J. K. Dietrich - FBE 432 – Fall, 2002 Module VI: Corporate Governance Week 14 – November 25 and 27, 2002

J. K. Dietrich - FBE 432 – Fall, 2002

Module VI:Corporate Governance

Week 14 – November 25 and 27, 2002


Objectives

Place the issues raised concerning corporate governance into an analytical framework

Review the major issues concerning corporate governance – In the United States, considered a leader– Around the world, a hot issue– Raise considerations relevant to corporate

governance in practice Analyze concerns with insider trading


Preliminary: Theory and Practice

We have analyzed the implications of financial theory for corporate policies using cases– Valuation – Financing and dividend decisions– Investment

What are the underlying assumptions of micro-economic theory underlying finance?


Corporations’ Objective Function

Maximize shareholders’ wealth– Satisfactory for all equity investors– Must provide products wanted in the market place at

lowest costs and fewest resources (economic efficiency)

Other stakeholders benefit– Customers, employees, and vendors– Parties to contracts (e.g. creditors)– Tax authorities and communities


Efficient Markets Market participants absorb relevant

information concerning firms’ prospects and future government policies

Prices reflect the impact of this information– Types of information: past, public, private– Market imperfections and efficiency

Markets provide signals necessary for the efficient allocation of investment capital

Information is valuable and critical


Corporations and Stakeholders

Firm

Capital Markets Goods Markets

Shareholders

Creditors

Board of Directors

Management

Customers

Vendors

Government

Governance


Corporate Governance: U.S. Shareholders = Investors = Owners

– Private shareholders– Investors in public companies– Insiders: officers and directors

Directors– Fiduciary responsibility to shareholders– Legal liabilities: contracts, crimes, regulations,

securities laws, torts– D&O insurance


Boards of Directors Elected by shareholders to term in office Duty of care requires performance of duties

in good faith, acting like a prudent person, based on reasonable belief (Model Business Corporation Act, Section 8.30(a))

Independent versus inside directors Committee structure

– Audit committee– Compensation committee


Sarbanes-Oxley Act of 2002

Provisions affecting management– Boards must have audit committees with a

“financial expert”– Timely reporting of insider trading and

“material changes” Audit committees

– Receive adequate funding– Approve auditor non-audit services services


Sarbanes-Oxley Act (continued) Corporate officers

– Certify financial statements– Prohibited from misleading auditors

Accounting firms– Establishes a new oversight board– Registration of audit firms with SEC– Restriction on accepting employment with

audited firms (one year)


GE’s 2002 Board Changes

Changes announced November 7, 2002 Go beyond requirements of Sarbanes-Oxley Increases power and autonomy of

independent directors and 11 of 17 directors will be independent

Eliminate stock and options as compensation


Insider Abuses

Insider trading Self-serving policies

– Defense of jobs (entrenched management)– Self-dealing (loans, affiliated firms, etc.)

Deception for self-serving advantages– Deceptive reporting to increase bonuses, share

prices Abuse of minority rights, other stakeholders


Transparency: A Global Issue

Information flows and legal environment differ around the world

Foreign conditions– Korean chaebols– Japanese keiretsu– Chinese state-owned enterprises (SOEs)– Indonesia family firms

U.S. usually taken to be a standard


Issues with Insider Trading

Examine the key economic and legal issues regarding insider trading

Discuss whether insider trading affects firm value, and if so, how and why

Periodic episodes of insider trading cast doubt on the “fairness” of markets


Definition

Illegal insider trading refers to the unlawful trading in securities by persons with material, nonpublic information

Who is an insider? It depends– Corporate insiders are officers, directors, and

shareholders with more than 10% of the outstanding stock

– Others: corporate outsiders and “tipees,” who pass information to those that do trade


Insider Trading is Not Obvious

Until 1929, insider trading was an acceptable business practice– It is still common -- and legal -- in many parts of

the world, although European countries (e.g., Germany) are copying the US laws

– For private placements insider trading does not apply

Manne argues that insider trading rules reduce market efficiency


Transmission of Information

Time

Sh

are

Pri

ce

Information becomes available to insiders

Informed trading by public possible

Adjustment Period

Issues: Trading During

Adjustment Period


Insider Trading and “Fairness”

It is “unfair” and a violation of ethics– Corporate executives are fiduciaries, and their

use of proprietary information (owned by shareholders) constitutes theft

It compromises market integrity and may discourage participation by small retail traders who are the source of liquidity


