Business & Society
Ethics, Sustainability, and Stakeholder
Management
Eighth Edition
Archie B. Carroll
Ann K. Buchholtz
© 2012 South-Western, a part of Cengage Learning
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Chapter 4
Corporate
Governance:
Foundational
Issues
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Learning Outcomes
1. Link the issue of legitimacy to corporate governance.
2. Identify the best practices that boards of directors can follow.
3. 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.
4. Discuss the principle ways in which shareholder activism
exerted pressure on corporate management groups to improve
governance.
5. Discuss the ways in which managers relate to shareholders
and the issues arising from that relationship.
6. Discuss the issue of shareholder democracy, its current state,
and the trend for the future.
© 2012 South-Western, a part of Cengage Learning
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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
• 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 totality of
business enterprises.
Attempt to change societal Subject to ratification.
expectations or norms to
conform to firm’s
practices.
Seek to enhance its
Existence is solely
legitimacy by identifying because society has given
itself with others that have it that right.
a powerful legitimate base
in society.
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Corporate Governance
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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The Corporation’s Hierarchy of
Authority
State Charter
Shareholders
Board of Directors
Management
Employees
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Separation of Ownership from Control
Precorporate Period
Corporate Period
Shareholders
(ownership)
Owners
(ownership)
Board of
Directors
Managers
(control)
Management
(control)
Agency problems develop when managers
pursue self-interest over owner interest
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The Need for Board Independence
•Outside directors – independent from
the firm
•Inside directors – have some tie to
the firm
Board independence is crucial to
good governance
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Issues Surrounding Compensation
CEO Compensation and Performance
Executive Retirement Plans
Outside Director Compensation
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Issues Surrounding Compensation
(continued)
1) Shareholder push to link pay to
performance
CEO Pay
Controversy
2) Increasing use of “clawback”
provisions where executives
must return pay under some
conditions
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CEO Pay/ Firm 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 average worker is 319
to 1 (down from 531 to 1 in 2000).
Say on Pay
• Evolved from concerns over excessive
executive compensation.
• Began in the United Kingdom in 2002 with
regulations on pay.
Clawback provisions
• Compensation recovery mechanisms that
enable a company to recoup compensation
funds, typically in the event of a financial
restatement or executive’s misbehavior.
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Executive Retirement Plans and
Exit Packages
 Retirement packages have come under
scrutiny.
•
Robert Nardelli received $210 million
when he was ousted from Home Depot by
shareholders.
• Contrast to most workers, many of whom
to do have a retirement plan.
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Outside Director Compensation
• Paying board members is a recent concept.
• Controversy over whether directors should
be paid at all, and whether they are paid
enough.
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Transparency
• SEC requires disclosure of executive
compensations.
• Disclosure forms are long and difficult.
Tax Gross-Up
• Reimbursement for taxes one would have
to pay on medical benefits or other such
costs.
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Impact of the Market on Corporate
Control
Poison pill
Golden parachutes
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Insider Trading
The practice of obtaining critical
information from inside a company and
using that information for one’s own
personal financial gain.
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Improving Corporate Governance:
Sarbanes-Oxley Act of 2002 (SOX)
• Limits the nonauditing services an auditor can
provide
• Requires auditing firms to rotate the auditors
working with a specific company
• Makes it unlawful for accounting firms to
provide services where conflicts of interests
exist
• CEOs and CFOs certify and are held
responsible for financial representations
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Improving Corporate Governance:
Sarbanes-Oxley Act of 2002 (SOX)
(continued)
•
•
•
•
Enhances financial disclosure with
requirements, such as:
• Reporting off-balance sheet transactions
• Prohibiting personal loans to executives
and directors
• Requiring auditors to assess and report
upon internal controls
Audit committees must have at least one
financial expert
Whistle-blowers are given protection
Code of ethics disclosure
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Improving Corporate Governance
Changes in boards of directors
•
•
Board diversity
•
Outside board directors
Use of board committees for:
•
Audit
•
Nominating
•
Compensation
•
Public policy
 The board should “get tough” with the CEO.
