1. Stockholder Rights and Corporate Governance
Chapter 15
Stockholder Rights and Corporate Governance
McGraw-Hill/Irwin
Copyright © The McGraw-Hill Companies, All Rights Reserved.

2. Ch. 15: 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
Investigating how recent corporate scandals have affected corporate governance
Analyzing the function of executive compensation and debating if top managers are paid too much
Knowing how investors organize to promote their economic and social objectives
Understanding how the government protects against stock market abuses, such as fraudulent accounting and insider trading
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3. 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

4. Individual household versus institutional ownership of stock in the United States
Figure 15.1

5. 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”

6. Major Legal Rights of Stockholders
Figure 15.2

7. 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

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 11 members
75% 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

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.

10. 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

11. Improving Corporate Governance Worldwide
OECD, representing 30 nations, issued a revised set of principles of corporate governance in 2004
European Union in 2006 proposed new rules to make it easier for shareholders to get information and to vote their proxies
In South Korea 2002, securities companies launched Corporate Governance Service to promote management transparency
In South Africa 2003, stock exchange announced new rules requiring companies to disclose all director compensation and corporate ties

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 2005, 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

13. Comparing Executive Compensation
Top managers in other countries earned much less
CEOs in the United Kingdom was just 55 % of their
U.S. counterparts, according to a 2006 study
In France, it was 27%
In Japan, 26%
In South Africa, 20%
Another way to look at executive compensation is to compare the pay of top managers with that of average employees
U. S. CEOs in 2004 made 431 times the average worker

14. Ratio of Average CEO Pay to Average Production Worker Pay, 1990-2005
Figure 15.3

15. 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
Multi-million-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

16. 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

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
Formed in 1985, now has 140 members representing $3trillion in holdings
Developed Shareholder Bill of Rights
Research shows involvement of institutional investors can improve company performance

18. 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 2005, $2.3trillion invested in socially responsibility funds; approximately 1 in 10 investment dollars
Rapid growth in similar funds in Europe and U.K.

19. 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 600 were sponsored in 2005
Resolutions can be about social issues, not company’s ordinary business

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 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
Proposed legislation was controversial, as suits could still be filed at state level

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

22. SEC – Information Transparency and Disclosure
Giving stockholders more and better company information is one of best ways to safeguard investor interests
Sarbanes-Oxley Act of 2002 greatly expanded SEC’s powers to regulate information disclosure
See Chapter 5 for summary of its provisions
Exhibit 15.B (next slide) presents controversies related to Section 404 of the law

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