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Speech by SEC Staff:
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This was prepared for the Distinguished Lunch Speaker address on April 1, 2005 at the Sixth Maryland Finance Symposium, "Governance, Markets, and Financial Policy" at the University of Maryland in College Park. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff. |
It's a real pleasure to speak at today's lunch at this interesting academic conference on "Governance, Markets, and Financial Policy" before so many old friends. I'd like to thank Lemma, Haluk and their colleagues at the University of Maryland and on the Program Committee for the invitation to speak this afternoon.
Today, I would like to use some of my experiences and observations from my service over the last nine months as Chief Economist of the Securities and Exchange Commission to examine the power of economic thinking for understanding the context and tradeoffs associated with a number of regulatory issues. In particular, I want to highlight the power of economic principles for assessing and understanding issues that are in the policy domain and some of the surprising ways in which economics sheds light on these contexts. At the onset of my remarks I should emphasize, that of course, the views and perspectives that I am expressing today are my own and not those of the Commission or my colleagues on the staff.
Given the overall focus and themes of this excellent conference, my examples will reflect a number of issues related to corporation finance and mutual funds rather than issues involving the market microstructure of security markets, which clearly also are of important interest and attention at the Commission. The main ideas and principles that I wish to emphasize in my remarks are basic price theory principles that are fundamental to microeconomics, the nature of financial options and options pricing frameworks, and the power of agency theory for understanding conflicting incentives among the parties in various financial contexts.
I'd like to begin with the example of the expensing of employee stock options. This has been highly contentious issue, particularly among companies for whom stock option grants represent a substantial portion of the effective cost of employee compensation. While the Commission's regulatory role on this issue is only indirect, it's been a subject of considerable attention within the Office of Economic Analysis because of the expertise of our staff in the valuation of options and financial instruments more broadly. We recently provided on the SEC web site an "Economic Perspective" on option expensing in conjunction with the Staff Accounting Bulletin developed by the Commission's Chief Accountant.1 As you may or may not know, the Office of Economic Analysis is the chief advisor to the Commission and the SEC staff on all economic issues associated with the SEC's responsibilities.
The principles of microeconomics help inform an understanding of this context and some of the arguments being advanced. For example, some distinguished critics of options expensing have even suggested that expensing is unnecessary and incorrect because the proper impact of the employee stock options on financial statements is solely through the potential dilution created by options, which already is reflected on the balance sheet. I certainly agree with such observers that (a) the adjustment for potential dilution would be sufficient if the options were purchased from the firm and also that (b) such an adjustment is still relevant for employee stock options. However, I disagree with the interpretation of those observers that expensing is not necessary to capture the impact of employee stock options on the firm's financial situation. The current accounting for dilution is not sufficient to reveal the expense.
Of course, in the case of employee stock options the value of the grant is potentially a significant portion of the employee's compensation package and based upon the arguments of companies that utilize such programs, crucial to employee retention. But then the expensing of employee stock options is important to ensuring the comparability of the anticipated costs of firms that compensate heavily by the use of options and those that use options only to a limited degree.
Interestingly, some firms that extensively use options suggest that it is difficult to assess the cost of these options at the time of the grant. This is an interesting argument, though it does raise the question of how a firm can be comfortable that it is meeting its fiduciary responsibility to its shareholders when a substantial portion of its compensation is paid through a tool whose anticipated cost it does not understand and cannot quantify. If managers are acting in the best interests of investors, we would expect firms to use compensation tools whose costs they clearly understand and can internalize and that tools whose anticipated cost cannot be identified at the time of the grant would not be attractive. Indeed, some firms who are large users of options are among the strongest critics of the adequacy of existing modeling tools for employee stock option valuation.
Many of the firms that extensively utilize options focus upon the valuation of the option to the employees and point to valuation approaches that emphasize the impact of the employee's risk aversion and barriers to the transferability of the option. Of course, the main goals of disclosure focus upon properly assessing the firm's cost rather than assessing the benefit derived by the employees and therefore, the valuation to be disclosed should reflect the firm's costs rather than the potentially lower benefit derived by a risk--averse employee. I do agree that employee risk aversion and barriers to transferability will influence the exercise decisions of the employees and therefore, need to be reflected in the valuation. However, as has been argued in the academic literature, the adjustment for the anticipated exercise experience is the manner by which the restrictions imposed upon the option holder and his risk aversion influence the valuation.2 To further adjust would constituent double counting the effect. However, this facet of the debate raises a further question-if the firms using options feel that the valuation to the employee is substantially less than the cost to the firm in light of employee risk aversion, then why is it efficient to compensate employees in this form rather than others in which the differential between the benefit to the employee and the cost to the firm is not as large?
