Lecture 6 - Gatekeepers: Failure and Reform

Question 1

Gatekeepers – Who?

Answer 1

o Reputational intermediaries
o Types:
 ♣ Auditors
 ♣ Securities analysts
 ♣ Debt rating agencies 
 ♣ Investment bankers
 ♣ Attorneys

Question 2

Gatekeepers – What?

Answer 2

o Provide verification and certification services to the market/investors
o Types:
♣ Financial statement verification
♣ Assessing the company’s business and financial prospects
♣ Assessing the company’s creditworthiness
♣ Providing “fairness” opinions

Question 3

Gatekeepers – Why?

Answer 3

♣ Disclosure in connection with transactions:
o Public offerings to sell or purchase its securities
♣ Periodic disclosure:
o Annual report on Form 10-K
o Annual proxy statements

Question 4

Form 10-K

Answer 4

an annual report required by the SEC, that gives a comprehensive summary of a company’s financial performance. The 10-K includes information such as company history, organizational structure, executive compensation, equity, subsidiaries, and audited financial statements, among other information.

Question 5

Gatekeepers – Problems (general)

Answer 5

o Increase in conflicts of interest/decline in objectivity
o Decrease in liability exposure
o Decreased leverage vis-à-vis managers
o Distinguishing reliance on dependent vs. independent gatekeepers

Question 6

Reversal of Control in corporate organization

Answer 6

o Shareholders and Directors

o Directors and Officers

Question 7

Gatekeepers - Increase in conflicts of interest/decline in

objectivity

Answer 7

o Provision of multiple services to corporations

o Capture of team working on client account

Question 8

Gatekeepers - Decrease in liability exposure

Answer 8

o Developments in litigation

o Transformation from gen’l partnership to LLP

Question 9

Gatekeepers - Decreased leverage vis-à-vis managers

Answer 9

o Bubble economies

o Promotion based on client service not accuracy

Question 10

Gatekeepers – Problems: Dependence and Independence:

Answer 10

o Dependent
♣ “Provide advice and recommendations to assist a
client in meeting its goals… often act in a fiduciary
capacity.”
♣ Examples: Attorney,underwriter
o Independent
♣ “Critically evaluate a set of facts and render an
unbiased opinion for an unknown audience.”
♣ Examples: External auditor, securities analyst, CRA

Question 11

Gatekeepers – Reforms

Answer 11

o Sarbanes-Oxley Act of 2002
o Credit Rating Agency Reform Act of 2006
o Dodd-Frank Act of 2010

Question 12

Strategies for Reducing Agency Costs - At Shareholder Level:

Answer 12

♣ Eliminate agents; owners act as directors and managers
• Dangers: Risk of confusion, risk of losing limited liability through a court’s decision to “pierce the corporate veil”
♣ Impose fiduciary duties on managers and allow shareholder enforcement via derivative lawsuits
• Limits: Review standards for fiduciary duties, BJR, demand requirement for derivative lawsuits
♣ Greater say – expanded voting rights
• Limits: Shareholder apathy, management control of ballot, patterns of shareholder dissent
• Downside: Risk of oppression of minority in case of controlling shareholder (limited fiduciary duties only in certain circumstances)
• Dangers: Loss of management flexibility, greater exposure to activist investors

Question 13

Strategies for Reducing Agency Costs - At Director Level:

Answer 13

♣ Independence requirements
• Limits: Loose standards for independence, director capture / reversal of control
♣ Two-tier boards
• Limits: Similar challenges and possibly aggravated information asymmetry
♣ Fiduciary duties
• Limits: See slide 12

Question 14

Directors – Fiduciary Duties: Erosion of Duty of Care

Answer 14

o Gross negligence review standard
o Business judgment rule
o DGCL §141(e) allows good faith reliance on info
from officers
o Exculpation permitted

Question 15

Directors – Fiduciary Duties: Erosion of Duty to Monitor

Answer 15

Stone v. Ritter decision

Question 16

Directors – Fiduciary Duties: Elimination or Reduction of Personal Liability

Answer 16

o Exculpation

o Indemnification, D&O Insurance

Question 17

Strategies for Reducing Agency Costs/Problems

At Officer Level

Answer 17

♣ Fiduciary duties
• Limits: Duty of care remains unclear, reliance on board
enforcement
♣ Gatekeepers
• Limits: See earlier slides
♣ Compensation review
• Limits: Compensation committees ineffective in limiting pay increases, shareholder “say on pay” votes are only advisory

Question 18

Shareholders, Directors, Officers

Answer 18

♣ Shareholders have legal rights (derived from corporate law), which include the right to elect directors
♣ Directors have legal power and authority (derived from corporate law) to manage the business and affairs of the corporation and owe legal duties (derived from corporate law) to the corporation and its common shareholders
♣ Officers have delegated power and authority (derived from corporation’s bylaws or board decisions) to perform all actions within the scope of the delegation and owe legal duties (derived from agency/corporate law) to the corporation and its common shareholders.

Question 19

Sarbanes-Oxley Act of 2002

Answer 19

Intended to ensure the reliability of publicly reported financial information and bolster confidence in U.S. capital markets. SOX contains expansive duties and penalties for corporate boards, executives, directors, auditors, attorneys, and securities analysts. Although most of SOX’s provisions are mandatory only for public companies that file a Form 10-K with the Securities and Exchange Commission (SEC), many private and nonprofit companies are facing market pressures to conform to the SOX standards. Privately held companies that fail to reasonably adopt SOX-type governance and internal control structures may face increased difficulty in raising capital, higher insurance premiums, greater civil liability, and a loss of status among potential customers, investors, and donors.

Question 20

Credit Rating Agency Reform Act of 2006

Answer 20

allowing the Securities and Exchange Commission (SEC) to regulate the internal processes, record-keeping and certain business practices of CRAs.

Question 21

Dodd-Frank Act of 2010

Answer 21

established the SEC Office of Credit Ratings, since credit rating agencies were accused of giving misleadingly favorable investment ratings that contributed to the financial crisis. The office is tasked with ensuring that agencies provide meaningful and reliable credit ratings of the entities they evaluate.