The Legal Infrastructure of Business

In Response to Banker’s Ex-Girlfriends Found Innocent on Insider Trading Accusations

Insider trading has been a controversial issue in the U.S. and other countries. Generally, it is not a recent matter in the business, but insider trading legislation and enforcement are relatively recent phenomena since the 1980s. In fact, insider trading had been legal in almost all the countries until the 1970s.

As Marcelo wrote in his blog post, insider trading seems “simply unfair.” Insider trading may undermine public confidence in the stock market since the two parties in a transaction do not have equal information and an outsider is put in a less competitive position, but there are no clear and simple answers to whether insider trading should be prohibited or not. Economics professors and other researchers in law and economics have applied economic principles to the legal issues about insider trading regulations. Those for insider trading regulations claim that the regulations are based on fairness or equity and may increase social welfare by preventing insiders’ undesirable behavior, but those against insider trading argue that the ban rather reduces market efficiency. 

Some studies have found that insider trading may have economic benefits for the capital market and a company under certain conditions. For opponents of insider trading prohibitions, there are two main arguments: an effect on the pricing of securities and an efficient compensation scheme.

1. The benefit for the capital market: insider trading promotes market efficiency by disseminating information

Insider trading has a positive effect on the market price of securities to move toward the accurate price by giving insiders incentives to make relevant information on the securities publicly available in the market. Through trade on the secondary market, insiders contribute to the efficient market. The regulations prevent the market from quickly adjusting to changes in the demand for and supply of corporate stocks, thus misleading market participants. Henry Manne, dean emeritus at George Mason University School of Law and an author of a seminal law and economics book “Insider Trading and the Stock Market,” explained in a WSJ article, “Corporate scandals such as Enron and Global Crossing would occur much less frequently and impose fewer costs if the government didn’t prohibit insider trading.”

2. The benefit for a company: assigning the property right to inside information to managers is an efficient compensation scheme

Insider trading is an efficient form of compensation to provide incentives for managers. It gives managers a right to alter their compensation given new knowledge on the company to avoid continual renegotiation. Insider trading reduces the uncertainty and costs of renegotiation, and increases the incentives of managers to produce valuable information. Moreover, compensation in the form of insider trading is cheap for long-term shareholders because it does not come from corporate profits.

I am not contesting the legitimacy of the current regulations here. These claims are not sufficiently backed by the empirical research, and insider trading might have some negative consequences on the capital market. Those who have found guilty of insider trading might have acted unlawfully under the current regulations, but there are still no simple and clear justifications that insider trading should be prohibited. I think that much research is required to fully justify—or to improve—insider trading regulations.

 

References:

The Law and Economics of Insider Trading: A Comprehensive Primer by Stephen M. Bainbridge (2002)

Insider Trading: An Economic and Legal Problem - How would O'Hagan Come Out Under the New German Securities Trading Act? by Joerg Hartmann

THE POLITICAL ECONOMY OF INSIDER TRADING LEGISLATION AND ENFORCEMENT: INTERNATIONAL EVIDENCE by Laura Nyantung Beny (2002)

5650 INSIDER TRADING by Stephen M. Bainbridge (1999)

Do Insider Trading Laws Matter? Some Preliminary Comparative Evidence by Laura Nyantung Beny (2005)

The Issue of Insider Trading in Law and Economics: Lessons for Emerging Financial Markets in the World by E. Mine Cinar (1999)

A Survey of Securities Laws and Enforcement by Lopez-de-Silanes, Florencio (2004)

Insider trading in financial markets: legality, ethics, efficiency by Phillip Anthony O’Hara (2012)

An Economic Defense of Insider Trading by Jeffrey A. Miron (2012), The Atlas Society

Learning to Love Insider Trading by Donald J. Boudreaux (2009), WSJ

Banker’s Ex-Girlfriends Found Innocent on Insider Trading Accusations

A couple of weeks ago Jessica Mang (30-year-old British chiropractor) and Christina Weckwerth, two girlfriends of former Mizuho investment Banker, Thomas Ammann, were found not guilty (by a court in London) of illegally trading on guidelines from him about Canon’s acquisition of OCE NV.

Background

In 2009, Thomas Ammann found out in his investment banking job that Canon Inc would acquire OCE. In an effort to avoid being caught (and an eventual prison time) while generating some cash, Ammann employed a couple of middlemen: his two girlfriends, who not only traded on the material non-public information, but also put up the cash for the investment. Once the M&A transaction became public, Weckwerth and Mang sold their shares making 1M euros and 29K pounds, respectively (both shared half of their profits with Ammann).

The Financial Services Authority (“FSA”) said: “Ammann passed information to Weckwerth and Mang and encouraged them to trade in the shares of OCE prior to the acquisition being announced. Both considered Ammann to be their boyfriend and had no idea of the existence of the other.”

According to court information “Mang bought OCE shares and then sold them five days later for almost twice what she invested. Mang wrote in her personal diary that Ammann advised her to invest, according to the prosecutor. Mang had been living in central London with a friend who worked in hedge-fund sales for Goldman Sachs. When told about Mang’s plans to invest in OCE, her friend “expressed her disapproval and kept calling it insider dealing.” In her diary, Mang wrote of her annoyance that her roommate insisted the trades were insider dealing. “Really?” Mang wrote, according to court documents. “Is that necessary? Increasingly prissy”.

Ammann pleaded guilty early this year to insider trading and encouraging Mang and Weckwerth to commit insider trading. Both girls pleaded not-guilty to similar serious charges.

