Bank and Market oriented In a bank-oriented system (Japan and Germany), banks are responsible for channeling funds from savers to borrowers, particularly non-financial corporates. By performing this intermediation role, banks constantly ‘monitor’ the borrowers on behalf of the deposit holders, a function which could not be conducted individually by each of those deposit holders or lenders. In Germany, two-tiered structure, and representation of employees on the supervisory board, termed co-determination, are mandatory. Financial institutions are one of the most important blockholder (same for Japan) followed by companies and families, the former one vote as a proxy of many individual shareholders. Hostile takeovers have been rare. The peculiarity of Japan is Keiretsu (crossholding) which can be vertical and horizontal. Companies own small portions of the shares in each other's companies, centered on a core bank (internal capital market); this system helps insulate each company from stock market fluctuations and takeover attempts, thus enabling long-term planning in innovative projects (no market myopia, high R&D). The advantages of the Japanese system are internal capital markets and soft solutions for financial distress. However, there is no market for corporate control and the system relies heavily on banks. In a market-oriented system (USA and UK), the companies are more inclined to issue securities (shares, bonds, etc.). Savers purchase these securities directly through distribution networks or banks. However, the key difference is the absence of any financial intermediary that alters the nature of the security issued. General characteristics of these two countries are: managers own only 2-3% of company shares, mutual and pension funds “vote with their feet”, focus on market price and short-term results and market myopia (Lower R&D expenses). The agency cost is management versus shareholders. According to LLSV common law countries provide the strongest degree of protection for shareholders which leads to higher dividend payout. The takeover market has been an important governance mechanism in both USA and UK. Agency costs Monitoring Costs: For example, the board of directors at a company acts on behalf of shareholders to monitor and restrict the activities of management. This is to ensure that behavior maximizes shareholder value. The cost of having a board of directors is therefore, at least to some extent, considered an agency monitoring cost. Costs associated with issuing financial statements and employee stock options are also monitoring costs. Bonding Costs: For example, a manager may agree to stay with a company even if the company is acquired (contractual obligation). The manager must forego other potential employment opportunities (implicit cost). Residual Losses: Residual losses are the costs incurred from divergent principal and agent interests despite the use of monitoring and bonding. Agency cost of Equity: The agency cost of equity arises because of the difference in interests between the shareholders and the management. The agency costs will include both, the cost due to the suboptimal decision by managers, and the cost incurred in monitoring the management to prevent them from taking these decisions. Another agency costs may arise between majority shareholders and minority ones, because the former one will base its decision only on its private benefits on the backs of the latter one (for example, tunneling). Agency cost of Debt: The agency cost of debt arises because of different interests of shareholders and debtholders. Firms may be prevented from undertaking good projects because debt covenants keep them from raising additional funds, or else they may be forced by creditors to liquidate when it is not efficient to do so. Also, when debt is not very concentrated the effective legal protection enjoyed by creditors is greater than dispersed equity holders. The crucial feature of the creditors’ legal rights is that concentrated action by multiple creditors is not required to act against a delinquent debtor, unilateral action is enough (theoretical justification for bankruptcy protection). Alignment of Interest According to Jensen: higher is the managers’ ownership the higher is the alignment of interests between shareholders and managers. The alignment of interest describes an arrangement or relationship in which all parties stand to benefit from one particular outcome. However, when key employees gain more and more ownership in the firm, the performance of the company suffers (entrenchment theory). Those theories can be plot in a graph where the x axis represent Alpha (the fraction of voting shares held by mangers) and the y axis represent the Q ratio. The latter one expresses the relationship between market valuation and intrinsic value. It is a mean of estimating whether a given business or market is overvalued or undervalued (if above 1 than a firm is managed well). It is calculated as the ratio of equity and liability market value over their respective book value. Empirical evidence has found that: ownership affects performance, but the reverse is not true, and efficiency goes down for sales of ownership that grows from 25%. If ownership is