Thus far, my comments about employee stock options have been framed in terms of basic economic principles and some reflections upon the arguments being brought to bear in the broader debate. I also think that it is helpful to make a few observations about the modeling of employee stock options. While the employee's stock option is not hedgable and most employees are risk averse, the valuation cost to the employer of the resulting liability can potentially be assessed. One method of valuing employee stock options is clear from the history of the market for mortgage-backed securities. This analogy is instructive because of the lack of transferability of the mortgage obligation and the importance of the mortgage borrower's risk preferences. The tools for developing the valuation of mortgage-backed securities were developed decades ago3 and in recent years a number of interesting papers explore the valuation of employee stock options.4 Interesting predictions about exercise and forfeiture behavior can be obtained from the mortgage-backed securities perspective and the use of arbitrage principles5 and the valuation tools of modern financial economics can be adapted to the employee stock option context.
However, despite these observations about employee stock option modeling I don't want to suggest that firms necessarily need to rely upon models to determine the valuation of their employee stock options. A few alternatives have been suggested that attempt to develop instruments that would replicate the valuation of these options from the perspective of a market instrument. Issuers may indeed benefit from efforts to construct marketed instruments that replicate the cash flows and valuations of employee stock options. Of course, it would be important for the instrument and the associated market process to be properly designed. Ultimately, the development of such markets and the potential availability of the underlying prepayment data and the market prices of these instruments would lead to further refinement of the underlying valuation models and provide benefits even beyond the specific issuer structuring such transactions.
Surprisingly, valuation analyses are quite powerful in a number of regulatory contexts. Obviously, the case of employee stock option valuation is an important illustrative example. Two additional examples for which I would likely to briefly comment are (a) pension expensing and (b) mutual valuation, market timing and late trading.
Pension expensing shares a number of elements in common with options expensing. While the accounting treatment for pension expense is rather intricate, the relevant financial and economic principles seem relatively straightforward, but powerful. Of course, financial theory emphasizes the comparison between the present value of the pension plan's liabilities and the market value of its assets and unlike the accounting treatment, does not introduce a hypothetical, but somewhat arbitrary, expected return on the assets. Pension plan assets share some elements in common with an asset with which many of you are quite familiar, university endowments.
The example of mutual fund valuation is also an important one in the wake of the market timing and late trading scandals in recent years. In situations in which many of the underlying asset prices are stale, financial theory offers considerable guidance for understanding the underlying timing option and provides proper valuation guidance. Analogously, it helps identify the types of situations in which timers would be likely to try to exploit staleness as well as the costs borne by passive investors.
Of course, as economists and students of markets we recognize and appreciate the value of information. Nevertheless, information is not the typical commodity. Indeed, it is an unusually awkward commodity from an economist's perspective in that it can be difficult for an information provider to price his services or even to identify a viable strategy for getting paid. At the root of this problem is traditional perspective in modern economics that information is a public good in that, like the building of a road or police and fire protections, its benefits can be consumed by many individuals simultaneously, so that it is not efficient to exclude individuals from its benefits. A direct consequence of the difficulty of excluding users from the benefits of information and the limited cost associated with the distribution of information relative to its production, the pricing of information for individual users is delicate. Consequently, information, like other public goods, can be under-provided absent an explicit pricing or institutional mechanism to overcome these issues.
With that introduction to the pricing of information, I think it useful to briefly discuss several market approaches to the pricing of information. The examples I will highlight are the services of equity analysts both in the context of "soft dollars" and the IPO process as well as the pricing of the services of credit rating agencies. While in each of these issuances various potential conflicts of interest have been widely identified and discussed, I think it is instructive to step back and reflect upon the nature of the underlying pricing model for informational services and the delicate nature of the economic viability of such products.
Because of the difficulty in getting investors to pay for research, issuers may stimulate research on their securities by paying for such research. Examples of this include the willingness of issuers to pay credit-rating firms and the importance of analyst coverage to issuers of IPOs. One context where asset managers are willing to pay for research is when the payment uses soft dollars that are generated as a byproduct of commissions. Notice that the soft dollars are really paid directly by the investors rather than by the advisor as the commissions are directly charged to the investors unlike direct payments for research, encouraging the advisor to purchase additional research. Of course, this is related to agency concerns with soft dollars and commissions.
Also, note that analysts and research can be supported by alternative models of bundling. On the one hand, the "IPO model" uses the sell side to "bundle" the distribution of securities with sell-side analysts and research. On the other hand, the "soft dollar model" bundles the payments of commissions, i.e., transactional services, with support for desired analysts. I should note that as finance professors we are familiar with the difficulty our universities face in getting paid directly for financial research, so they "bundle" research and education, potentially using tuition payments to help support the research enterprise. To some degree we can view the IPO mechanism and soft dollars as alternative mechanisms to help support research and as substitutes for one another. This illustrates how we can view the mechanism used to fund research as consistent with the inadequacy of the direct payment for research model.