In defense, both Mang and Weckwerth argued that they were used by Ammann who abused their trust. Mang basically said that “…to show him that I trust him – I needed to invest the money – once that’s done, we’ll go on holiday in Seychelles….and if she didn’t do it, he didn’t want to be with her anymore… Ammann suggested that she should invest so they could build a future together”. Additionally, she mentioned that she bought the shares of OCE only after she researched Ammann’s recommendation. Her own calculations showed her that the shares, which were trading at ~2.50 euros (beginning 2009), had a fundamental value of over 7 euros. Later, lawyers for Mang indicated that she was "clueless" as to what insider dealing really meant.

Thoughts

For me this case calls into question why insider trading is considered illegal, if it is possible to trade while in possession of confidential information, yet not engage in securities fraud.

I believe there is no discussion that the information Mang and Weckwerth received was material (evidenced also by the huge price increase upon public announcement) and that they acted on insider (non-public) information for their own benefit (they were actually allowed to keep the cash they gained). Moreover, it is clear that the inside information was intentionally shared with them.

The court might have resolved its decision on the ground that there was no understanding with Ammann about confidentiality or not trading on the information. Also that they both traded anonymously in the stock market and made no explicit face-to-face misrepresentations to investors from whom they bought the stock. Additionally, both Mang and Weckwerth are outsiders, not insiders or constructive insiders (i.e. like Ammann). In the United States, a violation of the insider trading SEC Rule 10b-5 occurs when a corporate insider trades in his corporation’s securities on the basis of material, confidential information he has obtained by reason of his position. If the UK has a similar 10b-5 SEC Rule, maybe both Mang and Weckwerth are not subject to it.

At the end of the day, I am still surprised by the court’s verdict. This decision puts into question the theory of the market as a “level playing field”. Maybe this theory is just over-reaching, but I believe that insider trading is simply unfair when an individual (either a corporate insider, outside adviser or just an outsider) takes advantage of access to information to earn substantial personal gains that are unavailable to other investors, regardless of who is the primary source of the information or who actually executed the trades. Both Mang and Weckwerth knew that they were trading on non-public information provided by their “boyfriend” and, as such, should have been found guilty as they engaged in securities fraud (even though they were not the primary source of the inside information).  

Sources:

http://dealbreaker.com/2012/11/women-who-insider-traded-on-shared-boyfriends-behalf-somehow-found-not-guilty/

http://www.bloomberg.com/news/2012-11-15/ex-mizuho-banker-s-girlfriends-not-guilty-of-inside-trade.html

http://dealbreaker.com/2012/10/girlfriend-insider-trading-on-two-timing-boyfriends-behalf-found-roommates-judgment-a-little-uncalled-for/

http://www.ft.com/intl/cms/s/0/51f2490e-2f38-11e2-b88b-00144feabdc0.html#axzz2DIvjgvA8

 

In response to: "Rating Agencies Just an Opinion", --Next Risks and Challenges--

This post is a reply to Andrew’s post and Karishma’s reply over the recent ruling by the Australian Curt that found Standard & Poor’s ratings to be “misleading and deceptive” for investors in a certain credit derivative product. This is a very controversial case that has been classified as a “landmark” for the future by some journals.

The Federal Court of Australia ordered that S&P, ABN Amro Bank and Local Government Financial Services (LFGS) combine to pay $15 million Australian dollars ($15.3 US dollars) to 13 Australian municipalities, plus legal costs and interests. This was a result of the lost in the financial crisis of 2008 of over 90% of the face value of the derivatives rated triple-A by S&P and purchased by these municipalities in 2006.

Controversy

Just as many people, I agree that credit agencies must be liable and fined if they fail on their functions of providing a “competent” rating analysis. If S&P failed to performed a deep and reasonable analysis over those complex credit derivatives (CPDOs), or did not fully understood the product and its risks to adequately assign a rating, then it should be held liable of its actions just as any other companies and individuals are liable and fined for their “incompetent” actions as they perform their profession or duties. Doctors, accountants or engineers are sued every day regarding “incompetent” actions in their profession, and have to manage those legal risks carefully.

Thus, this case certainly holds the big risk of being wrongly interpreted in the future and resulting in a sue to the credit rating each time a triple-A security defaults. A triple-A rating does not assure that any financial instrument would no default under any circumstance. These instruments could clearly default at
any time under the worst-case scenario, out of the statistical scope of an analysis. Thus, what this rating means is that their likelihood of default (encompassing both capacity and willingness to pay) is “statistically very low”.

Standard & Poor’s defines the securities rated in the highest categories as having the ability to withstand extreme or severe stress in absolute terms without defaulting. Specifically, S&P under its “General Criteria” document gives the Great Depression as an example of the scenario applied for a triple-A rating. S&P specifies that: “the issuer or obligation rated “AAA” should be able to withstand an extreme level of stress and meet its financial obligations in such a scenario as the Great Depression with a real GDP decline of 26.55%... unemployment peaking at 24.9%, production decline by 47% and stock market dropped by 85%...” Other scenarios such as the panic of 1857 are also used as an example by S&P.

 

Thus, there are clearly many other scenarios that could happen such as the 2008 Financial Crisis that resulted in even more adverse conditions in some metrics than the Great Depression, and there is no assurance that a triple-A security would resist that. S&P includes this in its disclosure, appealing to the First Amendment Act of the U.S.