around 80% the entrenchment effect is not relevant since the major shareholder identifies with the company. The threat of a takeover may induce managers to be more efficient not to risk being taken over and removed. Agency-costs from separation of ownership & control (External Solutions) Market for product: Inefficient companies will progressively have a lower market share and will eventually be out of the market. Even when it works, its actions come too late when all wealth has been destroyed and efficiency cannot be restored. NOTE: Market of products does not work in case of monopoly (e.g. Ferrovie Italiane e RAI) and in closed and regulated economies because the economy cannot be invaded by competition. It will occur as soon as the market will eventually open. Market for managers: Market should be efficient: inefficient managers and managers’ bad performance should reduce the stock price of the company and in turn the board should remove bad managers. But empirical evidence shows that is not easy to remove top managers: first, because board are not active since many members are not independent from the CEO (i.e. when you are a member of the board of director means that the CEO ask you to be there). Some Managers are even entrenched, having a high stake in the firm which virtually cannot be fired. Moreover, as CEO I will never go against those members that put him in such a high role and reputational capital exercise no more influence on an elder CEO. Market for corporate control: A takeover occurs when one company makes a successful bid to assume control of or acquire another. If the tender offer is accepted, then the acquirer can replace or at least control the management. Empirical evidence suggest management resistance to takeovers is very common (golden parachute and poison pills). However, takeovers are not only expensive and require a liquid market, but they may increase agency cost (empire building behavior by bidding management). Agency-costs from separation of ownership & control (Internal Solutions) Board of Directors: hire, fire, monitor, and compensate management, all with an eye toward maximizing shareholder value. CEO usually is also the chairperson of the board. Board size is negatively related to both general firm performance and the quality of decision making. European commissions have embraced the idea that appropriate board composition is important to good corporate governance (Codes of Best Practice). CEO turnover increased following issuance of the Code and that the sensitivity of turnover to performance is stronger following its issuance. Also, pink quotas help the functionality of board of directors. Debt’s discipline: LBOs are acquisition of another company using borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. Value creation happens through minimization of agency costs through debt and more optimal contracts. Low credit spreads help high leverage. Incentives Schemes and stock options: A better solution is to grant a manger long term incentive contract ex ante to align his interests with those of investors. If the manager has added economic value to the company (EVA) part of it will be converted in a bonus. However, bonuses based on accounting measures are always dangerous because managers tend to be risk lover. Stock option effects incentivate managers to create value in the relative short-time horizon but they align interest only when company’s performance is good. Managers are incentivized towards a fraudulent behavior: cook the book and backdating. Solution a mix of stock options and shares. (Dodd Franck Act regulates incentive schemes). Monitoring and active investors: Due to free riding of small shareholders who should monitor? Large shareholder (e.g. 5% of a listed company) or financial institutions because they provide loans to companies. Jensen suggested that financial institution should vote with their hands and not vote with their feet. Nowadays, there are several activists hedge funds: Algebris, Amber and Hermes UK Fund. Enron Case In year 2000, Enron controls one quarter of the energy transmission in USA, it is an active player in the new economy and becomes one of the Nasdaq’s stars. The Enron scandal surfaced in October 2001 when it was revealed that the seventh largest company was involved in corporate corruption and accounting fraud. It announces a loss of 1.2 billion $ in the third quarter. SEC starts to investigate on the partnerships system. After SEC revision Enron became a penny stock and asked for Chapter 11. Enron had hidden debts and inflated profits and turnover through: A vast variety of financial instruments, cooking books and SPE around the world (most of them in tax even countries). In order to finance the rapid acquisition campaign, Enron had raised lot of debts partly moved and hidden in the external companies which were not entering into the consolidated financial statements. When the market was going up: some offshore companies created by some Enron’s top managers were working for Enron and overbilling their services in order to transfer profits into their pockets. When the market was going down. Enron’s offshore companies were used to hide Enron’s losses. Enron’s SPE were used for several different