MGMT 209 Ch. 10 – Flashcards

-Corporation is a separate legal entity i. Corporation is responsible for its own debts ii. Limited liability for its owners (shareholders) a) Shareholders are not personally liable for corporate debt b) This makes it easier to attract capital market funds

a. Profits b. Growth c. As owners by purchased stock

a. Corporate form allows this by separating OWNERSHIP and MANAGEMENT b. This is clearly facilitated by LIMITED LIABILITY 1) Allows shareholders to be "rationally ignorant" of managerial practices 2) So shareholders do not have to spend as much time monitoring managerial behavior because they have limited liability, not going to be personally responsible for managers actions

--> owing stock in several corporations thereby reducing the riskiness of their investment portfolios

--> constraining and controlling managers of corporation so the corporation is governed in the best interest of the shareholders

a. Normally sold in organized securities markets i. New York Stock exchange ii. American Stock exchange iii. NASDAQ b. Shareholder can transfer their ownership interest i. Without the permission of the other shareholders and owners ii. Without the expense of locating buyers iii. Decision to sell or keep stock belongs to the shareholders alone Transfer of shares is facilitated by limited liability, people are more willing to buy due to the limited liability that comes with the purchase

a. Developed by James Watts b. Power source c. Allowed expansion of company d. Led to steam powered railroad

a. Transportation became easier and cheaper b. Increased the area a factory could serve due to i. Lower transportation costs ii. Could ship products further distances c. Led to larger business, which led to a need for more capital

--> State Law

a. Each corporation is organized under the general incorporation law of a state, which grants the corporation a charter b. Simple filing--> called the Articles of Incorporation c. Pay fee d. Corporation chartered in one state can operate in another state -subject to minor regulations --> registration requirements

i. What state the corporation does business in ii. Where the physical location of its headquarters are located

i. Articles of Incorporation --> act as corporations constitution ii. Bylaws -rules or private laws that govern the operation of that specific corporation *Both can be amended or deleted

a. Common stock owners have the right to vote i. Elect Board of Directors at shareholder meetings ii. Approve/Disapprove of fundamental corporate changes 1) Mergers 2) Amendments to the Articles of Incorporation iii. Shareholders can also question directors at annual meetings

a. If a shareholder cannot or does not want to go to the annual meeting, they can give proxy to someone else to vote their shares b. Regulated by the Securities and Exchange Act of 1934 i. Became main way shareholders voted ii. Was a way for directors to control shareholders iii. State law was insufficient so this is one of the rare internal areas of corporate law to have federal regulation c. Allows outsiders (those not connected with the existing/incumbent management team) to take control

a. Info about the nominees for the board of directors and when the election will occur b. Sometimes must identify the interest of the party soliciting the proxy

-Explain the matter and consequences of the vote

1. Notice 2. Agenda *forces disclosure of information shareholders would normally not have received

a. Shareholders have the right to make proposals at shareholder meetings b. However, some shareholder proposals can be excluded from proxy if 1. Frivolous or repetitious 2. In the ordinary course of business c. Rarely successful

a. A lawsuit FILED BY SHAREHOLDERS against someone or something who was financially harmed the corporation when the board of directors has chosen not to file a lawsuit b. shareholders must demand that the board of directors take action prior to filing the suit themselves on behalf of the corporation c. Some states still require a majority vote of shareholders prior to the suit being filed d. Some states require shareholders to post a security-for-expenses bond to be used to pay the defendants legal fees if shareholders lose

-Directors show decision not to file suit was based on good faith and legitimate business purpose

- "Disinterested" directors

-formulating, overseeing, and monitoring the corporate process to shape its strategic direction and performance, define its mission and scope, and assess its interactions with affected groups

a. Shareholders b. Board of directors c. Managers 1. Officers 2. Executive Officers

1. Corporation is OWNED BY SHAREHIOLDERS 2. Ownership carries voting rights 3. Shareholders elect Board of Directors

1. Oversee the running of corporation 2. Shape its overall strategy 3. Employ officers to other subordinate employees to manage the daily affairs of the corporation