Next Challenges and Risks for Credit Agencies

The risk is that as soon as any other triple-A rating defaults, we could expect sues holding the rating agencies liable for this case. But the court would need to understand that there is no wrongdoing or incompetence in rating the defaulted security as triple-A, but only in not performing an “adequate analysis” to get to that rating, given that that is the profession or responsibility of the rating
agency.

What would be the next challenge for the courts in Australia and probably in other countries would be to qualify the performed analysis as “adequate” or as “competent” given their low expertise in rating analyses. We would need to believe that the court judgment over this qualification is in fact more accurate than what the rating agency decided as relevant or important for its assessment. Qualifying
an analysis as “incompetent” and thus imposing a penalty over the rating agencies will definitively be a challenge for the legal system. Thus, there is no doubt that S&P and the other rating agencies will need not only to perfectly document each analysis and stress scenario for each credit rating as to prove a
competent analysis in each case, but also, to include an additional spread in their pricing as to include a higher probability of being fined in a case of litigation of a defaulted security. The result will certainly be in less triple-A rated securities in the system.

Sources

 http://picker.typepad.com/legalinfrastructure/2012/11/rating-agencies-just-an-opinion.html

http://www.standardandpoors.com/prot/ratings/articles/en/us/articleType=HTML&assetID=1245319385017

http://picker.typepad.com/legalinfrastructure/2012/11/in-response-to-rating-agencies-just-anopinion.html

http://www.dw.de/ratings-agency-sp-loses-landmark-case/a-16357204

 

Author: Amadeo Ibarra

Legal Issues Of Hostess Bankruptcy

As I am sure everyone knows, Hostess Brands, maker of such iconic American products as Twinkie and Wonder Bread has filed for bankruptcy and asked a court to begin liquidating its assets. Although it is believed the brands will live on after some other CPG company buys them in the liquidation process, almost all of the 18,500 people who work at Hostess will be laid off. Granted, some might get re-hired by the new brand owners, but it is not guaranteed. It will be interesting to see if there are any class-action suits that arise out of this development.

But first, let us understand what happened at Hostess and how we got to this end game. It can be said that is it not a simple Wall Street vs. Main Street, Union vs. Business battle that ended badly for everyone. Rather, it was a series of many bad decisions over many years. To get to this understanding we have to look at Hostess’ history, starting with its last bankruptcy in 2004…

In 2004, Hostess filed for bankruptcy protection due to (predictably) declining sales, bloated union contracts, and a general lack of competitiveness. However, unlike other companies that have used bankruptcy to make big changes, Hostess did not address its root and core issues. Instead, a PE company called Ripplewood Holdings bought the company for $130M and took it private, loading up the company with debt, and again, not making any radical (but needed) changes to labor, to products, to management, etc.

As expected, the company didn’t turn itself around, and with mounting interest payments on its debt, it went bankrupt again in 2012. It tried again to cut costs by squeezing unions out of their packages, but one union stood firm and decided that it would not give in, deciding the jobs weren’t worth saving at that point (or trying to call the PE firms bluff). Either way, the company is now done, and its assets being liquidated (with the PE firm taking a loss on its investment).

Therein lies some legal questions:

There is plenty of blame to go around, and blame can often get translated into lawsuits. At first glance the easiest blame to place is the bakers union not accepting revised contracts (which is understandable). However, I think the company’s management actually has more of the blame. Its overall strategic incompetence as a leadership team and its inability to turn the company around should have raised some eyebrows. Many companies have faced powerful unions and still survived and thrived (think Detroit automakers). So, could there be a class action lawsuit by laid off workers against the management team for their incompetence which ultimately cost them their jobs?

Secondly, the PE firm invested in a business and clearly itself did not know or have a plan to turn around the Hostess business. They loaded up the company with debt as PE firms do with seemingly nothing behind it except for lack of a better word “greed”. Will there be an internal audit or investigation? What stakeholders does Ripplewood have that might be able to go after (legally speaking) a decision maker or two in this horrendously botched investment?

Lastly, is there an opportunity here for a different kind of class action lawsuit against the bakers union by the other employees who will now get laid off? Since the bakers union was only a minority of the overall workforce, is it liable in any way for the business going under by rejecting a “fair” deal? I am not sure.

In the end – a sad story, and I will watch the news in the weeks to come to see what lawsuits spring up as a result.

Sources:

http://online.wsj.com/article/SB10001424127887324556304578122632560842670.html?mod=WSJ_business_LeadStoryCollection

http://www.washingtonpost.com/business/as-hostess-seeking-bankruptcy-court-approval-to-sell-assets-twinkies-are-likely-to-live-on/2012/11/18/059a5d26-31cc-11e2-92f0-496af208bf23_story.html

http://www.theatlantic.com/business/archive/2012/11/whos-to-blame-for-the-hostess-bankruptcy-wall-street-unions-or-carbs/265357/

http://www.prnewswire.com/news-releases/hostess-brands-to-wind-down-company-after-bctgm-union-strike-cripples-operations-179640671.html 

http://en.wikipedia.org/wiki/Class_action

 

 

 

 

 

 

 

 

In response to: Netflix’s poison pill reflects poor corporate governance?

A couple of days ago Juan uploaded a post about billionaire investor Carl Icahn revealing that his funds acquired a 9.98% stake in Netflix. Mr. Icahn argued Netflix has "significant strategic value for a variety of significantly larger companies that are engaging in more direct competition with one another due to the evolution of the internet, mobile, and traditional industry."

Netflix stock increased over 17% (as of 5/11/2012) since Icahn’s announcement.