purposes such as: get rid of “bad” receivables, uncovered positions on derivatives, revaluations of assets and bad investments. In January 2002, Enron was not traded anymore on Wall Street and the auditing company Arthur Andersen went bankrupt (Andersen’s employees destroyed important documents related to Enron). Enron managers are alleged of many crimes as fraud, money laundering, illegal association to commit crimes, insider trading and market manipulation. Sarbanes-Oxley Act Establishment of the PCAOB: It is responsible for setting auditing standards and overseeing the auditing process of public companies. Companies must have at least one member of their audit committee who is a financial expert as defined by the SEC. Auditor Independence: Audit firms cannot provide consulting services and must be rotated every five years. Auditor reports must be made to audit committees not to management. Auditor must not have employed company personnel in the past one year. Corporate responsibility: CEO and the CFO must certify that the financial reports, complies with sec regulation and fairly represents the financial position of the company. Significant penalties; Knowing violations: $1 million fine/10 years in prison. Willful violations: $5 million fine/20 years in prison. Enhanced financial distribution: All off-balance sheet transactions must be included in the annual and quarterly filing reports. Pro-forma statements should not be misleading or false. Loans to executives are prohibited. Disclosure of transactions involving management and principal stockholders within 2 days. Analysts conflict of interest: “Chinese walls” between investment banks and analyst working for brokerage firms: no more approval of the reports by investment bankers, no influence on analysts’ remuneration by investment bankers. Disclosure of any conflict of interest. Commission resources and authority: More resources to the security and exchange commission and powers to the authorities Corporate fraud accountability: Destroying or tampering evidence and records during an investigation is a criminal offence. SEC can petition the company to freeze extraordinary payments. Violators of s-ox act provisions may be barred from serving as an officer or director of a publicly traded company for the rest of their life. Even though it has improved the disclosure of off-balance sheet transactions, these studies have found economically significant costs of compliance, particularly of certifying financial statements, with these costs being proportionately larger for medium and small firms. Separation of ownership and control through legal devices Ownership/control: measure of how ownership of cash flow is connected to control. The wedge (which goes from 0 to 1). If it is 1, there is no separation between ownership and control, when it is below 1 there is some separation, the lower the higher separation. Legal devices (control devices) such as pyramids, non-voting shares and shareholders agreement help to have a cash flow dilution and safe control. It is also true if we deviate from one share - one vote regime (NV, MV, SV, LV, RV) and through dilution, stock split and equity financing carve out. For example, both Italy and France allows both multiple and loyalty shares. Pyramidal group and dividend taxation: Why pyramids were common in Italy and Europe and not in the US? Because families can control the company with low capital. In 1935, USA double taxed these dividends (10%-30%) While in Italy they are double taxed for 5% of dividends (Draghi law). If tax exempted, a pyramidal group will pay same taxes no matter the number of pyramidal layers. Non-voting shares are nor attractive any more since the 1998 TUF, as the non-voting shareholders decisions needed to approve some special extraordinary operations (which may harm non-voting shares, as merges or unifications) now need the approval of the non-voting shareholders’ meeting with at least 20% of non-voting equity. The partial double taxation on intergroup dividends is not effective when the controlling owner is the State, being also the subject who gets 100% of the taxes. When the controlling shareholder is the state, tax minimization (max shareholder’s value) is not a goal. Vice versa, the lower the ownership of cash flows by the Government, the higher the risk of laws aimed to maximize taxation (Robin hood tax for example). Separation of ownership and control through legal devices: major effects Entrenchment plus high separation of ownership and control could originate a severe conflict of interests between majority and minority shareholders: Private benefits and perquisites: The so called “public relationship money”, shareholders use the company’s money to buy Ferrari, private jets. Also, they can bribe politicians to gain political power (It can affect public opinion also through tv, newspaper and media). Majority shareholders may hire friends and relatives which in turn will enjoy high compensation and a safe job. Insider trading is very plausible. Political power: Can affect public opinion through tv, newspaper and media. Executive turnover: Companies do not fire managers if they are their relatives, in particular sons. For higher ownership dilution – sometimes the performance is low not to the managers fault, but because it is at the bottom of a group, so it is expropriated. High voting premium: The difference between the market price of voting and nonvoting shares. Overinvestment: Majority shareholder could undertake negative NPV investments if related private benefits exceed the diluted quota of negative NPV (given by the %ownership of CFs). Even if the NPV is negative but the private benefit is positive, majority shareholders may push for value destroying acquisitions. Minority shareholder expropriation through: Related party transactions, Inter-group acquisitions, Mergers and acquisition, Dual class reunification and “Ad-hoc” Stock option plans. Expropriation can be suffered also through cash flow, asset “in” or “out” and equity tunneling. Dual class unification is good, because: Increases firm’s value using a more efficient equity structure (“one share- one vote”). Reduce the O/C wedge or separation. Increase voting shares’ liquidity. Help entering or remaining in a major stock index and ease future equity issues. Since there is no regulation in Europe on how DCU should be done, but only on how issue new stock or create a new class of stock, companies can do whatever they want. In fact, in Italy, where the voting premium is one of the highest, DCU change little in overall firm value. There has been no compensation to voting shareholders: the controlling shareholders would purchase additional blocks of non-voting shares prior to the unification announcement and extract a private gain when non-voting shares appreciate in price upon the unification announcement. LLSV The goal of LLSV is to establish whether: laws and the quality of their enforcement, pertaining to investor protection, differ across countries and whether these differences have consequences for corporate finance (legal family is an exogenous variable). They have examined 49 countries’ laws around the world (no transition economies) governing: Investor protection (one share-one vote, anti-director rights sum of 6 dummy variables1, mandatory dividends). Creditor protection (creditor rights sum of 4 dummy variables2 and legal reserve required as a percentage of capital). Quality of laws enforcement (They improve with level of income). Ownership concentration (Dispersed ownership in large public companies is a myth). The data set omits merger and takeover rules, disclosure rules, regulations imposed by security exchanges or banking and financial institution regulations. LLSV concluded: 1 Common law tradition protects more investors and creditors than civil law tradition, especially French-civil-law. German and Scandinavian civil-law-countries have the best Proxy by mail allowed, Shares not blocked before meeting, Cumulative voting or proportional representation, Oppressed minorities mechanism, Preemptive rights, Percentage of share capital to call an extraordinary shareholders’ meeting. 2 No automatic stay on assets, Secured creditors first paid, Restrictions for going into reorganization, Management does not stay in reorganization. quality of law enforcement. In common law countries law enforcement is strong as well, whereas it is the weakest in the French-civil-law countries. Countries with poorer investor protection (depending on the legal family) have smaller and narrower capital markets. Common law countries have the strongest investor protection and the most developed capital markets. In countries with poorer investor protection ownership is more concentrated. The data support the hypothesis that countries develop substitute mechanisms for poor investor protection (mandatory dividends or legal reserve requirements). Also, good accounting standards and shareholders protection measures are associated with a lower concentration of ownership. Critiques of LLSV’s methodology are: The legal family theory is not able to explain cross time variation of relative financial market development (Interest group theory). Evolution of international and transnational law should be considered. Home bias problem. Use of number in comparative law may be problematic. Legal tools for shareholders protection Stronger internal governance mechanism: Independent directors and minority representation. Audit committees and compensation committees. More power to minority shareholders: One share one vote rules: dual class shares banned, voting caps banned, Limits to restrictions from shareholders agreement, Break-through rule in takeover regulation. More powers to shareholders: Higher quorums for major resolutions in shareholders’ meetings. Right to have one or more representative in the board (or, in alternative, cumulative voting). Shareholder approval of stock-based compensation plans. Lower threshold for calling or add a proposal to shareholder meeting. Easier way to exercise voting rights (remote participation). More disclosure: Codes of best practices mandated on a comply-or-explain rule. Self-dealing and compensation: IAS 24 requires disclosure on related party transactions. Disclosure of insiders trading transactions and directors’ compensation. Regulation of related-party transactions. Financial reporting and audit: Annual accounts with common standards in EU. CEO and CFO statement on truth of financial reports and adequacy of accounting procedures. Consolidation of all SPV3 and offshore companies respecting accounting standards. Auditor rotation and prohibition of non-audit services to companies being audited. 