Learning Outcomes
Link the issue of legitimacy to corporate governance.
Identify the best practices boards of directors can follow.
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.
Discuss the principle ways in which shareholder activism exerted pressure on corporate management groups to improve governance.
Discuss the ways in which managers relate to shareholders and the issues arising from that relationship.
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?
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© 2015 Cengage Learning1Chapter 4Corporate Governance: Foundational Issues© 2015 Cengage Learning2Learning OutcomesLink the issue of legitimacy to corporate governance.Identify the best practices boards of directors can follow.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.Discuss the principle ways in which shareholder activism exerted pressure on corporate management groups to improve governance.Discuss the ways in which managers relate to shareholders and the issues arising from that relationship.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? © 2015 Cengage Learning3Chapter OutlineLegitimacy and Corporate GovernanceProblems in Corporate GovernanceImproving Corporate GovernanceThe Role of ShareholdersThe Role of the SECShareholder ActivismInvestor RelationsAn Alternative Model of Corporate GovernanceSummary © 2015 Cengage Learning4Legitimacy and Corporate GovernanceLegitimacy -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.© 2015 Cengage Learning5Legitimacy© 2015 Cengage Learning6Micro Level of LegitimacyMacro Level of LegitimacyAdapt operational methods to perceived societal expectations.Focus is on the corporate system, the totality of business enterprises.Attempt to change societal expectations or norms to conform to firm’s practices.Business has a fragile mandate, subject to ratification.Seek to enhance its legitimacy by identifying itself with others that have a powerful legitimate base in society.Business exists solely because society has given it that right.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.© 2015 Cengage Learning7Roles 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© 2015 Cengage Learning8The Corporation’s Hierarchy of Authority© 2015 Cengage Learning9State CharterShareholdersBoard of DirectorsManagementEmployeesSeparation of Ownership from ControlContributes to Governance Problems© 2015 Cengage Learning10Precorporate PeriodOwners(ownership)Managers(control)Corporate PeriodShareholders(ownership)Board ofDirectorsManagement(control)The Need for Board Independence© 2015 Cengage Learning11Outside directors – are independent from the firmInside directors – have some tie to the firmBoard independence from management is crucial to good governance.Issues Surrounding Compensation© 2015 Cengage Learning12Excessive CEO PayOutside Director CompensationCEO Pay-Firm Performance RelationshipStock 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.Spring-Loading -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.© 2015 Cengage Learning13Excessive CEO PayRatio of CEO pay to that of average worker -1980, 42-12000, 531-12011, 380 to 1Say on Pay Evolved from concerns over excessive executive compensation.Clawback provisionsCompensation recovery mechanisms that enable a company to recoup CEO pay, typically in the event of a financial restatement or executive’s misbehavior.© 2015 Cengage Learning14CEO Pay Controversy 1. Shareholder push to link pay to performance2. Increasing use of “clawback” provisions where executives must return pay under some conditionsSay on Pay Movement© 2015 Cengage Learning15Executive Retirement Plans and Exit PackagesRetirement 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 LewisIn 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. © 2015 Cengage Learning16Outside 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.© 2015 Cengage Learning17Transparency - © 2015 Cengage Learning18Exec compensation packages may include deferred pay,Severance, pension benefits, & other perks over $10,000.SEC Rules require disclosure of executive compensationSuch disclosures may have a moderating impactprior to implementation. Governance Impact of the Market for Corporate Control© 2015 Cengage Learning19Mergers 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 informationA “tippee” receives the informationExecutives and others who work for a firm may have inside informationAlso those in relationships that include a duty of confidentiality may have inside information, including spouses, parents, children, friends.© 2015 Cengage Learning20Improving Corporate Governance (1 of 2)Sarbanes-Oxley Act of 2002 (SOX) - Amends securities laws to protect investors in public companiesEnhances public disclosure to require reporting of off-balance sheet transactions, and personal loans to executivesLimits the nonauditing services an auditor can provide to a firm it auditsMakes it unlawful for accounting firms to provide services where conflicts of interests existCEOs and CFOs must certify financials, and are held responsible for financial representations© 2015 Cengage Learning21Improving Corporate Governance (2 of 2)Changes in boards of directors - More Board diversityA greater ratio of outside board members to inside board members Use of board committees to:Ensure that financials are not misleadingEnsure that internal controls are adequate Follow-up allegations of irregularitiesRatify the selection of an external auditor© 2015 Cengage Learning22Red Flags Signaling Board ProblemsRanking of Red Flags- © 2015 Cengage Learning232. 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 RepairSteps to Take - Spread risk oversight among multiple committeesSeek outside help in identifying potential risksDeepen involvement in corporate strategyAlign board size and skill mix with strategyRevamp executive compensationPick compensation committee members who will question the status quoUse independent compensation consultantsEvaluate CEO on grooming potential successorsKnow what matters to your investors© 2015 Cengage Learning24The Board’s Relationship with CEOBoards are responsible for monitoring CEO performance and dismissing poorly performing CEOFormerly, CEOs were protected; no more; firings of CEOs are up significantlyIf CEO also serves as Chairman of the Board, this duality can offer some protectionActivists have moved to separate CEO and Board functions © 2015 Cengage Learning25Board 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 defenseThe argument in favor of the Business Judgment Rule is that Board members need to be free to take risks without fear of liability.© 2015 Cengage Learning26The Role of ShareholdersThe 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 VoteThe 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 AccessWould provide shareholders with the opportunity to propose nominees for the board of directors. © 2015 Cengage Learning27The 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.© 2015 Cengage Learning28Shareholder Activism© 2015 Cengage Learning29Investor Relations - A majority of corporate boards now communicate with their major investorsPublic corporations have obligations to current and potential shareholders, including Full disclosure (Transparency), and the 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 for capitalists.” © 2015 Cengage Learning30An Alternative Model ofCorporate GovernanceThe Anglo-American model of corporate governance is one of shareholder primacyA emerging perspective is a director-primacy model of corporate governanceA 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 stakeholdersBoards have a duty to shareholders, but boards are the ultimate decision-makers, whose duty is to the corporation© 2015 Cengage Learning31Key Terms (1 of 2) Accounting Reform and Investor Protection Act of 2002Agency problemsAnglo-American modelAudit committee BackdatingBoard of directorsBullet-dodgingBusiness judgment ruleCEO dualityCharterClassified boardsClawback provisionsCompensation committeeCorporate gadfliesCorporate governanceDirector-primacy modelDodd-Frank Wall Street Reform and Consumer Protection ActEmployeesFragile mandateFull disclosureGolden parachuteInformation asymmetryInside directorsInsider tradingLegitimacyLegitimationMajority voteManagementMaterial informationNominating committee© 2015 Cengage Learning32Shareholder activismShareholder democracyShareholder lawsuitShareholder resolutionsShareholdersSpring-loadingStock optionsTax gross-upTeam-production modelTippeeTipper Transparency© 2015 Cengage Learning33Out-of-pocket liabilityOutside directorsPersonal liabilityPoison pillPonzi schemePrivate Securities Litigation Reform Act of 1995Proxy accessRegulation FD (fair disclosure)Sarbanes-Oxley Act (SOX)Say on Pay movementSEC Rule 10b5-1SEC Rule 10b5-2Separation of ownership from controlKey Terms (2 of 2)
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