Corporate Behavior and Financial Markets

April 10 – 11, 2003

Investors have a strong interest in assessing the true value of companies. Yet the recent evidence indicates that many companies – particularly those in the technology sector – were overvalued in the 1998-2000 bubble. Can the overvaluation be ascribed to accounting misdeeds, to the failure of analysts to do their job, or just to irrational exuberance? Can financial markets provide more effective discipline of managers? Do institutional investors play a sufficiently aggressive role in monitoring companies and their management? Is disclosure by companies of their operations sufficient to the needs of investors? How important are accounting rules for proper valuation of companies? Does bad accounting lead to stock market mis-valuation? Does disclosure of bad accounting lead to stock price reactions? How important are key analysts in the valuation of companies? Do executive compensation arrangements provide perverse incentives? What is the relation between executive compensation and earnings reports and stock prices? Can financial markets discipline corporations or must more responsibility be put on the board of directors? Does poor corporate governance have a stock price effect? Can changes in regulation increase the effectiveness of market discipline – for example, would elimination of short sale restrictions help limit bubbles? Is the new issues market working properly or should changes be considered in the way companies raise equity capital?

Many of these questions were addressed at the 16^th annual conference of the Financial Markets Research Center, supported by a special grant from the New York Stock Exchange, and held on April 10-11, 2003 at Vanderbilt University. Day one of the conference took place at the conference facilities of Center member, Caterpillar Financial Services, located next to the campus, and day two took place at the Owen School. James Beard, President of Caterpillar Financial, and Hans Stoll, director of the Center, welcomed the conference participants.

The lead-off speaker, Harvey Goldschmid, Commissioner of the Securities and Exchange Commission, was introduced by Randall Thomas, Professor of Law at the Vanderbilt Law School. Commissioner Goldschmid noted that the corporate wrong-doings of the recent past were not an isolated problem or an example of one rotten apple, but rather the reflection of fundamental systemic problems. He called for greater independence and greater responsibility for corporate monitors – directors, auditors, analysts and lawyers. He discussed the role of the Sarbanes-Oxley Act in increasing independence of directors and auditors. He noted the importance of moving ahead with the Accounting Oversight Board, of providing better funding for the FASB, and of examining the role of rating agencies.

Richard Lindsey, President of Bear Stearns Securities Corporation, next chaired a session on Accounting and the Stock Market. Professor Paul Chaney, of the Owen School, presented the results of his paper (with Kirk Philipich), “Shredded Reputation: The Cost of Audit Failure.” The research demonstrates the importance of auditor reputation for the value of companies. Chaney reported that Arthur Andersen’s shredding of documents relating to its audit of Enron, resulted not only in a drop in the stock price of Enron, but also in a drop in the stock prices of all the companies audited by Andersen (relative to companies not audited by Andersen). The stock price effect of the shredding averaged more than $30 million per Andersen client.  Robert Fisher, Economist at the Securities and Exchange Commission, discussed alternative approaches to more effective auditing. On the one hand, one can strengthen and extend auditing rules. On the other hand, one can rely on broader auditing principles and hold auditors to those principals. He noted that an SEC study of these issues was due in July, 2003.

After a short break, conference participants returned for a talk by Susan Bies, Governor of the Federal Reserve Board, on the topic of corporate governance. Governor Bies noted that the Federal Reserve Board has been concerned with the governance of banks and the proper attention to risk management of banks. Banks are required to provide a management report on internal controls that includes an assessment of risks, internal controls, auditor quality and the like. Auditors are required to determine if the management report is a fair representation of the facts. Bank regulators have the authority to de-bar auditors that do not meet their responsibilities.

The first session of the afternoon dealt with the topic of investment banking, the new issues market and the role of analysts. Paul Bennett, Chief Economist of the New York Stock Exchange, chaired the session. Professor Jay Ritter, of the University of Florida, provided a comprehensive overview of the new issues market and the tendency for new issues to appreciate in the immediate aftermarket. He recommended actions to control practices such as spinning, laddering, and high commissions.  Professor Ron Masulis, of the Owen School, presented his paper (with Xi Li), “Venture Capital Investments by IPO Underwriters: Certification or Conflict of Interest.”  The authors find that IPOs in which the underwriter provides venture financing are underpriced to a lesser degree than IPOs in which the underwriter has no venture financing role. The authors conclude that venture financing has a beneficial certification role. Professor Leslie Boni, of the University of New Mexico, summarized academic work on conflicts of interest facing securities analysts and reported on joint research with Kent Womack that examines the quality of analysts recommendations. They find that analysts’ upgrades and downgrades predict returns of stocks, which implies that analysts’ recommendations have value.

