Module VI: Corporate Governance - PowerPoint PPT Presentation

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Module VI: Corporate Governance


Place the issues raised concerning corporate governance into an analytical framework ... Corporate insiders are officers, directors, and shareholders with more than 10 ... – PowerPoint PPT presentation

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Title: Module VI: Corporate Governance

Module VICorporate Governance
  • Week 14 November 25 and 27, 2002

  • Place the issues raised concerning corporate
    governance into an analytical framework
  • Review the major issues concerning corporate
  • 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
  • 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
  • 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
Goods Markets
Capital Markets
Board of Directors
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

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
  • 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)

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
  • 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
  • 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

  • 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
  • Manne argues that insider trading rules reduce
    market efficiency

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

Civil Litigation
  • Shareholder legal actions
  • The so-called plaintiffs bar
  • Class-action lawsuits
  • Effectiveness depends on enforceability of court
  • Damages and role of experts
  • Costs to corporations and economic efficiency

  • 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 NYSEs 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
  • 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
  • Effect is dilution of voting power of acquiring
  • 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
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