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Chapter 4
Corporate
Governance:
Foundational
Issues
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Learning Outcomes
1.
2.
3.
4.
5.
6.
Link the issue of legitimacy to corporate governance.
Identify the best practices boards of directors can follow.
Discuss the problems that have led to the recent spate of
corporate scandals and the efforts that are currently underway to
keep them from happening again.
Discuss the principle ways in which shareholder activism exerted
pressure on corporate management groups to improve
governance.
Discuss the ways in which managers relate to shareholders and
the issues arising from that relationship.
Compare and contrast the shareholder-primacy and directorprimacy models of corporate governance. What are their
respective strengths and weaknesses? Which do you prefer and
why?
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Chapter Outline
• Legitimacy and Corporate Governance
• Problems in Corporate Governance
• Improving Corporate Governance
• The Role of Shareholders
• The Role of the SEC
• Shareholder Activism
• Investor Relations
• An Alternative Model of Corporate Governance
• Summary
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Legitimacy
and Corporate Governance
Legitimacy • A condition that prevails when there is a
congruence between an organization’s
activities and society’s expectations.
Legitimation • A dynamic process by which a business
seeks to perpetuate its acceptance.
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Legitimacy
Micro Level of Legitimacy Macro Level of Legitimacy
Adapt operational
methods to perceived
societal expectations.
Focus is on the corporate
system, the totality of
business enterprises.
Attempt to change
societal expectations or
norms to conform to
firm’s practices.
Business has a fragile
mandate, subject to
ratification.
Seek to enhance its
legitimacy by identifying
itself with others that
have a powerful
legitimate base in society.
Business exists solely
because society has given
it that right.
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Corporate Governance • Refers to the method by which a firm is
being governed, directed, administered, or
controlled, and to the goals for which it is
being governed.
• Is concerned with the relative roles, rights,
and accountability of such stakeholder
groups as owners, boards of directors,
managers, employees, and other
stakeholders.
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Roles of Four Major Groups Shareholders •
Own stock in the firm, giving them ultimate
control (the shareholder-primacy model).
Board of Directors •
Govern and oversee management of the
business.
Managers •
The individuals hired by the Board to manage
the business on a daily basis.
Employees •
Hired to perform actual operational work
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The Corporation’s
Hierarchy of Authority
State Charter
Shareholders
Board of Directors
Management
Employees
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Separation of Ownership from Control
Contributes to Governance Problems
Corporate Period
Precorporate Period
Shareholders
(ownership)
Owners
(ownership)
Board of
Directors
Managers
(control)
Management
(control)
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The Need for Board Independence
Outside directors –
• are independent from the firm
Inside directors –
• have some tie to the firm
Board independence from management is crucial
to good governance.
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Issues Surrounding Compensation
CEO Pay-Firm Performance Relationship
Excessive CEO Pay
Executive Retirement Plans & Exit Packages
Outside Director Compensation
Transparency; SEC Rules
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CEO PayFirm Performance Relationship
Stock Options •
Allows the recipient to purchase stock in the
future at the price it is today.
Backdating •
Allows the recipient to purchase stock at
yesterday’s price, resulting in immediate wealth
increase.
Spring-Loading •
Granting of a stock option at today’s price, but
with the inside knowledge that stock’s value is
improving.
Bullet Dodging •
Delaying of a stock option grant until right after
bad news.
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Excessive CEO Pay
Ratio of CEO pay to that of average worker • 1980, 42-1
• 2000, 531-1
• 2011, 380 to 1
Say on Pay
• Evolved from concerns over excessive
executive compensation.
Clawback provisions
• Compensation recovery mechanisms that
enable a company to recoup CEO pay,
typically in the event of a financial
restatement or executive’s misbehavior.
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CEO Pay Controversy
1. Shareholder push to link pay to
performance
Say on Pay
Movement
2. Increasing use of “clawback”
provisions where executives
must return pay under some
conditions
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Executive Retirement Plans and
Exit Packages
Retirement packages –
• have come under scrutiny.
•
•
$210 million to Robert Nardelli when he
was ousted from Home Depot.
$125 million to outgoing Bank of America
CEO, Ken Lewis
• In contrast, many of today’s workers do
not have a retirement plan.
• Those who do generally have a defined
contribution plan, rather than a defined
benefit plan.
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Outside Director Compensation • Paying board members is a recent idea.
• Today, outside board members are paid.
• From 2003-2010, their median pay rose
about a third, from $175,800 to $233,800.
• Controversy over whether directors should
be paid at all, and whether they are paid
enough.
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Transparency Exec compensation packages may include deferred pay,
Severance, pension benefits, & other perks over $10,000.
SEC Rules require disclosure of executive compensation
Such disclosures may have a moderating impact
prior to implementation.
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Governance Impact of the Market
for Corporate Control
Mergers and acquisitions -
• Expectation is that the threat of a possible
takeover will motivate top managers to
pursue shareholder, rather than self-interest.
• But many corporate CEOs and boards go to
great lengths to protect themselves from
takeovers, using:
• poison pills (discourages a hostile takeover by
making the firm difficult to take on)
• golden parachutes (firm agrees to pay key
officers in the event of a change in control of
the corporation)
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Insider Trading •
•
•
•
•
•
The practice of buying or selling a security by
someone who has access to material information
that is not available to the public.
“Material Information” is information that a
reasonable investor might want to use, and is
likely to affect the price of the firm’s stock.
