Joseph J. Gerakos

Institutional Investor Preferences for Corporate Governance Mechanisms

We examine institutional investors’ preferences for corporate governance mechanisms. We find little evidence of an association between total institutional ownership and governance mechanisms. However, using revealed preferences, we identify a small group of “governance-sensitive�? institutions that exhibit persistent associations between their ownership levels and firms’ governance mechanisms. We also find that firms with a high level of ownership by institutions sensitive to shareholder rights have significant future improvements in shareholder rights, consistent with shareholder activism. Further, we find that factors describing the characteristics of institutions’ portfolios are correlated with governance preferences. Large institutions, those holding a large number of portfolio stocks, and those with preferences for growth firms are more likely to be sensitive to corporate governance mechanisms, suggesting those mechanisms may be a means for decreasing monitoring costs and may be more essential for firms with a high level of growth opportunities. Finally, our results suggest that common proxies for governance sensitivity by investors (e.g., legal type, blockholding) do not cleanly measure governance preferences.

Performance Shocks and Misreporting

We propose a parsimonious stochastic model of reported earnings that links misreporting to performance shocks. Our main analytical prediction is that misreporting leads to a negative second-order autocorrelation in the residuals from a regression of current earnings on lagged earnings. We also propose a stylized dynamic model of earnings manipulation and demonstrate that both earnings smoothing and target-beating considerations result in the same predictions of negative second-order autocorrelations. Empirically, we find that the distribution of this measure is asymmetric around zero with 27% of the firms having significantly negative estimates. Using this measure, we specify a methodology to estimate the intensity of misreporting and to create estimates of unmanipulated earnings. Our estimates of unmanipulated earnings are more correlated with contemporaneous returns and have higher volatility than reported earnings. With respect to economic magnitude, we find that, in absolute terms, median misreporting is 0.7% of total assets. Moreover, firms in our sample subject to SEC AAERs have significantly higher estimates of manipulation intensity.We propose a parsimonious stochastic model of earnings that takes into account economic shocks and reporting bias. Our main prediction is that earnings manipulation leads to a negative second lag autocorrelation in the residuals from a regression of current earnings on lagged earnings. We nd that our measure of earnings manipulation is statistically signi cant for 17 20 percent of the rms with su cient data on Compustat. Furthermore, traditional measures of accruals quality and earnings smoothing do not correlate with our measure. Several of the traditional measures do, however, vary monotonically with our rm-level measure of the volatility of economic shocks, suggesting that they capture not only strategic biases, but also other stochastic properties of the rms earnings process.

The Structure of Performance-Vested Stock Option Grants

U.S. executive compensation traditionally relies on stock options that vest over time. Recently, however, a growing number of institutional investors have called for the use of performance-vested options that link vesting to the achievement of performance targets. We examine the factors influencing the structure of performance-vested stock option grants to U.S. CEOs. We find that performance-vested options comprise a greater proportion of equity compensation in firms with lower stock return volatility and market-to-book ratios, and in those with new external CEO appointments, providing some support for theories on the options’ incentive and sorting benefits. However, firms with larger holdings by pension funds are less likely to completely replace traditional options with performance-vested options, and make traditional options a greater percentage of option grants, suggesting that token performance-vested option grants may also be used to placate pension funds that are calling for their use. In addition, our exploratory examination of performance-vesting criteria finds similarities and differences to prior studies on the choice of performance measures in compensation contracts.

Determinants of Hedge Fund Internal Controls and Fees

We investigate the determinants of hedge fund internal controls and their association with the fees that funds charge investors. Hedge funds are subject to minimal regulation. Hence, hedge fund managers voluntarily implement internal controls, and managers and investors freely contract on fees. We find that internal controls are stronger in funds with higher potential agency costs. Further, internal controls are stronger in funds domiciled in jurisdictions that provide investors with limited legal redress for fraud and financial misstatements. Short selling funds, however, are more likely to protect information about their investment positions by implementing weaker internal controls. With respect to fees, we find that the percentage of positive profits that the manager receives increases in the strength of the fund’s internal controls. Finally, removing the manager from setting and reporting the fund’s official net asset value, along with reputational incentives and monitoring by leverage providers, are all associated with lower likelihoods of future regulatory investigations of fraud and/or financial mis-

Listing Choices and Self-Regulation: The Experience of the AIM

We compare companies listing on the London AIM to regulated exchanges in the US and UK. The AIM is unique in that it is privately-regulated and relies on Nominated Advisors to provide oversight rather than traditional regulators. We find that AIM firms perform poorly on a variety of dimensions. Their post-listing returns significantly underperform stocks on other exchanges. Liquidity is low and there is evidence of substantial information asymmetry. Results are similar across subsets of firms including US firms that directly list on AIM, firms that cross list, and domestic listings. AIM firms do not appear to distinguish themselves through choice of Nomad. Failure rates are very high and there is no evidence that significant numbers develop into “highfliers” or graduate to better exchanges. AIM stocks even underperform stocks that trade on the unregulated “Pink Sheets” in the US, inconsistent with a significant bonding effect of AIM listing.

