Chapter 10 Questions

What Federal Agency regulates the Sale of Securities?

Securities Exchange Commission

What is the market for corporate control? How does it address the principal-agent problem in corporate governance?

See problem 11.

What principal-agent problems arise in corporate governance?

Shareholders as principals hire board of directors as agents. Directors as principals that hire officers/managers as their agents. Principal agent relationships create major problems in many older, publicly owned corporations due to the separation of ownership and control. This gives rise to the separation of ownership and control.

What are the generally accepted accounting principles and who uses them?

The GAAP are designed to promote consistency and transparency. All U.S. companies must use in their accounting statements.

Why did corporations grow in importance beginning in the Nineteenth Century?

The first general incorporation law was passed in CT in 1837 and made in legal for anyone to incorporate for any lawful purpose. During the late 1800s, corporations began to dominate commercial activities, this was due to the law changing to make it easier to incorporate and due to technological changes like steam engines and railroads. By the end of the 19th century, the corporate form had become the dominant form of business organization.

What is meant by the phrase "separation of ownership and control"?

A company like GM, GE, or Boeing is owned by hundreds of thousands if not millions of shareholders, each of which owns a very small percentage of the corporations shares. This ownership structure creates a problem known as the separation of ownership and control. Because of this fractured ownership, no one shareholder finds it in his or her self-interest to monitor actively the performance of the company. Rather, most simply look at the stock price and decide if the company is still a good investment.

What are the legal duties of officers and directors?

First, they owe a fiduciary duty to corporation and shareholders which is defined by common law and specifies the standards of care and loyalty. The primary enforcement method is to hold directors and officers personally liable for corporate losses, such as derivative lawsuits. Second, they assume the duty of due care and diligence. This duty has been interpreted to mean that they must act in good faith and exercise a level of care that an ordinary prudent person would under similar circumstances. Does NOT mean they have to make the right decision whatever that may be. Lastly, they must follow the corporate opportunity doctrine. This doctrine mandates that should an officer or a director discover a business opportunity, he or she must first present it to the corporation.

What is the Williams act?

It compels any prospective purchaser of more than 5% of a public company's stock to file a tender offer with the SEC. The prospective purchaser must also inform the target company and its shareholders about the terms of the proposed purchase. Under the Williams act, all takeover offers must be put on the table for at least 20 days, and shareholders who agreed to sell their shares have 7 days after the offer expires to withdraw their shares from sale.

What solutions are available to reduce principal-agent problems in corporate governance? Private? Public?

PRIVATE: (A). Alignment of financial interests - this is the first approach to addressing the p-a problem in corporate governance is to align the financial interests of the officers and the board members with those of the shareholders. One way to do this is to compensate officers and board members with stock instead of salary. (B). Outside directors - Increase the number, power, and independence of outside directors on the company's board of directors by adopting one or all of the following options: Separate the role of board chairsperson and teh company CEO, increase the number of outside directors on the board relative to inside directors, and increase the independence and power of the board. (C). Institutional Investors and Corporate Democracy - In 1986 a group of institutional investors got together to create the Council of Institutional investors (CII) to promote accountability or corporate executives. CII monitors the governance of publicly traded corporations to be sure it is set up to promote shareholders interest. (D). Product market competition - Puts constraints on the officers ability to act in their own interest rather than in the shareholders best interests (E). The Market for Executive Talent - labor market for executive officers also compels corporate officers to act as faithful agents to shareholders. (F). The Market for Corporate Control - If the corporation is not functioning as profitable due to the officers not acting as faithful agents to the shareholder then they could be at risk of a tender offer or being bought out and thus vulnerable to losing their jobs. PUBLIC: (1) the legal responsibilities imposed on board of directors and executive officers by common law and statutory law, and (2) regulatory constraints imposed by the Securities and Exchange commission.

What are the rights of a shareholder?

