Conflicts of Interest

Corporate Governance and Financial Markets

By: Luc Thevenoz (Editor), Rashid Bahar (Editor)

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Hardcover | 1 July 2008

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Conflicts of interest arise naturally in all walks of life, particularly in business life. As general and indeed inevitable phenomena, conflicts of interest should not be prohibited but properly managed. This book presents indepth analysis of such management in three areas of corporate governance where the conflict-of-interest problems are particularly acute: executive compensation, financial analysis, and asset management. "Conflicts of Interest" presents the results of a two-year-long research project bringing together academics and practitioners in both law and finance from Europe and the US under the auspices of the Centre for Banking and Financial Law of the University of Geneva. This book discusses the following issues: the duty of loyalty; remedies, such as disclosure, incentives, organizational measures; regulation and enforcement; and market considerations. With its intense focus on the material effects of actual conflicts of interest at the core of modern corporate governance and financial markets, this incomparable book will inform not only business people, practitioners, and academics, but also legislators, regulators, and all concerned with the far-reaching ramifications of conflict-of-interest management.

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List of Contributors	p. xix
Preface	p. xxi
Foreword	p. xxiii
Conflicts of Interest: Disclosure, Incentives, and the Market	p. 1
What are Conflicts of Interest?	p. 2
The Traditional Approach: Fiduciaries and the Duty of Loyalty	p. 2
The Ever-Broadening Scope of Conflicts of Interest	p. 4
Erosion and Waivers of the Duty of Loyalty	p. 7
Compensation	p. 8
Compensation as a Source of Conflicts of Interest	p. 8
Compensation as a Solution to Conflicts of Interest	p. 10
Intrinsic Motivation and Non-Monetary Incentives	p. 11
Remedies: Disclosure and Organizational Measures	p. 12
Can the Market Solve the Problem?	p. 12
Prohibition	p. 14
Organizational Measures	p. 16
Disclosure	p. 18
Enforcement	p. 21
Private Law Remedies of the Principal	p. 21
Class Actions and Derivative Suits	p. 22
Criminal Law	p. 23
Regulatory Enforcement	p. 24
Conclusion	p. 25
Structure of Executive Compensation and Conflicts of Interests - Legal Constraints and Practical Recommendations under Swiss Law	p. 31
Introduction	p. 31
The Role of Executive Compensation from an Economic Point of View	p. 32
The Agency Problem	p. 32
Overview of Remedies Against the Agency Problem	p. 34
Incentives and Performance-based Compensation in Particular	p. 36
Conflicts of Interests in Executive Compensation	p. 39
Conflicts of Interests and the Design of Executive Compensation Arrangements under Swiss Law	p. 42
Objectives of Executive Compensation Arrangements	p. 42
Key Factors	p. 43
Overall Target Level of Compensation and Key Contract Terms	p. 44
The Relationship between Fixed and Variable Compensation	p. 45
In General	p. 45
Choice of Performance Measure	p. 47
Form of Compensation	p. 48
Legal Restrictions and Practical Recommendations Regarding Executive Compensation Elements	p. 49
The Use of Shares and Share Options	p. 49
General	p. 49
Legal Restrictions	p. 50
Recommendations	p. 52
The Use of Bonus Plans	p. 56
General	p. 56
Legal Restrictions	p. 56
Recommendations	p. 57
The Use of Severance Payments	p. 58
General	p. 58
Legal Restrictions	p. 59
Recommendations	p. 60
The Use of Executive Loans	p. 61
General	p. 61
Legal Restrictions	p. 61
Recommendations	p. 62
The Use of other Forms of Compensation	p. 62
General	p. 62
Legal Restrictions	p. 63
Recommendations	p. 63
Our own Recommended Package	p. 64
Competences and Conflicts of Interests in Executive Compensation	p. 64
(Executive) Directors' Compensation	p. 65
Overlapping Competences of the Board of Directors and the Shareholders Meeting	p. 65
Is Directors' Compensation a Non-transferable Duty of the Board of Directors?	p. 66
Dealing with Conflicts of Interests	p. 68
Duty to Abstain from Voting	p. 68
No Self-Dealing	p. 69
The Role of Compensation Committees and Independent/Non-Executive Directors	p. 70
The Role of Shareholders	p. 71
Management Compensation	p. 73
Competence of the Board of Directors	p. 73
Is Management Compensation a Non-Transferable Duty of the Board of Directors?	p. 74
