The Corporate Governance
Game, The Case of the United
States
Apostolos Gotsias Ph.D.
Assistant Professor of Economic Analysis
University of the Aegean
and
James G. Tompkins Ph.D.
Professor of Finance
Kennesaw State University
1
Agenda





What is Corporate
Governance?
Conflicts of Interest and
Corporate Governance
Existing Governance
Legislation in the United
States
The Cost of Weak
Corporate Governance:
The Case of
HealthSouth
Summary and
questions
2
What is Corporate
Governance?


Corporate Governance is the set of
processes by which a corporation is
directed and controlled.
Different variations in the world. We will
focus on the processes in the United
States.
3
What is Corporate
Governance?


Weak corporate governance results
from numerous potentials for conflicts of
interest.
Today we will discuss some of these
conflicts and how to address these
problems through effective corporate
governance.
4
A Game…

Need a volunteer.
5
Questions for the Volunteer




Are you rich?
What will you do with your money?
Who will you pick to run your business?
Would you like your manager to run
your business in your best interests?
6
The Corporation

Shareholders



Own the company.
Typically many
shareholders.
Management


Manage the
company on behalf
of the firm.
“Agents” for the
shareholders.
7
Questions for Manager/CEO



Will you operate business according to
the shareholder’s best interests?
Would you like to pay yourself twice
your market value?
In the real world, do self-interested
managers ever spend shareholder
money at the detrimental expense of
shareholders?
8
Conflict of Interest #1



The game illustrates perhaps the largest
conflict of interest inherent in a corporation.
The conflict of interest between shareholders
(who own the corporation) and managers
who operate the corporation on the
shareholders behalf.
The resulting cost to shareholders is an
example of an “agency cost”.
9
Conflict of Interest #1

In 2003, the CEO of Tyco corporation is
accused of spending shareholder
money:



$1 million on his wife’s birthday party
$6000 on a shower curtain
What could you do to avoid this type of
conflict of interest?

Board of Directors
10
The Board of Directors

Primary purpose of
the Board of
Directors:

To ensure that
managers operate
the corporation in the
best interests of the
shareholders.
11
The Board of Directors
Management reports to the Board of Directors.
12
The Game Continues….

Conflict of interest
#2
13
Question to Managers/CEO

Would you like to be
your own Board of
Directors?

Possible problems?
14
Conflict of Interest #2


Asking managers to serve as their own
Board is like asking the fox to guard the
chicken house.
For now therefore, let us assume that
no management, or only a minority can
serve on the Board of Directors.
15
Conflict of Interests #2



Definition: An “outside” Director is a member
of the Board who is not employed by the
company.
Definition: An “inside” Director is a member
of the Board who is employed by the
company.
Until 2002, there were no regulations or
listing requirements that prevented a majority
of the Board being inside directors.
16
The Game Continues….

Assume therefore
that a majority of
directors have to be
outsiders.
17
Questions to Managers/CEO



Would you like to
choose your own
outside Board of
Directors?
Please pick a few.
Why did you pick
these directors?
18
Question to Outside Directors

Are you likely to
have more loyalty
towards
management or
shareholders?

Possible problems?
19
Conflict of Interest #2

Another major conflict of interest is
where the Board of Directors have
greater loyalty to management than
they do towards shareholders.
20
Conflict of Interest #2

If managers can choose their own
Board, the directors might be:





Former employees
Family members
Directors with consulting contracts
Interlocking directors (you be on my Board
and I’ll be on your Board)
Many other possibilities…
21
Conflict of Interest #2


In 2003, Tyco Director Frank Walsh
pleaded guilty to trying to hide $20
million in consulting fees he received
from Tyco.
Do you think receiving such a consulting
fee made him loyal to the CEO?
22
Conflict of Interest #2

Problem: Outside
directors may still
have more loyalty to
management than
shareholders.