1. SHAREHOLDER VOTING - common stock owners have the right to vote to elect the board of directors and approve or disapprove of fundamental corporate changes like mergers and amendments to the articles of incorporation. 2. PROXY SOLICITATION - If a shareholder cannot or does not want to do to the annual meeting, they can give proxy to someone else to vote their shares. 3. SHAREHOLDER PROPOSALS - shareholders have the right to make proposals at shareholder meetings (more democratic) 4. DERIVATIVE ACTIONS - A lawsuit filed by shareholders against someone or something who has financially harmed the corporation when the board of directors has chosen not to file suit.

Why is Delaware important in corporation?

A firm incorporated in one state may operate in any other state. The law of the chartering sate governs the internal relations of the firm regardless of which state the firm operates in or the physical location of its headquarters. For example, many major corporations are incorporated in Delaware and thus governed by its laws, although most are headquartered and do most of their business elsewhere.

What is Rule 10b-5? To whom does it apply? When? Defenses?

A major rule covering insider trading. It applies to any person (not just insiders), directly or indirectly and is very far reaching. It applies to any situation where misappropriation of material inside information for profit happens, no statutory definition of insider trading.

What is a proxy?

A written authorization by the shareholder on form typically provided by the corporation, designating an agent to vote on behalf of the shareholder at the shareholders' meeting.

What is corporate governance?

Corporate governance involves formulating, overseeing, and monitoring the processes by which a corporation is governed in order to shape its strategic direction and performance, define its mission and scope, and assess its interactions with affected groups. It also involved formulating and implementing the rights, responsibilities, and accountability of three distinct groups within the corporation -- its stockholders, its board of directors, and its managers (officers or executive officers).

How is a corporation created?

Corporate law = State law. Each corporation is organized under the general incorporation law of a state, which grants the corporation a charter. This is normally a simple filing, usually called the Articles of Incorporation. Then you have to pay a fee and the corporate charter is issued, which is similar to a birth certificate and recognizes the separate existence of the corporation.

Who must notify the SEC of any stock purchases or sales and the source of funds for that purchase?

Corporate officers, directors, and large shareholders (>10% of stock).

What are the major provisions of the Sarbanes-Oxley Act?

Created an audit committee of the board of directors. Only outside directors could be on audit committee. CEO and CFO must certify certain financial statements. Ethical auditing standards.

What are the goals of the Sarbanes-Oxley Act?

First it seeks to strengthen corporate governance of publicly traded corporations by new requirements on auditors, corporate board, and corporate executives. Second, SOX addresses perceived problems within the public accounting profession.

What is the principal-agent problem?

How do we ensure that the agent will always put the interest of shareholder/principal first? The firm may: a. directly monitor the agent b. impose control systems to audit the agent after the fact c. develop a system of rewards and punishments d. utilize legal remedies and sue the agent for damages.

What is the difference between an inside director and an outside director?

INSIDE DIRECTORS are executive officers that serve on the board of directors in order to allow the board to benefit from their intimate knowledge of the corporation's business. OUTSIDE DIRECTORS are directors who are not executive officers of the corporation.

Discuss how SEC regulation affects corporate governance?

SEC laws are designed to promote public confidence and the disclosure of laws to give investors information to make informed decisions.

Why does the SEC focus on ensuring the quality and accuracy of the information presented to investors, rather than on whether a given investment is a wise one or not?

That would be anti-competitive.

What is Rule 16(b)? To whom does it apply? When? Defenses?

The "Short Swing" Profits Rule -- Section 16(b). It applies to all directors, all officers, and any shareholder owning ten (10%) percent of companies stock. If any capital gain is made by buying and selling their own company stock within any 6 mo period then the gain must be returned to corporate treasury. The actual reason for the purchase does not matter, NO DEFENSES.

What is the business judgement rule?

This rule states that corporate officers and directors are held harmless for any decisions they make in good faith, after prudently exercising due care and diligence, even if those decisions late prove to have been in error. 1. The action taken was an informed decision 2. There was no conflicts of interest between the decision maker and the corporation 3. There was a rational basis for the decision.

Why is the Dirks v. SEC case important in a discussion of corporate governance?

Tippees, those that receive information from people with insider information inherit the insider's liability like a friend, relative, or any acquaintance. Then, if the tippee misappropriates the material inside information for profit, the person will be liable as will anyone else down the line.