Business and society ethics sustainability and stakehoder management 9e by caroll ch04

Chapter Outline• Legitimacy and Corporate Governance • Problems in Corporate Governance • Improving Corporate Governance • The Role of Shareholders • The Role of the SEC • Shareholder Ac

Chapter 4

Corporate Governance: Foundational

Issues

Learning Outcomes

1 Link the issue of legitimacy to corporate governance.

2 Identify the best practices boards of directors can follow.

3 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.

4 Discuss the principle ways in which shareholder activism exerted

pressure on corporate management groups to improve governance.

5 Discuss the ways in which managers relate to shareholders and the

issues arising from that relationship.

6 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?

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

•

Legitimacy and Corporate Governance

Legitimacy

-•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.

Legitimacy

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.

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

The Corporation’s

Hierarchy of Authority

State Charter Shareholders Board of Directors Management Employees

Separation of Ownership from Control Contributes to Governance Problems

Precorporate Period

Owners (ownership)

Managers (control)

Owners (ownership)

Managers (control)

Corporate Period

Shareholders (ownership)

Shareholders (ownership)

Board of Directors

Board of Directors

Management (control) Management (control)

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

Issues Surrounding Compensation

Excessive CEO Pay

Outside Director Compensation

CEO Firm Performance Relationship

Pay-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.

SpringLoading

-•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.

Excessive CEO Pay

Ratio of CEO pay to that of average worker -

•Compensation recovery mechanisms that

enable a company to recoup CEO pay,

typically in the event of a financial

CEO Pay Controversy

1 Shareholder push to link pay to

conditions

2 Increasing use of “clawback” provisions where executives must return pay under some

conditions

Say on Pay

Movement

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

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.

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

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)

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,

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

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

Red Flags Signaling Board Problems

Ranking of Red Flags-

2 Poor employee morale

1 Company has to restate earnings

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

Steps to Take for Board Repair

Steps to Take -

1.Spread risk oversight among multiple committees 2.Seek outside help in identifying potential risks

3.Deepen involvement in corporate strategy

4.Align board size and skill mix with strategy

5.Revamp executive compensation

6.Pick compensation committee members who will question the status quo

7.Use independent compensation consultants

8.Evaluate CEO on grooming potential successors

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

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

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

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.

Shareholder Activism

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

• Management is also responsible for

communicating with shareholders

• CEO Warren Buffet calls his annual

shareholder meeting a “Woodstock weekend

An Alternative Model of

Corporate Governance

• The Anglo-American model of corporate

• 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 © 2015 Cengage Learning 31

Key Terms (1 of 2)

Investor Protection Act of

Reform and Consumer Protection Act

• Sarbanes-Oxley Act (SOX)

• Say on Pay movement