Bài giảng Financial Markets - Lecture 8: Human Foibles, Fraud, and Regulation

Lecture 8: Human Foibles, Fraud, and Regulation“Millionaire in the Making”money.cnn.com Dave Farley earns $120k as manager at Ford plantSaves $1600 per monthNet worth $270,000Plans to retire in 10 years age 45with $1 million (at r=3.5% this gives annuity income of $54k for 30 years, half what he consumes now)Calculations imply he expects return of 10%/year.Human Nature and Workings of MarketsGambling behaviorLoyalty to friends transcends loyalty to societySalesmanship, spammingFraud, near-fraudGreen Stamps & Human Foibles1896 Thomas Sperry & Shelly Hutchinson started first trading stamp business. Zero interest bonds.1913 Two members of the Beinecke family, who had married into Sperry family, bought the company. Beinecke Library.In 1950s, S&H discovered stamps were better received if paid in merchandise, rather than cash.By 1956, almost half US households were pasting stamps into books.S&H Green Stamps TodayPublic interest waned in 1970s, exists only in backward areas of US today.Beinecke family sold S&H to a conglomerate, which kept the stamps barely alive.1999 Walter Beinecke III buys S&H back from conglomerate to do trading stamps on the web. “Greenpoints” replace Green Stamps.Purposes of RegulationEnforce rules of the gameProtect the weak from exploitation by cynical operators.Property and SocietyKarl Marx believed human societies used to practice “primitive communism,” with no private property.In fact, concepts of property exist across diverse cultures, though nature of rights varies.Rights to fruits of one’s own laborProperty law Complexities of Property Definition in Modern EconomyInformation has value, but producer of information is hard to define.Property rights can be entangled in maze of intersecting contracts.French law allows an artist to sell works subject to contract that it never be altered.Trust law in common law countries allows trustee to act on behalf of owner without intermingling own assets.Countries with poorly defined property rights do poorly. Hernando de Soto and squatters in Latin AmericaSecurities and Exchange CommissionLouis Brandeis, Other People’s Money, 1914 was intellectual origin. DisclosureBlue Sky Laws of Progressive Era1920s were period of much fraud, manipulation.SEC part of Roosevelt’s New Deal, 1934.Initially viewed by business as a radical, almost socialist, institution. Peculiar that it started in US, imitated by other countries.Public vs. Private SecuritiesMotive was repeated examples of exploitation of minority or unobservant shareholders.Public securities: undergo approved process of issuance under SEC surveillancePublic companies must file public statements. EDGAR database on www.sec.gov.Inital Public Offering (IPO) is SEC procedure for going public.Reverse direction: going private.SEC RulesEvery broker must register with SECEvery stock exchange must registerEvery security issue must registerRegistration does not literally mean SEC approvalInsiders vs. OutsidersInsiders are people with special access to information about a company.Inside information represents wealthSEC tries to define access to this wealth, by disclosure rules.Regulation FD (Full Disclosure) 2000: requires that when a company tells any material fact to an analyst, it must immediately tell the public.Germany did not have any laws against insider trading until 1994Some argue insider trading is good. Hayne Leland Market SurveillanceSEC Sophisticated computer equipmentSROs; self regulatory organizationsResults of Market SurveillanceMay 1995 secretary at IBM was asked to xerox documents related to secret plans to take over Lotus, to be announced June 5.She told husband, a beeper salesmanJune 2 he told two friends who immediately bought.By June 5, 25 people spent half a million dollars to buy on this tip: pizza chef, electrical engineer, bank executive, dairy wholesaler, schoolteacher, and four stockbrokers. All caught by surveillance.Emulex CorporationMark S. Jacob, 23, had shorted stock of his former employer, stood to lose moneySent fake news release to Internet wire, was picked up by Bloomberg, Dow Jones News Wire and CNBC. He immediately covered.FBI, using Internet Protocol Numbers, tracked down initial news to El Camino Community College library. Police questioned librarians, and eventually tracked him down.Front Running and DecimalizationFront-Running occurs when a broker buys shares in front of a large order that will boost stock price.Decimalization on NYSE and Amex began January 29, 2001. (NASDAQ April 2001)Decimalization favors front-runningNYSE Surveillance will search this outFinancial Accounting Standards BoardFASB officially recognized as authoritative by SEC in 1973. Though SEC has statutory right to make accounting standards, prefers private sector do it. FASB (Norwalk CT) defines Generally Accepted Accounting Principles (GAAP), used for EDGAR DefinitionsGAAP Define “Net Income” which is the bottom line, traditionally, and “operating income,” revenue minus cost of doing businessOperating earnings, Core Earnings, Pro Forma Earnings, EBITDA, and Adjusted Earnings are not GAAPFASB is at work on developing new definitions, but this takes years.Great confusion today about