Corporate Governance Failures

Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis

James P. Hawley
Shyam J. Kamath
Andrew T. Williams
Copyright Date: 2011
Pages: 352
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  • Book Info
    Corporate Governance Failures
    Book Description:

    Corporate governance, the internal policies and leadership that guide the actions of corporations, played a major part in the recent global financial crisis. While much blame has been targeted at compensation arrangements that rewarded extreme risk-taking but did not punish failure, the performance of large, supposedly sophisticated institutional investors in this crisis has gone for the most part unexamined. Shareholding organizations, such as pension funds and mutual funds, hold considerable sway over the financial industry from Wall Street to the City of London. Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis exposes the misdeeds and lapses of these institutional investors leading up to the recent economic meltdown. In this collection of original essays, edited by pioneers in the field of fiduciary capitalism, top legal and financial practitioners and researchers discuss detrimental actions and inaction of institutional investors. Corporate Governance Failures reveals how these organizations exposed themselves and their clientele to extremely complex financial instruments, such as credit default swaps, through investments in hedge and private equity funds as well as more traditional equity investments in large financial institutions. The book's contributors critique fund executives for tolerating the "pursuit of alpha" culture that led managers to pursue risky financial strategies in hopes of outperforming the market. The volume also points out how and why institutional investors failed to effectively monitor such volatile investments, ignoring relatively well-established corporate governance principles and best practices. Along with detailed investigations of institutional investor missteps, Corporate Governance Failures offers nuanced and realistic proposals to mitigate future financial pitfalls. This volume provides fresh perspectives on ways institutional investors can best act as gatekeepers and promote responsible investment.

    eISBN: 978-0-8122-0464-3
    Subjects: Finance

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. Chapter 1 Introduction
    (pp. 1-25)
    James P. Hawley, Shyam J. Kamath and Andrew T. Williams

    In late 2008 and early 2009, the subject of financial risk was widely debated and discussed among academics and practitioners, in the business press and on blogs, and among the general public, as well as in the U.S. Congress and parliaments abroad. Yet some of us were struck by how little serious attention (indeed, how little attention of any sort) was being paid to the relation of corporate governance to financial risk, especially the role (or lack thereof) of large institutional investors who have dominated corporate governance activities globally over the past two decades or so.

    Institutional investors (public and...

  4. Chapter 2 Beyond Risk: Notes Toward a Responsible Investment Theory
    (pp. 26-51)
    Steve Lydenberg

    This chapter argues that today’s dominant theory of investment, modern portfolio theory (MPT), is based on a definition of success that fails to acknowledge adequately the extent to which investments at the portfolio level can affect the overall financial markets. In particular, its techniques intended to control risks at the portfolio level while maximizing returns—such as diversification, securitization, hedging, arbitrage, and leverage—can create market-level risks that threaten financial and economic stability.

    The portfolio-level benefits that accrue from this theory are by definition part of a zero-sum game at best and available to only a limited number of investors....

  5. Chapter 3 The Quality of Corporate Governance Within Financial Firms in Stressed Markets
    (pp. 52-82)
    Robert Mark

    The recent financial crisis has caused internal and external corporate stakeholders to increase their scrutiny of the quality of corporate governance within financial firms in stressed markets. This scrutiny includes examining the impact that financial models, financial products (e.g., credit default swaps), and business operating styles (e.g., the amount of financial leverage) have on managing and hedging risk.¹ The financial crisis has also raised issues on how the individual objectives of firms on Wall Street are harmonized to achieve broader societal goals (e.g., increased home ownership).

    The risk governance objective of a chief risk officer (CRO) in financial firms is...

  6. Chapter 4 Chasing Alpha: An Ideological Explanation of the Catastrophic Failure in the U.K.’s Financial Services Industry
    (pp. 83-96)
    Philip Augar

    “Alpha” is shorthand in the City of London for supercharged profit, and “chasing alpha” is what Britain’s bankers, investors, and corporate chief executives did in the last two decades of the twentieth century and the opening years of this millennium, culminating between 2003 and 2007 in an orgy of leverage and reckless growth plans.

    But to most participants and observers, the years 1997–2007 seemed to show that chasing alpha worked. By the year 2007, the U.K. had come to play a pivotal role in the global financial services industry. The financial districts of London—the Square Mile around the...

  7. Chapter 5 Corporate Governance, Risk Analysis, and the Financial Crisis: Did Universal Owners Contribute to the Crisis?
    (pp. 97-114)
    James P. Hawley

    My colleague Andrew Williams and I ended our book on fiduciary capitalism (published in 2000) by suggesting that a critical element in corporate governance was “who will watch the watchers?”—who will monitor the monitors? In light of the 2007–2010 financial and economic crises we should have added, “and for what will they monitor?” This chapter argues that overwhelmingly large institutional investors, including those centrally involved in “responsible investment” developments (most of which are universal owners—UOs),¹ failed to implement well-established corporate governance principles in most alternative investments (especially those directly and indirectly in the financial sector), and did...

