Spring 2006 Conference on
Conflicts of Interest in
Financial Markets
In many realms of financial
markets, principals rely on agents to accomplish their goals. Because agents
have their own interests at heart, conflicts arise between the goals of agents
and the goals of principals. Examples of potential conflicts are many. Investors
hire brokers to achieve best execution, while brokers have an incentive to trade
where they receive payment for order flow. Investors hire money managers to
trade their assets most efficiently, but money managers have an incentive to
trade with brokers that provide soft dollar credits that can be used to pay for
research services. As Enron and other recent scandals have shown, street-side
research analysts can neglect their obligation to their investor clienteles by
writing reports favorable to the corporate clients of the brokerage firm rather
than accurately depicting the state of the corporation. In corporations,
managers have incentives to shirk their obligations to shareholders in favor of
their own interests, perhaps leading to distortion of accounting numbers and to
overly generous management compensation plans. What is the evidence on the
presence and severity of these various conflicts? Should regulators limit
activities that may lead to conflicts, or would transparency, full disclosure and
competition be adequate to deal with conflicts?
These and related issues were
discussed at the 19th annual conference of the Financial Markets
Research Center, held on April 20-21, 2006 at Vanderbilt University. The
conference was supported by a special grant from Hirtle, Callaghan & Co., Chief
Investment Officers. Day one of the conference took place at the conference
facilities of Caterpillar Financial Services, located next to the campus, and
day two took place at the Owen School. Ed Scott, Chief Financial Officer
of Caterpillar Financial, and Jim Bradford, Dean of the Owen School,
welcomed the conference participants.
Jim Bradford
Hans Stoll, director of the
Center introduced Jon Hirtle, co-founder of Hirtle Callaghan, who spoke
on conflicts of interest in investment management, noting that his own firm was
founded on the premise of eliminating conflicts inherent in multi-purpose money
management organizations. The next speaker, Chester Spatt, Chief
Economist of the Securities and Exchange Commission (on leave from Carnegie
Mellon University), gave an overview of the regulatory approaches to different
conflicts. These approaches included 1)requirement for board and auditor
oversight, 2)self-policing by self-regulatory organizations, 3)specific policies
and procedures that limit conflicts, 4)public disclosure of conflicts, 5)rules
against certain abuses enforced by regulators, 6)Chinese walls, and 7)complete
separation of functions (i.e. separation of auditor and consultant). He gave
examples of some of these approaches and discussed some unintended consequences
of certain approaches.
Jon Hirtle
Chester Spatt
The next session, chaired by
Bob Whaley, professor at the Owen School, examined three types of conflicts
facing securities analysts. The first dealt with fairness opinions and was
addressed in a paper by Donna Hitscherich, from Columbia University
(written with Charles Calomiris), “Banker fee and acquisition premia for targets
in cash tender offers: Challenges to the popular wisdom on banker conflicts.”
Hitscherich noted the narrow purpose of the fairness opinion – to give comfort
to the board of the target company – and concluded that the fees charged were
reasonably related to the cost of rendering the opinion. A second conflict was
examined in a paper, “Information leakage and opportunistic behavior before
analyst recommendations: An analysis of the quoting behavior of Nasdaq market
makers,” presented by Xi Li, from the University of Miami, (written with
Hans Heidle). Heidle and Li find that market makers change their bid-ask quotes
in anticipation of changes in stock recommendations by analysts from the same
firm. They suggest that this may imply a break in the “Chinese Wall” between
securities analysts and market makers. The third paper considered the effects of
the global settlement among the SEC, NYSE, NASD, the New York attorney general
and 10 investment banking firms to separate securities analysis and investment
banking, to make certain other changes, and to pay a penalty of $1.4 billion.
The paper, “Conflicts of interest and stock recommendations: The effect of the
global settlement and related regulations,” presented by Ohad Kadan of
Washington University (written with Leonardo Madureira, Rong Wong and Tzachi
Zach) finds that analyst recommendations are now more balanced, and the
over-optimism by analysts of securities firms managing a recent offering is
reduced. Craig Lewis, from the Owen School, commented on the three
papers. He suggested ways to more clearly distinguish the benign and jaundiced
views of fairness opinions. With regard to the Heidle/Li paper, he argued that
their results reflect information leakage rather than front-running by market
makers. On the global settlement paper, he suggested tests to determine if the
reduced optimism of analysts was due to the settlement or to changed market
conditions.
