This article concentrates on conflict of interest, secrecy and insider information of corporate directors in a functional and comparative way. The main concepts are loans and credit to directors, self-dealing, competition with the company, corporate opportunities, wrongful profiting from position and remuneration. Prevention techniques, remedies and enforcement are also in the focus. The main jurisdictions dealt with are the European Union, Austria, France, Germany, Switzerland and the UK, but references to other countries are made where appropriate.
Posts Tagged ‘Conflicts of interest’
A series of broad based developments over the last year combine to encourage governing boards to apply closer attention to conflicts of interest issues. These developments include several prominent judicial decisions; a series of focused articles in The New York Times; a highly public state attorney general investigation; the SEC internal investigation of its general counsel — and the subsequent investigation of its own Inspector General. Collectively, they draw new attention to the proper identification, disclosure and resolution of potential conflicts of interest. This new attention is consistent with an increasing lack of public, judicial and regulatory tolerance for perceived ethical lapses by corporate fiduciaries, their advisors, and others in a position of trust and confidence.
A major reason for the existence of conglomerates or business groups is to create internal capital markets to promote the efficiency of the group. One of many efficiency measures that internal capital markets can offer is an insurance pool, which provides temporary liquidity to the members of the group in the event of adverse shocks. If mutual fund families, which are a collection of legally independent entities tied together by the sponsoring management company, are regarded as groups, it seems reasonable to assume that there would be a group interest. If so, it seems natural to ask whether insurance pools could exist in these families where cash-rich mutual funds direct capital to family funds that are facing large redemption requests, as these redemptions could lead to large fire sale losses. However, by law, they cannot. This is because, while the provision of such an insurance pool against temporary liquidity shocks benefits the family, the cost is borne by the shareholders of the fund providing this “free” insurance. A mutual fund owes a fiduciary responsibility only to its own shareholders, and not to its family.
In our paper, Conflicting Family Values in Mutual Fund Families, forthcoming in the Journal of Finance, we address whether such insurance pools exist in mutual fund families. We examine this by analyzing the investments of affiliated funds of mutual funds (AFoMFs). AFoMFs are mutual funds that only invest in other mutual funds within the family. Instead of the investors or their financial advisors choosing which mutual funds of the family to invest in, AFoMFs do that for the investors. Virtually non-existent in the 1990s, these funds have become very popular. In 2007, which is the last year of our sample. Of the 30 large families that made up around 75% of the industry’s assets, 27 had AFoMFs.
The private equity industry should expect increased scrutiny by the Securities and Exchange Commission (SEC), particularly with respect to insider trading and how firms address conflicts of interest, according to recent speeches by representatives of the SEC Division of Enforcement’s new Asset Management Unit. Moreover, The Wall Street Journal has reported that the SEC has “launched a wide-ranging inquiry into the private equity industry.” 
The Enforcement Division’s increasing attention to private equity corresponds with the implementation of new rules under the Dodd-Frank Act that will significantly increase the number of private equity firms subject to SEC regulation as “investment advisers.” The Asset Management Unit, one of a number of specialized enforcement units formed by the Division of Enforcement in 2010 to focus on “priority areas,”  is staffed with 65 professionals, including private equity experts.
Once registered as investment advisers, private equity firms must appoint a chief compliance officer and maintain written policies and procedures reasonably designed to prevent violation of the federal securities laws, including laws prohibiting insider trading. According to the SEC Staff, these policies and procedures should also promote compliance with firms’ fiduciary duties and regulatory obligations, including identifying and addressing conflicts of interest.
On February 29, 2012, Chancellor Strine of the Delaware Court of Chancery issued an opinion that is highly critical of the sale process run by El Paso Corporation in connection with its $21.1 billion acquisition by Kinder Morgan, Inc. See In re El Paso Corporation Shareholder Litigation, No. 6949-CS (Delaware Court of Chancery). The Court focuses on various alleged conflicts of interest involving El Paso’s CEO and its financial advisor, which persuaded the Court that the plaintiffs have a reasonable probability of success on a claim that the merger was tainted by breaches of fiduciary duty. But despite the “disturbing nature of some of the behavior,” the Court concluded that the balance of hardships did not support a preliminary injunction because the “stockholders should not be deprived of the chance to decide for themselves about the Merger.”
