Articles / Interesting Case of the Month
Why Do Companies Turn Down Profitable Investments?:
Reported in Kellogg Insight, a team of faculty and researchers exploring company investment decisions found that companies are acting contrary to “classical corporate finance theory,” and as a result often turn down profitable investment opportunities. As they note in the introduction to their research report,
“According to classical corporate finance theory, [the “threshold question: how profitable must an investment be in order to pull the trigger?”] — often known as a hurdle or discount rate — ought to be pretty close to what an investor could earn putting the money toward a different project with comparable risk.
Based on that theory, one would expect company investment decisions to be consistent based upon the applicable risk. The researchers’ findings, however, proved otherwise. Firms in fact used “more conservative criteria for funding new investments—turning down investment opportunities that would be profitable when evaluated on a stand-alone basis.”
The researchers were able to link 127 survey responses to specific companies, and then compare these companies’ average discount rate for taking on a new project compared to their average cost of capital. What they found is that “the average cost of financial capital for these firms was about 8%, [while] their average discount rate for taking on a new project was 15%.”
Why the discrepancy? The researchers’ answer – “In a word: bandwidth. New investments require more than just dollars—they require managerial oversight, as well as onboarding additional employees and training new parts of the organization to work together.”
Interestingly, the researchers also found that that “cash-rich firms have the most conservative thresholds of all.”
“‘Firms that hold a lot of cash are often growth firms. They hold cash because they expect to have a lot of investment options.’ . . .These firms ‘have the flexibility to wait and take the best projects’ [say the researchers].
This actually puts them in the best position to pass up lesser, though still profitable, investments. ‘Then, when the right opportunity comes, they’re able to move in fast.’”
The research revealed another trend that was contrary to theory: “firms are more wary of taking on risk that is specific to their firm, or idiosyncratic, versus risk that is spread across the entire market, or systematic.”
“A firm should theoretically prefer to take on projects heavy in idiosyncratic risk, because its shareholders can diversify their portfolios, mitigating the risk. ‘Think about Boeing and McDonnell Douglas bidding on defense contracts. One of them will get it and the other won’t. If you hold both the companies’ stocks, you’re indifferent,’ says [the research team’s lead author].
Yet the researchers found that firms in fact avoid idiosyncratic risk. ‘The firms are using a higher discount rate when there’s more idiosyncratic risk.’
Why is this? One explanation is that the managers are actively avoiding idiosyncratic risk in an effort to preserve their own careers and reputations. After all, if Siri falls to Alexa, Apple’s management team looks bad. If both companies are hit hard by a recession, the blame is much harder to pin down.”
Research of Ravi Jagannathan, David A. Matsa, Iwan Meier and Veha Tarhan, “Why Do Companies Turn Down Profitable Investments? Limited organizational bandwidth can restrict managers’ options,” Kellogg Insight, July 6, 2017
Emoluments Clause Litigation:
In the April/May issue of this Newsletter, I presented several articles describing the litigation by Citizens for Responsibility and Ethics in Washington (“CREW”) asserting that Donald Trump has violated the emoluments clause of the constitution. For those who don’t recall or did not see that issue, CREW’s legal team comprises some of the country’s highest profile legal scholars, and includes as counsel on its complaint Laurence H. Tribe (Harvard Law School), Erwin Chemerinsky (Dean of the School of Law, University of California, Irvine), and Ambassador (Ret.) Norman L. Eisen. As I noted in May, “the CREW lawsuit is not an action brought by lightweights or some seeking a quick buck or their five minutes of fame.”
Since the publication of the April/May issue of this Newsletter, as most know, two additional suits have been filed by serious litigants: one by the attorneys general of Maryland and Washington, D.C., and one by nearly 200 congressional Democrats who argue that Trump is required to obtain congressional approval before accepting any gifts or compensation.
In Mid-June, government lawyers responded to the CREW complaint (yes – our tax-payor dollars are being used to pay Department of Justice lawyers to defined our president in these suits). The government’s arguments are interesting, hence I thought I’d present them to those who may be interested.
As I did in the prior edition, I’ll start by setting forth the actual language of the Constitution which is at issue. There are actually two emoluments clauses: one dealing with emoluments received from foreign entities, and one from domestic.
Beginning with the foreign emoluments clause, it is embedded in the section of the Constitution prohibiting the granting of titles of nobility. The entire clause (US Constitution, Article I, Section 9, Clause 8) states as follows:
No Title of Nobility shall be granted by the United States: And no Person holding any Office of Profit or Trust under them, shall, without the Consent of the Congress, accept of any present, Emolument, Office, or Title, of any kind whatever, from any King, Prince, or foreign State.
