Lecture Business and society - Chapter 4: Corporate Governance: Foundational Issues

Contents: 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.

Chapter 4

Corporate Governance: Foundational

Issues

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?

• 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

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

Pay-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

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

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

Outside Director Compensation -

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

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

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

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 committees2.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

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

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

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

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 © 2015 Cengage Learning 31

Key Terms (1 of 2)

• Accounting Reform and

Investor Protection Act of