The EU Alternative Investment Fund Managers Directive (the “Directive”) came into force on 21 July 2011. The Directive promises to reshape the regulation of managers of alternative investment funds in the EU and beyond, and is required to be implemented across the EU by 22 July 2013. Yet the Directive requires significant rulemaking in the form of so-called Level 2 implementing measures in order to put flesh on its bones. The body tasked with bringing forth those implementing measures, the European Commission (the “Commission”), has now received final advice from the European Securities and Markets Authority (“ESMA”). That advice, upon which the Commission is expected to rely heavily in its own rulemaking, has been the subject of fierce debate during consultation. This note analyses ESMA’s Final Advice and the possible consequences for the fund management industry going forward.
After two years of development, argument and fine-tuning, the Directive was finally published in the Official Journal of the European Union on 1 July 2011 and entered into force for European law purposes on 21 July 2011. EU Member States are required to implement the Directive by 22 July 2013.
In its recent green paper, the European Commission expressed concern about the effects of conflicts of interest on institutional investors’ willingness and ability to engage investee companies actively on corporate governance matters. Given the pervasiveness of asset manager conflicts and their adverse impact on shareholder engagement and voting behaviour, the remedies pursued must venture beyond the EC’s proposal of requiring ‘independence of the asset manager’s governing body’.
Three Layers of Conflicts
Conflicts of interest at investment firms arise at three levels – institution, individual, and group – all of which pose risks to effective stewardship by institutional investors.
Institutionally, the core conflict of interest pertains to asset managers’ unwillingness to actively engage and hold the boards and management of investee companies accountable because they fear losing corporate business. In reality, the risk of commercial harm varies by market. In the UK, for example, companies do not usually retaliate by withholding business when investment managers vote against management’s proposals. Nonetheless, the occasional veiled threat – such as when the company secretary of a UK manufacturer reminded a fund manager who was intending to vote against the company’s remuneration report that his firm was bidding for an investment mandate from the corporation’s pension plan – may be enough to make investment houses hesitate about embracing stewardship.
Recently, there was the announcement of a proposed $89.4 million settlement of shareholder claims arising out of the buyout of Del Monte Foods Company. The shareholders had alleged that the sales process was tainted by collusion between the buyers and Del Monte’s banker, which had sought to provide financing to the buyout group. The settlement follows the closing of the transaction and will be funded by both the new owners of the company and the banker.
The $89.4 million payment is one of the larger settlements to occur in Delaware shareholder litigation. The driver of the settlement was the Court of Chancery’s February ruling granting a motion for a preliminary injunction. (See our memo of February 15, 2011 on the decision.) The case highlights the following considerations relevant to sale-of-a-company processes:
In the paper State Ownership and Corporate Governance, which was recently made publicly available on SSRN, I explore the role of the state as shareholder in the political economy of corporate governance. Although atypical in the United States, state ownership of listed companies is pervasive and growing elsewhere in the world. According to a recent survey, state-owned enterprises are now responsible for approximately one-fifth of global stock market value, which is more than two times the level observed just one decade ago.
There is a large literature exploring the potential inefficiencies of state control of enterprise, and a growing literature on the ways in which the law, and in particular corporate law, might be structured to limit those inefficiencies. In this paper, I look at the other side of the problem: what is the effect of state ownership on the structure of corporation and capital markets law, not just as it applies to state-controlled firms but as it applies in general to firms that are entirely privately owned? The latter issue is arguably as important as, or even more important than, the problem of controlling the inefficiencies of state ownership, but it has been almost entirely neglected.
In our paper, The Impact of Common Advisors on Mergers and Acquisitions, which was recently made publicly available on SSRN, we examine the conflict of interest that an investment bank faces when advising both the target and acquirer in a merger or acquisition (M&A) by investigating how common advisors affect deal outcomes.
When the New York Stock Exchange merged with Archipelago Holdings, Inc. in 2004, Goldman Sachs served as the lead M&A advisor to both sides of the deal. Goldman’s dual role was fraught with obvious conflicts of interest. The rationale given was that the bank, as the former underwriter of Archipelago’s IPO, had valuable insights about the potential synergies from the merger.
Whether a common M&A advisor has an adverse effect on one or both sides of a deal is unclear a priori, for two reasons. First, the advisor may be deterred from exploiting its clients by potential litigation costs, damage to its reputation, and the repeat nature of the business. Second, as considerable empirical evidence suggests, market participants may consider financial intermediaries’ conflicts of interest when making their own decisions.