The domestic emoluments clause (US Constitution, Article II, Section 1, Clause 7) states:
The President shall, at stated Times, receive for his Services, a Compensation, which shall neither be increased nor diminished during the Period for which he shall have been elected, and he shall not receive within that Period any other Emolument from the United States, or any of them.
Nowhere in the Constitution is the word “emoluments” defined.
The Justice Department’s (DOJ) defense of our president begins by asserting technical arguments giving rise to a court’s power to adjudicate the dispute. The DOJ argues first that CREW has no provable injury, hence has no “actual case or controversy.” With respect to the indivudal plaintiffs in the CREW complaint (restaurant and hotel owners and workers who claim lost business), the DOJ asserts that those persons “failed to allege sufficient facts to support any non-speculative loss of business,” hence they too are barred from bringing the suit. Additionally, the DOJ argues
“[the plaintiffs’] claims are outside the Emoluments Clauses’ zone of interests because their asserted injuries—diversion of an advocacy organization’s resources and loss of restaurant or hotel business—are not what the Clauses are intended to protect.”
Further, in an obvious play to Scalia “originalist” legal thinkers, the DOJ states
“Plaintiffs’ expansive reading of the Emoluments Clauses is contrary to the original understanding of the Clauses and to historical practice. The term ‘Emolument’ in this context refers to benefits arising from personal service in an employment or equivalent relationship.”
Finally, the DOJ argues
“Given the President’s unique status in the constitutional scheme, the Framers envisioned only political means to ensure a President’s compliance with constitutional provisions such as the Emoluments Clauses, not official-capacity injunctions against the President.”
Regarding the technical arguments of “standing” and properly alleged claims for relief, I’ll leave those to the attorneys who may read the DOJ’s brief, which I’ve linked below. Of general interest, however, may be the DOJ’s arguments regarding the scope or applicability of the emoluments clauses. Per the DOJ:
“[T]he Emoluments Clauses apply only to the receipt of compensation for personal services and to the receipt of honors and gifts based on official position. They do not prohibit any company in which the President has any financial interest from doing business with any foreign, federal, or state instrumentality.
* * *
Neither the text nor the history of the Clauses shows that they were intended to reach benefits arising from a President’s private business pursuits having nothing to do with his office or personal service to a foreign power.”. . . Were Plaintiffs’ interpretation correct, Presidents from the very beginning of the Republic, including George Washington, would have received prohibited ‘emolument.’”
This commentator notes that the CREW complaint does not allege mere receipt of “benefits arising from a President’s private business pursuits having nothing to do with his office.” To the contrary, their complaint alleges
- After Trump was elected president, his Washington DC hotel hired a “director of diplomatic sales” to facilitate business with foreign states and their diplomats and agents, luring the director away from a competitor hotel in Washington.
- Diplomats and their agents have expressed an intention to stay at or hold events at Trump hotels because he is president, and in fact have done so. One “Middle Eastern diplomat” told the Washington Post about Trumps DC hotel: “Believe me, all the delegations will go there.” An “Asian diplomat” explained: “Why wouldn’t I stay at his hotel blocks from the White House, so I can tell the new president, ‘I love your new hotel!’ Isn’t it rude to come to his city and say, ‘I am staying at your competitor?’”
- Per the Wall Street Jounal, “Saudi Arabia, Kuwait, Turkey and other countries have held state-sponsored events at Trump’s D.C. hotel, and other entities associated with foreign governments lend money to his businesses or lease space in his properties.”
The Department of Justice’s Memorandum of Law in Support of Its Motion to Dismiss [the lawsuit filed by Citizens for Responsibility and Ethics in Washington], Filed in the US District Court for the Southern District of New York, Case # 17 Civ. 458 (RA), June 9, 2017
Jonathan O’Connell, “Foreign payments to Trump’s businesses are legally permitted, argues Justice Department,” Wall Street Journal, June 10, 2017
How Not to Get a Job:
Finally, to those who have young adult children or friends in the job market, I present an op/ed piece by Allan Ripp appearing in the New York Times. Ripp runs a PR firm and advertised for an account director position at his firm. He relates that his ad specifically stated that candidates were to contact him “only if they had backgrounds in journalism, P.R. or law.”
So, what were the backgrounds of the applicants who applied? Fragrance design. Home health aide. Bed-and-breakfast manager. Youth hockey coach. Why, he asks, did these people believe they were qualified to apply to his firm? Why didn’t “a single candidate bother to look us up and refer to what we do in the cover note?”
The piece is light-hearted, amusing, and yet instructive and to the point. By relating what not to do, he informs what to do. If you’ve a job-seeker in the family or among your friends, you may wish to read the piece and forward it along.
Allan Ripp, “How Not to Get a Job,” New York Times, July 7, 2017