3 A special purpose vehicle, also called a special purpose entity (SPE), is a subsidiary created by a parent company to isolate financial risk. Its legal status as a separate company makes its obligations secure even if the parent company goes bankrupt. Public enforcement: Market abuse directive, PCAOB, S-O Act, Dodd-Frank Act. Private enforcement: Low threshold to suit managers. Certainty of penal sanctions. Court decisions in a relative short time. No amnesties or cancellation of crimes. Contingency fees to attorneys, otherwise too expensive to suit majority shareholder. Mandatory bid rule with passivity and break-through rule. Interest group theory Since the state of development of the financial sector does not change monotonically over time. The Interest group theory of financial development suggests that incumbents oppose financial development because it breeds competition. The theory predicts that incumbent’s opposition will be weaker when an economy allows both cross-border trade and capital flows (Schumpeterian view: the role of finance is creative destruction). Incumbents can be hostile to arm’s length markets because they do not respect the value of incumbency and instead can give birth to competition. In contrast to “Law and Finance theory”, interest groups are the primary driver of the development of financial system, not the law. Also, in Civil Law country, it is easier for incumbents to influence the implementation of friendly policies. This can become a problem if national and private benefits are misaligned. Many countries have underdeveloped financial sectors merely for the absence of demand, lacks social capital and inadequate legal, cultural, or political system. If a country has inherited an aptitude towards finance, the pre-disposition should continue to be strong since structural factors are relatively time-invariant. The indicators to measure financial development are ratio of deposit to GDP (banking sector), ratio of equity issues by domestic corporations to GFCG (equity markets), stock market capitalization to GDP (equity market) and number of listed companies. In fact, in contrast to LLSV: Financial systems were highly developed in 1913. Common law countries were not more financial developed in 1913. Countries most advanced in 1913 do not necessarily stay advanced. Indicators of financial development fall then rise between 1913 and 1999. After, the 1930s, due to the Great Depression, the Gold Standard did not allow governments to provide social security and welfare support to the needy. Indicators of financial development fall in all countries. After WWII, developed countries accepted open trade, pushed by USA, but they wanted some restrictions on cross-border capital flows. These restrictions explain why financial markets did not recover even though trade expanded. After, the breakdown of the Bretton Woods system, so the dismantlement of capital controls, the financial system was forced to modernize by the end of the 1980s Corporate Governance Reforms and Investors’ Protection in Italy Draghi law: Disclosure thresholds: Filings to the regulator (Consob) and to the participated company must be done by 2% and 10% of voting capital of listed and unlisted company. When holdings exceed 2%, 5%, 7.5%, 10% and following 5% multiples, or when holdings are reduced below the same thresholds. In case the required filing is not done, the shares cannot exercise their voting right. Cross shareholdings: Not more than 2% between listed companies. The limit can be higher and equal to 5% if both the shareholders’ meeting of both firms has given previous authorization. Shareholders’ agreements or pacts: T.U.F regulates both: “sindacati di voto e di blocco”. Pacts are not valid if are not publicly disclosed and cannot last more than three years if they have an expiration. In case of takeover shareholders of the pact have the right of withdrawal without previous notice Board of statutory auditors: Lower limit (at least 3 respecting minorities) for auditors. The role of the statuary board is to control that laws, by laws, accounting and internal control system and organizational structure. Also, it monitors if firm is properly managed. It has the power to sue directors and to call a shareholders and board of directors meeting. One share is enough to inform the board about management misconduct. More power to qualified minorities: Lower threshold to call an ESM (1/2, 1/3, 1/5 of the voting capital in the first, second and third call respectively). Resolution quorum have always to be approved with 2/3 of voting capital represented by the meeting (33,34% stake would block any resolution). 