Conflicts of Interest

Name: Conflicts of Interest | Corporate Governance and Financial Markets
Brand: Kluwer Law International
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Corporate Governance and Financial Markets

Luc Thevenoz Rashid Bahar(Editor)

Kluwer Law International (Publisher)

Published on 24. January 2007

420 pages

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978-90-411-5043-1 (ISBN)

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Cover
Half Title Page
Title Page
Copyright Page
Summary of Contents
Table of Contents
List of Contributors
Preface
Foreword
Chapter 1 Conflicts of Interest: Disclosure, Incentives, and the Market
I. WHAT ARE CONFLICTS OF INTEREST?
A. The Traditional Approach: Fiduciaries and the Duty of Loyalty
B. The Ever-Broadening Scope of Conflicts of Interest
C. Erosion and Waivers of the Duty of Loyalty
II. COMPENSATION
A. Compensation as a Source of Conflicts of Interest
B. Compensation as a Solution to Conflicts of Interest
C. Intrinsic Motivation and Non-Monetary Incentives
III. REMEDIES: DISCLOSURE AND ORGANIZATIONAL MEASURES
A. Can the Market Solve the Problem?
B. Prohibition
C. Organizational Measures
D. Disclosure
IV. ENFORCEMENT
A. Private Law Remedies of the Principal
B. Class Actions and Derivative Suits
C. Criminal Law
D. Regulatory Enforcement
V. CONCLUSION
Chapter 2 Structure of Executive Compensation and Conflicts of Interests - Legal Constraints and Practical Recommendations under Swiss Law
I. INTRODUCTION
II. THE ROLE OF EXECUTIVE COMPENSATION FROM AN ECONOMIC POINT OF VIEW
A. The Agency Problem
B. Overview of Remedies Against the Agency Problem
C. Incentives and Performance-based Compensation in Particular
D. Conflicts of Interests in Executive Compensation
III. CONFLICTS OF INTERESTS AND THE DESIGN OF EXECUTIVE COMPENSATION ARRANGEMENTS UNDER SWISS LAW
A. Objectives of Executive Compensation Arrangements
B. Key Factors
1. Overall Target Level of Compensation and Key Contract Terms
2. The Relationship between Fixed and Variable Compensation
a. In General
b. Choice of Performance Measure
3. Form of Compensation
C. Legal Restrictions and Practical Recommendations Regarding Executive Compensation Elements
1. The Use of Shares and Share Options
a. General
b. Legal Restrictions
c. Recommendations
2. The Use of Bonus Plans
a. General
b. Legal Restrictions
c. Recommendations
3. The Use of Severance Payments
a. General
b. Legal Restrictions
c. Recommendations
4. The Use of Executive Loans
a. General
b. Legal Restrictions
c. Recommendations
5. The Use of other Forms of Compensation
a. General
b. Legal Restrictions
c. Recommendations
D. Our own Recommended Package
IV. COMPETENCES AND CONFLICTS OF INTERESTS IN EXECUTIVE COMPENSATION
A. (Executive) Directors' Compensation
1. Overlapping Competences of the Board of Directors and the Shareholders Meeting
2. Is Directors' Compensation a Non-transferable Duty of the Board of Directors?
3. Dealing with Conflicts of Interests
a. Duty to Abstain from Voting
b. No Self-Dealing
c. The Role of Compensation Committees and Independent/Non-Executive Directors
d. The Role of Shareholders
B. Management Compensation
1. Competence of the Board of Directors
2. Is Management Compensation a Non-Transferable Duty of the Board of Directors?
3. Dealing with Conflicts of Interests
a. The Role of the Board of Directors, Compensation Committees, and Non-Executive and Independent Directors
b. The Role of Shareholders
C. Shareholders' Approval for Directors' and/or Management Compensation?
1. Recent Developments
2. Pros and Cons of Shareholders' Approval
V. CONCLUSION
A. The Design of Executive Compensation Arrangements
B. Competences in Executive Compensation
Chapter 3 Executive Compensation: Is Disclosure Enough?
I. PURPOSE OF EXECUTIVE COMPENSATION
A. Three Perspectives on Executive Compensation
1. Fairness
2. Agency
3. Intrinsic Motivation