Efficiency and Insider Trading

It may hurt economic efficiency by widening bid-ask spreads and possibly causing market failure

Regulations against insider trading eliminate perverse incentives to managers to, withhold bad information or increase stock price volatility

Hidden compensation for executives


Insider Trading and Criminal Law

Review key provisions of the securities laws– Disclosure– Trading activities

Major cases illustrating problems with prosecuting insider-trading cases


Insider Trading Rules

Two provisions of the Securities Exchange Act of 1934 are commonly applied – Section 16(b)– Section 10(b)

Insider Trading Sanctions Act (ITSA) of 1984 and the Insider Trading and Securities Fraud Enforcement Act (ITSFEA) of 1988– Increase penalties for violations and widen the scope

of laws to include derivatives etc.


Section 16(b) (Short Swing Rule)

Provides for profit recapture from short swing trading (a round-trip transaction within six months) by a corporate insider – Does not require proof of possession or intent of

use of inside information– Only corporations or shareholders can sue for profit

recovery Although the burden of proof is minimal, the

law applies very narrowly


Section 10(b) and Rule 10b-5

Rule 10b-5 is an anti-fraud provision prohibiting insider trading, prohibiting manipulation, fraud, and deception– Does not distinguish between corporate and non-

corporate insiders– Trading on material nonpublic information is not

per se illegal– Must be linked illegal activity like a breach of

fiduciary duty or misappropriation of information


US v. Chiarella (1978)

– Chiarella, a printer, made $30,000 of profits on trades based on documents he was printing

– Although found guilty in District Court under 10b-5, the Supreme Court reversed this since he was not a fiduciary with whom sellers had “trust and confidence,” but a “complete stranger.”

– Rule 14e-3 was passed to fix this loophole


Dirks v. SEC (1983)

– Ray Dirks, an analyst, learned from an employee that Equity Funding Corp.’s assets were overstated and fraudulent

– He informed his clients who sold Equity stock– The SEC censured Dirks for “tipping” his

clients about inside information, – The Supreme Court reversed this arguing Dirks

had no fiduciary duty to Equity


US v. Winans (1985)

In the Winans (Heard on the Street) case, the author tipped off brokers and others about his stories in the WSJ (1982-1984)– Brokers made $700,000, passing $30,000 to

Winans– Winans served 18 months in Federal prison,

convicted of mail and wire fraud, not section 10b-5


Civil Litigation

Shareholder legal actions– The so-called plaintiffs bar– Class-action lawsuits– Effectiveness depends on enforceability of

court rulings Damages and role of experts Costs to corporations and economic

efficiency


Assessment

There are still clearly some gaps in the law, especially as regards to defining fiduciary responsibility and identifying the source of inside information

Misappropriation theory is gaining ground– Illegalities focus on using information obtained

for reasons other than securities trading for the purpose of making profits while trading


Detection of Insider Trading

To be effective, mechanisms must be put in place to detect insider trading

But what organization or institution should perform this function?

Candidates:– Corporations– Markets– Government agencies


Enforcement of Insider Laws Corporations

– Not credible

– Not effective against insider trading “rings” Markets

– The current practice. The NYSE’s StockWatch invests considerable resources in attempting to detect insider trading

Government Agencies– Unrealistic? Unsuitable?


Insiders’ Takeover Defenses Poison pill defense discussed next Staggered board

– Usually three classes of directors with three-year terms

– Takes two years for potential acquirer to gain control

Packing the board Finding the “right” banker

– Opinion letter from investment bankers used to defend against accusation of bad decisions


Poison Pill Takeover Defense

Provisions of corporate bylaws Typical provisions:

– If one investor acquires a trigger level (typically 10% to 20%), remaining investors gain rights to buy more shares at sharply discounted price

– Effect is dilution of voting power of acquiring investor

Statutory authority varies among states


Insider Accounting Abuses

Typical of recent scandals (Enron, Global Crossing, WorldCom, Adelphia)

Insiders are motivated by– Stock options and stock ownership– Compensation schemes based on performance

Previous scandals– Equity funding

Legislative response: Sarbanes-Oxley


Next Week – Dec. 2 and 4, 2002

Prepare to discuss Vyaderm case on Wednesday

Begin reviewing for final examination to take advantage of course summary and review on Thursday and special optional session on Friday

Review midterm to understand answers and see me if you have any questions about your grade going into the final

Documents

J. K. Dietrich - FBE 432 – Fall, 2002 Module VI: Corporate Governance Week 14 – November 25 and 27, 2002