Introduction

THE PREVIOUS CHAPTERS ANALYZED THE activities of the stock market with emphasis on its contribution to the efficient allocation of resources. Specifically, we dealt with the market's role as a link between investors (savers) and entrepreneurs, and defined the various types of efficiency promoted through the workings of the stock market. Next, we discussed mergers and takeovers as a mechanism through which shareholders assert their control over managers, and commented on the crucial role of evolving stock markets in the former centrally planned economies of central and eastern Europe in their transition to full-fledged market economies.

In this chapter, we draw upon the business ethics literature to assess two areas of the functioning of the stock market. First, we consider the ethical issues in mergers and takeovers. We focus on the various defensive measures taken by management of the target companies and show how they undermine the social benefits of the stock market. Second, we review the controversy on the moral defensibility of the practice of "insider trading," much debated in the press, and highlight the tenuous nature of the arguments for its regulation.

The dominant theme of this chapter is that takeover threats and stock market transactions, together with the rules of behaviour given by the "loyal agent" concept (discussed below) force managers to act ethically, i.e. in the interest of shareholders. Stock markets are populated by a large number of buyers and sellers and, as discussed in chapter 4, absorb and process information with considerable efficiency. Because of these features, they come quite close to the economics textbooks' definition of the "competitive market". In a functioning competitive market, no one buyer or seller can significantly influence the price or any other terms. Individual market participants cannot, therefore, deliberately exercise any "social responsibility" or obligation to sacrifice their own good for the benefit of the society at large, other than the duty to obey the law (Friedman, 1962). The enforcement of social interests rests, in a large part, with the market.

Takeover transactions described in chapter 3 - and more generally the stock market acting as a "giant voting booth" - are crucial components of the market for corporate control which replaces managers who fall short of their mandate. A recent example is the Royal Oak Mines attempt to buy Lac Minerals, where Royal Oak Chairperson Margaret Witte has claimed that Lac management has been wasteful with their operating expenditures. She claims to be able to trim millions of dollars a year by selling the corporate jet, closing the "opulent" head office, and reducing the number of managers.

The media periodically raise concerns about the ethics of the activities of the various actors directly involved in the day-to-day working of the stock market, including investment dealers, underwriters, brokers, and floor traders. The history of the stock market experience in many countries abounds with examples of questionable practices in this segment of the securities industry, and the resulting close attention paid to them by government regulators. We deal with some of these issues and regulatory responses in chapter 7, "Whither Regulation?".

The distinction between the interests of shareholders and the interests of managers is an important aspect of the application of ethical concepts to the area of corporate decision making, including the participation of business firms in the activities of the stock market. We therefore begin this chapter with a brief selective summary of the long-standing debate on "corporate social responsibility" and show the key role of the stock market in enforcing the performance of management's duties toward shareholders. We then proceed to discuss the weaknesses in the various defences against takeovers and leveraged buyouts, and conclude with an evaluation of insider trading and the controversy surrounding its regulation.

Ethical concepts in corporate decision making

The ethics of management behaviour should be judged by its consistency with the interests of shareholders. In this section, we briefly discuss the limits on management loyalty to shareholders, and some aspects of the distinction between the actions of corporations and actions of human persons.

Executive officers of a corporation are usually elected by the shareholders (or appointed by shareholder representatives). Following a well-known economic view of a corporation (Friedman, 1962), shareholders are capable of deciding whether the corporation will behave in a "socially responsible way," for example, whether it will make charitable donations. The executive officers have a responsibility to pursue the interests of shareholders, within the rights and duties of the corporation. Decisions regarding "socially responsible" or "charitable" behaviour of the corporation cannot therefore be left to the executive officers, but must be made by shareholders. These types of behaviours can, of course, be motivated by managers' desires to improve the corporate image or the loyalty of the corporation's employees. In such cases, these decisions are merely good business practice, and not a demonstration that the corporation possesses some kind of "moral virtue."