B. Executive Compensation as a Source of Agency Conflicts
C. Risk Aversion and Non-Diversification of Managers
D. The Difficulty of Designing an Appropriate Compensation Scheme
II. GOVERNANCE OF EXECUTIVE COMPENSATION
A. The Bargaining Paradigm and its Shortcomings
1. Limited Decision-Making Power of Shareholders
2. Decision-Making Power of the Board of Directors
3. Shortcomings of the Bargaining Paradigm
a. Conflicts of Interest at Board Level
b. Influence of Management at Board Level
c. Lack of Emotional Independence
B. Corporate Governance Solutions
1. Improvements at Board Level
2. Control by Shareholders
a. Lack of Control by Vote
b. Control by Exit
c. Control by Courts
C. Conclusion
III. DISCLOSURE AND EXECUTIVE COMPENSATION
A. Is Disclosure a Solution to the Conflict of Interest?
1. The Swiss Regulatory Framework
2. The Substantive Shortcomings of the Swiss Regulatory Framework
a. Insufficient Disclosure of Deferred Compensation
b. Insufficient Disclosure of Stock Option Plans
c. No Disclosure of the Unwinding of Incentive Schemes
d. No Discussion or Analysis of Compensation Policy
3. Formal Shortcomings of the Regulatory Framework
B. Efficacy of Disclosure: The 'Spot the Compensation' Game
1. Transparency as a Source of Shareholder Empowerment
2. Transparency as a Cause of Inefficient Remuneration
a. In General
b. Perks
c. Options
d. Pension Funds
C. Transparency as a Problem
1. Political Costs of Transparency
2. The Lake Wobegon Effect: All Managers are above Average
3. Transparency as a Norm-Setting Mechanism
a. Economic Function of Social Norms
b. Transparency as a Norm-Creating Device
c. The Expressive Function of Codes of Best Practice
D. Conclusion
IV. REVISING THE GOVERNANCE OF EXECUTIVE COMPENSATION
A. Current Governance of Executive Compensation: Managers and Politicians
B. The Solution: Empower Shareholders
1. Put Shareholders at the Centre of the Debate
2. Shareholder Votes on Executive Compensation
V. CONCLUSION
Chapter 4 Executive Compensation and Analyst Guidance: The Link between CEO Pay and Expectations Management
I. INTRODUCTION
II. REVIEW OF THE LITERATURE
III. HYPOTHESES ON EXPECTATIONS MANAGEMENt AND EXECUTIVE COMPENSATION
IV. SAMPLE AND METHODOLOGY
A. Sample Selection
B. Sample Selection
C. Measuring CEO Compensation Components and Ownership Variables
D. Control Variables
E. Measuring the Impact of CEO Compensation on Expectations Management
V. RESULTS
A. CEO Compensation and Expectations Management
B. Sensitivity Tests
C. Does the Market Figure it Out?
VI. CONCLUSION
Chapter 5 Investment Research: How to Solve Conflicts of Interest More Efficiently
I. HOW SERIOUS ARE CONFLICTS OF INTERESTS - OR: WHY DID NO ONE CRY 'FOUL' UNTILAS RECENTLY AS 1999?
A. General
B. Did Sin Really Come So Late?
C. Why Attention Now and Not Then?
II. THE APPLICABLE SWISS RULES AS AN EXAMPLE OF HOW FINANCIAL ANALYST CONFLICTS OF INTEREST CAN BE ADDRESSED
A. Preliminary Remark: Conflicts of Interest in Connection with Financial Research are Only One Example of the Numerous Conflicts of Interests Within Banks
B. Basic Principles for Solving Conflicts of Interest in Swiss Law
1. Statutory Basis: Art. 11 (1) Stock Exchange Act
2. Assurance of Proper Business Conduct (Gewährspflicht): An Important Principle in the Management of Conflicts of Interest
C. Implementation of these Principles
1. Code of Conduct for Securities Dealers
2. Directives on the Independence of Financial Research
III. REGULATORS' TYPICAL APPROACH TO SOLVING CONFLICTS OF INTEREST
A. Overview
B. Instruments Most Often Used to Regulate Research Analysts' Conflicts of Interest
C. Conclusion: Three-pillar Approach
IV. POLICY THOUGHTS AND PROPOSALS
A. High Costs of Current Regulation
B. Four Policy Proposals
1. First Proposal: Replace Excessive Rule-based Separation Requirements by Escalating Measures
2. Second Proposal: Differentiate Between Institutional (Sophisticated) and Retail Investors