Solutions?
23
Independent Directors

Per Kennesaw State University Governance
Center principles:
 “An “independent” director has no current
or prior professional or personal ties to the
corporation or its management other than
service as a director. Independent directors
must be able and willing to be objective in
their judgments. The vast majority of the
directors should be independent in both
fact and appearance.”.
24
Questions for Shareholders



Would you want legislation that allows
the Board to have a majority as
insiders?
Would you want a majority of
independent directors?
Who would you want to control the
process of nominating directors:

Independent directors or inside directors?
25
Legislation in USA

Incredibly, it was not until 2002, with the
passage of the Sarbanes-Oxley act, and
stock exchange listing requirements enacted
in 2003 that the following were mandated:


A majority of independent Directors on the board
Nominating committee (responsible for the
processes in identifying and nominating new
candidates for the Board of Directors) must be all
comprised of independent directors.
26
Other Conflicts of Interest and
Pertinent Legislation

Between Managers and
Shareholders



Between Directors and
Shareholders




CEO/Chair Duality
CEO compensation
Director Compensation
Director Time and Diligence
Director Entrenchment
Related to Reporting
Financial Results
27
The Game Continues….

More conflicts of
interest between
management and
shareholders.
28
CEO / Chair Duality

Question for Chief
Executive Officer:



Would you like to
also be the
Chairman of the
Board?
Why?
Possible problems?
29
CEO/Chair Duality

Possible Solutions?




Requirement that the Chairman of the Board be
an independent director.
If the Chairman is an insider, requirement that the
independent directors elect a Lead independent
director.
Routine executive sessions.
Adoption of leadership in setting agenda by
independent director (Chairman or independent
Lead director).
30
CEO/Chair Duality



In the USA, there is no legislation that
the CEO can not also be the Chairman.
But there are listing requirements
regarding a Lead independent director.
No requirements regarding the agenda
setting process.
31
CEO Compensation

Question for Chief
Executive Officer:


Would you like to set
your own
compensation
package?
Would the
shareholders like
this?
32
CEO Compensation

Possible solutions?



Compensation committee to consist of all
independent directors.
Directors to have access to independent
consultants.
CEO compensation subject to annual
shareholder vote
33
CEO Compensation


In the USA, listing requirements mandate that
companies have compensation committees
with all members being independent
directors.
Listing requirements also require the adoption
and disclosure of guidelines for directors to
have access to independent consultants.
34
CEO Compensation


Beginning in 2011, the SEC ruled that
companies must allow shareholders with “say
for pay” voting rights. This is where the CEO
compensation package is voted on by
shareholders, and the Board takes the vote
under advisement.
Starting with 2007 proxy statements, the SEC
mandated that compensation committees
disclose the process on how they determine
CEO and Executive compensation.
35
The Game Continues….

More conflicts of
interest between
directors and
shareholders.
36
Director Compensation

Question for
Directors:


Would you like to set
your own
compensation
package?
Would the
shareholders like
this?
37
Director Compensation

Possible solutions?




Hire directors with a record of integrity.
Directors to have access to independent
consultants.
Director compensation subject to annual
shareholder vote.
Director compensation must be publicly
disclosed.
38
Director Compensation



Typically only outside directors receive
compensation.
Director compensation must be disclosed.
NYSE listing requirements include disclosing
the general principles for determining the
form and amount of director compensation.
39
Director Time and Diligence

Question for
Directors:

Would you enjoy the
prestige and
financial gain of
being a director
without putting in
much effort or
diligence?
40
Director Time and Diligence

Possible solutions?




Hire directors with a record of a strong
work ethic.
Legislation which requires “duty of care”
by directors.
Court rulings that make directors
personally liable for a lack of diligence.
Director evaluations.
41
Director Time and Diligence



NYSE 2003 listing requirements state the
Board should conduct a self-evaluation at
least annually to determine whether it and its
committees are functioning effectively.
There are however no requirements for
individual director evaluations.
“Duty of care” legislation has been in effect
for decades.
42
Director Entrenchment

Question for
Directors:



Would you want to
keep your job even if
it hurt shareholders?
How could this
happen / examples?
Is there such a thing
as being on a Board
too long?
43
Director Entrenchment

Possible solutions?


Term limits or mandatory retirement age.
There is no legislation in the USA that
regulates how long a director can serve
on a Board.
44
The Game Continues….

Conflicts of interest
related to reporting
financial results.
45
A Possible Scenario




Shareholders are expecting results reflecting
2 $ per share for the quarter. But actual
earnings are only 1 $ per share.
The CEO’s 5 million $ bonus depends on
meeting earnings expectations.
CEO also has stock options whose value is
very sensitive to share price.
Role playing exercise: CEO has ordered the
chief auditor to meet and discuss the
earnings per share announcement.
46
Possible Meeting Outcomes

CEO orders chief auditor to “adjust” books to meet
expectations.