Corporations are legal persons (entities with rights and duties before the law), and as such can act justly or unjustly. It is less clear, however, whether the behaviour of corporations can be judged by the standards normally applied to human persons - for example, whether they can be said to have virtues and vices, such as generosity, courage, meanness or cowardice. Virtues "are a matter of caring about certain sorts of things" (Ewin, 1991, p. 752), but the corporation, as distinct from its representatives, does not care about its interests. The interests of a corporation are determined by the purpose for which it was formed. It may be to maximize the returns to its shareholders, but (as in the case of corporations formed for charitable purposes) the objective could also be to raise and distribute the largest possible amount of money for a particular cause.

We take the view that managers are required to act as representatives of owners; if they deviate from the objective of the corporation, they can be said to have failed in their duty. There are, however, limits to the manager's duties which arise from our legal and social institutions. Specifically, the rules of agency, as commonly understood, stipulate that by agreeing to serve as someone's agent, a person accepts a legal (and moral) duty to serve the client loyally, obediently, and in a confidential manner. But in determining whether the orders of the client (or of the employer(s), or representative(s) of shareholders) are reasonable, the agent must consider business or professional ethics, and in no way has a duty to perform acts which are illegal or unethical. Put another way, an agreement to serve other people does not automatically justify doing wrong on their behalf.

Debate on the ethics of takeovers

The periodic waves of corporate mergers and takeovers have been the subject of considerable attention in the media, much of it in the form of attacks on "corporate greed." Unfortunately, the contribution of mergers and takeovers to economic efficiency and competitiveness is much too often disregarded or underplayed. In what follows, we review the main objections to takeovers, and their weaknesses, from the perspective of economic efficiency.

A major target of criticism is takeovers initiated for the purpose of liquidating the target company. This occurs in situations where there is a significant gap between the market value and the breakup value of the company assets. If the incumbent management is unable or unwilling to close the gap by changing its practices, an outside bidder (or in the emotionally charged language of the media, a "corporate raider" or a "shark") [Based on the pejorative characterization of the bidding firm as a "shark," the anti-takeover defences are sometimes described as "shark repellents."] offers to buy a significant percentage of the company shares from other shareholders at prices exceeding the current market value. If successful, the bidder buys the company, and sells off the underlying assets at a profit.

The usual objections against the practice of breaking up and selling off parts of the purchased company ("liquidating buyouts") fall into three categories (Almeder and Carey, 1991).

1. Liquidating buyouts have a negative effect on some individuals and groups

This objection is directed at buyouts of companies that are profitable and whose employees are, by implication, not obviously incompetent. The buyouts may lead to layoffs and changes in management ranks and have a variety of negative effects on the community where the company is located. Critics assert that "the pleasure and limited good of a few" derived from enlarging the pre-takeover profit cannot be justified by "the overwhelming human suffering typically involved when a large company is liquidated" (Almeder and Carey, 1991, p. 472).

The basis of such criticism seems to be the belief that the increased profits are the result of wealth transfers, rather than long-term efficiency improvements brought about by the merger. The immediate consequence of layoffs may indeed be a reduction or loss of income for some individuals. However, policies restricting or preventing takeovers would induce investors to take their capital elsewhere and eventually lead to the decline of the firm and reduction in the efficiency of the economy.

It is legitimate to ask in this context why the good of the shareholders should be dominant in determining the responsibilities of managers - why not also the good of the workers, the community where the plant is located, or the society at large? The experience of centrally-planned economies and other bureaucratized systems provides a rather convincing answer: asking managers to maximize some measure of total social goodness, while superficially appealing, does not deliver the right amount of goods at the right time and place, and at the right price. The excessively broad definition of managerial duties was one of the sources of the failure of that system.

Utilitarian ethics postulates that human actions are to be judged by their consequences - in this case by their contribution to economic prosperity - and provides a justification for narrowing of the focus of managerial responsibility. Shareholder profits are relatively easy to measure; this is one of the advantages of using them as a criterion of management performance. A structure of incentives based on profits is logical and minimizes the need for information. Takeover threats and stock market responses to management performance are a part of this system of incentives (Sen, 1993, p. 219).

2. The "neglect of long-term investments" (once again)

Critics contend that the threat of corporate takeover compels managers to show evidence of continuous profitability and avoid long-term investments (e.g., in R&D). This pressure allegedly undermines long-term capital formation and competitiveness of the economy. A special target of such criticism appear to be liquidating buyouts.