In the next session, John Biggs, retired Chairman and CEO of TIAA-CREF, spoke on how corporations can be more effectively monitored. He noted that the current governance structure can be described as “strong management, weak boards, and passive investors.” He favored strengthening the board, particularly the audit committee, while retaining a strong CEO. He recommended that major institutional investors develop research programs to monitor governance of their portfolio companies and that they act via proxy votes and direct negotiation with companies to improve corporate governance.

Thursday’s last session on the subject of corporate governance was chaired by Craig Lewis, of the Owen School.  Anup Agrawal presented a paper, Corporate Governance and Accounting Scandals (with Sahiba Chadha) in which he analyzed the frequency of earnings restatements as a function of corporate governance characteristics, such as degree of board independence, auditor independence, and financial sophistication of the board. He concluded that restatements are not related to most governance characteristics except that the financial sophistication of the board is associated with fewer restatements. Robert Thompson, Professor of Law at Vanderbilt, commented on the Agrawal paper and discussed the nature and source of the regulation of corporate governance. He noted that state law has changed little with regard to corporate governance. Instead, Federal law – the Sarbanes-Oxley Act – and exchange listing standards have been the source of changes in corporate governance regulations.

On Friday morning, attendees assembled at the Owen Graduate School of Management to hear from two panels. The first panel, chaired by Thomas Peterffy, Chairman of Interactive Brokers, dealt primarily with equities markets. Paul Bennett, Chief Economist of the New York Stock Exchange, discussed several trends in equities markets – the increased use of a VWAP (value weighted average price) standard for evaluating a broker, the growth in program trading, and the increase in the frequency of quote changes. Adena Friedman, Executive Vice President of the Nasdaq Stock Market, reviewed recent developments in Nasdaq, such as Supermontage, Viewsuite (which provides information on depth), and a new opening procedure. She expressed concern that market fragmentation in the trading of Nasdaq stocks has weakened Nasdaq’s ability to provide regulatory oversight. David Krell, Chief Executive Officer of the three year old International Securities Exchange, reported on the continued growth in his exchange’s share of option volume. In March 2003, the ISE accounted for 24.7% of option volume, second only to the CBOE. He ascribed the ISE success to its technology, to its internal competition, and to the ease with which the exchange can be accessed. William Rainer, Chief Executive Officer of OneChicago and former chairman of the Commodity Futures Trading Commission, traced the genesis of single stock futures, noted their benefits, and commented on the still slow development of that market. Larry Harris, Chief Economist of the Securities and Exchange Commission, departed from his prepared remarks to summarize and comment on the remarks of the other panelists. On the question of market data fees, he suggested alternative ways to allocate fees, including that they be allocated on the basis of the quality of a market as measured by the frequency with which the market is at the inside. On the question of market linkage, he noted the difficulties of linking markets when different markets proceed at different speeds. With regard to single stock futures, he noted the benefits of easier short selling made possible by such a market.

The second panel, chaired by James Klingler, Senior Vice President of Eclipse Capital, dealt primarily with developments in futures and options markets. John Damgard, President of the Futures Industry Association, argued forcefully for a single futures clearing organization as opposed to the separate clearing houses that now exist for each of the principal futures markets. Sharon Brown-Hruska, Commissioner of the Commodity Futures Trading Commission, noted the purpose of the Commodity Futures Modernization Act of 2000 to lessen or simplify regulation, and she discussed several issues coming before the Commission.  Richard DuFour, Executive Vice President of the Chicago Board Options Exchange, commented on the earlier discussion of option markets by David Krell. He noted that the ISE has multiple quoters which narrows the ISE’s posted quote in comparison to the CBOE which disseminates the quote of the single specialist. He also described the development at the CBOE of an integrated screen and floor based trading system. Jack Gaine, President of the Managed Funds Association, discussed the growing interest of regulators in the operation of hedge funds. He noted that the Securities and Exchange Commission is conducting a study of hedge funds which would, among other things, consider valuation practices, retailization of hedge funds, and the role of the prime broker.

Participants