5% is enough to call a shareholder meeting. Takeover law: 30% threshold to be passed in order to EOR to apply, BTR and BNR rule. Vietti Reform: Greater autonomy and flexibility achievable by company bylaws, introduction of one and twotiered system, wider application of the right to withdrawal and higher protection for controlled companies in intergroup operations. A 5% taxation is paid on dividends to the parent company in pyramidal groups. Law on Savings: It protects public savings and prevents corporate fraud (inspired by O-S act): Prospectus needed for bonds issued by banks, more powers to regulators, new penalties for financial fraud and limitation to the bank of Italy mandate. At least one director must be reserved to the minority shareholders’ list and directors can be sued with 2,5% vote ownership. Related party transaction: In both major and minor transactions (5% of Market Cap, Equity at book value, total assets, and liabilities) independent directors must be involved and the former one must be approved by them. If the board wants to make the transaction notwithstanding the negative opinion of one or more of the independent directors, then the transactions must be approved by the general shareholders meeting without the related parties. The market must be informed with a detail document motivated by independent directors’ opinion. Pirelli case In November 2007, Pirelli’s board of directors proposed to pay back part of the firm’s equity by reducing the par value of both classes of shares. Since nonvoting shares were granted a minimum dividend payment set as a percentage of the par value, this proposal significantly harmed nonvoting shareholders and originated a wealth transfer between the two classes of shares (-14.4% wealth transfer). Given that the proposed plan modified the rights of the nonvoting shares, it required the approval of both Pirelli’s voting and nonvoting classes of shareholders (Draghi law). Obviously, the voting shareholders approved the plan as Pirelli was controlled by a voting pact among nine shareholders controlling 46.22% of voting rights. More surprisingly, the operation was also approved by the nonvoting class of shares, which apparently voted against their interests. What initially looked like “self-expropriation” was actually “self-interest”. In fact, the media misled investors by reporting that the operation was favorable to both classes of shares, and most of the 14 institutional investors that surprisingly voted for the plan had either strong ownership ties with the firm’s controlling shareholders, dual-class ownership, or both. Another possible explanation of nonvoting shareholders who cast a vote against their interest can be explained by the impossibility in proposing and approving standard extraordinary dividends or “obey to authority” effect The results showed that when an operation gives rise to a wealth transfer between two classes of shares, dual-class ownership significantly increases the probability that shareholders will vote for self-expropriating one class of their shares if they benefit on the other (unregulated conflict of interest). Am I right or am I right? The value of a right, since it is not an obligation, should not be lower than zero, however, negative voting premiums often appear in recent empirical evidence. In the existing literature on the value of voting rights have employed empirical measures that have often resulted in negative values even as averages for single countries (Nenova, La Porta).The implicit assumption is that the voting or superior-voting shares trade at a premium vis-à-vis the non-voting or inferior-voting shares. Such measures completely ignore dividend differences and other privileges which are usually granted to the non-voting or inferior-voting shares all over the world. For example, Relative Price Difference (RPD=(Pv-Pnv)/Nv where PV is price of voting shares and Pnv price of nonvoting shares) do not consider dividend privileges granted to non-voting shares. Same reasoning for Nenova measure who is represented by the ratio between the sum of all the Relative Price differences (Total RPDs) over the total firm’s market capitalization for both classes of shares (Mkt Cap). The Relative Voting Segment (Manne) is the only one who take into consideration the value of the specific different privileges granted to non-voting shares. RVS is the ratio between the Vote segment over the Pnv, where the vote segment is the difference between Pv and Investment segment, which in turn id the difference between Pnv and the present value of the dividend privileges granted to non-voting shares. The estimate of the voting right can be greatly distorted by some other factors, in fact an observed sample should not include non-voting shares which are partially convertible, so illiquid to have unreliable prices, announced to be converted into voting shares, under a tender offer and belonging to severely distressed companies. FSAP The EU’s Financial Services Action Plan (FSAP) was designed to open up a single market for financial services in the EU. Begun in 1999, it comprises 42 measures designed to harmonize the member states’ rules on securities, banking, insurance, mortgages, pensions, and all other forms of financial transaction (wholesale and retail markets included). By the end of 2004, almost all of these measures have been adopted. Provisions contained in the FSAP measures that deals with dominant shareholders’ opportunism are: The IAS/IFRS regulation: It requires EU companies that are listed in a European regulated market