1. Chapter 4 Corporate Governance: Foundational Issues © 2012 South-Western, a part of Cengage Learning 1

2. Corporate Governance 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. © 2012 South-Western, a part of Cengage Learning 2

3. The Corporation’s Hierarchy of Authority 3 © 2012 South-Western, a part of Cengage Learning State Charter Shareholders Board of Directors Management Employees

4. The Need for Board Independence 4 © 2012 South-Western, a part of Cengage Learning Outside directors – independent from the firm Inside directors – have some tie to the firm  Board independence is crucial to good governance

5. Issues Surrounding Compensation 5 © 2012 South-Western, a part of Cengage Learning

6. Issues Surrounding Compensation (continued) 6 © 2012 South-Western, a part of Cengage Learning 1)Shareholder push to link pay to performance 1)Shareholder push to link pay to performance 2) Increasing use of “clawback” provisions where executives must return pay under some conditions 2) Increasing use of “clawback” provisions where executives must return pay under some conditions CEO Pay Controversy CEO Pay Controversy

7. CEO Pay/ Firm Performance 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. 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. 7 © 2012 South-Western, a part of Cengage Learning

8. Excessive CEO Pay  Ratio of CEO pay to average worker is 319 to 1 (down from 531 to 1 in 2000). Say on Pay Evolved from concerns over excessive executive compensation. Began in the United Kingdom in 2002 with regulations on pay. Clawback provisions Compensation recovery mechanisms that enable a company to recoup compensation funds, typically in the event of a financial restatement or executive’s misbehavior. 8 © 2012 South-Western, a part of Cengage Learning

9. Executive Retirement Plans and Exit Packages  Retirement packages have come under scrutiny. Robert Nardelli received $210 million when he was ousted from Home Depot by shareholders. Contrast to most workers, many of whom to do have a retirement plan. 9 © 2012 South-Western, a part of Cengage Learning

10. Outside Director Compensation Paying board members is a recent concept. Controversy over whether directors should be paid at all, and whether they are paid enough. 10 © 2012 South-Western, a part of Cengage Learning

11. Insider Trading The practice of obtaining critical information from inside a company and using that information for one’s own personal financial gain. 11 © 2012 South-Western, a part of Cengage Learning

12. Improving Corporate Governance: Sarbanes-Oxley Act of 2002 (SOX) Limits the nonauditing services an auditor can provide Requires auditing firms to rotate the auditors working with a specific company Makes it unlawful for accounting firms to provide services where conflicts of interests exist CEOs and CFOs certify and are held responsible for financial representations 12 © 2012 South-Western, a part of Cengage Learning

13. Improving Corporate Governance: Sarbanes-Oxley Act of 2002 (SOX) (continued) Enhances financial disclosure with requirements, such as: Reporting off-balance sheet transactions Prohibiting personal loans to executives and directors Requiring auditors to assess and report upon internal controls Audit committees must have at least one financial expert Whistle-blowers are given protection Code of ethics disclosure 13 © 2012 South-Western, a part of Cengage Learning

14. Improving Corporate Governance Changes in boards of directors Board diversity Outside board directors Use of board committees for: Audit Nominating Compensation Public policy  The board should “get tough” with the CEO. 14 © 2012 South-Western, a part of Cengage Learning

15. Ranking of Red Flags Signaling Board Problems 15 © 2012 South-Western, a part of Cengage Learning

16. Steps to Take for Board Repair 16 © 2012 South-Western, a part of Cengage Learning

17. Board Diversity Board diversity is lacking Only around 15% of directors in U.S. are women. Sixty-six Fortune 500 firms have no female board members. Hispanics, Asian Americans and African Americans also under-represented. Diverse boards are also less likely to fall prey to groupthink because they have a range of perspectives.  Is a global problem. 17 © 2012 South-Western, a part of Cengage Learning

18. Use of Board Committees Principle Responsibilities of an Audit Committee 1.To ensure that published financial statements are not misleading. 2.To ensure that internal controls are adequate. 3.To follow up on allegations of material, financial, ethical, and legal irregularities. 4.To ratify the selection of the external auditor. 18 © 2012 South-Western, a part of Cengage Learning

19. Other Board Committees Nominating committee Is composed of outside directors. Has the responsibility of selecting competent, objective board members. Compensation committee Evaluates executive performance and recommending terms and conditions of employment. Public issues committee (Public policy committee) Responds to public or social issues. Deals with areas in which public or ethical issues are present. 19 © 2012 South-Western, a part of Cengage Learning

20. Board Member Liability Business judgment rule Holds that courts should not challenge board members who act in good faith, making informed decisions that reflect the company’s best interests.  Board members need to be free to take risks without fear of liability. 20 © 2012 South-Western, a part of Cengage Learning

21. Board Member Liability (continued) The “Caremark Standard,” which heightened concerns over personal liability, states that directors can be held personally liable if: 1.The director utterly failed to implement any reporting or information system or controls, or 2.Having implemented such a system or controls, consciously failed to monitor or oversee its operations, disabling their ability to be informed of risks or problems requiring their attention. 21 © 2012 South-Western, a part of Cengage Learning

22. The Role of the SEC Is responsible for protecting investor interests. Critics argue that the SEC is more focused on businesses than on investors.  SEC failed to catch the Bernard Madoff Ponzi scheme before losing investors billions. 22 © 2012 South-Western, a part of Cengage Learning

23. Investor Relations Full disclosure (Transparency) Information filed at regular and frequent intervals that contains information that might affect investment decisions.  Management is responsible for communicating with shareholders. 23 © 2012 South-Western, a part of Cengage Learning