This portion of the example illustrates that trying to remove all potential conflicts of interest may not be optimal if there are other frictions in the environment. At the core of this is the classic "public goods" nature of research, which is not an easy problem to remedy. While bundling is an attempt to resolve the public goods problem for funding research, the bundling approach itself can distort marginal incentives and leads to inefficiency. In both the IPO and soft dollar settings, this has been the subject of considerable attention in recent years. Yet because of the underlying public goods problem associated with paying for research, any attempts to address the agency problem underlying the IPO mechanism or soft dollars must be intertwined and recognize the difficulty of funding research by alternative routes.
On a prior occasion6 I spoke about the pricing of the services of credit rating agencies. Some of the source of value from the perspectives of credit rating agencies is the use of the ratings for various regulatory purposes. However, this requires that the ratings are widely available. This is not compatible with excluding users and charging the users for ratings. Instead, the approach of the credit rating agencies is to charge companies for rating their instruments, which is a natural approach for dealing with the exclusion problem. There is considerable demand by listed companies to have their companies rated. Consequently, the rating service is able to contract with and charge companies in return for rating their issues and exclude from ratings those companies that do not pay. However, curiously, the bond-rating services also evaluate companies who do not pay for a rating, providing "unsolicited" ratings. From an incentive compatibility perspective this would appear to weaken the incentive constraint that encourages a firm to pay for being rated. After all, if the firm might be rated anyway, then the incentive to purchase a rating would be reduced. If the rating services evaluated non-paying companies that would undermine the ability of the rating service to charge the rated companies, at least if the rating provided were equivalent for a company that pays the rating service and one that decides not to pay. This suggests that it is puzzling that the rating services evaluate companies that do not pay for ratings. To emphasize the point, note that this puzzle does not require that the unsolicited rating is costly for the rating agency to provide and in fact, would be reinforced by assuming that such evaluations are costly.
The most natural way to resolve the puzzle to an economic theorist would be if the unsolicited ratings were not as favorable to the rated company as the paid or solicited ratings. Indeed, unsolicited ratings do not appear to be as favorable empirically as solicited ratings.7 The systematic downward bias in unsolicited ratings compared to solicited ratings for the same firm together with the basic use of unsolicited ratings are consistent with the interpretation that the rating process is being used, in the language of game theorists, to "punish" firms that would otherwise not purchase ratings coverage from a particular credit-rating service. Of course, as game theorists recognize punishment can be credible and affect the incentives to purchase ratings, even if the punishment is not widely undertaken. I should note that a much more benign interpretation for the lower unsolicited ratings is that these reflect the probability of default and that in some cases the evaluation underlying the unsolicited rating relies upon considerable pooling because of the lack of access to "soft information." However, this does not resolve the questions as to why there are unsolicited ratings and why the firm being evaluated would not offer the soft information if it were comfortable with the fairness of the unsolicited rating.
A subject of considerable popular interest is the issue of Executive Compensation. The current structure of disclosure does not provide complete clarity about the nature or magnitude of executive compensation-disclosure about these aspects of the firm may shed considerable light on decision-making within the firm. In fact, I anticipate that the development of frameworks for employee stock options expensing could enhance the quality of compensation disclosure.
In a keynote address that I gave at a conference a few months ago8 I provided a number of perspectives about the reasons for very high levels of executive compensation. For example, I noted that leisure is a normal good so that successful individuals need to be induced to work hard. I also noted that higher wealth can increase the manager's willingness to bear risk because of decreasing absolute risk aversion. Of course, even more directly incentive compensation increases the incentive to bear risk and helps overcome the manager's inherent risk aversion and limited wealth. Yet I don't think that it is especially surprising that the senior executive shares only a limited portion of the firm's risk.9 This is a direct consequence of managerial risk aversion, i.e., limited liability and the executive's limited wealth relative to the capital market, as a whole, as well as the need to provide incentives to other key personnel. The issue of executive compensation also should be assessed within a broader landscape identified through agency theory, emphasizing the process by which senior executive compensation is determined and examining the role of the board and external compensation consultants as also noted by Professor Michael Jensen in his keynote address last night, including the adequacy and thoughtfulness of the benchmarking process for compensation determination.
Agency theory offers a valuable lens for assessing many regulatory issues. It provides a framework for identifying the potential differences in incentives among the parties to an economic situation. I have highlighted earlier its application to the executive compensation issue, but it is also highly relevant to a number of aspects of asset management and investment. In fact, in various contexts in which products are bundled there are important potential agency conflicts. The recommendations of analysts, the incentives to elect soft dollars rather than reduced commissions and the allocation of IP0s to valuable clients are examples of the types of issues in which there are strong conflicts of incentives in the investment banking and trading processes. Various types of intermediaries, such as pension consultants, credit rating agencies, governance experts and investment advisors are simultaneously entering into business transactions with different portions of the financial network. On the one hand, this naturally leverages and develops the expertise and comparative advantages of the parties, but does leave the system vulnerable to potential conflicts of interest.
