© 2015 Cengage Learning

Chapter 4 Corporate Governance: Foundational Issues © 2015 Cengage Learning

Learning Outcomes 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 director-primacy models of corporate governance. What are their respective strengths and weaknesses? Which do you prefer and why? © 2015 Cengage Learning

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 © 2015 Cengage Learning

Legitimacy and Corporate Governance 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. © 2015 Cengage Learning

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. © 2015 Cengage Learning

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. © 2015 Cengage Learning

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 © 2015 Cengage Learning

The Corporation’s Hierarchy of Authority State Charter Shareholders Board of Directors Management Employees © 2015 Cengage Learning

Shareholders (ownership) Separation of Ownership from Control Contributes to Governance Problems Corporate Period Precorporate Period Shareholders (ownership) Board of Directors Management (control) Owners (ownership) Managers (control) © 2015 Cengage Learning

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. © 2015 Cengage Learning

Issues Surrounding Compensation CEO Pay-Firm Performance Relationship Executive Retirement Plans & Exit Packages Transparency; SEC Rules Excessive CEO Pay Outside Director Compensation © 2015 Cengage Learning

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. © 2015 Cengage Learning

Excessive CEO Pay Say on Pay Clawback provisions 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. © 2015 Cengage Learning

CEO Pay Controversy Say on Pay Movement 1. Shareholder push to link pay to performance 2. Increasing use of “clawback” provisions where executives must return pay under some conditions Say on Pay Movement © 2015 Cengage Learning

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. © 2015 Cengage Learning

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. © 2015 Cengage Learning

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. © 2015 Cengage Learning

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) © 2015 Cengage Learning

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. © 2015 Cengage Learning

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 © 2015 Cengage Learning

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 © 2015 Cengage Learning

Red Flags Signaling Board Problems Ranking of Red Flags- 1. 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. © 2015 Cengage Learning

Steps to Take for Board Repair Spread risk oversight among multiple committees Seek outside help in identifying potential risks Deepen involvement in corporate strategy Align board size and skill mix 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 © 2015 Cengage Learning

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 © 2015 Cengage Learning

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. © 2015 Cengage Learning

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. © 2015 Cengage Learning

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. © 2015 Cengage Learning

Shareholder resolutions Shareholder Activism Shareholder activism Shareholder resolutions Shareholder lawsuits © 2015 Cengage Learning

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.” © 2015 Cengage Learning

An Alternative Model of Corporate Governance 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 © 2015 Cengage Learning

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 © 2015 Cengage Learning

Key Terms (2 of 2) 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 Shareholder activism Shareholder democracy Shareholder lawsuit Shareholder resolutions Shareholders Spring-loading Stock options Tax gross-up Team-production model Tippee Tipper Transparency © 2015 Cengage Learning