Module VI: Corporate Governance

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Module VICorporate Governance

• Week 14 November 25 and 27, 2002

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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

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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?

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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

5
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

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Corporations and Stakeholders
Goods Markets
Governance
Capital Markets
Board of Directors
Customers
Shareholders
Management
Vendors
Firm
Creditors
Government
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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
• DO insurance

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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

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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

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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)

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GEs 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

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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

13
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

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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

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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

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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

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Transmission of Information
Information becomes available to insiders
Informed trading by public possible
Share Price
Issues Trading During Adjustment Period
Time
Adjustment Period
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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

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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

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Insider Trading and Criminal Law

• Review key provisions of the securities laws
• Disclosure
• Trading activities
• Major cases illustrating problems with
  prosecuting insider-trading cases

21
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.

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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

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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

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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

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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

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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

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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

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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

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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

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Enforcement of Insider Laws

• Corporations
• Not credible
• Not effective against insider trading rings
• Markets
• The current practice. The NYSEs StockWatch
  invests considerable resources in attempting to
  detect insider trading
• Government Agencies
• Unrealistic? Unsuitable?

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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

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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

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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

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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