As discussed in chapter 3, neither the U.S. nor the Canadian empirical evidence supports the view that mergers, or the threat of takeovers, diminish long-term investment in R&D. Moreover, the fact that buyers are able to make a profit on liquidating buyouts suggests that the utilization of the assets of the target companies by the pre-takeover management left something to be desired. Once again, advocacy of restrictions on such buyouts on "ethical grounds" may lead to unethical results; regulations forbidding the new owners to break up the company might prevent them from remedying the mistakes of the previous managers.

3. Moral duties associated with ownership

Buyouts followed by break-up and sale of parts of the firm are sometimes viewed as an attack on the right of ownership (Almeder and Carey, 1991, p. 474). Institutional investors are singled out for a particular criticism on the grounds that they have only limited interest in the preservation of the existing companies "for future growth." However, the paramount social interest in producing long-term wealth requires that the right to private ownership and its free exercise not be restricted, except to protect society against practices which are shown to cause net long-term harm. In the case of takeovers and liquidating buyouts, much of the evidence summarized in chapter 3 supports the view that they promote efficient re-allocation of capital. The opposition of the target company management is motivated largely by the self-interest of incumbents.

It is of course possible that the bidder makes a mistake in attempting a liquidating takeover, and the management of the target firm should be permitted to defend the corporation. A successful defence requires a demonstration that the apparent inefficiency of the target corporation - manifest in the excess of breakup value of assets over market value - is only temporary, and that the preservation of the integrity of existing assets is in the long-term interest of shareholders. Anti-takeover defences are ethically permissible only if they have the support of the majority of the target company shareholders (Almeder and Carey, 1991, p. 480).

Leveraged management buyouts

Leveraged buyouts of firms by their own managers have been subject not only to critical scrutiny, but also to calls for outright prohibition. We believe that one should distinguish between two types of situations. First, there may be cases where managers manipulate the firm's earnings downward prior to the bid in order to reduce the buyout price to themselves. This occurs at the expense of shareholders, and should be dealt with as a violation of the fiduciary duty of managers.

A second, and more subtle, concern arises from the asymmetry of knowledge: Only the managers know what the value of the firm would be if some of its assets were sold off. Since this superior knowledge constitutes inside information, critics have argued that management buyouts violate the prohibition on insider trading, as well as the disclosure rules of the securities regulations because managers do not disclose that the firm is worth more than their bid (Jones and Hunt, 1991, p. 835).

In our view, regulatory restrictions on management buyouts are unnecessary and damaging in the long run. Management bids for shares of their own firm will be observed by other potential investors and taken as a signal that the firm is undervalued. This point is quite general and is well known in economics, at least since Hayek's (1945) development of the argument; market participants develop an understanding of the relationship between prices and privately held information. Thus, even traders who do not have access to private information will be able to infer something about its content from the movements of the current market price. The stock market makes it possible both for existing shareholders and for new investors to participate in the gains from changing ownership structure. These gains would not occur if management buyouts were prohibited.

The consequences of the informational asymmetry between managers and outsiders could be mitigated if it were possible to establish, in advance, a "fair" price for the company's shares. One definition of fairness is a "synthetic standard" price, established by estimating the value that shareholders could obtain if they synthesized the buyout on their own.

A group of shareholders could "synthetize" the buyout if they borrowed money, repurchased a large percentage of shares, and increased the share ownership of managers. The increase in the value of the firm resulting from these actions would accrue to shareholders. The magnitude of this increase therefore represents a starting point for buyout negotiations between managers and the board of directors (Jones and Hunt, 1991, p. 836).

The ethics of management defence against takeovers

Methods of defence

The managers of target companies have at their disposal numerous techniques and practices which could be used to ward off a potential takeover threat. Some of them have been discussed in previous chapters. A fairly complete list includes the following: The "poison pill"; issuing a large block of new common stock; supermajority requirements; staggered board terms (classified boards of directors); noncumulative voting; the issuance of two-class common stock; the "scorched earth" tactic; and the "premium-price selective buyback" (Almeder and Carey, 1991, pp. 480-482; Meade and Davidson, 1993, pp. 90-91). In this section, we briefly outline the mechanics of some of these defences and show that their success in many cases depends on the passivity of shareholders or their unwillingness to incur costs in protecting their interests.

