Welcome to Class 5 Corporate Boards of Directors Chapter 4

Early in the last century the majority of large corporations were owned and controlled by a small number of capitalists. Over time the stockholdings were dispersed to many beneficiaries. management Beneficiaries were generally uninvolved in the firms so they passed control of operational decision-making to insiders with specialized expertise ( management.) separation management ownership This meant a separation of management from ownership. The separation gave rise to two different theories of implications: 1. Agency Theory 2. Stewardship Theory

Separation of management and ownership created the potential for fiduciary lapses and conflicts of interest according to Agency Theory. Fiduciary lapses occur when management makes self-serving decisions without regard to shareholders.

Shareholders depend on its board of directors as a governance mechanism to protect against fiduciary lapses. Corporate boards are an important component of the governance structure. Boards have the legal authority to dismiss poorly performing TMTs. closely involved Boards are expected to be closely involved in major corporate decisions. ARE NOT Many boards ARE NOT fulfilling their responsibilities.

In the 1980s, frustrated by board refusal to challenge management decisions, investors began to D DD DEMAND CHANGES. 1. Boards were expected to be more proactive in their oversight role. 2. Boards were expected to END d dd duality in which the Board Chair is also the CEO.

The worldwide financial meltdown of 2009 was considered by many analysts to be a confirmation of corporate board incompetence. Governmental agencies from around the world began issuing a stream of new regulations related to corporate boards.But Not everyone is critical of Boards!

Stewardship Theorists Stewardship Theorists believe TMTs can be trusted as capable and honest stewards of a firm’s resources. The theory says no one understands or cares about the corporation more than those who actually manage it. DO NOT need They DO NOT need independent board oversight. positive contribution Duality is believed to make a positive contribution to corporate governance.

There are fewer Stewardship Theorists than there are Agency Theorists.

Studies of Corporate Boards reveal that not all boards perform in the same way. Some Boards fulfill their fiduciary responsibility appropriately and effectively while others do not. Transformational Motivators can alter the quality of Board performance: Primary Transformational Motivators are: 1. Board Environment 2. Board Re-Configuration

Transformational Motivators Board Environment Board Reconfiguration

a. Peer Pressure a. Peer Pressure by other board members to conform to a new norms. b. Lawsuits b. Lawsuits by shareholders or creditors – High profile lawsuits against corporations or corporate directors are likely to motivate directors to become more concerned about TMT decisions and actions.

c. Dismal firm performance c. Dismal firm performance in comparison to competitors is likely to unnerve directors and encourage them to get more deeply involved in decision-making. d. Government regulations d. Government regulations – new laws or more rigorous enforcement of existing laws is perhaps the strongest motivator for changes in board behavior. The Sarbanes-Oxley Act of 2002 (SOX) is a more recent example.

BoardEnvironment PeerPressure Lawsuits Dismal Performance Regulation

a. Women positively social responsibility a. Women – Increasing the representation of women on corporate boards “ positively ” influences organizational citizenship ( social responsibility ). b. Professional expertise b. Professional expertise – Changing the configuration of professional expertise on boards influences performance. Bankers and others with financial experience on corporate boards have been associated with stabilizing stock returns. c. Average age c. Average age – Younger boards tend to outperform those with older boards. Research has shown:

d. Committee membership changes d. Committee membership changes – When membership on powerful committees such as executive compensation committees changes, board power shifts from insiders to outsiders or vice versa. e. Inside/outside director ratio: As r e. Inside/outside director ratio: As ratio of outside board members increases challenges to CEO decision- making has been to increase. f. Board interlocks f. Board interlocks ( Interlocking Directorates ) Board interlocks occur when two or more corporate boards have common members. Common control* of two or more competing corporations may result from interlocking directorates. The concern – potential unfair restriction of competition. * Common control = two different firms controlled by same individuals

Consequently, some interlocking directorates are subject to prohibition and regulation under the Clayton Antitrust Act. 15 U.S.C. §19 enacted in The antitrust rule against interlocking directorates was designed to prevent anti-competitive coordination between organizations. However, the Federal Trade Commission (FTC) seldom pursues violations unless a complaint is filed.

g. Board Size g. Board Size – A s boards become larger they tend to display dysfunctional characteristics. h. CEO Tenure h. CEO Tenure – A s the tenure of the Chief Executive Officer increases, so does the influence over the board – boards become less independent. i. Duality CEO is also the Board Chair i. Duality – CEO is also the Board Chair (COB) With Duality insiders tend to neutralize independent board oversight.

Board Reconfiguration WomenExpertiseAge Committee Changes In/out Ratio InterlocksSize CEO Tenure Duality

Substantial penalties associated with boards that fail to exercise due diligence. Easier to prosecute securities fraud, particularly financial fraud. Reasserts board independence from corporate management. Places greater responsibility on senior management and directors, particularly independent directors. Independent directors on the audit committee are to be more diligent in: 1. Overseeing and monitoring the financial reporting process 2. Establishing internal controls 3. Assuring performance transparency SOX provides teeth for civil and criminal enforcement over the conduct of corporate boards.

Interlocks are a common practice in the United States – a perpetual concern of the federal government. The U.S. Government has attempted to manage some of the more troubling aspects with antitrust laws For example, as far back as 1890, the U.S. Government passed the Sherman Antitrust Act. non-competing companies However, none of these Acts make it illegal to sit on multiple boards of non-competing companies and this practice of interlocking boards continues.

Concerns of Interlocking Boards: 1. Potential for unfair, self-serving exchange of non- public information. 2. Sitting on too many boards = too little time for exercising due diligence in protecting the interests of shareholders. directors may measure their achievements by the number of boards they are on rather than by what they actually contribute. 3. Risk of addiction to the perks of multiple corporate boards – directors may measure their achievements by the number of boards they are on rather than by what they actually contribute.

Benefits of Interlocking Boards These Directors may: 1. Offer unique knowledge of a particular commercial market. 2. Be uniquely qualified to interpret the conditions and environment surrounding diversification targets. 3. Be able to provide objective expertise about potential strategies and tactics for diversification process.

All corporate boards can be divided into two basic categories: proactive (1) those that do something (proactive) and; sedate (2) those that do nothing (sedate).

Proactive boards Q Question the actions and decision of management and are not afraid to insist that changes be made. Sedate boards Are frequently Are frequently head bobbers, nodding in agreement with all proposals. They do not want to “rock-the- boat.”

 1. Number of directors  2. Number of insiders on the board  3. Number of women on the board  4. Number of educators on the board  5. Number of outside directors with accounting/finance experience on the board  6. Whether or not the company practices duality (CEO is also COB)  7. Average age of board members  8. Oldest board member  9. Youngest board member  10. Average tenure of board member  11. Shortest tenure  12. Longest tenure

Directors?

 Next Class (Class 6) you meet with your individual teams. There will be no formal class meeting in the classroom but you are required to attend your team meeting.  Attendance will be taken by the team secretary.  Presidents you MUST notify the other team of which company you will be defending or your entire team will lose 100 points!!  Merger Activity: Review carefully the following site:  erind.pdf erind.pdf erind.pdf