Dealing with Conflicts of Interests	p. 74
The Role of the Board of Directors, Compensation Committees, and Non-Executive and Independent Directors	p. 74
The Role of Shareholders	p. 76
Shareholders' Approval for Directors' and/or Management Compensation?	p. 76
Recent Developments	p. 76
Pros and Cons of Shareholders' Approval	p. 78
Conclusion	p. 81
The Design of Executive Compensation Arrangements	p. 82
Competences in Executive Compensation	p. 83
Executive Compensation: Is Disclosure Enough?	p. 85
Purpose of Executive Compensation	p. 86
Three Perspectives on Executive Compensation	p. 86
Fairness	p. 86
Agency	p. 87
Intrinsic Motivation	p. 88
Executive Compensation as a Source of Agency Conflicts	p. 89
Risk Aversion and Non-Diversification of Managers	p. 89
The Difficulty of Designing an Appropriate Compensation Scheme	p. 90
Governance of Executive Compensation	p. 91
The Bargaining Paradigm and its Shortcomings	p. 91
Limited Decision-Making Power of Shareholders	p. 91
Decision-Making Power of the Board of Directors	p. 93
Shortcomings of the Bargaining Paradigm	p. 94
Conflicts of Interest at Board Level	p. 94
Influence of Management at Board Level	p. 95
Lack of Emotional Independence	p. 96
Corporate Governance Solutions	p. 97
Improvements at Board Level	p. 97
Control by Shareholders	p. 99
Lack of Control by Vote	p. 99
Control by Exit	p. 101
Control by Courts	p. 101
Conclusion	p. 103
Disclosure and Executive Compensation	p. 103
Is Disclosure a Solution to the Conflict of Interest?	p. 103
The Swiss Regulatory Framework	p. 104
The Substantive Shortcomings of the Swiss Regulatory Framework	p. 107
Insufficient Disclosure of Deferred Compensation	p. 107
Insufficient Disclosure of Stock Option Plans	p. 108
No Disclosure of the Unwinding of Incentive Schemes	p. 108
No Discussion or Analysis of Compensation Policy	p. 109
Formal Shortcomings of the Regulatory Framework	p. 110
Efficacy of Disclosure: The 'Spot the Compensation' Game	p. 112
Transparency as a Source of Shareholder Empowerment	p. 112
Transparency as a Cause of Inefficient Remuneration	p. 113
In General	p. 113
Perks	p. 113
Options	p. 114
Pension Funds	p. 115
Transparency as a Problem	p. 116
Political Costs of Transparency	p. 116
The Lake Wobegon Effect: All Managers are above Average	p. 118
Transparency as a Norm-Setting Mechanism	p. 119
Economic Function of Social Norms	p. 119
Transparency as a Norm-Creating Device	p. 120
The Expressive Function of Codes of Best Practice	p. 121
Conclusion	p. 123
Revising the Governance of Executive Compensation	p. 123
Current Governance of Executive Compensation: Managers and Politicians	p. 123
The Solution: Empower Shareholders	p. 125
Put Shareholders at the Centre of the Debate	p. 125
Shareholder Votes on Executive Compensation	p. 126
Conclusion	p. 128
Executive Compensation and Analyst Guidance: The Link between CEO Pay and Expectations Management	p. 137
Introduction	p. 137
Review of the Literature	p. 140
Hypotheses on Expectations Management and Executive Compensation	p. 141
Sample and Methodology	p. 144
Sample Selection	p. 144
Sample Selection	p. 145
Measuring CEO Compensation Components and Ownership Variables	p. 148
Control Variables	p. 151
Measuring the Impact of CEO Compensation on Expectations Management	p. 155
Results	p. 155
CEO Compensation and Expectations Management	p. 155
Sensitivity Tests	p. 157
Does the Market Figure it Out?	p. 160
Conclusion	p. 161
Investment Research: How to Solve Conflicts of Interest More Efficiently	p. 171
How Serious are Conflicts of Interests - or: Why Did No One Cry 'Foul' Until as Recently as 1999?	p. 172
General	p. 172
Did Sin Really Come So Late?	p. 173
Why Attention Now and Not Then?	p. 174
The Applicable Swiss Rules as an Example of How Financial Analyst Conflicts of Interest Can be Addressed	p. 175
Preliminary Remark: Conflicts of Interest in Connection with Financial Research are Only One Example of the Numerous Conflicts of Interests Within Banks	p. 175
Basic Principles for Solving Conflicts of Interest in Swiss Law	p. 176
Statutory Basis: Art. 11 (1) Stock Exchange Act	p. 176
Assurance of Proper Business Conduct (Gewahrspflicht): An Important Principle in the Management of Conflicts of Interest	p. 177
Implementation of These Principles	p. 178
Code of Conduct for Securities Dealers	p. 178
Directives on the Independence of Financial Research	p. 179
Regulators' Typical Approach to Solving Conflicts of Interest	p. 180