The "poison pill" may take the form of a new issue of preferred stock [Preferred stock is a security (usually non-voting) with a claim on assets and income of the corporation which ranks higher than the claim of common stocks, but lower than debt instruments.] of the target company which the management distributes to the existing shareholders. If the takeover succeeds, the holders of preferred shares have the option to buy shares of the acquired company at a discount - sometimes as much as 50 percent of its market price. This makes the takeover very costly to the acquirer. If the poison pill is in place before a specific bid is made, the bidder is likely to offer a lower price and the takeover may not succeed.

The distribution of preferred shares is welcome news to those recipients who have a vested interest in preservation of the existing management. Other shareholders, however, may not approve of the management tactics and may fight the poison pill in shareholder meetings and in the courts. This was the case, for example, in late 1988 when the management of Inco, concerned with a potential takeover, proposed and implemented a special cash dividend payment and a plan to increase the number of outstanding shares in the event of a takeover. In this instance, the minority shareholders were unsuccessful and the poison pill remained in place.

Supermajority requirements are amendments to company bylaws which stipulate that a merger, or sale of assets, or other specified transactions must be approved by substantially more than 50 percent of shareholder votes. The required majority level often exceeds the normal shareholder participation at meetings, which makes it virtually impossible to approve a merger.

In principle, shareholders could join together and defeat such amendments by means of proxy voting and similar actions. In practice, however, a typical small shareholder is not prepared to organize a concerted action, since the share of the total benefits accruing to an individual shareholders is quite small, while the costs borne by the individual may be substantial. The weakening of shareholder rights resulting from the presence of supermajority requirements should, in theory, be reflected in a lower market price of the stock. In practice, however, it is unlikely that most investors consider such factors in their decision to purchase the stock.

Similar considerations apply with respect to shareholder reactions to a takeover defence in the form of staggered terms for members of the board of directors. The consequence of this arrangement is that only a fraction (one half or one third) of the board members are eligible for election each year. This prevents the acquiring company from taking control of the board until at least two regular board elections have been held.

Some companies have implemented cumulative voting procedures to allow minority groups representation on the board of directors. Each shareholder has votes equal to the number of his or her shares times the number of directors to be elected, and the shareholder is allowed to cast all of those votes for a single director. Noncumulative voting, by contrast, enforces the "one share one vote" rule and thus confers an advantage on large shareholders. In this sense, it may be interpreted as a takeover defence, since it makes it difficult for small shareholders to concentrate all of their votes for one candidate. A minority shareholder who is also a potential acquirer thus may not be able to get representation on the board of the target company.

Dual class capitalization plans create a second category of common stock, typically giving superior voting rights to long-term (more loyal) stockholders (see our discussion in chapter 2). Another type, called "substantial shareholder provision", reduces the voting power of the holder when a prespecified amount of ownership is reached. In those situations where there exist two classes of common shares, those with the greater voting power are frequently concentrated in the hands of shareholders sympathetic to the incumbent management. As a result, the acquirer faces greater obstacles in assuming control of the target company.

Our observations on the Canadian Tire Corporation in chapter 2 illustrate the point. The Billes family owned 4 percent of the outstanding shares of the company, but commanded 60 percent of the votes. The vast majority of shareholders would clearly have no say in any potential takeover of the corporation.

The "scorched earth" defences include the selling off of desirable assets of the target company, or the reverse, depleting its cash reserves by making extensive (and not necessarily profitable) acquisitions, possibly incurring large debts in the process. While these tactics may protect the management against a takeover, they render the company vulnerable to the vagaries of the business cycle.

In a "premium-price selective buyback," management of the target company offers to buy at a premium all shares except those purchased by the acquiring company. [U.S. courts have upheld the right of management to act in this fashion, on the grounds that it reflects "good business judgement." The business judgment rule excuses the officers or directors of a company from liability for any errors in judgment resulting in damages suffered by the firm, if the error was made in good faith and the decisions were based on sound business judgment of the officers or directors. For this defence to be accepted, it must be shown that the board of directors undertook a reasonable investigation and took appropriate action. Many of the scholars studying the application of the rule by U.S. courts concluded that the interests of shareholders have not been adequately safeguarded.] The management is in a position to offer such a premium in anticipation of the increase in the value of the company resulting from the prospective taeover. This tactic makes the takeover unprofitable, since the premium accrues to the existing shareholders, rather than to the bidder. As a result, the potential bidder may withdraw the offer. Alternatively, the management may offer to buy back, at a premium, the shares already owned by the bidder. This practice is called "greenmail."

