Transcript Lecture 7: Human Foibles, Fraud, and Regulation

Lecture 8: Human Foibles, Fraud,
and Regulation
“Millionaire in the Making”
money.cnn.com
• Dave Farley earns $120k
as manager at Ford plant
• Saves $1600 per month
• Net worth $270,000
• Plans to retire in 10 years
age 45with $1 million (at
r=3.5% this gives annuity
income of $54k for 30
years, half what he
consumes now)
• Calculations imply he
expects return of
10%/year.
Human Nature and Workings of
Markets
• Gambling behavior
• Loyalty to friends transcends loyalty to
society
• Salesmanship, spamming
• Fraud, near-fraud
Green Stamps & Human Foibles
• 1896 Thomas Sperry & Shelly Hutchinson started
first trading stamp business. Zero interest bonds.
• 1913 Two members of the Beinecke family, who
had married into Sperry family, bought the
company. Beinecke Library.
• In 1950s, S&H discovered stamps were better
received if paid in merchandise, rather than cash.
• By 1956, almost half US households were pasting
stamps into books.
S&H Green Stamps Today
• Public interest waned in 1970s, exists only in
backward areas of US today.
• Beinecke family sold S&H to a conglomerate,
which kept the stamps barely alive.
• 1999 Walter Beinecke III buys S&H back from
conglomerate to do trading stamps on the web.
“Greenpoints” replace Green Stamps.
Purposes of Regulation
• Enforce rules of the game
• Protect the weak from exploitation by
cynical operators.
Property and Society
• Karl Marx believed human societies used to
practice “primitive communism,” with no
private property.
• In fact, concepts of property exist across
diverse cultures, though nature of rights
varies.
• Rights to fruits of one’s own labor
• Property law
Complexities of Property
Definition in Modern Economy
• Information has value, but producer of
information is hard to define.
• Property rights can be entangled in maze of
intersecting contracts.
• French law allows an artist to sell works subject to
contract that it never be altered.
• Trust law in common law countries allows trustee
to act on behalf of owner without intermingling
own assets.
• Countries with poorly defined property rights do
poorly. Hernando de Soto and squatters in Latin
Securities and Exchange
Commission
• Louis Brandeis, Other People’s Money, 1914 was
intellectual origin. Disclosure
• Blue Sky Laws of Progressive Era
• 1920s were period of much fraud, manipulation.
• SEC part of Roosevelt’s New Deal, 1934.
• Initially viewed by business as a radical, almost
socialist, institution. Peculiar that it started in US,
imitated by other countries.
Public vs. Private Securities
• Motive was repeated examples of exploitation of
minority or unobservant shareholders.
• Public securities: undergo approved process of
issuance under SEC surveillance
• Public companies must file public statements.
EDGAR database on www.sec.gov.
• Inital Public Offering (IPO) is SEC procedure for
going public.
• Reverse direction: going private.
SEC Rules
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Every broker must register with SEC
Every stock exchange must register
Every security issue must register
Registration does not literally mean SEC
approval
Insiders vs. Outsiders
• Insiders are people with special access to
information about a company.
• Inside information represents wealth
• SEC tries to define access to this wealth, by
disclosure rules.
• Regulation FD (Full Disclosure) 2000: requires
that when a company tells any material fact to an
analyst, it must immediately tell the public.
• Germany did not have any laws against insider
trading until 1994
• Some argue insider trading is good. Hayne Leland
Market Surveillance
• SEC Sophisticated computer equipment
• SROs; self regulatory organizations
Results of Market Surveillance
• May 1995 secretary at IBM was asked to xerox
documents related to secret plans to take over
Lotus, to be announced June 5.
• She told husband, a beeper salesman
• June 2 he told two friends who immediately
bought.
• By June 5, 25 people spent half a million dollars
to buy on this tip: pizza chef, electrical engineer,
bank executive, dairy wholesaler, schoolteacher,
and four stockbrokers. All caught by surveillance.
Emulex Corporation
• Mark S. Jacob, 23, had shorted stock of his former
employer, stood to lose money
• Sent fake news release to Internet wire, was
picked up by Bloomberg, Dow Jones News Wire
and CNBC. He immediately covered.
• FBI, using Internet Protocol Numbers, tracked
down initial news to El Camino Community
College library. Police questioned librarians, and
eventually tracked him down.
Front Running and
Decimalization
• Front-Running occurs when a broker buys
shares in front of a large order that will
boost stock price.
• Decimalization on NYSE and Amex began
January 29, 2001. (NASDAQ April 2001)
• Decimalization favors front-running
• NYSE Surveillance will search this out
Financial Accounting Standards
Board
• FASB officially recognized as authoritative by
SEC in 1973. Though SEC has statutory right to
make accounting standards, prefers private sector
do it.
• FASB (Norwalk CT) defines Generally Accepted
Accounting Principles (GAAP), used for EDGAR
• http://accounting.rutgers.edu/raw/fasb/facts/index.
html
Earnings Definitions
• GAAP Define “Net Income” which is the bottom
line, traditionally, and “operating income,”
revenue minus cost of doing business
• Operating earnings, Core Earnings, Pro Forma
Earnings, EBITDA, and Adjusted Earnings are not
GAAP
• FASB is at work on developing new definitions,
but this takes years.
