Module VI: Corporate Governance

1. Module VI:Corporate Governance Week 13 – April 13, 2006

2. 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

3. 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?

4. 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

6. Corporations and Stakeholders Governance Goods Markets Capital Markets Board of Directors Customers Shareholders Management Vendors Firm Creditors Government

7. 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

8. 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

9. 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

10. 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)

11. 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

12. 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

14. 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

15. 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

16. 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

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

18. 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

19. 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

20. 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.

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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?

31. 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

32. 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

33. 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

34. 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