After a luncheon break, the
conference continued with a panel on Conflicts in Markets, chaired by Richard
Lindsey, President of Bear Stearns Securities Corporation. Lindsey
introduced the discussion by outlining categories of conflicts – conflicts in
trading as between a broker and his customer, conflicts in competition as
between an exchange and its users, conflicts in governance as between a board
and the management, and conflicts in regulation as between an SRO and its
members. Dick DuFour, Executive VP of the CBOE, discussed how multiple
listing of options and increased competition led to payment for order flow as
specialists in each option exchange tried to attract business. Eric Noll,
Head of Strategic Relationships at Susquehanna International Group, noted that
conflicts had some benefits. The practice of payment for order flow, for
example, helped automate and improve the system for routing orders among
exchanges. Jim Overdahl, Chief economist of the CFTC, discussed the
conflicts inherent in exchange self-regulation. He noted that under CFTC
regulation there are 18 core principals but no guide on SRO conflicts. John
Damgard, President of the Futures Industry Association, spoke in favor of
more truly independent directors on the boards of commodity exchanges and for
greater competition in the futures industry.
Panelists (left to right): Dick DuFour, Eric Noll,
Jim Overdahl, and John Damgard
Professor Stoll next introduced
Rick Kilcollin, of Sanborn Kilcollin, who chaired a session on Conflicts in
the IPO Market. The first speaker in this session was Ron Masulis, from
the Owen School, who presented the results of a paper (written with Xi Li),
“Venture capital investments by IPO underwriters: Certification, alignment of
interest, or moral hazard?” Masulis and Li compare VC backed IPOs in which the
underwriter was and was not a VC investor. They conclude that when the VC is
also the underwriter, under-pricing is less and the offering is a greater
success, results which they take as evidence of their certification hypothesis,
namely that a VC position by the underwriter helps certify the quality of the
IPO in the eyes of investors. Jennifer Marietta-Westberg, from Michigan
State University, in a paper with William Johnson, “Universal banking, asset
management, and stock underwriting,” examines the conflict of interest when an
underwriter is part of a universal bank that also has an asset management
division. She finds that holdings of the IPOs by the asset management division
are greater when the firm acts as underwriter. Returns are also greater,
however. She concludes that universal banks use their asset management division
to improve an offering’s success but that this “quid pro quo” policy has no
adverse effect on returns in the asset management division. Cindy Alexander,
Assistant Chief Economist at the SEC, commented on the two papers and made
several suggestions.
The last session of Thursday, on
Hedge Funds, was chaired by Rick Cooper, Chief Investment Officer of CTS
Strategic Investments. The sole paper of the session, “Why is Santa so kind to
hedge funds? The December return puzzle,” (written with Vikas Agarwal and
Narayan Naik) was presented by Naveen Daniel, of Purdue University. Based
on a large sample of hedge funds for the period 1994 – 2002, the authors find a
large positive return in December, which they ascribe to hedge funds managing
their returns in order to earn incentive fees. Commentator, Nick Bollen,
from the Owen School, noted that the pattern of returns observed for hedge funds
is also observed for mutual funds. He concluded that additional work would be
desirable to determine if the December return of hedge funds was truly an abnormal
characteristic of hedge funds or a characteristic of the historical period
covered by the data.
Rick Cooper
The first session on Friday
produced a lively discussion on soft dollars. Soft dollars are that portion of
the commission used to pay for research either to the executing broker or to a
third party. Bob Thompson, Professor of Law at the Vanderbilt Law School,
chaired the session and introduced the paper presenter, Bruce Johnsen,
from the George Mason University School of Law. The paper, written with Stephen
Horan, is entitled “Can third party payments benefit the principal? The case of
soft dollar brokerage.” Johnsen defended soft dollar payments as an incentive
alignment tool in contrast to its many critics who view it as unjust enrichment
for brokers. David B. Jones, Senior V.P. of Fidelity Management &
Research Corporation, discussed the question of how research should be paid for
without being too explicit about Fidelity’s approach to this question. George
Sofianos, Vice President at Goldman Sachs, discussed the issue from the sell
side perspective. He noted that brokers were offering a portfolio of trading
strategies ranging from highly automated and low cost to highly tailored and high cost. The result is that commissions vary considerably
according to the services supplied.
The conference’s session on
conflicts in mutual funds was chaired by Jim Klingler, Senior Vice
President of Eclipse Capital Management. While mutual funds have been criticized
on a variety of grounds – high expenses, late trading, poor performance – the
research presented in this session focused on corporate governance and the
efficacy of alternative governance structures. The paper, entitled “Mutual fund
governance: What works and what doesn’t?” was presented by Dragon Tang of
Kennesaw State University and was written with Sophie Kong. Tang and Kong
examine the effect of three governance mechanisms on fees and other measures of
performance. They conclude that unitary boards are associated with better
performance, while board independence by itself has no association with
performance. Sean Collins, Senior Economist at the Investment Company
Institute, commented on the paper. He noted that the majority of mutual fund
complexes have a unitary board. He also noted that competition among fund
complexes works in that investors shop for low fee funds.
Dewey Daane Invitational
Tennis Tournament
Inclement weather
forced the combatants for the contents of the Daane Cup indoors, where Jim
Lodas prevailed and Hans Stoll managed the runner-up position. Dewey
Daane oversaw the event and awarded the prizes to the winners.
Dewey Daane flanked by
runner-up, Hans Stoll, and winner, Jim Lodas
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