CEO gets bonus, cashes in high value of stock options and
keeps job.
Chief auditor keeps job and can expect a big raise from
CEO.
CEO is unable to persuade chief auditor to “adjust
books”.


CEO might fire chief auditor or give low or no raise.
CEO does not get bonus and is unable to cash in stock
options. CEO possibly loses his or her job.
47
Possible Meeting Outcomes

CEO is honest and orders the release of the
low earnings per share number.


CEO does not get bonus and is unable to cash in
stock options. CEO possibly loses his or her job.
Chief Auditor keeps his or her job.
48
Financial Reporting Conflicts
of Interest

Solutions?


The audit department should be hired by
and report directly to a committee of
independent directors (audit committee).
The audit committee and audit department
should not be paid heavily with stock
options or other compensation highly
sensitive to stock price.
49
Financial Reporting Conflicts
of Interest

Solutions?


The audit committee should be responsible
for the oversight of ensuring integrity with
financial reporting.
The audit committee should be qualified
and competent with reading and
understanding detailed financial
statements.
50
Legislation in USA






Audit committee with all independent directors.
Audit committee must have a designated “financial
expert.”
External auditor is hired by the audit committee and
reports directly to them.
However, this is not true of the internal auditor.
SOX 2002 requires CEO’s and CFO’s to “certify”
the financial statements.
Many other rules in this area exist to address
conflicts of interest in financial reporting.
51
Agenda




What is Corporate
Governance?
Conflicts of Interest and
Corporate Governance
Existing Governance
Legislation
The Cost of Weak
Corporate
Governance: The
Case of HealthSouth
52
The Case of HealthSouth


The importance of effective corporate
governance can be illustrated with the
case of HealthSouth.
HealthSouth is a very large healthcare
service provider company.
53
SEC Alleges HealthSouth
Faked $1.4 Billion in Profits


Case hits the media March 20, 2003.
Former CFO (Weston Smith) tells authorities:




Senior executives at the health-care giant had been
falsifying financial results for more than five years.
CEO and Chairman Richard Scrushy met regularly with CFO
and another executive and told him to inflate earnings to
meet Wall Street estimates.
Do you see any corporate governance related
problems?
What do you think would happen to the stock price?
54
SEC Alleges HealthSouth
Faked $1.4 Billion in Profits
55
SEC Alleges HealthSouth
Faked $1.4 Billion in Profits




Stock price closed on March 18,
2003 at $3.91 per share.
SEC halts trading.
Trading resumes March 26, 2003 at
a share price of $0.11 per share.
97.2% decline in share price!
56
Importance of Corporate
Governance

MAJOR LESSON:

Poor
Corporate
Governance
Can Be Very
Expensive!!!
57
Efficient Markets
• What is an efficient market? E.G. an efficient stock market?
• A stock market is considered efficient if the stock price
reacts both immediately and wholly to the flow of
information.
58
Risk and Return Question


Why did the stock price react as it did?
If the US passes corporate governance laws
that decrease the risk of being in the stock
market, how would you expect the stock
market to react?


If effective Corporate governance is riskdecreasing to the shareholder then the stock
markets would rise.
Assumptions:


Expected cost of the improved governance is less than
the expected benefit.
Efficient markets.
59
Summary

Corporate governance are the
processes by which a corporation is
directed and controlled.
60
Summary

Major conflicts of interest within a corporation:

Between management and shareholders


e.g. 1 million dollar birthday party
Between the Board of Directors and shareholders

The Board has more loyalty to:



management than shareholders
themselves than shareholders.
Financial statement related.
61
Summary

Effective corporate governance will
address these conflicts of interest.




Majority of independent directors on Board
Nominating, compensation and audit
committee of all independent directors.
Auditors to report directly to the audit
committee.
Many others.
62
Summary

Poor
Corporate
Governance
Can Be Very
Expensive!!!
63
Questions?
64
Summary

Major conflicts of interest within a corporation:

Between management and shareholders


e.g. 1 million dollar birthday party
Between the Board of Directors and shareholders

The Board has more loyalty to management than shareholders
65
Summary

Effective corporate governance will
address these conflicts of interest.



Majority of independent directors on Board
Nominating, compensation and audit
committee of all independent directors.
Many others.
66