to prepare their consolidated financial statements in accordance with IFRS. In particular IAS 24 require disclosure on: the nature of relationships between parents and subsidiaries, even if there were no transactions between those related parties. The Market Abuse Directive bans insider trading and market manipulation. The Prospectus Directive requires public companies to disclose information regarding related party transaction when securities are offered to the public or admitted to trading. The Takeover Bid Directive regulates takeover bids. The Transparency Directive aims to harmonize transparency requirements for issuers with securities admitted to trading in regulated markets. Economics of Insider Trading According to the Efficient Capital Market Hypothesis is that asset prices reflect all available information A direct implication is that it is impossible to "beat the market" consistently on a riskadjusted basis since market prices should only react to new information. This statement is highly optimistic since markets are divided in: weak (Market prices reflect only historical information), semi-strong (market prices all public available information) reflect and strong form efficiency (market prices reflect all available information so no insider trading). Insider trading is the activity of trading financial instruments carried out, also through a third part, by people able to possess inside information. Market manipulation is the activity of trading financial instruments carried out by people who want to change the price of some securities by spreading false, exaggerated, or misleading information. Pro and Con arguments: Insider trading can be beneficial because it improves the signaling function of prices and the law is useless and dangerous in dealing with the former since economic agents are able to defend themselves. On the contrary, being deprived of a law regulating insider trading, allows director to exploit and manipulate market prices which in turn will cause a loss of efficiency. This is theory suggests offering to all investors the same condition of knowledge and opportunity since insider trading is immoral. Market Abuse Directive Directive 2003/6/EC4: The Market Abuse Directive bans insider trading and market manipulation. He is a primary insider any person who possesses an inside information: 1. by virtue of his membership of the administrative, management or supervisory bodies of the issuer or 2. by virtue of his holding in the capital of the issuer, or 3. by virtue of his having access to the information through the exercise of his employment, profession or duties, or 4. by virtue of his criminal activities. Members states shall ensure that the directive also applies to any person: Who possess inside information for using that information by acquiring or disposing of financial instruments to which that information relates (for himself or for the account of a third party). Disclose inside information to any person while the public is not being aware (Tipping) or recommending or inducing another person, on the basis of inside information, to acquire or dispose of financial instruments to which that information relates (Tuyautage). 4 The new legislative technique is based on four-level approach, namely framework principles, implementing measures, cooperation, and enforcement. Level 1, the Directive, should confine itself to broad general "framework" principles while Level 2 should contain technical implementing measures to be adopted by the Commission with the assistance of a committee. There are different types of manipulation: Trade base manipulation: the manipulator tries to change the price of a security by trading in the market. (speculative bubble). Information based manipulation: the manipulator tries to change the price of a security by spreading false, exaggerated, or misleading information. Action based manipulation: the manipulator tries to change the price of a security through actions that give the appearance of an active market in such security. The manipulator bears no risk (Wash sales and Matched Trades). Front-running: Trading stock or any other financial asset by a broker who has inside knowledge of a future transaction that is about to affect its price substantially. The prohibitions provided for in this Directive shall not apply to trading in own shares in “buyback” programs or to the stabilization of a financial instrument. The competent authority has several powers including: having access to any information from documents and people involved, carrying out inspections and suspend related activities. Takeovers Takeovers are a means to redeploy corporate assets more efficiently and to discipline incumbent management. The empirical evidence lends only limited support to the notion that takeovers are directed at underperforming firms or at firms with poor investment record. Even if takeovers may not be an effective means to correct inefficiencies, they may create value by exploiting synergies. At the beginning of the XX century takeovers waves led to formation of monopolies (vertical integration) and later oligopolies (horizontal integration). In 1965 until 1970s crisis (stagflation) was characterized by growth through