Basics on Shareholder Activism

Shareholder activists are attracted to public companies that have disappointed shareholders and are selling / trading at a discount to potential value. That discount attracts a toehold share (minority stake) purchase by an activist investor, who then threatens a takeover or proxy fight to try and force the target company to either make some corrective change in strategy or sell itself to another company for a premium. If the company under attack does either of those things, the share price will eventually increase. Consequently, both the activist investor and non-activists shareholders benefit from the higher share price.

Netflix Board Response

As mentioned in Juan’s blog post, in response to Icahn, the board put up the traditional first line of defense against a corporate takeover: shareholder rights plan (“poison pill”).

An important aspect about this particular poison pill is that Netflix board adopted a right with a different threshold for “passive” and “active” investors. In a press release, a representative of one of Icahn’s funds said that “any poison pill without a shareholder vote is an example of poor corporate governance, and find the pill Netflix just adopted is particularly troubling due to its remarkably low and discriminatory 10 percent threshold. As one of the company’s largest shareholders we are concerned about the poor corporate governance at Netflix that these and other actions reflect”.

Besides arguing that the poison pill is “intended to protect Netflix and its stockholders from efforts to obtain control of Netflix that the Board of Directors determines are not in the best interests of Netflix and its stockholders” (quoting Juan’s blog post), Netflix board justifies its poison pill structure by arguing that Mr. Icahn has specifically mentioned his goal of selling the company (thus it is only taking aim at limiting the activist shareholders and not passive ones) posing a tangible threat to the firm and its shareholders (reason enough to defend their position).

Thoughts

I believe that Netflix’s board move would most probably be upheld by the courts as a matter of practicality or common business practice. Making reference to Juan’s blog, it appears that Netflix passes both Unocal tests. However, I am always skeptical when firms use, by default, poison pills as a measure to “protect” shareholders from a “mean” activist investor. Even though poison pills are usually known as “shareholder rights plan” they could also be known as “management/board rights plans”, since what they ultimately do is limit shareholder’s ability to choose.

In occasions the adoption of a poison pill should be seen by investors as a red flag. As in the case for Netlfix, most of the companies that implement them have been poorly managed and have depressed stock prices (with unsettled shareholders), setting them as perfect targets for activist investors or hostile strategic buyers. “Hostile” takeovers may not be something shareholders should necessarily consider catastrophic (it may actually be “hostile” to current management / board only). You can clearly see the conflicting interests inherent in a company that is underperforming and subsequently adopts a poison pill (i.e. Netflix), in particular with their staggered boards (as per Juan’s blog post). One could thus argue that good corporate governance should give shareholders enough power to change boards/management, when it is in their best interest.

One of the biggest themes in shareholder activism is forcing a sale of the company. Perhaps the target company can be better run by the board & management team of another company, a leveraged buyout house, or some other outside investor put in an ownership position. Perhaps a sale will result in a premium from a strategic buyer, and shareholders do not believe the target company could achieve equivalent future value by remaining independent. Perhaps a sale is not the best alternative, but for whatever reason it would result in a premium to the target company’s stock price. In that case a target company’s board may be forced to put the company up for sale anyway.

Conclusion

Regardless of the outcome in this case, I believe Icahn and team are correct to highlight the negative implications of Netflix poison pill decision. Many academics argue that shareholders should have the right to making a decision themselves about these situations. Sadly, shareholders do not “control” a public corporation, but they do retain certain fundamental rights: the right to complain; the right to sell; the right to sue; the right to vote.

However, the Unocal case has had many worrying ramifications on the fundamental rights that shareholders have. Unocal permits the use of poison pill defenses (under certain tests), truncating the “right to sell”. Further, under Unocal the board may be able to frustrate a direct vote on a takeover but can’t preclude a vote to replace the board. Boards are protected by Unocal especially upon a suit to enjoin them (not likely to succeed).   

Overall I believe that Netflix’s poison pill decision has to be analyzed very carefully. A “shareholder rights plan” might not be in the best interest of shareholders. It will be extremely interesting to see how the events in this case unfold and what Icahn’s reaction will be.

http://online.wsj.com/article/SB10001424052970204755404578101370648530206.html

http://dealbook.nytimes.com/2012/11/06/netflixs-poison-pill-has-a-shareholder-friendly-flavor/

http://dealbook.nytimes.com/2012/11/05/netflix-adopts-poison-pill/

http://money.cnn.com/2012/10/31/technology/netflix-icahn/index.html

http://www.forbes.com/sites/steveschaefer/2012/11/13/netflix-poison-pill-or-poisoned-chalice/

 

Netflix’s poison pill reflects poor corporate governance?

Last week Netflix announced that its board of directors had adopted a shareholder rights plan, commonly known as a poison pill. Usually a poison pill is a defensive tactic used by a corporation’s board of directors against a hostile takeover. In the case of Netflix, the poison pill has a threshold of 10% for active investors; this means that if an active investor acquires more than a 10% stake, the company would double the number of Netflix shares on the market, making it very expensive to the active investor to buy a bigger stake. However, Netflix threat passive investors differently and has set threshold of 20% for institutional shareholders who take a passive stake, this gives the poison pill a “shareholder-friendly” flavor.

Netflix reaction came after activist investor Carl Icahn disclosed he had bought 9.98% of the company. The board of directors has adopted the poison pill without the shareholders vote and the company has said the poison pill defense is "intended to protect Netflix and its stockholders from efforts to obtain control of Netflix that the Board of Directors determines are not in the best interests of Netflix and its stockholders." Moreover, Netflix has a powerful antitakeover provision already, it has a staggered board. This means that every director has a three year term with the expiration of the terms staggered over a three year period. Therefore, to replace a majority of directors would require at least two annual meetings.

