Transcript Class 2 - University of Southern California

Module VI:
Corporate Governance
Week 13 – April 13, 2006
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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?
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
Corporations and Stakeholders
Capital Markets Governance
Goods Markets
Board of Directors
Shareholders
Customers
Management
Vendors
Creditors
Firm
Government
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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)
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
Share Price
Transmission of Information
Information
becomes
available to
insiders
Informed
trading by
public
possible
Issues:
Trading During
Adjustment Period
Time
Adjustment Period
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
Insider Trading and Criminal Law
 Review
key provisions of the securities
laws
– Disclosure
– Trading activities
 Major
cases illustrating problems with
prosecuting insider-trading cases
J. K. Dietrich - FBE 532 – Spring 2006
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.
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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?
J. K. Dietrich - FBE 532 – Spring 2006
Insiders’ Takeover Defenses
 Poison
pill defense discussed next
 Staggered board
– Usually three classes of directors with threeyear 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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
response: Sarbanes-Oxley
Next Week – April 20, 2006
 Prepare
to discuss Circon case on April 20
 Begin reviewing for final examination to
take advantage of course summary and
review on April 27 and prepare Vyaderm
case for that class
 Review midterm to understand answers and
see me if you have any questions about your
grade going into the final
J. K. Dietrich - FBE 532 – Spring 2006