Question 1) The European Court of Justice (ECJ) decisions in the legal matters of Centros, Überseering and Inspire Art dealt with so called inbound cases in which the ECJ had to decide whether certain discriminations of specific European companies were in compliance with the EC Treaty. In Centros the ECJ ruled that the registration of a foreign company in a commercial register must not be refused by a member state if the company was effectively incorporated in another member state, even if the company does not deploy any business in its state of incorporation at all. This judgment was further developed in Überseering, the ECJ stating that a company which was incorporated in one member state must be capable of holding rights and being a party to legal proceedings in another member state in which she has got her administrative centre. Ultimately, the ECJ ruled in Inspire Art that the establishment of a pseudo-foreign company must not be restricted through legal provisions imposing a minimum capital requirement or additional disclosure requirements which otherwise infringe Art. 43 EC and 48 EC. In summary, the Court ruled continuous in favor of the freedom of establishment. Except in the cases of fraud, a company is entitled to incorporate in a member state with the sole aim to establish itself and conduct its entire business in another member state. Choosing a certain jurisdiction for its favorable legal standards is not an abuse by itself. Furthermore, not even the protection of creditors may satisfy the public interest standard to justify such additional provisions. To review the decisions in a more general way, the real seat theory was displaced by the incorporation theory.
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This ruling disposed all doubts and led in fact to a cross-border migration and the increased emergence of pseudo-foreign companies, especially the English Limited (Ltd.). At that time, the incorporation of a Ltd. was both, the fastest and cheapest way to incorporate a company with virtually no minimum capital required. These circumstances caused a regulatory competition among EU member states, fostered by the fact that a harmonization on a EU level failed. In order to make their business entity more competitive, several member states, e.g. France, Ireland and Cyprus abolished a minimum capital requirement. Even the conservative German legislator introduced a sub-form of the German GmbH (close corporation with limited liability) which can be incorporated with €1 only.
Enabled by the ECJ's decisions in the Centros triad, the newly formed corporate mobility has its implications on insolvency regulations in the EU as well. Although the insolvency law within the EU is still a matter of national law, the European Insolvency Regulation (EIR) went into force in 2002 to provide a framework for cross-border insolvency proceedings. According to Art. 3 para. 1 EIR, the main insolvency proceeding will arise in the jurisdiction the debtor has its "Centre of Main Interest" (COMI) in, which is rebuttable presumed to be in the state of the company's registered office. The importance of the COMI concept arises from Art. 4 EIR, stating that insolvency proceedings are subject to the jurisdiction in which they are opened. It is readily identifiable that the COMI is an ambiguous and easy to manipulate concept, leading to a run on the most favorable jurisdiction, often referred to as forum shopping. A company shifting its COMI to another member state is protected by the freedom of establishment and may not be discriminated by pre-insolvency rules, e.g. minimum capital requirements. The question that arises is, if companies that are close to an insolvency are entitled to freely chose their insolvency law regime by shifting their COMI but without a reincorporation. This leads to a divergence between the company and insolvency law applicable. Therefore, shifting the COMI from one member state to another must be seen as abusive if it does not contribute to the maximization of debtor's assets in order to benefit the creditors. These shifts are motivated by distributive and not efficiency concerns.
Question 2a) Corporate governance problems are often related to agency problems which are caused by asymmetric information the agent enjoys over his principal. This may stimulate the agent to act opportunistically while the principal bears high costs of monitoring the agent as well as of motivating him to act in the principals interests.
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In dispersed ownership regimes, these agency problems arise between shareholders and mangers of a company. In the recent corporate governance scandals in the US, the opportunistic attitude of agent-managers led to accounting irregularities which were not detected by principal-shareholders. While managers were under the pressure of producing high earnings' growth rates each single business period, they manipulated revenue recognitions and created artificial earnings peaks. This focus on short-term revenues was caused by the shift in manager's compensation from cash-based to equity-bases. Under the pressure of institutional investors who used compensation packages to align managers' and their interests, managers had an incentive to keep the stock price high and maximize share value of their companies by inflating earnings.
In contrast, this kind of fraud is unlikely to happen in concentrated ownership regimes where managers' compensation is much lower and less equity-based. Furthermore, controlling shareholders may simply monitor or even replace managers and are not interested in short-term earnings. Thus, agency problems in these regimes occur between minority shareholders and large blockholders. The latter may extract private benefits from the company in question or squeeze-out minority shareholders. Using translated party transactions, controlling shareholders may transfer assets from one company to another in which they have greater cash flow rights, thus manipulating balance sheets and not income statements.
