Chapter 14 Stockholder Rights and Corporate Governance Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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 14-2

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 14-3

Stockholders Trends  In 2010, institutions accounted for 63% of the value of all U.S. stocks, worth $15 trillion  About eight times the value of institutional holdings two decade earlier  Slightly over half of all U.S. households own stocks, either directly or indirectly through holdings in mutual funds  Older people are more likely to own stock, slightly less than 40% of young households do so  At all ages, equity ownership is higher as income and education rises 14-4

Household versus Institutional Ownership in the United States Figure

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 markets (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” 14-6

Major Legal Rights of Stockholders Figure

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 14-8

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 12 members  Typically, 10 or 11 of these 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 14-9

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 14-11

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, and 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 14-12

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 2011, the median total compensation of chief executives of the largest corporations in the United States was $9.6 million (including salaries, bonuses, benefits and stock options) Stock options is controversial subject on its own 14-13

Relative Median Executive Compensation in the United States and Selected European Nations Figure

Ratio of Average CEO Pay to Average Production Worker Pay, 1990–2010 Figure

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 14-16

Executive Compensation Reform  Has been the subject of shareholder pressure  Some companies have changed the way they structure executive pay, e.g., by tying 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  The say-on-pay provisions of the Dodd-Frank Act, which went into effect in 2011, require public companies to hold shareholder votes on executive compensation at least once every three years 14-17

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 14-18

Shareholder Activism – Social Investment  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 2010, $3.1 trillion in the United States was invested in mutual funds or pensions using social responsibility as an investment criterion  Rapid growth in similar funds in Europe and beyond 14-19

Shareholder Activism – Social Responsibility Shareholder Resolutions  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 400 were sponsored in 2011  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  In 2011, such resolutions garnered, on average, 21 percent of votes cast, an all-time high 14-20

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 timely disclosure of material information  The outcome can be very expensive for companies 14-21

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 14-22

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 14-23

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 14-24

Stockholders and the Corporation  Stockholders have become an increasingly powerful and vocal stakeholder group in corporations  Provide capital  Monitor corporate performance  Assure the effective operation of stock markets  Bring new issues to the attention of management 14-25