1 Corporate Governance: Foundational Issues Business and Society: Ethics and Stakeholder Management, 7e Carroll & Buchholtz Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved Prepared by Deborah Baker Texas Christian University Chapter 4

2 Thought for the day  “Corporations have been enthroned….An era of corruption in high places will follow and the money power will endeavor to prolong its reign by working on the prejudices of the people…until wealth is aggregated in a few hands…and the Republic is destroyed.” Abraham Lincoln

3 Legitimacy and Corporate Governance Legitimacy A condition wherein there is a congruence between anorganization’s activities andsociety’s expectations. Legitimation A dynamic process by which a business seeks to perpetuateits acceptance.

4 Micro Level of LegitimacyMacro Level of Legitimacy Legitimacy and Corporate Governance 1. Adapt operational methods to perceived societal expectations 2. Attempt to change societal expectations or norms to conform to firm’s practices 3. Seek to enhance its legitimacy by identifying itself with others that have a powerful legitimate base in society 1. Focus is on the totality of business enterprises 2. Subject to ratification 3. Existence is solely because society has given it that right

5 The Corporation’s Hierarchy of Authority State Charter Shareholders Board of Directors Management Employees Figure 4-1

6 Separation of Ownership from Control Precorporate PeriodCorporate Period Owners (ownership) Managers (control) Owners (ownership) Managers (control) Shareholders (ownership) Board of Directors Management (control) Figure 4-2

7 The Need for Board Independence Inside Directors Outside Directors

8 Issues Surrounding Compensation CEO Compensation Executive Retirement Plans Outside Director Compensation

9 Issues Surrounding Compensation 1) the extent to which CEO pay is tied to firm performance 2) the overall size of CEO pay CEO Pay Controversy CEO Pay Controversy

10 CEO Pay/Firm Performance Relationship Stock Options Allows the recipient to purchase stockin the future at the price it is today Backdating Allows the recipient to purchase stockat yesterday’s price, resulting inimmediate wealth increase Spring-Loading Granting of a stock option at today’sprice, but with the inside knowledgethat stock’s value is improving Bullet-Dodging Delaying of a stock option grantuntil right after bad news

11 Text Quote – Pg. 129  1982 – Average CEO compensation was 42 times the compensation of an average employee.  2000 – Average CEO compensation was more than 531 times the compensation of an average employee.  Average CEO compensation was more than 411 times the compensation of an average employee.

12 Excessive CEO Pay Clawback Provisions Compensation recovery mechanismsthat enable a company to recoupexecutive compensation funds

13 Impact of the Market for Corporate Control Poison pill Golden parachutes

14 Insider Trading The practice of obtaining criticalinformation from inside a company andusing that information for one’s ownpersonal financial gain

15 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

16 Improving Corporate Governance  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  CEOs and CFOs certify and are held responsible for financial representations  Whistle-blowers are afforded protection  Code of ethics disclosure Sarbanes-Oxley Act of 2002 (SOX)

17 Sarbanes-Oxley Blues My audit costs are rising My D&O is due My bottom line's falling more behind I got the Sarbanes-Oxley blues Board of directors resigning My auditor's front page news My CFO's calling in from Rio I got the Sarbanes-Oxley blues I used to know lots of CEOs talking sweet on CNBC But your numbers miss and your stock price slips Mr. Spitzer you're bound to see Perp walk in lower Manhattan They took the laces out of my shoes Where on earth is Leavenworth? I got the Sarbanes-Oxley blues I really miss the good ol' days When I told my board what to do Now my audit committee is slapping me silly I got the Sarbanes-Oxley blues 20 years rise above my peers sacrificing everything Now the handcuff's bite keeps me up at night Close as I'll get to the brass ring My audit costs are rising My D&O is due My bottom line's falling more behind I got the Sarbanes-Oxley blues  pages/festiveaudio.php pages/festiveaudio.php

18 Improving Corporate Governance  Changes in boards of directors board diversity Outside board directors  Use of board committees for: audit nominating compensation public policy  Board should “get tough” with the CEO

19 Improving Boards and Board Members Building a Better Board Define the role the board intends to undertake Be explicit about their financial goals Widen the talent pool for directors Encourage constructive dissent Divide and delegate work to promote deeper analysis Being a Better Board Member Be willing to change management Be willing to do lots of homework Control the flow of information Meet outside of the CEO’s sphere Don’t sacrifice performance for collegiality Figure 4-3

20 Use of Board Committees 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. Principal Responsibilities of an Audit Committee

21 Board Member Liability Business Judgment Rule Business Judgment Rule Holds that courts should not challengeboard members who act in good faith,making informed decisions that reflectthe company’s best interests.Board members need to be free to takerisks without fear of liability. Holds that courts should not challengeboard members who act in good faith,making informed decisions that reflectthe company’s best interests.Board members need to be free to takerisks without fear of liability.

22 Board Member Liability In November 2006, the Delaware Supreme Court affirmed the “Caremark Standard,” which states that directors can only be held 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.

23 Shareholder Democracy: Key Issues Majority Vote The requirement that board membersbe elected by a majority of votes cast. Classified Boards Boards that elect their members instaggered terms. Shareholder Ballot Access Provides shareholders with theopportunity to propose nominees forthe board of directors.

24 Shareholder Activism Shareholder activism Shareholder resolutions Shareholder lawsuits

25 Investor Relations Full Disclosure Information filed at regular andfrequent intervals that containsinformation that might affectinvestment decisions