Business & Society Business & Society Ethics, Sustainability, and Stakeholder Management Eighth Edition Archie B. Carroll Ann K. Buchholtz © 2012 South-Western, a part of Cengage Learning 1

Chapter 4 Corporate Governance: Foundational Issues © 2012 South-Western, a part of Cengage Learning 2

Learning Outcomes © 2012 South-Western, a part of Cengage Learning 1.Link the issue of legitimacy to corporate governance. 2.Identify the best practices that 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.Discuss the issue of shareholder democracy, its current state, and the trend for the future. 3

Chapter Outline Legitimacy and Corporate Governance Problems in Corporate Governance Improving Corporate Governance The Role of Shareholders Summary Key Terms Discussion Questions 4 © 2012 South-Western, a part of Cengage Learning

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

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 6

The Corporation’s Hierarchy of Authority 7 © 2012 South-Western, a part of Cengage Learning State Charter Shareholders Board of Directors Management Employees

Separation of Ownership from Control 8 © 2012 South-Western, a part of Cengage Learning Precorporate Period Owners (ownership) Managers (control) Owners (ownership) Managers (control) Corporate Period Shareholders (ownership) Board of Directors Management (control) Agency problems develop when managers pursue self-interest over owner interest

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. 9 © 2012 South-Western, a part of Cengage Learning

Excessive CEO Pay 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. 10 © 2012 South-Western, a part of Cengage Learning

Executive Retirement Plans and Exit Packages  Retirement packages have come under scrutiny. Lavish executive packages contrast to most workers, many of whom to do have a retirement plan. 11 © 2012 South-Western, a part of Cengage Learning

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. 12 © 2012 South-Western, a part of Cengage Learning

Transparency SEC requires disclosure of executive compensations. Disclosure forms are long and difficult. Tax Gross-Up Reimbursement for taxes one would have to pay on medical benefits or other such costs. 13 © 2012 South-Western, a part of Cengage Learning

Impact of the Market on Corporate Control 14 © 2012 South-Western, a part of Cengage Learning Poison pill Golden parachutes

Insider Trading The practice of obtaining critical information from inside a company and using that information for one’s own personal financial gain. 15 © 2012 South-Western, a part of Cengage Learning

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 16 © 2012 South-Western, a part of Cengage Learning

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 17 © 2012 South-Western, a part of Cengage Learning

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. 18 © 2012 South-Western, a part of Cengage Learning

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. 19 © 2012 South-Western, a part of Cengage Learning

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. 20 © 2012 South-Western, a part of Cengage Learning

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. 21 © 2012 South-Western, a part of Cengage Learning

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. 22 © 2012 South-Western, a part of Cengage Learning

Shareholder Democracy: Key Issues Majority Vote The requirement that board members be elected by a majority of votes cast. Classified Boards Boards that elect their members in staggered terms. Proxy Access Provides shareholders with the opportunity to propose nominees for the board of directors. 23 © 2012 South-Western, a part of Cengage Learning

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. 24 © 2012 South-Western, a part of Cengage Learning

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. 25 © 2012 South-Western, a part of Cengage Learning

Key Terms Accounting Reform and Investor Protection Act of 2002 Agency problems Audit committee Backdating Board of directors Business judgment rule Legitimacy Legitimation Charter Classified boards Clawback provisions Compensation committee Corporate gadfly Corporate governance Shareholder democracy Employees Full disclosure Inside directors Insider trading Golden parachute Legitimacy Legitimation Majority vote Management Nominating committee Out-of-pocket liability © 2012 South-Western, a part of Cengage Learning 26

Key Terms (continued) Sarbanes-Oxley Act Separation of ownership from control Shareholder activism Shareholder democracy Shareholder lawsuits Shareholder resolutions Shareholders Spring-loading Stock options Tax gross-up Transparency © 2012 South-Western, a part of Cengage Learning 27 Outside directors Personal liability Poison pill Ponzi scheme Public Securities Litigation Reform Act of 1995 Proxy access Public issues committee Public policy committee