Which U.S. Market Interactions Affect CEO Pay? Evidence from UK Companies

This paper examines how different types of interactions with U.S. markets by non-U.S. firms are associated with higher levels of CEO pay, greater emphasis on incentive-based compensation, and smaller pay gaps with U.S. firms. Using a sample of CEOs of UK firms and using both broad cross-sectional and narrow event-window tests, we find that capital market relationship in the form of a U.S. exchange listing is related to higher UK CEO pay; however, the effect is similar when UK firms have a listing in any foreign country, implying a foreign listing effect not unique to the United States. Product market relationships measured by the extent of sales in the United States by UK companies are associated with higher pay, greater use of U.S.-style pay arrangements, and a reduction in the U.S.--UK pay gap. The product market effect is incremental to the effect of a U.S. exchange listing, the extent of the firms non-U.S. foreign market interactions, and the characteristics of the executive. The U.S.--UK CEO pay gap reduces in UK firms that make U.S. acquisitions. Furthermore, the firms use of a U.S. compensation consultant increases the sensitivity of UK pay practices to U.S. product market relationships. This paper was accepted by Gerard P. Cachon, accounting.

Chief executive officers and the pay–pension tradeoff

The theory of equalizing differences predicts that workers trade pay for benefits, but empirical confirmation of such tradeoffs is rare. This study investigates the extent to which chief executive officers (CEOs) trade pay for pension benefits. For a sample of S&P 500 CEOs, I find that an additional dollar of pension benefits is associated with a 48 cent decrease in pay. Although the tradeoff estimate is significantly different from zero, it is also significantly less than the anticipated rate of dollar for dollar, especially for CEOs with relatively more power over their boards of directors. This implies that the implicit price of pension benefits decreases with the CEOs power, so pooling datasets on CEOs with varying degrees of power blurs the size of the pay-pension tradeoff.

Competition and Voluntary Disclosure: Evidence from Deregulation in the Banking Industry

We exploit the relaxation of interstate bank branching restrictions in the 1990s to examine how the threat of new entrants aects incumbents’ voluntary disclosure choices. The Interstate Banking and Branching Eciency Act relaxed interstate banking and branching restrictions, thereby increasing competitive entry threats. The Act was implemented over several years and to varying degrees by dierent states, allowing us to identify the eect of changes in potential entry on the voluntary disclosure decisions of both public and private banks. Controlling for changes in actual entry and changes in state-level economies, we find that increases in the threat of new entrants are associated with increases in the level of voluntary disclosure as measured by press releases. Our results are consistent with theoretical predictions that higher levels of entry threats lead to higher levels of disclosure.We use the relaxation of interstate branching restrictions under the Interstate Banking and Branching Efficiency Act (IBBEA) to examine how increases in competition affect incumbents’ voluntary disclosure choices. States implemented the IBBEA over several years and to varying degrees, allowing us to identify the effect of increased competition on the voluntary disclosure decisions of both public and private banks. We find that increases in competition are associated with an increase in press releases. Overall, press releases become more negative in tone as entry barriers decrease. However, disclosures by public banks and by banks issuing equity become incrementally positive in tone when entry barriers decrease. Thus, the increase in disclosure is consistent with a dominant incentive to deter entry via negative information, which is mitigated by an incentive to communicate positive information to investors.

Do Risk Management Practices Work? Evidence from Hedge Funds

We examine hedge fund risk management practices and their association with left-tail risk during the 2008 financial crisis. Consistent with risk management practices reducing left-tail risk, funds in our sample that use formal risk models performed significantly better in the extreme down months of 2008. We find no evidence that having either position limits or a dedicated head of risk management is associated with reduced left-tail risk. Funds employing value at risk models had more accurate expectations of how they would perform in a short-term equity bear market.

The Adoption and Characteristics of Performance Stock Option Grants

Traditional executive stock options are granted at fair market value on the grant date and vest over time. Although executive stock options are a popular compensation vehicle, they have received increasing criticism for providing inadequate incentives for executives to improve shareholder wealth. Critics of traditional options, together with a growing body of theoretical studies, call for the use of performance options that link option vesting or exercise to the achievement of performance targets. We examine the factors influencing the adoption and characteristics of performance (i.e., premium-priced and performance-vested) stock option grants to CEOs. We find some evidence that the characteristics of performance option grants (but not their adoption) are associated with the economic determinants identified in theoretical studies. However, many of the associations are opposite the predictions from the theoretical studies. We find stronger evidence that performance options are associated with exceptionally large option grants to CEOs of firms with weak governance structures and large pension fund holdings. Overall, our results are most consistent with the explanation that performance option grants are used to minimize criticism of controversial compensation decisions.