3. Third Proposal: Allow Reputation Cost to Work
4. Fourth Proposal: Reward Analysts for High Quality Work
Chapter 6 Do Conflicts of Interest Affect Analysts' Forecasts and Recommendations? A Survey
I. THE NATURE AND MAGNITUDE OF CONFLICTS OF INTEREST IN THE SECURITIES ANALYSIS INDUSTRY
A. Who are Financial Analysts and What Do They Do?
B. How Do Conflicts of Interest Arise?
C. Can Economic Incentives Mitigate Conflicts of Interest?
II. ANALYST FORECASTS AND RECOMMENDATIONS SURROUNDING STOCK ISSUES
A. Studies on Short-term Earnings Forecasts
B. Studies Focusing on Investment Recommendations
C. Studies Focusing on Long-term Earnings Growth Forecasts
III. THE MAGNITUDE OF THE OPTIMISM BIAS IN INVESTMENT BANK FORECASTS AND RECOMMENDATIONS
A. Who Produces Investment Research?
B. Studies Focusing on Short-term Earnings Forecasts
C. Studies Focusing on Investment Recommendations
IV. ADDITIONAL RESULTS RELATING TO ANALYST CONFLICTS OF INTEREST
A. Do Analysts Issue Biased Research in Order to Generate Trades?
B. Is the Market for Financial Research Segmented?
C. Do Upward Biased Forecasts Generate Business for Investment Banks?
V. DOES ANALYST REGULATION HELP MITIGATE CONFLICTS OF INTEREST?
A. The Main Features of the New Regulation
B. The Empirical Evidence Relating to the New Regulations
VI. CONCLUSION
Chapter 7 Regulation of Financial Analysts: An Illustration of the Current Trends in Financial Market Law
I. ABSTRACT
II. FORMAL ELEMENTS
A. 'Regulatory Shower'
B. Reactive Regulation
C. Over-Regulation?
D. Self-Regulation
III. MATERIAL ELEMENTS
A. Inter-Regulation
B. Threefold Objective
C. Function Versus Institution
D. Disclosure
Chapter 8 Conflicts of Interest in Research: Independence of Financial Analysts - The Costs and Benefits of Regulation
I. INTRODUCTION
A. History
B. Why is There Still Research?
C. Effect of Increased Costs on Research
1. Analysis of Costs
2. Analysis of Potential Benefits
II. OUR SURVEY ON CONFLICTS OF INTEREST IN RESEARCH
A. The Questionnaire for Portfolio Managers
1. General Questions About the Interviewee and the Employer
2. Disclosure Requirements
3. Proprietary Trading by Financial Analysts
4. Independence of Research
5. Value of Research
6. General Questions
7. Additional Questions
B. The Questionnaire for Financial Analysts
1. General Questions About the Interviewee and the Employer
2. Additional Working Time and Effort Due to the Directives
3. Material, Non-Public Information
4. Proprietary Trading by Financial Analysts
5. Attractiveness of the Profession
6. Quality of Research from the Analysts' Viewpoint
7. General Questions
8. Additional Questions
C. Conclusion of the Questionnaire
III. TABLES
Table 1. Questionnaire for Portfolio Managers
Table 2. Disclosure Requirements
Table 3. Proprietary Trading by Financial Analysts
Table 4. Independence of Research
Table 5. Value of Research
Table 6. General Questions
Table 7. Additional Question
Table 8. Questionnaire for Financial Analysts
Table 9. Additional Effort Due to the Directives
Table 10. Material, Non-public Information
Table 11. Proprietary Trading by Financial Analysts
Table 12. Attractiveness of the Profession
Table 13. Quality of Research from the Point of View of Analysts
Table 14. General Questions
Table 15. Additional Questions
Chapter 9 Conflicts of Interest, Especially in Asset Management
I. CONFLICTS OF INTEREST ARE INEVITABLE IN FINANCIAL SERVICES
II. PROVISIONS IN THE EU DIRECTIVES DEALING WITH CONFLICTS OF INTEREST
III. WHY WORRY ABOUT CONFLICTS OF INTEREST IN FINANCIAL SERVICES, ESPECIALLY ASSET MANAGEMENT?
IV. STRUCTURAL ASPECTS OF CONFLICTS OF INTEREST IN THE FIELD OF ASSET MANAGEMENT
A. Regulation
B. Factual Developments
Chapter 10 Conflicts of Interest in Institutional Asset Management: Is the EU Regulatory Approach Adequate?
I. CONFLICTS OF INTEREST IN GENERAL
A. Conflicts of Interest as a Legal Concept
B. Conflicts of Interest as an Economic Agency Problem