1. Have power and authority to engage in all legal activities necessary 2. Often members of the Board of Directors

--> are not officers or executives of the corporation

--> are officers who are also directors on the board of directors

1. Parties: 1) Principal hires agent 2) Agent works for principal a) Has a fiduciary responsibility b) Has a duty of loyalty c) Must act in best interest of the principal d) When acting within scope can bind the principal in contract and tort 3) Very common in business 4) PROBLEM-->How to ensure that the agent will always put the interest of the shareholder/principal first? 5) Firm may: a) Directly monitor the agent b) Impose control systems c) Develop a system of rewards and punishments d) Utilize legal remedies and sue the agent for damages 6) Agency-Principle in corporate governance a) Shareholders as principals hire board of directors as agents b) Directors as principals that hire officers/managers as their agents 7) Principal agent relationship create major problems in many older, publically owned corporations due to the separation of ownership and control a) GENERAL MOTORS, GENERAL ELECTRIC 8) Separation of ownership and control a) When corporations have thousands of shareholders, there is no one owner to monitor the board b) Owners lose control c) Result is board is free to do as it pleases d) Must implement programs and policies to encourage officers and board members to act as faithful agents i) Unless family founded and family still watches/controls the board. EX. Paul Allen in MICROSOFT EX. THE FORD FAMILY e) Proxy solicitation can also force the board to act properly i) However, the typical proxy is done by a corporate officer and will normally vote the way the board has been conducting business ii) Third party proxies are rarely successful

1. Expected long run present discounted value of the after tax stream of profits earned by the corporation 2. According to finance theory this equals the price of a company's stock

1. Pays outside directors an annual retainer of $100,000 plus stipends forchairing key board committees 2. $150,000 or Merck's common stock annually at the existing market price.

1. In some corporations, inside directors may outnumber outside directors, such as the CEO serving as board chairperson 2. Outside directors may feel obligated to the CEO or inside directors for their position and will not be effective in overseeing the CEO and other officers

1. Increase the number, power, and independence of outside directors on the companies board of directors by adopting one or all of the following options 1) Separate the role of board chairperson and the company CEO a) Having one person in this dual capacity DOES NOT WORK EX. In 2000, MERCK'S CEO and chairman were the same person 2) Increase the number of outside directors on the board relative to inside directors a) Inside directors have inherent conflicts of interest in their dual roles as executive officers and board members b) If outside directors constitute the majority of the board, the board is more likely to exercise independent judgment and to oversee the performance of the officers 3) Increase the independence and power of the board a) Reduce the power of the Ceo in the selection of board members b) Appointing outsiders from other industries with no existing ties to the firm or to the CEO brings new insights and fresh ideas EX. MERCK --> board has several directors that are CEO's or former CEO's of other companies --> MERCK's board was ranked among the top 15 "best boards" by Business Week

--> large, professionally managed providers of capital, such as a) Pension funds b) Insurance companies c) Mutual funds --> as a whole they are large shareholders a) Each separately owns a small percentage of outstanding stock b) Cumulatively can own up to 60% of a typical company on the NYSE

1. Monitors the governance of publicly traded corporations to be sure it is set up to promote shareholders interests EX. The CII has lobbied against corporations adopting takeover defenses such as "poison pills" without the formal approval of their shareholders

1. California Public Employees Retirement System (CalPERS) a) As a major shareholder, CalPERS has sponsored many reform proposals including i) Make outside directors constitute the majority of the board of directors ii) Make the chairperson of the board an outside director iii) Audit committee should be composed only of outside directors b) CalPERS has been less than successful and has not won many votes i) Usually withdraws it petition before votes ii) Corporate officials typically dislike the adverse publicity iii) Often negotiate with CalPERS and promises to adopt governance reforms iv) So in the end, CalPERS achieves its goals in a roundabout way

1. Provides constraints on the officers ability to act in their own interest rather than in the shareholders best interest 2. Firm must remain competitive with its rivals 3. Officers have less ability to act as faithless agents 4. If the industry in non-competitive, then officers have more ability to run the company in their own interests, rather than in the interests of the shareholders