The Delaware courts have considered the legitimacy of shareholder rights plan as a valid instrument of takeover defense. There are three important cases that provide the basis of this discussion.

Moran vs. Household International, Inc.

In this case, the Delaware Supreme Court concluded that the directors of a Delaware corporation had the power to implement a shareholder rights plan and stated that proxy contests, as well as other takeover strategies, could still be used by investors to gain control of the company. Therefore, the adoption of the plan should be reviewed under the business-judgment rule.

Unocal v. Mesa Petroleum Co.

The court endorsed a two-part test (Unocal test) in assessing defensive tactics: (1) the board must show that it had reasonable grounds for believing that there was a threat to the corporation; and (2) the board’s defensive response was reasonable in relation to that threat.

Unitrin Inc. vs. American General Corp.

The Delaware Supreme Court revisited the Moran and Unocal decisions in this case. The Court held that in applying the Unocal test, courts must first determine whether the defense is preclusive or coercive toward shareholders before determining the defense's reasonableness.

Thoughts

Although this Netflix reaction could be upheld by the Delaware courts, it is very unlikely that the court will resolve that the shareholder rights plan adopted by Netflix is preclusive or coercive or that it doesn’t pass the Unocal test. Especially considering that (1) the court has already validated the use of a poison pill with a threshold of less than 5% in the Selectica, Inc. v. Versata Enterprises, Inc.'s case (the poison pill was used to preserve the company NOLs) and (2) Mr. Icahn has said that he would like the company to explore a sale.

Therefore, the debate is not about poison pills being allowed in the U.S. states, but if they reflect good corporate governance reactions against potential takeovers. In one side, a poison pill could be seen as an active reaction by the board of directors to avoid a hostile takeover that would not benefit the long term interests of the company shareholders. This position gives the board a protective role in which they should avoid coercive bids and support auctions so that they can get a higher price for their shareholders.

In the other hand, poison pills are usually put by the board of directors without a shareholders vote, which is why it gives a very high power to the board against some shareholders’ interests. This could be used by poor managers that want to keep their positions inside the company, although they have not delivered a good performance in the past. Moreover, the fact that the company has a shareholder rights plan could make it less likely that it become a takeover target and reduce the potential bids that it could receive, losing the potential premium that the shareholders could get in the takeover.

In Netflix’s case, the company has not presented a good performance in the last months, situation that has been reflected in its stock price. Furthermore, the company has adopted an aggressive poison pill (10% threshold) which, together with its staggered board, gives the company a strong antitakeover defense mechanism and protects current managers’ jobs. Furthermore, there are many shareholders of the company that do not support the current management and the board of directors’ policies, such as the one that states the CEO salary doesn’t depend on Netflix’s business performance.  Therefore, in this case the question is if the board is adopting a poison pill to protect the shareholders interest from the potential risk that an active investor as Mr. Icahn could imply for the company, or if the board and the management are adopting the poison to protect their jobs against any potential takeover.

http://dealbook.nytimes.com/2012/11/05/netflix-adopts-poison-pill/

http://www.reuters.com/article/2012/11/05/us-netflix-poisonpill-idUSBRE8A40QM20121105

http://www3.gmiratings.com/home/2012/11/gmi-ratings-governance-update-netflix-inc/

http://dealbook.nytimes.com/2012/11/06/netflixs-poison-pill-has-a-shareholder-friendly-flavor/

Best Buy board waives Minnesota law to gain more credible offer

In August, Richard Schulze made an offer to acquire Best Buy for up to $8.8Bn. The company founder resigned from the board in June. The retailer has been struggling for the past few years, so a takeover offer wasn't a complete surprise, but since Best Buy is domiciled in Minnesota (instead of Delaware), Schulze will be subjected to strict antitakeover laws.

In Minnesota, the business combination act says that if a shareholder wants to acquire more than 10% of a company, an independent group of directors must approve the transaction. If the board does not provide approval, the shareholder must wait four years before "squeezing out" the remaining shareholders. In Delaware, a more takeover friendly state, the requirements are 15% of the company and a three year waiting period. Additionally, if the board does not approve of the offer, 66.66% of the remaining shareholders can approve the transaction.

Schulze acquired his current 20% stake in Best Buy well over four years ago, so he wouldn't be subject to a four year waiting period before taking his offer hostile, or directly to shareholders. However, Schulze would not be able to finance such a large buyout himself. Once he takes on a partner (PE firm, bank, etc.), that institution would become part of the "interested shareholder" group, which resets the four year waiting period.

Following his initial, highly contingent, offer, Schulze sent the board another letter, requesting permission to form an investor group and requesting the opportunity to perform due diligence. The board of directors waived the law, saying that Schulze could engage in financing discussions with potential partners. This would allow him to strengthen his initial offer by naming private-equity partners in a proposal to the board. The board's response indicates they want a more substantial proposal from Schulze before seriously considering his offer. However, as a company in the middle of a turn around plan, the board was hesitant to open their books to Schulze and his partners.

The two parties disagreed on the standstill agreement associated with due diligence. This term would prevent Schulze from going hostile for a certain period of time if the groups failed to reach a friendly transaction. Best Buy initially proposed a period of 18 months, but Schulze rejected that offer. Eventually, the company allowed Schulze to conduct his due diligence, but they stipulated that he would have to put forth a formal offer within 60 days of accessing the company's financials. The board would then have 30 days to respond to his offer, and if they rejected it, Schulze would not be able to go hostile until January 2013. If the second offer were rejected by shareholders and the board, Schulze and his partners couldn't make a subsequent offer for a full year.

