Lecture 8: Human Foibles, Fraud, and Regulation

1. Lecture 8: Human Foibles, Fraud, and Regulation

2. “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.

3. Human Nature and Workings of Markets • Gambling behavior • Loyalty to friends transcends loyalty to society • Salesmanship, spamming • Fraud, near-fraud

4. 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.

5. 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.

6. Purposes of Regulation • Enforce rules of the game • Protect the weak from exploitation by cynical operators.

7. 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

8. 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 America

9. 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.

10. 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.

11. SEC Rules • Every broker must register with SEC • Every stock exchange must register • Every security issue must register • Registration does not literally mean SEC approval

12. 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

13. Market Surveillance • SEC Sophisticated computer equipment • SROs; self regulatory organizations

14. 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.

15. 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.

16. 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

17. 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

18. 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

19. 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

20. Other Enron Innovations • Enron was first company to issue credit-sensitive 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

21. 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

22. 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

24. United Kingdom • Until 2000, varied agencies performed task of SEC. • United in 200 under FSA (Financial Services Administration

25. 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

26. 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.

27. 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."

28. 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.

29. 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.

30. 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.

31. How Tunneling is Achieved • Asset sales • Contracts, as for prices paid for inputs • Excessive executive compensation • Loan guarantees • Expropriation of corporate opportunities • Dilutive share issues • Insider trading

32. 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.

33. 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.

34. 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

35. 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

36. China Plans to Promote Stock (WSJ Feb 12, 2004)