The scandals in each regime resulted from gatekeepers' failure and therefore new mechanisms to mitigate the problems were introduced. The focus in the US was threefold. First, shareholders' rights were strengthened by the possibility to vote on compensation packages and to block defensive tactics in takeover negotiations. Second, the accounting regulations were reformed, requiring public companies to establish audit committees, including independent directors and at least one financial expert, to appoint and oversee auditors. CEOs and CFOs have to certify the validity of financial statements, external auditors have to be changed after a five-year period and are prohibited from providing some non-audit services. Finally, the board of directors is mandated to be independent, including outside directors and choosing another chairman than the CEO. This approach will not work for concentrated ownership regimes because even if auditors are independent and not captured by managers, they still report to a board influenced by controlling shareholders. Thus, minority shareholders have to rely on the assistance of large banks monitoring the company and other techniques, like mandatory bid requirements or supermajority votes. The protective legislation of the EU is another important factor which is outline below.
Question2b) The most important legal reform in the US was certainly the Public Company Accounting Reform and Investor Protection Act 2002 (Sarbanes-Oxley Act) which besides the changes mentioned above introduced a new accounting regulator, the Public Companies Accounting Oversight Board. On European level, the EU announced an action plan to modernize the company law, strengthen shareholder rights and increase the transparency of related party transactions. In addition, the Commission released plans to reform the statutory audit and proposed an amendment to the Council Directive to enforce boards' responsibility for financial statements.
Question 3) The main difference between the US and the UK takeover regime is probably the influence managers and shareholders respectively are able to exert in a hostile takeover scenario. Managers subject to the US regime have a variety of defenses, including poison pills and the ability to influence the board of the company which makes a hostile takeover less likely to be successful. On the contrary, the takeover regime in the UK is by far more shareholder oriented, hence, managers are not allowed to take any defensive actions without shareholders' approval. Poison pills are not allowed at all. In addition, shareholders may remove directors by ordinary resolution and thus, boards are less staggered compared to the US. Another difference emerges from the fact that bidders in the US are flexible in the percentage of company's stock they want to acquire. Investors' protection is achieved by the requirement that bidders must pay the same price for each share, buying a pro rata amount of each shareholder interested to sell and the bid has to be kept open at least 20 days. In contrast, the minority protection in the UK is accomplished by a mandatory bid rule which forces each bidder who intends to acquire a controlling stake in a company to make an offer for the rest of the shares outstanding, too. Another important difference arises from the fact that takeover regulation is the domain of courts and regulators in the US. Since it is a common strategy to file a suit against managers' defenses, lawyers and judges play a great role in solving such disputes. In the UK, the bidder lodges a protest with the Takeover Panel if managers try to interfere. The Panel relies on the City Code on Takeovers and Mergers which is soft law and self-regulatory in nature. Furthermore, the Panel addresses bids as soon as they are made and in this flexible approach norms are adjusted to cases and changes in the market place. As a result, lawyers play only a little role.
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The main factors that contributed to these differences outlined above were launched with the banking and securities reforms in 1933 and 1934 in the US, which broke the banks monopoly and set a governmental regulator in place, the SEC. In the 1960s, when hostile tender offers became popular, Wall Street investment banks refused to represent bidders. Thus, lawyers took over and enforced their importance in the takeover regime. The Williams Act 1968 prevented so called "Saturday Night Special" tender offers, which was a clear advantage for managers because from there on they had enough time to conduct a campaign against bidders. Hostile takeovers began in the 1950s in the UK, and after some business incidents and the British Aluminium board's favoring of one bidder over another, the "Notes on Amalgamation of British Businesses" were announced and amended later on: shareholders should decide if to sell and board should be neutral. In 1968, simultaneously with the Williams Act, the Takeover Code was announced, which was shareholder friendly and banned all frustrating actions by management. Finally, the City Panel on Takeovers and Mergers was institutionalized to regulate takeover problems. This self-regulating approach kept lawyers out of the takeover regulation process and is based on norms. By contrast, the federal structure of the US gives managers the power to threaten single states to move the company and thereby push their interest. Finally, institutional investors played a greater role in the UK than in the US because the investment activities of pension funds and the like was encouraged by legislation. As a consequence, institutional investors had great influence on rule-making by creating market norms or lobbying regulators. In the US, institutional investors emerged after the takeover regime was settled. Because the courts of Delaware rely on formal case law and enjoy a great role in forming the takeover regime, the influence of institutional investors is limited.
