Buffet Lunch Sponsored by Partners Supporters Pat Cox

Buffet Lunch Sponsored by

Partners Supporters

Pat Cox Former 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 Bassi Director 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 Chair Former President of the European Parliament Ugo Bassi Director for Capital and Companies, DG Internal Market & Services, European Commission Chris Hodge Head of Corporate Governance, UK Financial Reporting Council Paul Haran Chairman, UCD, Michael Smurfit Graduate School of Business and Director of Glanbia Professor Niamh Brennan Professor of Management, UCD Dr. Thomas B. Courtney Arthur Cox, Dublin

Coffee Break Sponsored by

Partners Supporters

Pat Cox Former President of the European Parliament

ECGI Session Short-termism, the impact of financial markets and the UK Kay Review Professor Patrick Bolton Jörgen Holmquist Chairman of the European Corporate Governance Institute, former Director General, DG Internal Market & Services, European Commission Professor of Business, Columbia Business School Professor Alex Edmans Assistant Professor of Finance, The Wharton School, University of Pennsylvania

Short-termist Financial Markets and Corporate Governance Challenges Professor Patrick Bolton Professor 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 cashflow 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

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; 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 US The average holding period has been decreasing for 45 years: Years Source: NYSE overview statistics Average Holding Period for a stock on the NYSE (in years)

UK and Europe… 9 8 7 6 5 4 3 2 1 0 Average Holding Period in other major stock exchanges (in years) 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 Average Holding Period for a stock on the FTSE (years) Source: London Stock Exchange Source: World Federation of Exchanges

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) ü “More than three-fourths of the surveyed executives would give up economic value in exchange for smooth earnings […] ü Many executives feel that they are choosing a lesser evil by sacrificing longterm value to avoid short-term turmoil […] ü Many managers would reject a positive NPV project in order to meet the analyst consensus estimate!” ü 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 idea All shareholders are entitled to a Loyalty Warrant Loyalty period (3 years) Exercise period (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 longterm investors. ’

Conclusion • Short-termism of Financial Markets is a major problem • Solutions are available, but so far little has been done to respond to shorttermist 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 Edmans Assistant 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 $9 m 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. $1 m 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 $129 m of stock in 12 m 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. 4 bn and $1 bn 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 § • “Constant percentage principle” – rebalance the account so that % of stock remains 60% at all times § • “Long horizon principle” – account vests gradually, including after retirement § Superior to clawbacks: prevention, not cure; runs on auto-pilot 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 1980 s advocacy of Japanese model Shareholders who are short-term and uninformed will indeed trade on shortterm 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 § • If a manager is underperforming, or boards are setting inappropriate contracts, shareholders can “vote with their feet” / follow the “Wall Street Rule” § • • • But, hard to implement in practice Admati and Pfleiderer (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 Mayer Chair Peter Moores Professor of Management Studies, Saïd Business School & University of Oxford Chris Hitchen Chief Executive of the Railways Pension Trustee Company, Chairman of the Pensions Quality Mark & Member of the Advisory Board for the Kay Review Professor Patrick Bolton Professor of Business, Columbia Business School Myles Lee Chief Executive, CRH plc Professor Alex Edmans Assistant Professor of Finance, The Wharton School, University of Pennsylvania