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Ranking of Red Flags Signaling
Board Problems
Red Flags
Company has to restate earnings
Poor employee morale
Adverse Sarbanes Oxley 404 opinion
Poor Customer satisfaction track record
Management misses strategic performance
goals
Company is target of employee lawsuits
Stock price declines
Quarterly financial results miss analysts’
expectations
Low corporate governance quotient rating
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Steps to Take for Board Repair
Steps to Board Repair
Spread risk oversight among multiple
committees
Seek outside help in identifying potential risks
Deep involvement in corporate strategy
Align board size and skill with strategy
Revamp executive compensation
Pick compensation committee members who
will question the status quo
Use independent compensation consultants
Evaluate CEO on grooming potential successors
Know what matters to your investors
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Board Diversity
Board diversity is lacking
• Only around 15% of directors in U.S. are
women.
• Sixty-six Fortune 500 firms have no female
board members.
• Hispanics, Asian Americans and African
Americans also under-represented.
• Diverse boards are also less likely to fall
prey to groupthink because they have a
range of perspectives.
 Is a global problem.
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Use of Board Committees
Principle Responsibilities of an Audit
Committee
1. To ensure that published financial statements are
not misleading.
2. To ensure that internal controls are adequate.
3. To follow up on allegations of material, financial,
ethical, and legal irregularities.
4. To ratify the selection of the external auditor.
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Other Board Committees
Nominating committee
•
•
Is composed of outside directors.
Has the responsibility of selecting competent,
objective board members.
Compensation committee
•
Evaluates executive performance and
recommending terms and conditions of
employment.
Public issues committee (Public policy
committee)
•
•
Responds to public or social issues.
Deals with areas in which public or ethical
issues are present.
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Board Member Liability
Business judgment rule
• Holds that courts should not challenge
board members who act in good faith,
making informed decisions that reflect
the company’s best interests.
 Board members need to be free to take
risks without fear of liability.
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Board Member Liability (continued)
The “Caremark Standard,” which heightened
concerns over personal liability, states that
directors can be held personally liable if:
1. The director utterly failed to implement
any reporting or information system or
controls, or
2. Having implemented such a system or
controls, consciously failed to monitor or
oversee its operations, disabling their
ability to be informed of risks or problems
requiring their attention.
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Shareholder Democracy: Key Issues
Majority Vote
• The requirement that board members be
elected by a majority of votes cast.
Classified Boards
• Boards that elect their members in
staggered terms.
Proxy Access
• Provides shareholders with the opportunity
to propose nominees for the board of
directors.
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The Role of the SEC
• Is responsible for protecting investor
interests.
• Critics argue that the SEC is more focused
on businesses than on investors.
 SEC failed to catch the Bernard Madoff
Ponzi scheme before losing investors
billions.
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Shareholder Activism
Shareholder activism
Shareholder resolutions
Shareholder lawsuits
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Investor Relations
Full disclosure (Transparency)
• Information filed at regular and frequent
intervals that contains information that
might affect investment decisions.
 Management is responsible for
communicating with shareholders.
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Key Terms
• Accounting Reform
and Investor Protection
Act of 2002
• Agency problems
• Audit committee
• Backdating
• Board of directors
• Business judgment rule
• Legitimacy
• Legitimation
• Charter
• Classified boards
• Clawback provisions
• Compensation
committee
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Corporate gadfly
Corporate governance
Shareholder democracy
Employees
Full disclosure
Inside directors
Insider trading
Golden parachute
Legitimacy
Legitimation
Majority vote
Management
Nominating committee
Out-of-pocket liability
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Key Terms (continued)
•
•
•
•
•
Outside directors
Personal liability
Poison pill
Ponzi scheme
Public Securities
Litigation Reform Act
of 1995
• Proxy access
• Public issues
committee
• Public policy
committee
• Sarbanes-Oxley Act
• Separation of
ownership from control
• Shareholder activism
• Shareholder democracy
• Shareholder lawsuits
• Shareholder resolutions
• Shareholders
• Spring-loading
• Stock options
• Tax gross-up
• Transparency
© 2012 South-Western, a part of Cengage Learning
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