When evaluating the facts mentioned above from an efficiency point of view, the UK approach has some clear advantages over the US model. The UK takeover regime allows bidders to replace underperforming managers which creates value for the target's shareholders as studies have shown. Furthermore, whole procedure is faster and framed by a clear timetable, imposed by the EU takeover directive, which enhance the certainty and predictability of takeover bids. While tactical litigations of the target's board to frustrate bids are common in the US, procedures take more time and are far more expensive. Finally, the UK regime can be deemed as dynamic because it changes over time and is proactive in its response to the market whereas the US regime is reactive because litigations follow changes in the market place.
Question 4 A) The implementation of Section 404 of the Sarbanes-Oxley Act 2002 established an accounting standard for public companies' internal controls regarding financial reporting and financial statements. The goal was to strengthen investors confidence in adequate internal controls and financial statements. In practice, auditors failed to adopt an audit plan that fitted the special requirements of each individual company but used standardized checklists, thereby focusing on low-risk areas which are less likely to contain material misstatements. This one-size fits all approach caused high costs for companies to comply with Section 404 and since the auditing firms were granted with a monopoly for attestation services, they were able to raise their fees in addition. The "check in the box" approach addressed by Donaldson criticizes the focus on compliance rather than on creating efficient business solutions. Thus, companies will no longer make innovative business decisions if they focus on the rule book which is not adequate to cover every business solution. As a consequence, "politically correct dictates" are inhibited, meaning that corporate governance will no longer be further developed by the companies' boards which are in charge of defining the company's unique culture and ethical fundamentals.
B) As already mentioned above, the Sarbanes-Oxley Act forced public companies to establish independent audit committees which channel the contact with registered public accounting firms. The Act also imposed new responsibilities on auditors who are meant to exercise a "whistleblower" function and detect illegal material acts. As a consequence, auditors need to be independent with respect to their clients as well. Therefore, lucrative contracts for providing non-auditing services are prohibited because they may impair the auditors' independence from the company or its managers respectively. Auditors might knuckle under the pressure of management in order to get beneficial and well-paid consulting mandates, manipulating the audit as a trade-off and jeopardize its validity. The prohibited services include bookkeeping, financial information system design, appraisal or valuation, actuarial services, internal audits, human resources, broker-dealer and legal services. Finally, providing management functions to audit clients will be deemed unlawful because performed decision-making or supervisory functions will necessarily impair auditors' independence. However, some services, e.g. tax planning advices, are still allowed as long as the audit committee pre-approved their appropriateness.
C) The Enron scandal was affected by improper corporate governance practices, the board's failure to oversee Enron's management and some serious accounting frauds. Discussing the latter, I shall start with the formation of "Chewco". After Enron went into a joint venture investment partnership with Calpers creating "JEDI", Enron did not consolidate JEDI because both parties had joint control. Thus, Enron kept the gains and losses from JEDI from its financial statements and JEDI's debt from its balance sheet. Chewco was formed to purchase Calpers' interest in JEDI, so Calpers would enter into a larger partnership with Enron. To further avoid the consolidation of JEDI, Chewco had to have an outside investor with a minimum equity capital of 3% at risk but failed to attract such. As a result, JEDI's purchase was financed with debt only, not equity. This infringed the accounting rules for SPEs and led to a huge increase in Enron's debt. Another accounting irregularity was conducted in conjunction with the business relationships to the partnerships LJM1 and LJM2. Enron's board even approved that relationship and Fastow's investment, thereby ignoring the conflict of interest that would arise. As a first misconduct, Enron sold assets to LJMs to remove it from its balance sheet. But when Enron bought back some interests and protected the LJM partnerships from losses, Enron failed to transfer risk to the LJMs so that transaction could hardly be considered a "sale". As a result, financial results were artificially inflated. Another misconduct was related to hedging, in which normally a third party takes the economic risk of an investment and bears the losses. But Enron created SPEs and provided them with its stock and outside equity of LJM1 to meet the non-consolidation threshold of 3% in order to cover Enron's losses from its merchant investment in Rhythms. The main source the SPEs backed up Enron's investment was Enron's own stock. Hence, no economic risk was transferred at all. The same was the case for the "Raptor" vehicles where Enron's stock was used to secure merchant investments. By using the "hedging gains" to offset the losses from investments, Enron circumvented accounting rules. When the investment and Enron's stock fell at the same time, the SPEs had not efficient credit capacity any more. To top it all off, Arthur Andersen assisted Enron in its accounting treatment and helped Enron to structure its deals with Chewco and the LJMs.
