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 Bradfordjim-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 HirtleJohn Hirtle

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.

Chester SpattChester Spatt

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 Damgarddufour-noll-overdahl-damgard-300x111

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 Cooperrick-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 TournamentJim Bradford

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