earningsEnron CorporationCompany was created 1985 when Internorth Inc. bought Houston National Gas, CEO Kenneth Lay (Ph.D. economics, University of Houston) Renamed Enron 1986, had largest gas pipeline in United StatesWith deregulation of natural gas, transformed Enron into gas market-makerStarting 1994, Did similar thing with electricity1999, Started same thing with broadband, built own fiber-optics network for final deliveryOther Enron InnovationsEnron was first company to issue credit-sensitive notes (Bear, Stearns 1989)Enron pioneered financial contracts to manage weather risk (1997)Enron had plans in works at time of bankruptcy to start trading index-based commercial real estate contractsFailure of Enron, 2001-2Pursued too many projectsSome projects were only hypeDishonestly concealed truth about failures too longStrongly encouraged Enron employees to hold company stock in 401(k) plansDoes not discredit the long run importance of financial innovationFinal failure occurred when truth got out, no one wanted to deal with Enron any moreOff-Balance Sheet AccountingEnron created hundreds, perhaps thousands, of partnershipsAt least 3% of each partnership was not held by Enron, so their losses did not go on Enron’s booksPartnerships used to conceal lossesFASB has not issued directives against such use of partnerships to conceal lossesUnited KingdomUntil 2000, varied agencies performed task of SEC. United in 200 under FSA (Financial Services AdministrationGermanyFrankfurt Stock Exchange sets its own rules subject to approval of the State of HesseAlso Bundesaufsichtsamt fuer den Wertpapierhandel Failed merger attempt with London Stock Exchange, to produce the ix, would produce interesting questions, regulated by Hesse?Proposed Euro SECSecurities Investor Protection Corporation (SIPC)Followed 1970 failure of Goodbody & Co., fifth-largest brokerage in the US, because of stock fraud. Merrill Lynch assumed Goodbody accounts, no customers lost moneyTo plan for such events in the future, SIPC was created by US Congress 1970 (Sen. Ed Muskie)Protects customers of brokerage firm or clearinghouse against failure up to $500,000 per account, $100,000 for cash.SIPC much criticized. Very defensive, pays more to the lawyers than to claimants.Disallows claims that were not filed “promptly.”If broker stole the money before it was invested, smaller claim allowed. (no securities stolen).SIPC extremely slow to pay.SIPC Survey of US Population, 2001When asked to identify the "organization that insures you against losing money in the stock market or as the result of investment fraud," only 16 percent of investors knew that there is no such group.   Just 36 percent of those surveyed knew that if they suspect brokerage theft they should "set out (their) concerns in writing to the brokerage firm and keep a copy for self." Weakness of Securities Regulation Outside USFrom 1995-99, there were only 19 successful procecutions for insider trading in all of the UK, France, Germany, Italy and SwitzerlandManhattan Federal Court alone prosecuted 46 in that period.European regulators do not have the budgets or sophisticated computer systems that US SEC does.More Weakness of Foreign RegulationIn Britain, Italy and Switzerland it has been impossible to bring a civil suit against insiders. Civil suits require lower burden of proof.Britain allows civil suits starting in 2001.TunnelingJohnson, LaPorta, Lopez-de-Silanos, and Shleifer, AER May 2000Tunneling = Expropriation by minority shareholders (figuratively, as by an underground tunnel)More common in civil law countries (especially French) than in common law countries (LaPorta et al. 1998). Hence, higher proportion of private and family-owned companies in civil law countries.How Tunneling is AchievedAsset sales Contracts, as for prices paid for inputsExcessive executive compensationLoan guaranteesExpropriation of corporate opportunitiesDilutive share issuesInsider tradingDirectors’ Duties to Prevent TunnelingDuty of Care: Act as a reasonable, prudent or rational person would.Duty of loyalty: Prevent insiders from benefiting at expense of shareholders Common law countries give more judicial discretion to judge conformance with these duties, and so are more effective in preventing self-dealing transactions.Tunneling in FranceSARL Peronnet, a French company owned primarily by the Perronet family leases a warehouse from the Peronnet family at a high price. When minority shareholders sued, French court ruled that the transaction had a legitimate business purpose, and that it was beyond the court to judge whether the price was too high. In US or UK, price would have been a factor.Asian Financial IrregularitiesWorld’s largest IPO 2003: China Life, US$3.5 billionChinese state auditors blow whistle on accounting irregularities. “Little treasuries”Korean government bailout 2003 of LG Card, US$4.5 billionChina Share CategoriesA Shares: Only mainlanders and selected foreign institutional investors allowed, traded in renmenbiB Shares: Shanghai and Shenzhen, until 2001 only foreigners could hold, now mainlanders with foreign currency accounts; traded in foreign currenciesH Shares: Traded in Hong KongN Shares: Traded in New YorkChina Plans to Promote Stock (WSJ Feb 12, 2004)