This arrangement enables the board to review an offer that initially represented as much as a 48% premium. However, it also guarantees that Schulze cannot have too much influence over the company during the critical holiday shopping period. Since Schulze took the aggressive approach of publicly negotiating with Best Buy, he is certainly expected to come forward with a more credible offer. He can no longer use Minnesota law as rationale for uncertain financing, since the board gave him permission to engage PE firms and banks. Schulze has until mid November to make his offer, and then the ball is back in the board's court. 

 

Sources:

http://dealbook.nytimes.com/2012/08/07/minnesota-minefield-for-a-best-buy-deal/

http://online.wsj.com/article/BT-CO-20120816-711010.html

http://dealbook.nytimes.com/2012/08/22/behind-the-due-diligence-dispute-at-best-buy/

http://dealbook.nytimes.com/2012/08/27/best-buy-to-open-books-for-founder/

http://finance.fortune.cnn.com/2012/10/25/the-best-buy-buyout-just-got-harder/

From "Insider Trading" to "Inside a Jail"

                Rajat Gupta, the former CEO of McKinsey & Co., and board member for Goldman Sachs, Procter and Gamble, Genpact and AMR was sentenced to two years in prison and was fined $5 million for insider trading in association with former hedge fund manager Ram Rajaratnam.  Gupta was found guilty of three counts of securities fraud, the most infamous of which was his divulging of the information that, during the financial crisis, Berkshire Hathaway would be giving Goldman Sachs a large infusion of capital that would more than likely save the bank from the many issues that would challenge its peers in the financial sector for years to come.

                Rajaratnam used this information, as well as other tips regarding Procter & Gamble, to make huge sums of money for his firm Galleon Capital.  While neither party directly traded on the information for personal gain, it was still an infringement of the insider trading laws as defined by the United States Securities and Exchange Commission. 

                Rajaratnam is currently appealing his 11 year sentence for insider trading and it is expected that Gupta will serve about 85% of his 2 year sentence.

                While this is a horrible shock to boards everywhere and raises serious issues about the effectiveness of corporate governance, it has many other ramifications beyond just a malfeasance by two individuals in the securities industry.  The law clearly states, “Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information (sec.gov).”  The actions of Gupta and Rajaratnam were clear breaches of this code.

                Gupta was the leader of one of the best consulting firms in the world and a board member for some of the best and largest companies in the world - positions that commanded and earned him a tremendous amount of respect and trust.  Given his stature and the trust and respect bestowed upon him, one can draw corollaries to many other men and women who are actively engaged in senior management and board positions at hundreds of large, publicly traded companies.  Anyone who serves a company in this capacity is privy to endless streams of confidential information and is thus held to a higher standard of conduct and morals - both legally and ethically.  In this case, the charge and conviction of insider trading highlights an important truth for the layman: there are groups of people who have the information, connections and capital to make markets move, which severely tilts the playing field in favor of the well-connected and well-informed.  It raises the question as to whether anyone can truly be trusted in such a position.  From a psychological standpoint, the group dynamic between several men and women who serve on boards could easily deteriorate into a situation where egos are tested and each person thrives on knowing something big and important about a company that few others know.  This notion is supported by the fact that Gupta and Rajaratnam were said to not have directly profited from the knowledge and sharing of the insider information, which again raises the question behind the motive of this situation, even when considering the indirect benefits of the tipping / information sharing.  That being said, both parties clearly broke the law, but in many respects, Gupta’s breach should be handled more leniently due to his lack of personal involvement.  Based on the facts of the case and the assumption that further deterrence of these breaches is the goal, the actions taken by the court seem to be reasonable, justifiable and appropriate.

The feeling of discontent with the general public was further tested when many of the large banks received government bailouts which were necessary because of excessive risk taking.  As the financial crisis took hold and the number and size of the bailouts was tallied, many individual investors began to think that the “game” of the market was indeed a fixed game for the big players and powerful individuals in the corporate world.  While all board members are held to a higher standard and often in a better light, Gupta was considered to be one of the most respected through his deft management / directorship of many excellent companies and his philanthropic activity.  Now that Gupta has been implicated in this breach, the faith of the general public is undoubtedly shaken and possible irreparably so.

                Another issue brought to light by this situation is the apparent lack of control and effectiveness of corporate governance laws in the U.S.  Obviously these laws apply to individuals and those laws can only stop behavior on an individual level.  Every board member is aware of these laws and needs to abide by them on an individual basis.  It is very difficult to enforce these laws prior to breaches, except for the further education of the board members.  But the law is clear on the sharing of non-public or material information.  We believe that this raises an interesting question - how can boards be better controlled?  How can the layman feel comfortable that a) the people representing the boards of companies they invest in are operating in their best interest? and b) the “playing field” is level in terms of access to information and the associated actions based on the information gathered?

                Now that so many parties are being prosecuted for breaches of these laws it is certainly clear that the consequences are real and that board members need to take their roles extremely seriously, both from the perspective of being educated on the firms operations and finances as well as behaving within the laws set forth by the SEC. 

                This upgraded seriousness with the consequences of being part of a publicly traded company’s board must entail some changes from public companies.  Board members need to be compensated more for the time and effort that comes with being as prepared and compliant as laws and regulations demand.  Also, publicly traded companies need to go through rigorous personal and professional background screenings prior to the election of new board members.  While no one could have known that Rajat Gupta would be a person would have breached his duties as a board member, enhanced compensation and increased scrutiny can hopefully in the long run lead to more effective and dutiful boards.