Overview	p. 180
Instruments Most Often Used to Regulate Research Analysts' Conflicts of Interest	p. 180
Conclusion: Three-pillar Approach	p. 181
Policy Thoughts and Proposals	p. 182
High Costs of Current Regulation	p. 182
Four Policy Proposals	p. 183
First Proposal: Replace Excessive Rule-based Separation Requirements by Escalating Measures	p. 183
Second Proposal: Differentiate Between Institutional (Sophisticated) and Retail Investors	p. 184
Third Proposal: Allow Reputation Cost to Work	p. 184
Fourth Proposal: Reward Analysts for High Quality Work	p. 185
Do Conflicts of Interest Affect Analysts' Forecasts and Recommendations? A Survey	p. 187
The Nature and Magnitude of Conflicts of Interest in the Securities Analysis Industry	p. 188
Who are Financial Analysts and What Do They Do?	p. 188
How Do Conflicts of Interest Arise?	p. 189
Can Economic Incentives Mitigate Conflicts of Interest?	p. 190
Analyst Forecasts and Recommendations Surrounding Stock Issues	p. 191
Studies on Short-term Earnings Forecasts	p. 192
Studies Focusing on Investment Recommendations	p. 193
Studies Focusing on Long-term Earnings Growth Forecasts	p. 196
The Magnitude of the Optimism Bias in Investment Bank Forecasts and Recommendations	p. 196
Who Produces Investment Research?	p. 197
Studies Focusing on Short-term Earnings Forecasts	p. 197
Studies Focusing on Investment Recommendations	p. 198
Additional Results Relating to Analyst Conflicts of Interest	p. 200
Do Analysts Issue Biased Research in Order to Generate Trades?	p. 200
Is the Market for Financial Research Segmented?	p. 201
Do Upward Biased Forecasts Generate Business for Investment Banks?	p. 203
Does Analyst Regulation Help Mitigate Conflicts of Interest?	p. 204
The Main Features of the New Regulation	p. 204
The Empirical Evidence Relating to the New Regulations	p. 205
Conclusion	p. 206
Regulation of Financial Analysts: An Illustration of the Current Trends in Financial Market Law	p. 211
Abstract	p. 213
Formal Elements	p. 214
'Regulatory Shower'	p. 214
Reactive Regulation	p. 216
Over-Regulation?	p. 218
Self-Regulation	p. 220
Material Elements	p. 221
Inter-Regulation	p. 221
Threefold Objective	p. 222
Function Versus Institution	p. 224
Disclosure	p. 225
Conflicts of Interest in Research: Independence of Financial Analysts - The Costs and Benefits of Regulation	p. 227
Introduction	p. 228
History	p. 228
Why is There Still Research?	p. 229
Effect of Increased Costs on Research	p. 230
Analysis of Costs	p. 230
Analysis of Potential Benefits	p. 230
Our Survey on Conflicts of Interest in Research	p. 231
The Questionnaire for Portfolio Managers	p. 231
General Questions About the Interviewee and the Employer	p. 231
Disclosure Requirements	p. 232
Proprietary Trading by Financial Analysts	p. 232
Independence of Research	p. 233
Value of Research	p. 233
General Questions	p. 234
Additional Questions	p. 235
The Questionnaire for Financial Analysts	p. 235
General Questions About the Interviewee and the Employer	p. 235
Additional Working Time and Effort Due to the Directives	p. 236
Material, Non-Public Information	p. 237
Proprietary Trading by Financial Analysts	p. 237
Attractiveness of the Profession	p. 238
Quality of Research from the Analysts' Viewpoint	p. 238
General Questions	p. 239
Additional Questions	p. 239
Conclusion of the Questionnaire	p. 239
Tables	p. 240
Questionnaire for Portfolio Managers	p. 240
Disclosure Requirements	p. 243
Proprietary Trading by Financial Analysts	p. 244
Independence of Research	p. 245
Value of Research	p. 246
General Questions	p. 247
Additional Question	p. 248
Questionnaire for Financial Analysts	p. 249
Additional Effort Due to the Directives	p. 252
Material, Non-public Information	p. 253
Proprietary Trading by Financial Analysts	p. 254
Attractiveness of the Profession	p. 255
Quality of Research from the Point of View of Analysts	p. 256
General Questions	p. 257
Additional Questions	p. 258
Conflicts of Interest, Especially in Asset Management	p. 261
Conflicts of Interest are Inevitable in Financial Services	p. 261
Provisions in the EU Directives Dealing with Conflicts of Interest	p. 262
Why Worry about Conflicts of Interest in Financial Services, Especially Asset Management?	p. 266
Structural Aspects of Conflicts of Interest in the Field of Asset Management	p. 269
Regulation	p. 269
Factual Developments	p. 270
Conflicts of Interest in Institutional Asset Management: Is the EU Regulatory Approach Adequate?	p. 277