1. Develop new products 2. Reduce costs 3. Eliminate waste

1. Compels corporate officers to act as faithless agents to shareholders

1. If the corporation is NOT FUNCTIONING AS PROFITABLE due to the officers not acting as faithless agents to the shareholder, as determined by some other team of managers, then that group or corporation might try to take over control of the "less profitable" company a) Tender offer --> acquiring company offers more than face value for stock attempting to purchase a controlling interest in the target company b) Friendly offer is where the acquiring company had asked the target board of directors and they have agreed to endorse the takeover and recommend its acceptance by the shareholders c) Provides strong incentive for the board to operate the company as efficiently as possible

1. Vulnerable to having the company taken over by others 2. Losing their jobs in the aftermath 3. Insiders may endorse the takeover to save jobs 4. Outside directors would not be acting in their own self interest making the company more efficient and therefor, less vulnerable to a takeover. Thus more evidence of why CalPERS desires outside directors

1. HIGHEST LEGAL DUTY OF GOOD FAITH 2. Law of fiduciary duty is DEFINED BY COMMON LAW and specifies the standards of care and loyalty

1. Act in good faith 2. Exercise a level of care that an ordinary prudent would exercise in similar circumstances 3. Does not require them to always make the "right" decision a) Courts do not second guess corporate executives b) Courts recognize that corporate officers and directors are continually forced to make difficult decisions involving large sums of money with imperfect information in a constantly changing business environment c) Courts also agree that if allowed lawsuits constantly suing the board of officers would i) Bog down the court system

--> the decision does not necessarily have to be the correct one or even be supported by the weight of available information as long as the decision was made on some rational basis EX. Case of the $140 million severance package paid by the Walt Disney Corporation to Michael Ovitz a) Derivative lawsuit against the board of directors at Disney b) Claimed that the board as individuals were responsible for the severance amount due to breach of fidicuciary duty to shareholders by hiring Ovitz i) Did not properly consider Ovitz as the right person for the job ii) Agreed to an outrageous, expensive, and wasteful severance package c) Judge felt that as long as the board believed they were acting in the best interests of the company and were not grossly negligent, the court should defer to the directors decision under the business judgment rule

1. Holding directors personally liable in situations where hindsight reveals that they made a mistake would make it difficult to attract top quality individuals to serve on the board 2. Without the rule, those who agreed to serve might be unwilling to approve any venture, even one that appeared to be in the best interests of the corporation 1) Worried to be held personally liable 2) Even if the surest gamble failed

1. Addresses conflicts of interest that may arise from time to time in the performance of the managers duties 2. Courts have low tolerance--> EX. GUTH VS. LOFT INC. 3. Concern is that directors and officers will use position to benefit themselves

1. One form of fiduciary loyalty owed by the officers and directors of the corporation 2. If officer or director discovers a business opportunity he/she must first make it available to the corporation

1. Under todays common law, this is not considered a breach of the duty of loyalty 2. Two different types: 1) Transactions between director or officer and the corporation i) Sale of property by the director or officer to the corporation at a price greater than the marker price ii) The payment to a director or officer of an exorbitant salary 2) Transactions between corporations with common directors, one of the corporations might not be treated fairly in the transactions

a) If a deal is fair to the corporation, it will be upheld b) Deal will be set aside if it involves i) Fraud ii) Undue overreaching iii) Waste of corporate assets c) If court is not convinced that the deal is fair, then the deal will only be allowed if it gets ratified i) After full disclosure by the majority of shareholders OR ii) By a disinterested majority of the board without the participation of the interested director

1. Where an insider profits from trading in company stock due to insider information a) Breach of fiduciary duty b) Violation of federal law 2. Insider --> any person that has access to confidential corporate information a) Employees--->even a janitor b) Officers c) Directors d) Outsider experts who learn information through dealing with the corporation i) Lawyers ii) Accountants iii) Investment bankers 3. Insiders are not allowed to profit from inside information