diversification (lateral integration). During the 80s a massive deregulation program led to an overuse of LBOs which eliminated inefficiencies in the market (disintegration). The final wave started in the 90s and concluded with 9/11 and permitted market adjustment to globalization processes. Every takeover wave began with a response to a shock and concluded with stock market crash. Common characteristics are high GDP growth period and favorable financial condition such as: low interest rate, bullish stock market and low market risk premium. If an acquiring firm appropriates a too small fraction of the surplus to cover its cost, it does not make a bid, even if the takeover were to create value. A value increasing takeover of a completely dispersed firm cannot succeed because of the small shareholders’ free riding behaviour (P=V post offering). A possible solution is to force minority shareholders to sell their shares at or below the tender offer price (squeeze out) or allowing the rider to buy a % stake before having to launch a tender offer (toehold). Ex-ante takeover defenses are poison pills, crown’s jewel, golden parachute to top managers and shark repellant. Ex-post takeover defenses are buyback, leverage increase and white knight. Market rule or Equal opportunity rule? The Market Rule (USA) confers maximum freedom on a company’s incumbent controller by enabling sale shares (hence control over the target company) to any acquirer offering an acceptable price. The condition for control to be transferred is: Delta W greater than – (1 – alpha)/alpha multiplied by delta B. Where W is the total firm value (M +B), alpha is the old owner control stake and B private benefits of control and M market capitalization. Efficient control transfer happens if delta B is below zero, while inefficient control transfer if delta B is greater than zero and alpha is low. If private benefits are low and not too much dependent on the type of owner, then delta B equal 0 and control transfer condition become: delta W greater or equal than zero and delta M greater or equal than zero. Only efficient transactions take place. Market rule preferred by countries with low private benefits of control and assume that only who has the corporate control is entitled to get the control premium. The Equal Opportunity Rule (EOR, also termed Mandatory Bid Rule) has its origins in the UK and now applies throughout the EU and in many other countries. Under a mandatory bid, an acquirer of a controlling stake (30%) in a listed company has to offer the remaining shareholders a buy‐out of their minority stakes at a price equal to the payment received by the incumbent controller. The condition for control to be transferred is: delta W greater than (1-aplha)/alpha multiplied by B old. Only efficient control transfer take place (Delta W greater than zero and B greater than zero by definition). However, many efficient transactions cannot take place as a bigger delta W is needed, the lower is the alpha and the higher are private benefits (B) enjoyed by old management. EU Takeover Directive The EU Takeover Directive deals with European company law's treatment of mergers and acquisitions. It concerns the standards takeover bidders must comply with in how long a bid stays open to, who they offer to, and the information companies must give to the public about the bid. Control definition is left to the member states. Three controversial provisions of the directive are: The Mandatory Bid Rule requires any person acquiring, alone or in concert with other persons, a percentage of voting rights sufficient to grant control of a company, to make a mandatory bid rule for all the voting shares of a company at an “equitable price”. That is, at the highest price paid for the same securities by the acquirer over a given period prior to the bid. The Passivity Rule (Board Neutrality Rule) compels a target company’s directors to obtain a prior shareholders’ authorization when engaging in defensive actions to preserve the company’s independence. It tries to neutralize post-bid defenses. Supporters of the rule highlight that board neutrality prohibits conflicted incumbent management from raising obstacles to hostile takeovers, which in turn are considered beneficial as they promote synergies and economies of scale and scope. The Break-through rule contains several provisions aimed at neutralizing pre-bid defenses such as: differential share structure or restrictions on transfers of shares and voting rights, ineffective as soon as the bidder makes its offer, while they are lawful outside the offering period. It makes easier to accept the bid since it removes any penalties imposed on shareholders by the contractual agreement entered by them. The final compromise on the directive is that member states decide not to make them mandatory, it cannot prevent companies from applying these rules on a voluntary basis. Also, the reciprocity exception allows member states to permit companies applying one or both of these rules to disapply them, and thus to "retaliate" against a bidder who is not subject to the same rules. The reciprocating power can be used only if it is authorized by both the member State and the general meeting of the target company.