Conflicts of Interest in General	p. 278
Conflicts of Interest as a Legal Concept	p. 278
Conflicts of Interest as an Economic Agency Problem	p. 283
Conflicts of Interest in Asset Management	p. 288
The Inevitability of Conflicts of Interest in Institutional Asset Management	p. 288
Possible Conflicts of Interest for Portfolio Managers	p. 290
Conflicts Because the Manager has Several Clients	p. 290
Conflicts Because the Manager Also Offers Other Services	p. 292
Conflicts Because the Manager has a Stake in the Consequences of Transactions	p. 296
Resulting Agency Costs for Asset Management	p. 296
Adverse Impact on the Interests of the (Small?) Investor	p. 297
Undermining Capital Market Integrity	p. 300
Suboptimal Asset Management Market Efficiency	p. 302
Legal Approaches to Conflicts of Interest in Asset Management	p. 303
Imposing Fiduciary Duties	p. 303
Regulatory Conduct of Business Rules	p. 307
A Regulatory General Standard of Loyalty	p. 307
Imposing Specific Rules for Asset Management Services?	p. 311
Specific Requirements of Suitability of Investment Decisions	p. 314
Client Order Handling Rules	p. 317
Specific Measures to Tackle Conflicts of Interest	p. 319
Which Conflicts of Interest?	p. 320
Structural and Organizational Measures	p. 322
Disclosure Requirements	p. 324
Some Concluding Remarks	p. 331
Conflicts of Interest in the Distribution of Investment Funds	p. 337
General Context	p. 338
Remuneration of Fund Distributors - an Overview	p. 341
Conflicts of Interest at Two Levels	p. 343
Fund Providers	p. 343
Duty of Loyalty	p. 344
Retrocession Paid by Fund Providers on the Management Fee	p. 345
Retrocession Paid by Fund Providers on Entry Fees	p. 346
Fund Distributors	p. 347
Duty of Loyalty	p. 347
Retrocession Received by Fund Distributors	p. 348
Possible Solutions	p. 349
Prohibiting Retrocessions	p. 349
Regulating the Level of Retrocessions	p. 351
Disclosing Retrocessions to Investors	p. 352
The Case for Disclosure	p. 355
The Case Against Disclosure	p. 357
Who is to Disclose What, When, and How?	p. 358
Is Disclosure Enough?	p. 360
United States Mutual Fund Investors, Their Managers and Distributors	p. 363
Conflicts of Interest in the United States: What They Mean and When They Matter	p. 364
When Does Fiduciary Law Arise?	p. 364
The Issue of the Fiduciaries' Fees	p. 367
The Contest of Categories	p. 367
The Prohibition on Conflicts of Interest	p. 368
An Overview of Mutual Funds and Their Promoters	p. 370
The Two Parental Promoters	p. 370
The Structure of United States Mutual Funds and the Managers' role, Status, and Incentives	p. 371
Managers' Incentives Focus on the Sale of Their Mutual Funds Shares, as Compared to Trustees of Private Trusts	p. 372
The Managers Manage Funds as Chief Executive Officers Manage Corporations	p. 372
Solicitors	p. 374
The Distributors' Role, Status and Incentives	p. 374
Distributors' Compensation	p. 375
The Alliance: What Managers Want From Distributors and What Distributors Want in Return	p. 375
Give-Ups and Their Evolution	p. 376
Revenue Sharing	p. 377
Managers and Investors' Conflicts of Interest: The Sale of Fund Securities and Allocation of Fund Brokerage Business	p. 377
Misappropriation of the Discounts	p. 378
Poor Execution of Trades	p. 378
Increased Turnover (Churning)	p. 379
Disadvantages of Fund Size	p. 379
Misappropriation of Economies of Scale	p. 379
Even Direct Cash to Distributors Comes from the Investors' Pockets	p. 379
Opening the Doors to Other Abuses: The Issue of Culture	p. 379
The Law's Response	p. 380
Another Crack in the Wall: Permissible Soft Dollars Arrangements	p. 380
The Dilemma: The Commodity Contract Approach	p. 381
One Case	p. 382
Theoretical Models for Managers to Address Managers' Conflicts of Interest	p. 384
What is Wrong with Rewarding Managers with Benefits from Their Control over Investors' Money?	p. 384
The Disclosure and Implied Consent Solution	p. 386
Mutual Funds as Businesses	p. 387
Theoretical Frames for Remedies on Conflicts of Interest	p. 388
Mutual Funds Regulation Adopted Both Responses to Conflicts of Interest	p. 389
The Change in Judicial Interpretation of Statutes	p. 390
The Puzzle and the Danger	p. 391
Is the Concern About Conflicts of Interests Described in This Paper Exaggerated?	p. 392
The Issue of Culture	p. 392
Conclusion	p. 393
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Conflicts of Interest

Corporate Governance and Financial Markets

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