II. CONFLICTS OF INTEREST IN ASSET MANAGEMENT
A. The Inevitability of Conflicts of Interest in Institutional Asset Management
B. Possible Conflicts of Interest for Portfolio Managers
1. Conflicts Because the Manager has Several Clients
2. Conflicts Because the Manager Also Offers Other Services
3. Conflicts Because the Manager has a Stake in the Consequences of Transactions
C. Resulting Agency Costs for Asset Management
1. Adverse Impact on the Interests of the (Small?) Investor
2. Undermining Capital Market Integrity
3. Suboptimal Asset Management Market Efficiency
III. LEGALAPPROACHES TO CONFLICTS OF INTEREST IN ASSET MANAGEMENT
A. Imposing Fiduciary Duties
B. Regulatory Conduct of Business Rules
1. A Regulatory General Standard of Loyalty
2. Imposing Specific Rules for Asset Management Services?
3. Specific Requirements of Suitability of Investment Decisions
4. Client Order Handling Rules
C. Specific Measures to Tackle Conflicts of Interest
1. Which Conflicts of Interest?
2. Structural and Organizational Measures
3. Disclosure Requirements
IV. SOME CONCLUDING REMARKS
Chapter 11 Conflicts of Interest in the Distribution of Investment Funds
I. GENERAL CONTEXT
II. REMUNERATION OF FUND DISTRIBUTORS - AN OVERVIEW
III. CONFLICTS OF INTERESTAT TWO LEVELS
A. Fund Providers
1. Duty of Loyalty
2. Retrocession Paid by Fund Providers on the Management Fee
3. Retrocession Paid by Fund Providers on Entry Fees
B. Fund Distributors
1. Duty of Loyalty
2. Retrocession Received by Fund Distributors
IV. POSSIBLE SOLUTIONS
A. Prohibiting Retrocessions
B. Regulating the Level of Retrocessions
C. Disclosing Retrocessions to Investors
V. THE CASE FOR DISCLOSURE
VI. THE CASE AGAINST DISCLOSURE
VII. WHO IS TO DISCLOSE WHAT, WHEN, AND HOW?
VIII. IS DISCLOSURE ENOUGH?
Chapter 12 United States Mutual Fund Investors, Their Managers and Distributors
I. CONFLICTS OF INTEREST IN THE UNITED STATES: WHAT THEY MEAN AND WHEN THEY MATTER
A. When Does Fiduciary Law Arise?
1. The Issue of the Fiduciaries' Fees
2. The Contest of Categories
3. The Prohibition on Conflicts of Interest
II. AN OVERVIEW OF MUTUAL FUNDS AND THEIR PROMOTERS
A. The Two Parental Promoters
B. The Structure of United States Mutual Funds and the Managers' Role, Status, and Incentives
1. Managers' Incentives Focus on the Sale of Their Mutual Funds Shares, as Compared to Trustees of Private Trusts
C. The Managers Manage Funds as Chief Executive Officers Manage Corporations
D. Solicitors
E. The Distributors' Role, Status and Incentives
F. Distributors' Compensation
G. The Alliance: What Managers Want From Distributors and What Distributors Want in Return
H. Give-Ups and Their Evolution
1. Revenue Sharing
III. MANAGERS AND INVESTORS' CONFLICTS OF INTEREST: THE SALE OF FUND SECURITIES AND ALLOCATION OF FUND BROKERAGE BUSINESS
A. Misappropriation of the Discounts
B. Poor Execution of Trades
C. Increased Turnover (Churning)
D. Disadvantages of Fund Size
E. Misappropriation of Economies of Scale
F. Even Direct Cash to Distributors Comes from the Investors' Pockets
G. Opening the Doors to Other Abuses: The Issue of Culture
H. The Law's Response
I. Another Crack in the Wall: Permissible Soft Dollars Arrangements
J. The Dilemma: The Commodity Contract Approach
1. One Case
IV. THEORETICAL MODELS FOR MANAGERS TO ADDRESS MANAGERS' CONFLICTS OF INTEREST
A. What is Wrong with Rewarding Managers with Benefits from Their Control over Investors' Money?
B. The Disclosure and Implied Consent Solution
C. Mutual Funds as Businesses
D. Theoretical Frames for Remedies on Conflicts of Interest
E. Mutual Funds Regulation Adopted Both Responses to Conflicts of Interest
F. The Change in Judicial Interpretation of Statutes
G. The Puzzle and the Danger
H. Is the Concern About Conflicts of Interests Described in This Paper Exaggerated?
I. The Issue of Culture
V. CONCLUSION
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