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Corporate Governance: Analyzing Issues and Insider Trading Concerns

Dive into the world of corporate governance, exploration of key issues, legal implications, and the impact of insider trading on firm value. Examine U.S. corporate governance practices, efficient markets, and the role of stakeholders in today's business landscape.

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Corporate Governance: Analyzing Issues and Insider Trading Concerns

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  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

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