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FINS3626 Lecture Notes - Lecture 2: United Kingdom Company Law, Singapore Post, Financial Statement

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UNSW, UNSW Sydney
Department
Finance
Course
FINS3626
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All

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Document Summary

Board of directors needs to be on the shareholder"s side. Odd number of people to avoid a deadlock but also, there could be an argument for an even number of people because if you had an odd number, the last person could be the decider. You don"t want a decision to be basically based on 1 person"s vote. With an even number, you could argue that the decision was based on a majority vote by at least two people. Directors are the middlepersons between owners and management. The law imposes upon the board a strict and absolute fiduciary duty to ensure that a company is run in the long-term interest of the owners (monks & minow, 2011) Do not run or become intimately involved in the running of a company. It is the managers who run the company, they just monitor management on behalf of shareholders.

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Related Questions

You are the CEO of a small pharmaceutical company. Your company is privately held, with 75 shareholders; however, you own a majority of the shares and thus, you maintain control over the Board of Directors. Your company successfully developed and patented a drug to treat a rare blood disease. You have recouped your research and development costs on the drug and are making a profit by selling the pills at $10 each. Because the number of people with the disease is very small, no other companies have entered into the market for this drug. Big Drugs, Inc. has approached you about acquiring the rights to the drug. Big Drug’s offer is substantial and if you were to accept it, you would likely be able to fund research for a drug for a related, and also rare and debilitating disease. However, you have heard speculation by many in the industry that Big Drug has been implementing a strategy of buying up the patents on rare disease/small market drugs in order to raise the prices significantly. The last purchase of this type by another big pharma company resulted in an increase in the price from $15.00 per pill to $500 per pill. Meanwhile, the FDA is investigating the price hikes of certain drugs. The agency is considering a program to subsidize the prices through an arrangement with insurance companies. The proposed subsidy would allow you to increase the price to approximately $14.00 per pill. Even with this increase, however, your profits will fall far short of the amount to be gained from the Big Drug purchase offer. You need to respond to the offer from Big Drug. You are pretty confident that selling will result in a price hike that will create an immense hardship on the patients using the drug. Your investors are anxious for you to seize the opportunity to turn a tidy profit and have sufficient resources to boost your R&D. As you consider how to advise the Board of Directors, what are the ethical considerations involved in this decision? Choose two ethical theories that you studied this term that you think can help you make the “right” decision. Describe how those theories apply to this situation, and what decision would be ethical using each of the theories. Finally, what is your recommendation to the Board of Directors? Use the IRAC format to respond to the question.

Jane Smith, CFA, has recently joined Zero Asset Management, Inc. (Zero) as a board member. Since Smith is also outside council for Zero, she is already very familiar with Zero’s operations and expects to begin contributing good ideas right away. Zero is a publicly traded investment management firm that historically focused on mutual fund management. Although there is current market opportunity to add a new type of mutual fund, the board recently decided against adding the fund. Instead, the board decided to expand its business to include a hedge fund operation within the existing corporation. Bill Week, CEO of Zero, has publicly stated that he is willing to bet the company’s future on hedge fund management. Week is the founder of Zero, as well as chairman of the board, and maintains a controlling interest in the company. Like the rest of Zero, the firm’s new hedge fund is quantitatively driven and index based. The fund has been set up in a separate office with new systems so that the analysts and managers can create a unique hedge fund culture. Trading and execution are the only operations that remain with Zero. The fund is run by one of Zero’s most successful portfolio managers. Smith learns that although none of the board members sit on other companies’ boards, most have at one point or another worked at Zero and so they are very familiar with Zero’s operations. A board member has attempted to make the health insurance and retirement concerns of the board members an agenda item, without success to date. Smith eagerly anticipates the next board meeting as they are always in a luxurious setting. At the board meeting, Smith asks a number of questions about Zero’s corporate gov- ernance system. The board becomes concerned by Smith’s questions and decides to hire an independent consultant to review their corporate governance responsibilities. The consultant starts his analysis by stating that a corporate governance systetem relies upon checks and bal- ances among managers, directors, and investors. Smith asks if Zero has the proper systems in place. The consultant says that he has looked at conflicts of interest and has one more area to review in order to verify that the board is meeting its major objectives. Concerned about the company’s stock price, Smith asks the consultant what work he has done concerning Zero’s corporate disclosures for investment professionals. The consultant indicates that he has reviewed Zero’s regulatory filings for clear and complete information, as well as the com-pany’s policies regarding related party transactions.

9. All of the following indicate Zero’s board’s lack of independence except:

A. personal relationships.

B. service of the outside counsel as a board member.

C. lack of interlocking directorships.

10. Which of the following is the most effective action for the board to take to address their oversight responsibilities concerning the hedge fund’s proxy voting?

A. Establish corporate values and governance structure for the company.

B. Establish long-term strategic objectives that are met and fully complied with.

C. Perform adequate training so that employees are able to perform their duties.

11. Which of the following omissions best describes a corporate governance shortcoming of Zero’s board of directors? The board’s failure to:

A. address the potential conflicts of interest between managing the firm’s hedge fund and its mutual fund business.

B. meet the market opportunity for a new kind of mutual fund.

C. establish the hedge fund operation in a separate corporation.

12. Given that Zero’s directors all previously worked at the company, which of the following would you recommend for a more effective system of corporate governance?