"Golden parachutes" (large severance payments offered to managers when their contracts are terminated) are sometimes mentioned on the list of takeover defences. However, as discussed in chapter 3, to the extent that they facilitate the replacement of incumbent managers, they should be viewed as a contribution to efficient allocation of resources. One complicating factor is that the cost of the golden parachutes may significantly contribute to the company debt. To guarantee their compatibility with shareholder interest, they should be approved by a majority vote.

The impact of the various anti-takeover defences is best seen in the context of our discussion of the economics of mergers and takeovers (chapter 3), the efficiency of the stock market (chapter 4), and its role in corporate governance (chapter 2). We have argued throughout that the benefits of the stock market for individual stockholders are maximized when stock markets are able to perform the full range of their functions.

In this section, we explained how anti-takeover defences limit shareholders in exercising their right of corporate ownership. Some of them aim at minimizing the influence of minority shareholders, but others are more general. They protect the interests of incumbent managers, and inhibit change in corporate control. Our objection to their use derives from the observation that they reduce the potential efficiency gains from mergers and takeovers. We argued that the interests of managers do not necessarily coincide with those of the shareholders. In such situations, anti-takeover defences effectively transfer wealth from shareholders to management and are objectionable on ethical grounds as well.

Insider trading

The term "insider trading" carries the connotation of unequal access to information and hence tends to generate an instinctive negative reaction. The economic consequences of insider trading are, however, somewhat subtle and deserve a brief elaboration. Insider trading is defined as the buying and selling of a company stock by its managers or by traders with access to information not accessible to those who would normally be able to obtain and use it. [The Ontario Securities Commission defines as "insiders" two categories of traders. One category are the officers and directors of a corporation whose securities are traded on an organized exchange in Ontario. Another category are shareholders who own 10% or more of the firm's shares (such shareholders are known as "beneficial owners"). Both types of insiders must report any transactions they have made in the firm's shares within 10 days after the end of the month in which the transaction(s) occurred (Sharpe, Alexander and Fowler, 1993, p. 399).] In most jrisdictions, insider trading is illegal. For example, Ontario law makes it illegal for anyone to enter into a security transaction if they have taken advantage of inside information about the corporation which is not available to other people. Any recipient of such information is also deemed to have committed an offence (Sharpe, Alexander and Fowler, 1993, p. 399).

The defenders of insider trading point out that it reveals valuable information, and prohibiting it would prevent the discovery of the true market price of the stock. They also claim that insider trading does not necessarily damage the non-participants; in fact non-participants (outsiders) may benefit, while the insiders bear the risk.

A typical scenario of the argument in favour of insider trading runs as follows: In the absence of insider trading the stock price fluctuates through time, without any obvious trend, until the management decides to make public valuable information. Consider first the release of positive information. The outsider shareholders may have an incentive to sell the stock before the information is released, i.e. before the stock reaches its equilibrium value. With insider trading, however, the stock price would gradually rise as those in possession of positive private information buy the stock. The outsiders will not sell until equilibrium value is reached. The same scenario holds in reverse when the information is negative (Martin and Peterson, 1991, pp. 57-58; Sen, 1993, pp. 222-225).

Insider trading thus speeds up the stock price change in either direction and facilitates the resulting wealth transfer. Neither the continuing holders of the stock, nor those who independently decide to sell while insiders are buying, are harmed by the actions of the insiders. Those outsiders who decide to keep the stocks benefit from their appreciation in value; those who sell before the equilibrium value is reached benefit at least partially. When insiders engage in selling, outsiders may respond to this signal by bailing out of the depreciating stock earlier than would be the case if insider trading did not take place. Most of the risk of this process is borne by the insiders who do the trading, since they typically buy and sell large volumes of shares and are uncertain how the market will respond.

Given this argument, prohibiting insider trading may be viewed as misguided, since the prohibition makes it impossible for some owners of information to benefit from it. In addition, since managers are prohibited from trading their firm's securities at will, they have to be compensated by higher salaries, the cost of which is passed on to consumers in the form of higher prices.