• Great confusion today about earnings
Enron Corporation
• Company was created 1985 when Internorth Inc.
bought Houston National Gas, CEO Kenneth Lay
(Ph.D. economics, University of Houston)
• Renamed Enron 1986, had largest gas pipeline in
United States
• With deregulation of natural gas, transformed
Enron into gas market-maker
• Starting 1994, Did similar thing with electricity
• 1999, Started same thing with broadband, built
own fiber-optics network for final delivery
Other Enron Innovations
• Enron was first company to issue creditsensitive notes (Bear, Stearns 1989)
• Enron pioneered financial contracts to
manage weather risk (1997)
• Enron had plans in works at time of
bankruptcy to start trading index-based
commercial real estate contracts
Failure of Enron, 2001-2
• Pursued too many projects
• Some projects were only hype
• Dishonestly concealed truth about failures too
long
• Strongly encouraged Enron employees to hold
company stock in 401(k) plans
• Does not discredit the long run importance of
financial innovation
• Final failure occurred when truth got out, no one
wanted to deal with Enron any more
Off-Balance Sheet Accounting
• Enron created hundreds, perhaps thousands,
of partnerships
• At least 3% of each partnership was not
held by Enron, so their losses did not go on
Enron’s books
• Partnerships used to conceal losses
• FASB has not issued directives against such
use of partnerships to conceal losses
United Kingdom
• Until 2000, varied agencies performed task
of SEC.
• United in 200 under FSA (Financial
Services Administration
Germany
• Frankfurt Stock Exchange sets its own rules
subject to approval of the State of Hesse
• Also Bundesaufsichtsamt fuer den
Wertpapierhandel
• Failed merger attempt with London Stock
Exchange, to produce the ix, would produce
interesting questions, regulated by Hesse?
• Proposed Euro SEC
Securities Investor Protection
Corporation (SIPC)
• Followed 1970 failure of Goodbody & Co., fifth-largest brokerage in
the US, because of stock fraud. Merrill Lynch assumed Goodbody
accounts, no customers lost money
• To plan for such events in the future, SIPC was created by US
Congress 1970 (Sen. Ed Muskie)
• Protects customers of brokerage firm or clearinghouse against failure
up to $500,000 per account, $100,000 for cash.
• SIPC much criticized. Very defensive, pays more to the lawyers than to
claimants.
• Disallows claims that were not filed “promptly.”
• If broker stole the money before it was invested, smaller claim
allowed. (no securities stolen).
• SIPC extremely slow to pay.
SIPC Survey of US Population, 2001
• When asked to identify the "organization that
insures you against losing money in the stock
market or as the result of investment fraud,"
only 16 percent of investors knew that there is
no such group.
• Just 36 percent of those surveyed knew that if
they suspect brokerage theft they should "set
out (their) concerns in writing to the
brokerage firm and keep a copy for self."
Weakness of Securities
Regulation Outside US
• From 1995-99, there were only 19 successful
procecutions for insider trading in all of the UK,
France, Germany, Italy and Switzerland
• Manhattan Federal Court alone prosecuted 46 in
that period.
• European regulators do not have the budgets or
sophisticated computer systems that US SEC does.
More Weakness of Foreign
Regulation
• In Britain, Italy and Switzerland it has been
impossible to bring a civil suit against
insiders. Civil suits require lower burden of
proof.
• Britain allows civil suits starting in 2001.
Tunneling
• Johnson, LaPorta, Lopez-de-Silanos, and Shleifer,
AER May 2000
• Tunneling = Expropriation by minority
shareholders (figuratively, as by an underground
tunnel)
• More common in civil law countries (especially
French) than in common law countries (LaPorta et
al. 1998). Hence, higher proportion of private and
family-owned companies in civil law countries.
How Tunneling is Achieved
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Asset sales
Contracts, as for prices paid for inputs
Excessive executive compensation
Loan guarantees
Expropriation of corporate opportunities
Dilutive share issues
Insider trading
Directors’ Duties to Prevent
Tunneling
• Duty of Care: Act as a reasonable, prudent
or rational person would.
• Duty of loyalty: Prevent insiders from
benefiting at expense of shareholders
Common law countries give more
judicial discretion to judge conformance
with these duties, and so are more effective
in preventing self-dealing transactions.
Tunneling in France
• SARL Peronnet, a French company owned
primarily by the Perronet family leases a
warehouse from the Peronnet family at a
high price. When minority shareholders
sued, French court ruled that the transaction
had a legitimate business purpose, and that
it was beyond the court to judge whether the
price was too high. In US or UK, price
would have been a factor.
Asian Financial Irregularities
• World’s largest IPO 2003: China Life,
US$3.5 billion
• Chinese state auditors blow whistle on
accounting irregularities. “Little treasuries”
• Korean government bailout 2003 of LG
Card, US$4.5 billion
China Share Categories
• A Shares: Only mainlanders and selected foreign
institutional investors allowed, traded in renmenbi
• B Shares: Shanghai and Shenzhen, until 2001 only
foreigners could hold, now mainlanders with
foreign currency accounts; traded in foreign
currencies
• H Shares: Traded in Hong Kong
• N Shares: Traded in New York
China Plans to Promote Stock (WSJ Feb 12, 2004)