In the asset management process itself there are strong potential conflicts that arise because of the inherent nature of the fee and compensation relationship, the differences in risk-bearing capacity between the investor and manager and the differential importance to the agent / portfolio manager of the multiple principals that he faces. For example, in the investment management process the allocation of hot IPOs by a mutual fund, exploiting implicit "lookback" options when trades are not completely allocated in a timely fashion and trading for some accounts ahead of others to either front run or reduce price impact are examples of the types of problems that can arise. In fact, agency conflicts extend all the way through the distribution stream as a broker's or advisor's compensation structure influences the nature of his recommendations among investment vehicles. Empirical research has been valuable in identifying a number of facets of the agency problem in asset management.10
As an economist, I also should emphasize that the existence of natural conflicts in incentives does not necessarily imply a breech of duty or responsibility by the agent or "wrongdoing," but I do think the lens of agency theory certainly augments our understanding of investment management behavior and in some situations can help identify behavior that is problematic.
To summarize, as I think you can see, the skills and perspectives of economic and financial theory can provide a valuable lens for evaluation of important facets of various regulatory contexts and debates and illustrate the power of economic thinking about particular regulatory issues. Quite often the principles of the economics discipline apply in surprising ways in the regulatory arena.
I should note that the broad regulatory approach and framework of the Securities and Exchange Commission has historically emphasized "disclosure." This is a very attractive approach from an economist's perspective-it emphasizes the importance of requiring the disclosure of the relevant information and allowing the operation of market incentives and consequences.
I welcome your questions, both about my remarks and experiences.
Bettis, J.C., J. Bizjak, and M. Lemmon, 2005, "Exercise Behavior, Valuation, and the Incentive Effects of Employee Stock Options," Journal of Financial Economics, forthcoming.
Butler, A. and K. Rodgers, June 2003, "Relationship Rating: How do Bond Rating Agencies Process Information?" unpublished manuscript.
Byoun, S and Y. Shin, October 2002, "Unsolicited Credit Ratings: Theory and Empirical Analysis," unpublished manuscript.
Carpenter, J., 1998, "The Exercise and Valuation of Executive Stock Options," Journal of Financial Economics 48, 127-158.
Dunn, K. and J. McConnell, 1981, "Valuation of GNMA Mortgage-Backed Securities," Journal of Finance 36, 599-616.
Dunn, K. and C. Spatt, 1999, "Call Options, Points and Dominance Restrictions on Debt Contracts," Journal of Finance 54, 2317-2337.
Jensen, M. and K. Murphy, 1990, "Performance Pay and Top-Management Incentives," Journal of Political Economy 98, 225-264.
Klein, A., November 24, 2004, "Credit Raters' Power Leads to Some Abuses, Some Borrowers Say," Washington Post, p. A01.
Marquardt, C., 2002, "The Cost of Employee Stock Option Grants: An Empirical Analysis," Journal of Accounting Research 40, 1191-1217.
Massa, M., Matos, P., and J. Gaspar, 2005, "Favoritism in Mutual Fund Families? Evidence on Strategic Cross-Fund Subsidization," Journal of Finance, forthcoming.
Merton, R., 1973, "Theory of Rational Option Pricing," Bell Journal of Economics and Management Science, 4, 141-183.
Richard, S. and R. Roll, 1989, "Prepayments on Fixed Rate Mortgage-Backed Securities," Journal of Portfolio Management 15, 73-82.
Securities and Exchange Commission, Office of Economic Analysis Memorandum, "Economic Perspective on Employee Stock Option Expensing: Valuation and Implementation of FAS 123(R)," March 18, 2005. http://www.sec.gov/interps/account/secoeamemo032905.pdf
Securities and Exchange Commission, Staff Accounting Bulletin No. 107, March 29, 2005. http://www.sec.gov/interps/account/sab107.pdf
Spatt, C., "Executive Compensation and Contracting," keynote address presented at the Ohio State-Federal Reserve Bank of New York-Journal of Financial Economics Conference on "Agency Problems and Conflict of Interest in Financial Intermediaries" in Columbus on December 3, 2004. http://www.sec.gov/news/speech/spch120304cs.htm
Spatt, C., "Frictions in the Bond Market," keynote address presented at the Second MTS Conference on "Financial Markets: The Organization and Performance of Fixed-Income Markets" in Vienna, Dec. 16, 2004. http://www.sec.gov/news/speech/spch121604cs.htm
http://www.sec.gov/news/speech/spch040105css.htm
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