Despite its possible benefits, both for insiders and for outsiders (non-participants), Werhane (1991) considers insider trading morally indefensible, because when managers buy and sell their company's stock, their interests may conflict with those of the rest of the shareholders. For example, instead of taking steps to correct the consequences of negligent performance of their responsibilities, managers may focus their effort on getting rid of the company stock before the potential negative impact of their mismanagement becomes known to the other shareholders.

In general, when insiders trade in the corporate stock, they are using shareholder property for their private gain. If the same information was available to other traders, it might affect their activity. In this sense, insider trading creates unfairness by "tilting the level playing field."

Insider trading also affects the process through which the final transaction price is established. This may reduce the efficiency of the stock market and thus impose costs on society (Sen, 1993, pp. 224-225). In the presence of insiders with superior information, outside traders tend to increase the "bid-ask spreads." As a result, fewer stocks are traded as the gap between the number of potential sellers and potential buyers grows larger. Since fewer stocks are traded, the potential economic benefits conferred by the stock market are reduced.

In order to enhance their chances, insiders may even manipulate the timing of crucial announcements made by the firm, possibly to the detriment of other stakeholders. An example is the alleged delaying of the announcement of assay results from mineral exploration programs by mining companies.

As is shown in chapter 4, insiders are able to make abnormal returns on their inside trades. Outsiders are also able to make abnormal returns by mimicking the trades of insiders, even with a lag. Insider trading is a high profile activity, since it is easily understood and has the appearance of unfairness. Many of the criticisms of the Vancouver Stock Exchange, for example, relate to insider trading activities. Similarly, the scandals on Wall Street in the 1980s prominently featured the insider trading violations of Dennis Levine, Ivan Boesky, and Foster Winans.

It has been argued that prohibitions on insider trading would weaken the pressure on managerial performance, since managers are not exposed to the risk of falling share prices. However, an efficient and well-functioning board of directors should devise a system of incentives ensuring that managers discharge their fiduciary responsibility to shareholders. Allowing managers to operate in a risk-free environment is as unethical and inefficient as insider trading (Werhane, 1991, p. 730). We discuss further the regulation of insider trading in chapter 7.

One approach to aligning the interests of management with the interests of outside shareholders is to encourage stock ownership by managers, for example, by introducing stock options as a component of managerial compensation. Typically, the option represents the right to buy the company stock at a stated price (usually the market price at the time when the option was granted). Alternatively, managers may be compensated in the form of "stock appreciation rights", i.e. based on the difference between the market price of the stock at the time of compensation and some previously stipulated benchmark price.

Ownership of shares and stock options by managers is effective in aligning their interests with those of the outside contributors of corporate capital only if there is some guarantee that the managers will retain the securities at least until such time as the relevant decisions are made (Barnea et al., 1985, pp. 97-99).

Conclusions

This chapter has examined some of the ethical issues related to the functioning of the stock market. We conclude that anti-takeover devices that prevent desirable mergers interfere with the ownership rights of shareholders and constitute an obstacle to efficient reallocation of resources.

The consequences of mergers and takeovers may include redistribution of income, closing of some plants and expansion of others, and elimination of specific managerial and other positions and creation of others. We argue that attempts to prevent the negative consequences by restricting takeovers are misguided and undermine the long-term growth of the economy. The same objection applies to attempts to restrict liquidating buyouts, since regulations constraining the actions of new owners might prevent them from remedying the shortcomings of the previous management.

Our review of the various anti-takeover defences concludes that they tend to favour the interests of managers over those of shareholders. In those cases where a company becomes a target of a liquidating takeover attempt because of a temporary excess of the breakup value of its assets over market value of its shares, anti-takeover defences may be ethically permissible. The justification for their use rests on the support of the majority of shareholders and on the demonstration that preservation of the integrity of the company is in the long-term interest of shareholders.

We have also dealt with the problem of informational asymmetry, which arises in situations where some agents (e.g. managers and other insiders) become knowledgeable about important corporate developments sooner than others (e.g. minority shareholders). Management buyouts and insider trading are among the most frequently discussed instances of informational asymmetry in the functioning of the stock market.