Regulatory arbitrage describes outsourcing of business activities from one country to the company's subsidiaries in another country by using loopholes to escape supervisory authorities. This evasion of supervision is used to keep prohibited transactions confidential, especially the shift of credit risks of banks in pension and hedge funds.Part 2 - Case Study
For the purpose of the assessment of this case study, I will start with some general notes about hedge funds in order to further develop my reasoning. Over recent years, hedge funds have grown persistently and represent nowadays a large part of trading activities at stock exchanges. Hedge funds are private investment entities which pool money of investors and are run by a professional investment managers. Although activist hedge funds still represent only a rather small portion of the entirety of hedge funds, they are the important players in the case study and thus, I will focus on them. Normally, actively managed hedge funds acquire large stakes of a company to challenge and monitor its management. They have a rather short-term orientation to improve shareholder value and reach their own goals, although the period hedge funds hold stocks in a corporation increased from one to two to three years. The success of a hedge fund's activity is dependent on the collaboration of other shareholders and the use of defensive tactics by the management.
I shall now turn to the identification and evaluation of some key concepts that are essential for activist hedge funds in theory. Simultaneously, I will assess if the theoretic approaches can be confirmed in the light of the two cases at hand, Wendy's and McDonald's. I will further discuss the similarities and differences between these cases regarding the activity of the hedge funds.
Before hedge funds engage into a firm commitment, they conduct an extensive research and market analysis of a specific company before they invest into it. By evaluating the potential market value of the firm, hedge funds assess assets and liabilities and target primarily undervalued firms afterwards. As a result, hedge funds enhance the liquidity and efficiency of the market and reduce the costs of capital for companies. When hedge funds bought a stake in Wendy's and McDonald's, they believed that the companies were undervalued because their stock price did not fully reflect the contribution of their growth-driving subsidiaries. But in the case of McDonald's, Ackman acquired only 4.9% of the shares, thereby avoiding a filing of the Schedule 13D with the SEC. As a consequence, the information why he invested into the company did not float to the market and potential investors did not benefit. Thus, the efficiency of the market was not increased.
Discussing corporate governance issues that arise with the investment of hedge funds, they are in general said to be short-term-horizon investors who sacrifice long-term benefits for short-term cash. One advantage of hedge funds is certainly, that they help companies to better deal with agency problems between managers and shareholders arising from the separation of ownership and control. Their hybrid position between internal and external monitoring grants them with advantages over corporate raiders, which do not cooperate with management and acquire larger shares, and institutional investors because hedge funds are highly incentivized, independent, flexible and largely unregulated. On the other hand, hedge funds have to satisfy their own investors and need to focus on short-term payoffs. As a consequence, they propose financial strategies which generate immediate cash and result in a better performance of the company, disregarding long-term benefits. Mentioning Wendy's, this was Ackman's intention by the proposed sale of a large portion of restaurants, the spinoff of Tim Hortons and the share repurchase. In addition, Wendy's increased its dividends and reduced its debt, boosting its stock price by 55% and making Ackmans's activism a success. Moreover, this short-term orientation of hedge funds can have serious impacts on the management of the target company. While hedge funds rarely intend to take over the control of the company, they tend to work together with management and support it in operational day-today business as well as with strategic questions. But hedge funds normally target companies with underperforming management. In the case of McDonald's, the company did not alter its strategic targets regarding sales and revenue growth as well as operating income growth for several years. As a result, its share price traded for a long time at a low- to mid-priced range and below comparable peer companies. This justified the hedge fund's activism and led to the negative impacts they exert on management. By imposing pressure, hedge funds try to discipline the board of management and influence it to increase short-term profits. It can be reasonably argued that the effective control over a company should stay with the board of management because it is best to increase efficiency and add long term value to the company. In neither Wendy's nor McDonald's case, Ackman pressured the boards too much, let's say by threatening a proxy fight, but he certainly made them think about their business strategies. Furthermore, there is no evidence that the payment for the CEOs decreased and the turnover rate of the CEOs increased, often associated with activist hedge funds.