As with any change in corporate governance structure and law, we must consider a balancing act.  The Board of Directors is an extremely important part of a company and how it operates and hopefully thrives in the long term.  That being said, it would be ill-advised to use this situation as a springboard to make many aggressive changes that will ultimately decrease the ability for companies to attract top talent to serve on their boards.

online.wsj.com/article/SB10001424052970203897404578077050403577468.html

http://investing.businessweek.com/research/stocks/private/person.asp?personId=162849&privcapId=46723447&previousCapId=33328&previousTitle=Procter%20&%20Gamble%20Co.

http://money.cnn.com/2011/12/05/news/companies/rajaratnam_prison/index.htm

http://www.sec.gov/answers/insider.htm

Authors

Bill Mele

Phil Yeager

KBR Ordered to Pay $85 Million to Iraq Vets

The case is "Rocky Bixby, et al., v. KBR, Inc., et al," Case No. 3:09-CV-632-PK in the U.S. District Court for the District
of Oregon.
Background
A federal jury in Portland, Oregon found US-based defense contractor KBR (formerly a division of Halliburton) guilty of negligence on
Friday. Defendants were awarded $85 million in damages after the company was charged with negligence for exposing National Guard soldiers to carcinogen
hexavalent chromium at the Qarmat Ali water plant in Iraq. Each of the 12 soldiers was awarded $850,000 in noneconomic damages and $6.25 million in punitive
damages after the soldiers reportedly suffered from continued respiratory and skin disorders.
Discussion
The defense argues the exposure to sodium dichromate was due to a preexisting condition at the dilapidated facility, which the company was
contracted to restore. The contractor informed the U.S. Army of the potential risks after discovering remaining bags of the substance in the facility. Based on
this evidence, the factual causation of the case is problematic and does not seem to be clearly proven. To be specific, based on the preexisting presence of
the chemicals, it is technically challenging to prove KBR’s acts or failure to take safety precautions were the cause of the damage. 
"KBR did safe, professional and exceptional work in Iraq under difficult circumstances -- and
multiple U.S. Army officers testified under oath that KBR communicated openly
and honestly about potential health risks." - KBR attorney, Geoffrey Harrison
Even if the plaintiffs were exposed to sodium dichromate, expert witnesses disagree on the duration and level required cause serious
health concerns. The plaintiff may not recover damages without proving that the defendant's breach caused an economic, physical, or reputational injury. Having
limited tools on site to measure preexisting and future exposure levels makes proving causation and resulting injuries extremely difficulty. A primary piece
of evidence in the case was video testimony from National Guard James Gentry, who died in 2009 of lung cancer. Resulting symptoms appear to be the primary
indicator for measuring the level of toxins present during the facility’s restoration.
KBR has communicated that they planned to appeal the verdict. Without proving causation and harm directly resulting from the
reported negligence, this tort decision will be difficult to sustain in appeals court. 
About KBR
KBR is a global engineering, procurement and construction company focusing on the energy, petrochemicals, government services and civil
infrastructure sectors.
The company is the largest defense services provider, supporting U.S. and international government agencies, and has designed and
constructed more than half the world's liquefied natural gas (LNG) production capacity over the past 35 years.
Sources 
http://www.bloomberg.com/news/2012-11-03/kbr-ordered-to-pay-troops-85-million-in-chromium-case.html
http://www.google.com/hostednews/ap/article/ALeqM5jvpTg35JrWkVPb2oEE3HdSJ6AouQ?docId=d04285252cb4432d8fa39437a1aa1002
http://www.cnn.com/2012/11/02/justice/oregon-national-guard-lawsuit/index.html
http://www.kbr.com/About/Company-Profile/
http://en.wikipedia.org/wiki/Negligence#Legal_causation_or_remoteness

Are Accounting Standards a Relevant Disclosure of Information for Investors?: La Polar Case

Background

Empresas La Polar S.A is the fourth largest Chilean retail company in terms of number of locations, with 42 stores in Chile and 4 stores in Colombia. The company was founded in 1920 and went public in 2003.

The Latin American retail markets are divided into “traditional” and “modern” retail. Traditional retail chains include the classic “moms & pops” as well as the informal sector. Modern retail refers to supermarket chains, department stores and homecenters; and their market penetration varies by country. Chile is the economy with the highest modern retail penetration in Latin America (most players are fully integrated, owning the three basic retail concepts). The main reason for these players to achieve this higher penetration has been the use of consumer financing. Chilean retailers are one of the Latin American pioneers in bundling consumer finance with modern retail. These firms rely on their financing subsidiaries to boost retail sales and most importantly gain additional revenues through interest earned on their proprietary credit cards and consumer loans. This practice gave rise to a huge conflict of interest, which if not properly managed, could lead to severe consequences (i.e. providing credit to low income consumers who could not afford it).           

On 1999 La Polar was bought by the PE firm Southern Cross, and decided to change La Polar strategy targeting the low and middle income sectors by initially offering “lower name” brands at affordable prices as well as initiating its consumer financing business segment.  From 2003 to 2008 La Polar outperformed its peers, resulting in a significant  market share growth and a constant stock price increase. This  led to lower funding costs, allowing the company to further expand its business to lower income sectors. In addition, in 2009 La Polar’s CEO was elected the “executive of the decade” by its peers.