A “tipper” provides that information
A “tippee” receives the information
Executives and others who work for a firm may
have inside information
Also those in relationships that include a duty of
confidentiality may have inside information,
including spouses, parents, children, friends.
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Improving Corporate Governance (1 of 2)
• Sarbanes-Oxley Act of 2002 (SOX) • Amends securities laws to protect investors in
public companies
• Enhances public disclosure to require reporting
of off-balance sheet transactions, and personal
loans to executives
• Limits the nonauditing services an auditor can
provide to a firm it audits
• Makes it unlawful for accounting firms to provide
services where conflicts of interests exist
• CEOs and CFOs must certify financials, and are
held responsible for financial representations
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Improving Corporate Governance (2 of 2)
Changes in boards of directors • More Board diversity
• A greater ratio of outside board members
to inside board members
• Use of board committees to:
• Ensure that financials are not misleading
• Ensure that internal controls are adequate
• Follow-up allegations of irregularities
• Ratify the selection of an external auditor
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Red Flags Signaling Board Problems
Ranking of Red Flags1. Company has to restate earnings.
2. Poor employee morale.
3. Negative risk assessment from auditor.
4. Poor customer satisfaction track record.
5. Management misses strategic performance goals.
6. Company is target of employee lawsuits.
7. Stock price declines.
8. Quarterly financial results miss analysts’ expectations.
9. Low corporate governance quotient rating.
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Steps to Take for Board Repair
Steps to Take 1. Spread risk oversight among multiple committees
2. Seek outside help in identifying potential risks
3. Deepen involvement in corporate strategy
4. Align board size and skill mix with strategy
5. Revamp executive compensation
6. Pick compensation committee members who will
question the status quo
7. Use independent compensation consultants
8. Evaluate CEO on grooming potential successors
9. Know what matters to your investors
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The Board’s Relationship with CEO
• Boards are responsible for monitoring
CEO performance and dismissing poorly
performing CEO
• Formerly, CEOs were protected; no more;
firings of CEOs are up significantly
• If CEO also serves as Chairman of the
Board, this duality can offer some
protection
• Activists have moved to separate CEO and
Board functions
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Board Member Liability • The Business Judgment Rule protects
board members if:
•
•
•
they act in good faith,
making informed decisions
that reflect the company’s best interests,
and not their own interests.
• Good Faith is central to the defense
• The argument in favor of the Business
Judgment Rule is that Board members
need to be free to take risks without fear
of liability.
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The Role of Shareholders
The Shareholder Democracy Movement rises
from the fact that although they are owners,
shareholders may find that their votes are not counted.
They seek:
A Majority Vote
•
The requirement that board members be elected by
a majority of votes cast, rather than by a plurality.
Banning Classified or Staggered Boards
•
Electing members in staggered terms means that it
might take 3 or more years to replace a board.
Proxy Access
•
Would provide shareholders with the opportunity to
propose nominees for the board of directors.
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The Role of the SEC • The SEC Is responsible for protecting investor
interests.
• Critics argue that the SEC is more focused on
the needs of businesses than on that of
investors.
• The SEC failed to stop the Bernard Madoff
Ponzi scheme before losing investors billions,
although they had been warned of the
scheme a decade earlier.
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Shareholder Activism
Shareholder activism
Shareholder resolutions
Shareholder lawsuits
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Investor Relations •
A majority of corporate boards now
communicate with their major investors
• Public corporations have obligations to current
and potential shareholders, including Full
disclosure (Transparency), and the duty to
provide information that might affect
investment decisions.
• Management is also responsible for
communicating with shareholders.
• CEO Warren Buffet calls his annual shareholder
meeting a “Woodstock weekend for capitalists.”
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An Alternative Model of
Corporate Governance
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•
•
The Anglo-American model of corporate
governance is one of shareholder primacy
A emerging perspective is a director-primacy
model of corporate governance
A director-primacy model is based on the
concept of a corporation that is not owned, but
is an independent legal entity that owns itself.
•
•
Boards are mediating hierarchs, responsible for
balancing competing interests of stakeholders
Boards have a duty to shareholders, but boards are
the ultimate decision-makers, whose duty is to the
corporation
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Key Terms (1 of 2)
• Accounting Reform and
Investor Protection Act of
2002
• Agency problems
• Anglo-American model
• Audit committee
• Backdating
• Board of directors
• Bullet-dodging
• Business judgment rule
• CEO duality
• Charter
• Classified boards
• Clawback provisions
• Compensation committee
• Corporate gadflies
• Corporate governance
• Director-primacy model
• Dodd-Frank Wall Street
Reform and Consumer
Protection Act
• Employees
• Fragile mandate
• Full disclosure
• Golden parachute
• Information asymmetry
• Inside directors
• Insider trading
• Legitimacy
• Legitimation
• Majority vote
• Management
• Material information
• Nominating committee
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Key Terms (2 of 2)
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Out-of-pocket liability
Outside directors
Personal liability
Poison pill
Ponzi scheme
Private Securities Litigation
Reform Act of 1995
Proxy access
Regulation FD (fair
disclosure)
Sarbanes-Oxley Act (SOX)
Say on Pay movement
SEC Rule 10b5-1
SEC Rule 10b5-2
Separation of ownership
from control
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Shareholder activism
Shareholder democracy
Shareholder lawsuit
Shareholder resolutions
Shareholders
Spring-loading
Stock options
Tax gross-up
Team-production model
Tippee
Tipper
Transparency
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