Jonathan B. Cohn and Jay C. Hartzell, University of Texas at Austin, and Stuart L. Gillan, Texas Tech University
On the Optimality of Shareholder Control: Evidence from the Dodd-Frank Financial Reform Act
Cohn, Gillan, and Hartzell point out that events related to the Dodd-Frank Wall Street Reform and Consumer Protection Act provide natural experiments for examining the optimal degree of shareholder control. For example, market reactions to unanticipated changes in the so-called "proxy access rule" permitting shareholders to nominate representatives to corporate boards suggest that increased hurdles to proxy access are associated with losses in shareholder value for firms owned by institutional investors who are likely to use proxy access. Variation in stock-price responses based on details of the proposed rule further supports this conclusion. Data from earlier proxy contests suggest that the holding period requirements are likely to be important constraints.
Kenneth Ayotte, Northwestern University, and Henry Hansmann, Yale University
A Nexus of Contracts Theory of Legal Entities
Ayotte and Hansmann develop a theory that explains why firms are so commonly organized as legal entities that are formally distinct from their owners. A legal entity permits an owner to create a firm as a bundle of contracts that can be transferred to someone else, but only if they are transferred together. This bundled assignability allows for a balancing of several potentially conflicting interests. First, the owner who assembles the contracts wants liquidity -- that is, the ability to transfer the contracts and cash out. Second, the firm's contractual counterparties want protection from opportunistic transfers that will reduce the value of the performance they've been promised. Third, the owner wants long-term commitments from the firm's counterparties to protect the value of her investments in the bundle. Because transfers of equity interests in a legal entity generally will not be considered assignments of the entity's contracts, entities reduce the contracting costs of creating bundled assignability. The authors find that owners will prefer bundled assignability when investments in the bundle are alienable from the owner. When investments are specific to the owner, though, contracts that prohibit changes of control are optimal. The researchers examine a sample of 287 supply and lease contracts and find that bundled assignability is explicitly included in these contracts with great regularity, and that legal entities are the most common means of defining the bundles.
Kathryn E. Spier, Harvard University and NBER, and Albert Choi, University of Virginia
Should Consumers be Permitted to Waive Products Liability? Product Safety, Private Contracts, and Adverse Selection
Spier and Choi analyze the case in which a potentially dangerous product is supplied by a competitive market. The likelihood of a product-related accident depends on the unobservable precautions taken by the manufacturer and on the type of the consumer. Contracts include the price to be paid by the consumer ex ante and stipulated damages to be paid by the manufacturer ex post in the event of an accident. Although the stipulated damage payments are a potential solution to the moral hazard problem, firms have a private incentive to reduce the stipulated damages (and simultaneously to lower the up front price) in order to attract safer consumers who are less costly to serve. The competitive equilibrium -- if an equilibrium exists at all -- features suboptimally low stipulated damages and correspondingly suboptimal levels of product safety. Imposing tort liability on manufacturers for uncovered accident losses -- and prohibiting private parties from waiving that liability -- can improve social welfare, they conclude.
Joel Waldfogel, University of Minnesota and NBER
Bye, Bye, Miss American Pie? The Supply of New Recorded Music Since Napster (NBER Working Paper No. 16882)
In the decade since Napster, file-sharing has undermined the protection that copyright affords recorded music, reducing recorded music sales. What matters for consumers, however, is not sellers' revenue but the surplus they derive from new music. The legal monopoly created by copyright is justified by its encouragement of the creation of new works, but there is little evidence on this relationship. The file-sharing era can be viewed as a large-scale experiment allowing us to check whether events since Napster have stemmed the flow of new works. Waldfogel assembles a novel dataset on the number of high quality works released annually, since 1960, derived from retrospective critical assessments of music such as best-of-the-decade lists. This allows him to compare the quantity of new albums since Napster to: 1) its pre-Napster level, 2) pre-Napster trends, and 3) a possible control, the volume of new songs since the iTunes Music Store's revitalization of the single. He finds no evidence that changes since Napster have affected the quantity of new recorded music or artists coming to market. He reconciles stable quantities in the face of decreased demand with the reduced costs of bringing works to market and the growing role of independent labels.