Situation

As the economic crisis was damaging the Chilean Economy in 2011, many analysts were concerned about La Polar’s credit risk and their clients’ ability to pay their debt. On the other hand, company executives declared the situation was stable and they were not experiencing relevant decreases in the quality of their portfolio.

But this was eventually proven to be false. The company’s executives managed a way to show a healthy and current portfolio under the accounting standards, hiding the increasing defaulted accounts from their credit portfolio. The company unilaterally renegotiated more than 400,000 accounts by extending lines of credit, and restructured their dates of payment. PriceWaterhouseCoopers as auditor of the company approved the financial statements as adhering to the current accounting standards. At this moment, both PwC and La Polar’s executives were selling their stock positions in La Polar through the stock market.

Once the situation went public and became a scandal, La Polar announced a deep credit department restructure.

Aftermath

After the company’s announcement, La Polar’s stock price declined by more than 80% and the yield on its 2016 bonds increased from 3.8% to 37.6%. To avoid bankruptcy and finance working capital the shareholders of the company approved a share issuance plan that raised US$200 million. Some of the larger investors in La Polar were the private pension funds from Chile, reason why this scandal and decrease in stock value had a direct impact in the pensions of millions of Chileans.

Up to date, 18 former La Polar executives, including 11 senior officials, have been charged by the SVS (Chilean Securities and Insurance Supervisor) with providing false information regarding the financial situation of the company to the SVS and to the market in general. La Polar executives have also been charged with failing to abide by due diligence and inappropriate use of privileged information. Moreover, the majority of the members of the board and senior managers has been fired or tendered their resignations.

Furthermore, PwC has also been charged for selling shares of La Polar, while knowing about the company’s financial problems.

In addition, Sernac (Chilean government’s consumer defense agency) filed a class-action suit against La Polar for unilaterally refinancing customers’ debt. La Polar has agreed to compensate all customers that were affected by the unilateral renegotiations by paying a total amount of $651 million.

After this scandal, La Polar has changed the members of its Board of Directors and senior management. These new executives are trying to regain its business by changing their image, attracting new customers and taking advantage of its retail business in Colombia (higher growth market).

Thoughts

There are few doubts that the management of La Polar engaged in illegal actions by unilaterally refinancing their delinquent accounts and providing false information to the public. Thus, one of the big questions that have to be raised is how effective are the current rules for disclosure of information worldwide. Current requirements are focused on specific accounting rules that can be met strictly by applying IFRS or US GAAP, but the useful disclosure of information for investors sometimes deviates from these standards.

La Polar was able to easily reclassify its “delinquent accounts” as “current” in accordance with accounting principles, just by extending credit limits and renegotiating those accounts. According to the accounting rules, those accounts were not “delinquent” anymore, and no write-off or special disclosure was required for these cases. This was further approved by PwC, which as an auditor, focused on the correct application of the accounting rules. Thus, it is clear that La Polar investors were not able to assess the company’s financial problems. There was no disclosure of relevant information for the investors.

This is not a particular case of the emerging markets, as similar cases have been seen in Enron, WorldCom, Sunbeam, Tyco and many others throughout the last decade in different countries. Enron was able to hide relevant information to its investors by using SPV’s and still apply current accounting standards. It is not clear that the accounting standards are strictly related to the relevant disclosure of information for shareholders; thus, further reforms have to be taken to demand disclosure of information focused on principles and duties of the senior executives in the company, in addition to accounting rules, in search for a broader scope.

The second question relates to the role of the board of directors. Public companies are run to maximize shareholder value but are not actually run by the shareholders themselves. The essence of good corporate governance is to let an effective board of directors run the company and maximize shareholder value. The board is responsible for policymaking, while management is responsible for day-to-day running of the business. The extent to which the board is accountable for unauthorized management actions is questionable. In La Polar, board members have been accused of failing in their legal duties and thus held liable for the actions of managers, even when these actions were unauthorized. Board members claim they were provided with irregular, false and incomplete information.  

According to US law, the role of the Board of Directors is to safeguard shareholder interests. In the Enron case, the Board of Directors was accused of fiduciary failure as members knowingly allowed Enron to engage in high risk and fraudulent accounting practices. However, in La Polar case, the Board of Directors was unaware of the practices held by management and even more, had not authorized such policies. Is the board then just in place to provide oversight and not become involved in day-to-day operations? Should a board be held liable for prohibited management actions? Should members be responsible even if management provided inaccurate information and did not disclose their fraudulent practices? 

 

Sources

http://www.elmostrador.cl/noticias/pais/2011/07/14/caso-la-polar-los-antecedentes-con-los-que-la-svs-acuso-a-18-ex-directivos-y-al-auditor-de-la-compania/

http://www.sernac.cl/sernac/db_images/fckuploaded/SERNAC%20presenta%20demanda%20contra%20La%20Polar.pdf

http://www.santiagotimes.cl/business/economy-a-trade/23844-chilean-retailer-agrees-to-pay-up-after-credit-scandal

http://www.businessweek.com/news/2012-09-12/chile-s-la-polar-plans-to-double-sales-by-2014-after-share-sale

http://www.lapolar.cl/img/corporativo/memorias/memoria_2011.pdf

http://www.lapolar.cl/mipolar/empresa/historia.htm

http://es.wikipedia.org/wiki/La_Polar

http://www.americaeconomia.com/analisis-opinion/la-polar-estafa-financiera-en-chile

 

Authors 

Amadeo Ibarra Flores

Juan Pardo

Marcelo Ramos

Felipe Silva