Stockholder Rights and Corporate Governance Chapter 14 Stockholder Rights and Corporate Governance

Ch. 14: Key Learning Objectives Identifying different kinds of stockholders and understanding their objectives and legal rights Knowing how corporations are governed and explaining the role of the board of directors in protecting the interests of owners Analyzing the function of executive compensation and debating if top managers are paid too much Evaluating various ways stockholders can promote their economic and social objectives Understanding how the government protects against stock market abuses, such as fraudulent accounting and insider trading

Stockholders Stockholders (also called shareholders) The legal owners of business corporations Types of stockholders Individual stockholders are people who directly own shares of stock issued by companies Institutions, such as pension funds, mutual funds, insurance companies, and university endowments Called institutional investors

The Changing Nature of Market Investors Individuals Institutions

Stockholders Trends In 2007, institutions accounted for 75% of the value of all U.S. stocks, worth $16 trillion About two-and-a-half times the value of institutional holdings a decade earlier In 2008, nearly one-half of all U.S. households owned stock, either directly or as institutional investors This proportion had dropped somewhat since the early 2000s   Older people are more likely to own stock, slightly over 40% of young households do so. At all ages, equity ownership is higher as income and education rises.

Individual household versus institutional ownership of stock in the United States Figure 14.1

Objectives of Stock Ownership To produce a return greater than they could receive from alternative investments Stockholders make money when the price of the stock rises (capital appreciation) and when they receive their share of the company’s earnings (called dividends) Bull markets (in which share prices rise overall) alternate with bear market (in which share prices fall overall) Although stock prices can be volatile, stocks historically have produced a higher return over the long run than many other types of investments Some investors use stock ownership to achieve social or ethical objectives Discussed further under “social investment

Dow Jones Industrials 1900 to Present © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

DJ Industrials 1986-Present © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Primary Forces Driving Management Decisions Profits Sustainability Company Performance Financial Ratios Financial Market Psychology Stock Appreciation Performance

Major Legal Rights of Stockholders Figure 14.2

Knowing how corporations are governed and explaining the role of the board of directors in protecting the interests of owners

Does involvement of institutional investors can improve company performance? Boar of Directors Corporate Management Role of oversight

Corporate Governance Corporate governance Refers to the process by which a company is controlled, or governed Board of directors An elected group of individuals who have a legal duty to establish corporate objectives, develop broad policies, and select top-level personnel to carry out these objectives and policies

Boards of Directors Vary in size, composition, and structure to best serve the interests of the corporation and shareholders Survey of governance practices in leading firms in the Americas, Europe, and Asia Pacific: Average board size was 10 members Typically, 8 of the 10 are outside directors (not managers of the company) Work of the Board is done through committees: Typical committees: Compensation, Executive, Nominating, Audit Audit has key role to review financial reports, recommend outside auditors, and oversee integrity of internal financial controls

Boards of Directors Board members are elected by shareholders at the annual meeting, where absent owners vote by proxy Process is not truly democratic, but tends to be self-perpetuating The board nominating committee, working with the CEO and chairman, develops a list of candidates. Once approved by the Board, the names of these individuals are placed on the proxy ballot. Because alternative candidates are often not presented, the vote has little significance.

Key Features of Effective Boards Select outside directors to fill most positions Hold open elections for members of the board Appoint an independent lead director and hold regular meetings without the CEO present Align director compensation with corporate performance Evaluate the Board’s performance on a regular basis

Improving Corporate Governance Worldwide OECD, representing 30 nations, issued a revised set of principles of corporate governance in 2004 to serve as a benchmark for companies and policy makers worldwide. The OECD 2009 report concluded that the financial crisis affecting may of its member states had been caused, to an important extent by failures of corporate governance, it called for re-examination of the adequacy of these principles. EU, South Africa, and India have worked hard to modernize corporate governance practices, but progress has been slow in emerging markets

Analyzing the function of executive compensation and debating if top managers are paid too much

Executive Compensation Executive compensation is a key Board function An important mechanism for aligning the interests of the corporation and its stockholders with those of its top managers Many critics feel that this system is not working and executive pay has become excessive Executive compensation in the U.S., by international standards, is very high In 2008, the U.S. chief executives of the largest corporations earned, on average, $8.4 million (composed of salaries, bonuses, benefits and stock options) Stock options is controversial subject on its own

Ratio of Average CEO Pay to Average Production Worker Pay, 1990-2007 Figure 14.4

Executive Compensation: Is it Justified? Arguments of proponents of high executive pay Well-paid managers are simply being rewarded for outstanding performance High salaries provide an incentive for innovation and risk-taking Not many individuals are capable of running today’s large, complex organizations Arguments of critics of high executive pay Inflated executive pay hurts the ability of U.S. firms to compete with foreign rivals Multimillion dollar salaries cause resentment, sap the commitment of hardworking lower and midlevel employees As many extravagantly compensated executives preside over failure as they do over success