Hedge funds activism has also implications on the strategy of corporations they invest in, which goes along with proposals to spin off under-performing subsidiaries and to refocus business strategy. Hedge funds sometimes take part in pending mergers and acquisitions, enforcing or blocking them. In the case of McDonald's the proposed restructuring with the sale of the underperforming restaurant ownership McOpCo in a large IPO was substantial. In addition, Ackman wanted to issue a huge amount of debt to refinance the creation of a newly organized company model which should have focused on cash flow producing real estate and franchise businesses to attract new investors. This approach was rejected by McDonald's management because it did not consider the unique business model of the company. The sale of restaurant was seen as counterproductive and would have risked the relationship to its franchisees. Instead, McDonald's announced its own interim plans to increased shareholder value by selling underperforming restaurants to its franchisees, share repurchases and the increase in dividends. The concerns of the rating agencies towards Ackman's proposal which would have led to rating downgrades if the company increased its debt, made further clear that Ackman primarily enforced its own interest.
The real estate issue addressed in the McDonald's case shed some light on another interesting matter. While Ackman valued McDonald's real estate substantially higher than it was reflected in books but would still keep it to issue debt to finance a share repurchase, a second hedge fund, Vernado Realty Trust, which acquired a 1.2% stake, intended to spin off the real estate business into a real estate investment trust. This would have resulted in a loss of control for McDonald's. These divergent views clarify that there is often more than one "optimal" solution and hedge funds are not necessarily always right. They try to support their own ideas to achieve their specific goals. As a consequence, management of a target company has to evaluate different approaches and even consider other possibilities in order to achieve the best short- and, more importantly, long-term result in favor of the company. When Ackman recognized that McDonald's management would not concede easily, he revised his original plan, but again the management had its own ideas how to reorganize the company. Finally, they sold some of the company's owned stores, repurchased shares, increased dividends, promised to provide better information regarding its performance but rejected a restructuring. As some of these changes included in fact implementation proposed by Ackman, he dropped his campaign immediately and stated that his goals were achieve. Speaking for itself, this was the best prove for a short-term horizon of hedge funds activism.
As a last aspect I would like to mention that hedge fund activism is said to enhance the business communication within a company and increase shareholder value. As already shown above, the activities of Ackman indeed increased the payout of dividends and the companies' stock price by focusing on the capital structure and operational efficiencies. Mostly, a hedge fund's entry into a company is in addition associated with a positive market reaction, positive abnormal returns and the increase of returns on equity and assets. Furthermore, hedge funds are in a better position to represent shareholders' interest which can lead to an improved communication between the management of the company and the shareholders, thereby reducing certain agency problems. On the contrary, "empty voting" by hedge funds becomes more popular. That is the acquisition of voting rights of shares but not the economic ownership in order to achieve the hedge funds' interests which can differ significantly from interest of other shareholders.
In summary, the case study suggest that hedge fund's activism is manly short-term oriented and driven by own interest, disregarding the companies' long-term goals. In my opinion, this is not necessarily bad for the target company, depending on the amount of pressure the hedge fund can impose on the management and the management's freedom for an own reaction and evaluation of all circumstances. It seems that in the case of Wendy's the management merely implemented Ackman's proposals without considering its impacts, although they stated that the restructuring was the result of a cooperation with its financial advisor Goldman Sachs, ignoring Ackman's efforts at all. At least the management was convinced that their actions was an "approach to manage the company for the future". Despite short-term benefits, also long-term benefits due to proactive restructuring and strategic alignment of the company were targeted. In contrast, McDonald's management considered different possibilities and rejected to merely implement what was proposed by the hedge fund. Since McDonalds did not change its strategic goals for quite a long time, hedge funds activism made them rethink their stagnancy and the company managed to develop a business model to improve its business in the short, and in the long run.
As a final note, I would like to briefly mention the changing role of hedge funds in recent years. As already shown above, hedge funds do not only tend to deliver high returns by research and analysis, but moreover try to influence the policy and strategy of a company. Put in another way, they increasingly invest in equity instead of debt. In some industries, hedge funds even become long-term investors, waiting a long period before they sell their stake. While also entering the domain of private equity funds, hedge funds have a tendency towards self-regulation by listing their funds and raising money on public markets, preventing fund managers from opportunistic behavior. Finally, to become a more transparent investment entity, hedge funds join well-established industry associations.