1. Stock market crash of 1929 led to federal laws and regulations 1. Country did not trust the securities market after the stock market crash 2. Public concerns that corporate insiders were abusing their knowledge of inside information

1. Securities act of 1933 2. Securities Exchange Act of 1934 *Both laws were designed to a) Promote public confidence b) Disclosure laws to give investors information to make informed decisions

1. Purpose is to provide the potential investor with the information to make an informed decision due to the disclosure 2. Regulates the initial sale of securities to the public 1) Initial sellers of securities must file registration statement with the securities exchange commission (SEC) a) Bonds b) Common stock c) Preferred stock 2) Must file a registration statement a) Detailed information required i) Terms of the security ii) Audited financial statements of the issuer iii) Short biographies of the corporations top management team iv) Discussions of financial interests of the issuer 1. Stock holdings 2. Stock options v) Conflicts of interests vi) Enumeration of the potential risks of the investors vii) Status of any potential lawsuits 3) Regulates Securities 4) Security is determined by the HOWEY TEST --> court case (SEC VS. W.J. HOWEY CO.) a) An investment of money into a common enterprise AND with the expectation of profits to be generated primarily by someone else 5) Issuer who makes a MATERIAL MISREPRESENTATION is liable as are i) Underwriters ii) Corporate directors iii) Corporate officer who signed the document iv) Outside experts 1. Accountants 2. Lawyers 3. Engineers 4. Geologists v) Violators are subject to a fine of up to $10,000 and/or prison sentence of up to five(5) years

1. Regulates the resale of previously issued securities on secondary markets such as 1) NASDQ 2) NYSE 2. One portion of the law regulates the activities of stock exchanges, stock brokers, stock, and other professionals to 1) Endure against: a) Fraud b) Deceptive practices c) Unfair practices 2) EXAMPLE: Brokers are held to the "KNOW-THY-NEIGHBOR-RULE" --> must know what is in the best interest of any particular investor 3. Also deals with requiring disclosure about the securities themselves 1) ALL securities traded on public exchanges MUST BE REGISTERED WITH THE SEC 2) Issuers must file periodic reports to the SEC detailing with their financial performance on a timely basis AS WELL AS 3) Any time a "material" item occurs, as the event occurs, such as a) Merger offer b) Unexpected changes in earnings (good or bad) c) Significant new contracts d) Key employee/officer changes e) Loss of important customer 4) Goal is to provide investor with sufficient information for the investor to decide to sell or to hold securities 4. Goal is to also restrict the ability of the use of inside information by rule 16(b) and 10(b)

1. Capital gain made by buying and selling their own company stock within any six(6) month period 2. GAIN MUST BE RETURNED TO CORPORATE TREASURY 3. Applies to: a) All directors b) All officers c) Any shareholder owning 10% of companies stock 4. There is a presumption of use of insider information 5. Actual reason for the purchase is irrelevant--> no defenses 6. Corporation is supposed to bring suit, if does not, then shareholders can file a derivative action 7. Insiders have registration and disclosure requirements to the SEC 8. CANNOT AVOID short-swing liability by resigning position or selling stock just to be under the 10% rule; 9. Profits are not offset by losses during the six month period 10. Very harsh penalty

1. The major rule covering insider trading 1) Applies to ANY person (NOT JUST INSIDERS), directly or indirectly 2) Very far reaching 2. Applies to any situation where misrepresentation of material inside information for profit happens, NO STATUTORY DEFINITION of insider trading a) Misrepresentation means the misuse of information in violation of ones duty b) "Material" means that it will likely affect the price of the stock c) Profit can be: i) Tangible (money) ii) Intangible (promise of sexual favors) d) TIPPEES--> those that receive information from people with insider information INHERIT THE INSIDERS LIABILITY i) Friend ii) Relative iii) Any acquaintance e) Then if the tippee misappropriates the material inside information for profit, the person will be liable as will anyone else down the line