The Top 10 Highest Paid CEOs of 2010 COMPANY CEO NAME INDUSTRY Total 2010 realized comp. McKesson Corp. John H. Hammergren Health Care Providers & Services $145,266,971 Omnicare Joel F. Gemunder $98,283,242 TRW Automotive Holdings Corp. John C. Plant Auto Components $76,841,646 Verisk Analytics Frank Coyne Professional Services $68,416,726 CVS Caremark Thomas M. Ryan Food & Staples $68,079,823 General Growth Properties, Inc. Adam Metz Real Estate Investment Trust (REIT) $66,707,460 Polo Ralph Lauren Ralph Lauren Textiles, Apparel & Luxury Goods $66,651,515 Vornado Realty Trust Michael D. Fascitelli $64,402,468 Aetna Inc. Ronald A. Williams $57,787,786 GAMCO Investors Mario J. Gabelli Capital Markets $56,608,736 Source: GMI

Pay Comparisons 2007 2008 S&P 500 -- CEO total compensation* $11.16 million $10.9 million Full-Time Workers (median) $36,140 $37,544 *Numbers don't include the value of the many perks CEOs receive, which averaged $438,342. Nor do they include the pension benefits CEOs receive. Sources: Standard & Poors 500 U.S. Department of Labor

Executive Compensation Reform Has been the subject of shareholder pressure Some companies have changed the way they set executive pay; have compensation committees of entirely outside directors and tie pay more directly to company performance Small number of companies set multiple of executive pay versus others workers Government regulations Under U.S. rules, corporations must disclose top 5 executives’ compensation and the rationale for it Allows shareholders to vote on executive and director compensation United Kingdom requires such a vote

Evaluating various ways stockholders can promote their economic and social objectives

Shareholder Activism – Rise of Institutional Investors As shown earlier, holdings have increased significantly; have become more assertive in promoting interests of their members Have large blocks of stock so not easy to sell if become dissatisfied, therefore strong incentive to work to change management policy Council of Institutional Investors Represents institutions and pension funds with investments collectively exceeding $3 trillion in holdings Developed a Shareholder Bill of Rights Research shows involvement of institutional investors can improve company performance

Shareholder Activism – Social Investment Refers to the use of stock ownership as a strategy for promoting social objectives; also called social responsibility investment Social screening of stock Some stock purchasers choose stocks based on social or environmental criteria, called social screens In 2007, $2.7 trillion invested in socially responsibility funds; approximately 1 in 9 investment dollars Rapid growth in similar funds in Europe and beyond

Shareholder Activism – Social Responsibility Shareholder Resolutions A resolution on an issue of corporate social responsibility placed before stockholders for a vote at the company’s annual meeting Has been a significant rise in social responsibility shareholder resolutions in recent years – about 650 were sponsored in 2007 Sponsorship is often from a coalition of groups, like Interfaith Center on Corporate Responsibility Resolutions can be about social issues, not company’s ordinary business Only garner about 15% of votes, yet their influence is stronger as company managers respond ahead of annual meetings so they will be withdrawn

Shareholder Activism – Shareholder Lawsuits If owners think they or their company have been damaged by actions of company officers or director, they have right to bring lawsuits Can be initiated to check abuses, for example insider trading, inadequate stock buyout price, or lush executive pensions Some corporations have claimed were target of frivolous shareholder lawsuits As result Congress passed legislation making it more difficult for investors to sue corporations for fraud

Understanding how the government protects against stock market abuses, such as fraudulent accounting and insider trading

Securities and Exchange Commission (SEC) Government agency charged with protection of stockholder interests Established in 1934 in the wake of the Great Depression Mission is to protect stockholders’ rights by making sure that the stock markets are run fairly and that investment information if fully disclosed Unlike more government agencies, generates revenue to pay for its own operations

SEC – Information Transparency and Disclosure Giving stockholders more and better company information is one of best ways to safeguard investor interests. In recent years, management has tended to disclose more information than ever before to stockholders and other interested people. Although the overall trend has been to greater transparency, some observers felt that a lack of disclosure about complex financial instruments that became common in the mid-2000s, may have led investors to underestimate their risk.

SEC - Insider Trading Insider trading Occurs when a person gains access to confidential information about a company’s financial condition and then uses that information, before it becomes public knowledge, to buy or sell the company’s stock Is illegal under SEC Act of 1934, meaning against the law to: Steal nonpublic information and use it to trade a stock Trade a stock based on a tip from someone who had an obligation to keep quiet Pass information to others with an expectation of gain