law’s prohibition of anticompetitive agreements and concerted practices under EU Treaty Article 101 is at least as broad as Sherman Act §1’s prohibition of anticompetitive agreements, and is thus broad enough to condemn anticompetitive horizontal shareholding. Even broader is EU law on collective dominance and excessive pricing under EU Treaty Article 102, which provides a straightforward solution to the problem of horizontal shareholding.

Finally, I show that even if courts or agencies misinterpret competition law not to apply to horizontal shareholding directly, such horizontal shareholding still alters traditional merger analysis. After all, such traditional analysis requires assessing whether mergers and cross-shareholdings have likely anticompetitive effects, and the likelihood of such effects is increased by horizontal shareholding in concentrated markets. Indeed, the less that our antitrust regimes do to directly tackle horizontal shareholding, the lower the concentration levels they can tolerate when doing traditional merger analysis. Horizontal shareholding can also mean that a merger that would otherwise be deemed non-horizontal (because the merging firms compete in different markets) should instead be deemed horizontal if the merger increases shareholder overlap between the merged firm and its competitors. Given these implications, rising levels of horizontal shareholding, especially if we continue to do nothing to directly tackle them, provide strong support for current antitrust movements that decry our increasing levels of national industrial concentration.

The complete paper is available for download here.

View today's posts

5/21/2019 posts

CLS Blue Sky Blog: Directors’ Ties to Non-CEO Executives: Information Advantage or Entrenchment?
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Global Divestment Study
The Harvard Law School Forum on Corporate Governance and Financial Regulation: SEC Guidance on Auditor Independence
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Share Buybacks Under Fire
The Harvard Law School Forum on Corporate Governance and Financial Regulation: The Specter of the Giant Three
SEC Actions Blog: SEC Files Another Years Old Microcap Fraud Action Blog: SEC’s Upcoming Roundtable: Short-/Long-Termism
The Harvard Law School Forum on Corporate Governance and Financial Regulation: How Horizontal Shareholding Harms Our Economy—and Why Antitrust Law Can Fix It

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