1. CIVIL and CRIMINAL penalties for insider trading by anyone with inside information 2. Provides for TREBLE DAMAGES 3. 5 YEAR STATUTE OF LIMITATIONS 4. SEC places a high priority in stopping insider trading EXAMPLES: a) MARTHA STEWART case b) Affiliates of SAC CAPITAL ADVISORS c) Scott London of KPMG (ONGOING CASE) d) Thomas Conradt and IBM's plan to acquire SPSS (ONGOING CASE)

-->Person should be criminally liable for rule 10(b) violation IF that person conveys nonpublic information which was to be confidential EVEN IF the shareholders of the employer corporation are not injured

1. Officers, directors, and 10% shareholders must register with SEC 2. Must notify the SEC on a timely basis of a) Any purchase or sale of stock b) Source of funds used to purchase stock c) Reason for purchasing stock 3. This tells people without inside information what the insiders are doing (These are often published in the Wall Street Journal)

1. Investors have necessary and accurate information about terms and implications of a takeover 2. Small investors receive the same treatment and terms as the large investors in a takeover

1. TAKEOVERS 1) Any prospective purchase of MORE THAN 5% of a company's stock must file a TENDER OFFER PROPOSAL with the SEC 2) Prospective purchaser must also notify the target company and its shareholders 3) If the board of the target company opposes (hostile takeover), board must also file statement with the SEC 4) All takeover offers must be put on the table for AT LEAST 20 DAYS 5) Shareholders who agreed to sell have 7 days after the offer expires to withdraw shares from sale 6) If acquiring company sweetens the deal by raising the price, shareholders who tendered at the lower price can withdraw shares and re-tender at the higher price 7) Purpose of these requirements is to i) Prevent acquiring company from pressuring small shareholders to sell their shares with quick deadlines or coercive threats ("now or never") AND ii) Allow shareholders to have sufficient time to judge the attractiveness of the tender offer

1. Uniform rules 1) Consistent 2) Transparent 2. All U.S. companies must use in their accounting statements 3. Allows people to compare company A to company B and know how you are comparing apples and apples 4. This is NOT necessarily the case in the rest of the world, NOT AS TRANSPARENT in some countries like 1) GERMANY 2) JAPAN 3) FRANCE 5. These companies rely on bank loans more than private, shareholders as in the U.S. for more capital 1) U.S. METHOD IS MORE EFFICIENT 2) More and more Asian and European companies are starting to use U.S. GAAP and following SEC reporting requirements to have better access to U.S. investors

1. Enron 2. World Com 3. Tyco 4. Adelphia Communications

1. Purpose is to restore trust in capital market 2. Commonly called the SARBANES-OXLEY ACT 3. Goals of Sarbanes-Oxley Act 1) First it seeks to strengthen corporate governance of publicly traded corporations by new requirements on auditors, corporate board, and corporate executives. a) Created audit committee of the board of directors i) Only outside directors could be on audit committee ii) Audit committee oversees hiring and performance of its outside auditors, not the company's managers iii) Auditors report to audit committee any disagreements with corporate managers b) CEO and CFO must certify that certain financial statements are accurate which eliminates the "I didn't know" defense c) Include as internal controls report in the annual report to shareholders i) Must assess the effectiveness of the firms internal controls overseeing its financial reporting ii) Firms auditor must then assess the accuracy of managements assessment of its internal controls d) Eliminates most company loans to officers and directors (EX. WORLD COM) 2) Sarbanes-Oxley addresses perceived problems within the public accounting profession a) Created the PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD i) 5 person committee ii) Supposed to establish and enforce ethical and auditing standards for auditors of public companies b) Auditors are required to keep records for 5 YEARS c) Accounting firms are forbidden in providing certain types of consulting services to their audit customers (in response to AURTHOR-ANDERSON-ENRON RELATIONSHIP) 4. Sarbanes-Oxley Act is very controversial a) Critics--> does not go far enough and the same type of events will continue b) Other critics--> it is too expensive for smaller firms c) Some feel companies will avoid "going public" to avoid Sarbanes-Oxley d) Only time will tell