Howard F. Chang, University of Pennsylvania, and Hilary Sigman, Rutgers University and NBER
An Empirical Analysis of Cost Recovery in Superfund Cases: Implications for Brownfields and Joint and Several Liability (NBER Working Paper No. 16209)
Economic theory developed in the prior literature indicates that under the joint and several liability imposed by the federal Superfund statute, the government should recover more of its costs of cleaning up contaminated sites than it would under non-joint liability, and the amount recovered should increase with the number of defendants and with the independence among defendants in trial outcomes. Chang and Sigman test these predictions empirically using data on outcomes in federal Superfund cases. The theory also suggests that this increase in the amount recovered may discourage the sale and redevelopment of potentially contaminated sites (or "brownfields"). The authors find the increase to be substantial, which suggests that this implicit tax on sales may be an important deterrent for parties contemplating brownfields redevelopment.
Special Session on Corporate Governance
Robin Greenwood and C. Fritz Foley, Harvard Business School and NBER, and Sergey Chernenko, Harvard Business School
Agency Costs, Mispricing, and Ownership Structure (NBER Working Paper No. 15910)
Standard theories of corporate ownership assume that because markets are efficient, insiders ultimately bear all agency costs that they create, and thus have a strong incentive to minimize conflicts of interest with outside investors. Chernenko, Foley, and Greenwood argue that if equity is overvalued, mispricing offsets agency costs and can induce a controlling shareholder to list equity. Higher valuations may support listings associated with greater agency costs. They test the predictions that follow from this idea on a sample of publicly listed corporate subsidiaries in Japan. Subsidiaries in which the parent sells a larger stake, and subsidiaries with greater scope for expropriation by the parent firm, are more overpriced at listing, and minority shareholders fare poorly after listing as mispricing corrects. Parent firms often repurchase subsidiaries at large discounts to valuations at the time of listing and experience positive abnormal returns when repurchases are announced.
Alex Edmans, University of Pennsylvania; Xavier Gabaix, New York University and NBER; Tomasz Sadzik, New York University; and Yuliy Sannikov, Princeton University
Dynamic CEO Compensation
Edmans, Gabaix, Sadzik, and Sannikov study optimal executive compensation in a fully dynamic framework where the CEO consumes in multiple periods, can undo the contract by privately saving, and also can temporarily inflate the stock price. Despite the complex setup, the researchers obtain a simple closed-form contract. It yields clear predictions for how the optimal level and sensitivity of pay varies with the CEO's tenure and the contracting environment. The contract can be implemented by a "Dynamic Incentive Account": the CEO's expected pay is escrowed into an account, a proportion of which is invested in the firm's stock and the remainder in cash. The account features state-dependent rebalancing and time-dependent vesting. If the stock price falls, cash in the account is used to buy additional shares. Unlike the repricing of options, this re-incentivization does not come for free, and the CEO therefore is not rewarded for failure. The account vests gradually, both during the CEO's employment and after he quits, to deter short-termist actions before retirement.
Viral V. Acharya, New York University and NBER, and Marc Gabarro and Paolo Volpin, London Business School
Competition for Managers, Corporate Governance and Incentive Compensation
Acharya, Gabarro, and Volpin propose a model in which firms use corporate governance as part of an optimal compensation scheme: better governance incentivizes managers to perform better, thus saving on the cost of providing pay for performance. However, when managerial talent is scarce, firms compete to attract better managers. This reduces an individual firm's incentives to invest in corporate governance, because managerial rents are determined by the manager's reservation value when employed elsewhere, and thus by other firms' governance. In equilibrium, better managers end up at firms with weaker governance; conversely, better-governed firms have lower-quality managers. Consistent with these implications, the authors show that a firm's executive compensation is not chosen in isolation but also depends on other firms' governance. Better managers are matched to firms with weaker corporate governance.