Ethical issues.

The Finance in Practice box in Section 1-2 (See attached File) describes three corporate practices that have been criticized as unethical.

Select one of these and discuss at what point (if any) does the practice slide into unethical behavior.

Short-Selling

Investors who take short positions are betting that secu- rities will fall in price. Usually they do this by borrow- ing the security, selling it for cash, and then waiting in the hope that they will be able to buy it back cheaply.* In 2007, hedge fund manager John Paulson took a huge short position in mortgage-backed securities. The bet paid off, and that year Paulsons trade made a profit of $1 billion for his fund.*

Was Paulsons trade unethical? Some believe that he was not only profiting from the misery that resulted from the crash in mortgage-backed securities, but that his short trades accentuated the collapse. It is certainly true that short-sellers have never been popular. For example, following the crash of 1929, one commenta- tor compared short-selling to the ghoulishness of crea- tures who, at all great earthquakes and fires, spring up to rob broken homes and injured and dead humans.

Investors who sell their shares are often described as doing the Wall Street Walk. Short-selling is the Wall Street Walk on steroids. Not only do short-sellers sell all the shares they may have previously owned, they borrow more shares and sell them too, hoping to buy them back for less when the stock price falls. Poorly performing companies are natural targets for short- sellers, and the companies incumbent managers natu- rally complain, often bitterly. Governments sometimes listen to such complaints. For example, in 2008 the U.S. government temporarily banned short sales of financial stocks in an attempt to halt their decline.

But defendants of short-selling argue that to sell secu- rities that one believes are overpriced is no less legitimate than buying those that appear underpriced. The object of a well-functioning market is to set the correct stock prices, not always higher prices. Why impede short- selling if it conveys truly bad news, puts pressure on poor performers, and helps corporate governance work?

Corporate Raiders

In the movie Prett y Woman, Richard Gere plays the role of an asset stripper, Edward Lewis. He buys com- panies, takes them apart, and sells the bits for more than he paid for the total package. In the movie Wall Street, Gordon Gekko buys a failing airline, Blue Star, in order to break it up and sell the bits. Real corporate raiders may not be as ruthless as Edward Lewis or Gordon

Gekko, but they do target companies whose assets can be profitably split up and redeployed. This has led many to complain that raiders seek to carve up established companies, often leaving them with heavy debt burdens, basically in order to get rich quick. One German politician has likened them to swarms of locusts that fall on companies, devour all they can, and then move on.

But sometimes raids can enhance shareholder value. For example, in 2012 and 2013, Relational Investors teamed up with the California State Teachers Retirement System (CSTRS, a pension fund) to try to force Timken Co. to split into two separate companies, one for its steel business and one for its industrial bearings business. Relational and CSTRS believed that Timkens combina- tion of unrelated businesses was unfocused and ineffi- cient. Timken management responded that the breakup would deprive our shareholders of long-run valueall in an attempt to create illusory short-term gains through financial engineering. But Timkens stock price rose at the prospect of a breakup, and a nonbinding shareholder vote on Relationals proposal attracted a 53% majority.

How do you draw the ethical line in such examples? Was Relational Investors a raider (sounds bad) or an activist investor (sounds good)? Breaking up a portfo- lio of businesses can create difficult adjustments and job losses. Some stakeholders, such as the companys employ- ees, may lose. But shareholders and the overall economy can gain if businesses are managed more efficiently.

Tax Avoidance

In 2012, it was revealed that during the 14 years that Starbucks had operated in the U.K., it paid hardly any taxes. Public outrage led to a boycott of Starbucks shops, and the company responded by promising that it would voluntarily pay to the taxman about $16 million more than it was required to pay by law. Several months later, a U.S. Senate committee investigating tax Charlatans and swindlers are often able to hide behind booming markets. It is only when the tide goes out that you learn whos been swimming naked. ⁷ The tide went out in 2008, and a number of frauds were exposed. One notorious example was the Ponzi scheme run by the New York financier Bernard Madoff. Individuals and institutions put about $65 billion in the scheme before it collapsed in 2008. (Its not clear what Madoff did with all this money, but much of it was apparently paid out to early investors in the scheme to create an impression of superior investment performance.) With hindsight, the investors should not have trusted Madoff or the financial advisers who steered money to Madoff.

Madoffs Ponzi scheme was (we hope) a once-in-a-lifetime event. It was astonishingly unethical, illegal, and bound to end in tears. That much is obvious. The difficult ethical prob- lems for financial managers lurk in the grey areas. Look, for example, at the nearby Finance in Practice box that presents three ethical problems. Think about where you stand on these issues and where you would draw the ethical red line.

What is the underlying source of unethical business behavior? Sometimes it is simply because an employee is dishonest. But frequently the behavior stems from a culture in the firm that encourages high-pressure selling or unscrupulous dealing. In this case, the root of the problem lies with top management that promotes such values. (Click on the nearby Beyond the Page feature for an interesting demonstration of this in the banking industry.

Agency Problems and Corporate Governance

We have emphasized the separation ofownership and control in public corporations. The owners (shareholders) cannot control what the managers do, except indirectly through the board of direc- tors. This separation is necessary but also dangerous. You can see the risks. Managers may be tempted to buy sumptuous corporate jets or to schedule business meetings at tony resorts. They may shy away from attractive but risky projects because they are worried more about the safety of their jobs than about maximizing shareholder value. They may work just to maximize their own bonuses, and therefore redouble their efforts to make and resell flawed subprime mortgages. Conflicts between shareholders and managers objectives create agency problems. Agency problems arise when agents work for principals. The shareholders are the principals; the manag- ers are their agents. Agency costs are incurred when (1) managers do not attempt to maximize firm value and (2) shareholders incur costs to monitor the managers and constrain their actions. Agency problems can sometimes lead to outrageous behavior. For example, when Dennis Kozlowski, the CEO of Tyco, threw a $2 million 40th birthday bash for his wife, he charged half of the cost to the company. This of course was an extreme conflict of interest, as well as illegal. But more subtle and moderate agency problems arise whenever managers think just a little less hard about spending money when it is not their own