  8. Chapter 6 Great Expectations: Institutional Investors, Executive Remuneration, and “Say on Pay”
    (pp. 115-143)
    Kym Sheehan

    The year 2009 was a watershed for the regulation of executive remuneration. Around the world, governments considered how best to regulate in light of evidence from the global financial crisis of a link between certain remuneration structures and excessive risk-taking.¹ Two clear categories of regulatory response emerge from this latest crisis. First, there is the local adoption of the Financial Stability Board’s Principles for Sound Compensation Practices.² Governments are translating these principles into national standards and allocating the monitoring task typically to the prudential regulator (the regulator with primary responsibility for ensuring financial stability).

    The second pattern of regulatory responses...

  9. Chapter 7 Against Stupidity, the Gods Themselves Contend in Vain: The Limits of Corporate Governance in Dealing with Asset Bubbles
    (pp. 144-164)
    Bruce Dravis

    Existing laws on governance are aimed at preventing managers from abusing the resources that investors have committed to business institutions, by requiring corporate processes intended to detect and prevent misuse of those resources. The law does not require managers to maximize corporate resources. The law does not, and cannot, dictate outcomes of management decisions. The law does not, and, for the policy reasons discussed in the extensive case law precedents on the business judgment rule, should not, make managers guarantors of results.

    But to investors who lost billions of dollars in the 2007–2008 financial crisis resulting from the sudden...

  10. Chapter 8 Real Estate, Governance, and the Global Economic Crisis
    (pp. 165-187)
    Piet Eichholtz, Nils Kok and Erkan Yonder

    The real estate market played an important role in the current economic crisis. Investors’ bullish perspectives regarding the residential and commercial property markets not only allowed borrowers access to cheap and almost unlimited credit but also offered the possibility of raising large amounts of equity on the public capital markets. However, when the property boom eventually came to an end, this changed the situation with regard to these investments rapidly and fundamentally.

    In retrospect, the recent crisis is to a large extent a governance crisis, in which the lack of transparency of securitized products, such as mortgagebased securities (MBS), collateralized...

  11. Chapter 9 The Sophisticated Investor and the Global Financial Crisis
    (pp. 188-216)
    Jennifer S. Taub

    The financial instruments and risky practices that caused the global financial crisis of 2008 were enabled by decades of deregulation and anemic government enforcement efforts. The elements that combined to create the crisis were subprime mortgage securities, credit default swaps, highly leveraged hedge funds, and excessive short-term borrowing at investment banks.¹ They flourished without government oversight, transparency, or limits because proponents contended that “private ordering” of financial markets, instead of government intervention, was ideal. The champions of private ordering contended government interference was inappropriate for sophisticated investors (SIs) who had the expertise and incentives to properly assess risk, and to...

  12. Chapter 10 The Role of Investment Consultants in Transforming Pension Fund Decision Making: The Integration of Environmental, Social, and Governance Considerations into Corporate Valuation
    (pp. 217-241)
    Eric R. W. Knight and Adam D. Dixon

    The global financial crisis of late 2007 and beyond is arguably the most severe financial crisis since the Great Depression. A number of the world’s leading financial institutions have either gone bust or been bailed out by government, global capital markets remain in a climate of unease and limited confidence, and governments around the world had to return to Keynesian pump-priming fiscal policies to stimulate domestic economies into action and salvage the financial sector.

    The scope and scale of this crisis has encouraged academics to reflect on what went wrong. While it is popular for journalists to lay blame on...

  13. Chapter 11 Funding Climate Change: How Pension Fund Fiduciary Duty Masks Trustee Inertia and Short-Termism
    (pp. 242-278)
    Claire Woods

    On January 27, 2010, the U.S. Securities and Exchange Commission (SEC) voted to provide guidance on when public companies should disclose the impact of climate change-related business or legal developments. While the SEC’s guidance does not constitute a legal change, it underlines more powerfully than ever that climate change is a risk that investors cannot ignore. Institutional investors, with their broad exposure to systemic risk, should be particularly alert to the implications of this new development. Pension funds control, on average, assets equivalent to 76 percent of the GDP of their respective countries throughout the Western world.¹ In 2006, U.S.pension...

  14. Notes
    (pp. 279-334)
  15. List of Contributors
    (pp. 335-336)
  16. Index
    (pp. 337-342)
  17. Acknowledgments
    (pp. 343-344)