A. Ensure that assets are used efficiently and productively and in the best interests of investors and stakeholders.

B. Eliminate or mitigate conflicts of interest among stakeholders, particulularly between managers and shareholders

. C. Identify and measure accountabilities for the performance of the board’s responsibilities.

13. Which of the following best describes the objectives of Zero’s board that the consultant has not yet reviewed? The board should ensure:

A. that the assets of the company are used efficiently and productively and in the best interests of the investors and other stakeholders.

B. that material foreseeable risk factors are addressed and considered.

C. compliance with applicable laws and take into account the interest of stakeholders.

14. Which of the following is the most critical activity that an analyst can engage in to assess the quality of the corporate governance system at Zero, among those that the consultant did not review?

A. Look for vague references to off-balance-sheet or insider information.

B. Identify the responsiveness of the board to shareholder proxy votes.

C. Evaluate the quality and extent of financial information provided to investors.

Specific Electrics Co. asks you to implement a pay-for-performance incentive contract for its new CEO and four EVP's on the Executive Committee. The five managers can either work really hard with 70 hour weeks at a personal opportunity cost of $200,000in reduced personal entrepreneurship and increased stress-related health care costs or they can reduce effort, thereby avoiding personal costs. The CEO and EVP's face three possible random outcomes: the probability of the company experiencing good luck is 30 percent, medium luck is 40 percent, and bad luck is 30 percent. Although the senior management team can distinguish the three "states" of luck as the quarter unfolds, the Compensation Committee of the Board of Directors (and the shareholders) cannot do so. Once the board designs an incentive contract, soon thereafter the good, medium or bad luck occurs, and thereafter the senior managers decide to expend high or reduced work effort. One of the observable shareholder values listed below then results.

Good Luck Medium Luck Bad Luck

High Effort $1,000,000,000 $800,000,000 $500,000,000

Reduced Effort $800,000,000 $500,000,000 $300,000,000

Assume the company has 10 million shares outstanding offered at $65 initial share price, implying a $650,000,000 initial shareholder value. Since the EVP's and CEO effort and the company's luck are unobservable to the owners and company directors, it is not possible when the company's share price falls to $50 and the company's value to $500,000,000 to distinguish whether the company experienced reduced effort and medium luck or good luck and reduced effort or high effort and bad luck. Similarly, it is not possible to distinguish reduced effort and good luck from high effort and medium luck.

Answer the following questions from the perspective of a member of the Compensation Committee of the Board of directors who is aligned with shareholders' interests and is deciding on a performance-based pay plan (an "incentive contract) for the CEO and EVP's.

1. What is the maximum amount it would be worth to shareholders to elicit high effort all of the time rather than reduced effort all of the time?

2. If you decide to pay 1 percent of this amount (Question 1) as a cash bonus, what performance level (what share price or shareholder value) in the table should trigger the bonus? Suppose you decide to elicit high effort by paying a bonus should the company's value rise to $800,000,000. What two criticisms can you see of this incentive contract plan?

3. Suppose you decide to elicit high effort by paying a bonus only for an increase in the company's value to $1,000,000,000. When, and if, bad luck occurs, what two criticisms can you see of this incentive contract plan?

4. Suppose you decide to elicit high effort by paying the bonus when the company's value falls to $500,000,000. When, and if, bad luck occurs, what two criticisms can you see of this incentive contract plan?

5. If the bonus compensation scheme must be announced in advance, and if you must pick one on the three in questions 2, 3, and 4, which one would you pick and why? In other words , under incomplete information, what is the optimal decision by the Board's Compensation Committee (CC) dedicated to act in the shareholders' best interest?

6. Audits are basically sampling procedures to verify with a predetermined accuracy the sources and uses of the company receipts and expenditures; the larger the sampling, the higher the accuracy. In an effort to identify the share price that should trigger a bonus, how much would you, the CC, be willing to pay an auditing consultant who could sample the expense and revenue flows in real time and deliver perfect forecasting information about the luck the firm's sales force is experiencing? Compare shareholder value with this perfect forecast information relative to the best choice among the bonus plans you selected in question 5. Define the difference as the Potential Value Perfect Forecast Information.

7. Design stock option-based incentive plan to elicit high effort. Show that one million stock options at $70 exercise price improve shareholder value relative to the best of the cash bonus plans chosen in Question 5.

8. Design an incentive plan that seeks to elicit high effort by granting restricted stock. Show that one half-million shares granted at $70 improves shareholder value relative to all prior alternatives.

9. Sketch the game tree designing this optimal managerial incentive contract among the alternatives in question 2, 3, and 4. Who makes the first choice? Who makes the second choice? What role does randomness play? Which bonus pay contract represents a best reply response in each endgame? Which bonus pay contract should the CC of the Board select to maximize expected value? How does that compare with your selection based on the contingent claims analysis in questions 1-8?