Emerging Issues in Management (Mgmt 440) Professor Charles H. Smith Corporate Governance (Chapter 18 [pages only]) Spring 2010

Case Study – “Backdating With Dr. McGuire” Read this case study on pages on your own before class and discuss it with small groups in class. Questions –Was the fact that Dr. McGuire’s stock options were set on historical low days mere coincidence or something else? How was the truth discovered? –How is backdating prevented now? –What was Dr. McGuire’s settlement with the SEC? Do you think it was fair?

Introduction to Corporate Governance Corporate governance is the exercise of authority over members of the corporate community (shareholders, directors, officers and employees) based on formal structures, rules and processes. Sources for these formal structures, rules and processes include articles of incorporation, by-laws, and federal, state and local laws.

Corporate Personnel Shareholders – owners of the corporation. Directors – appointed/elected by the shareholders; set policy and create vision for the corporation; must have at least 3 under California law; no qualifications required by law but many corporations specify qualifications in by-laws. Officers – managers hired by the directors to implement policy and vision; have day-to-day responsibility; in California, must at least have CEO, Secretary and CFO. Employees – hired by officers to work on corporation’s behalf. All except shareholders must be people; can fill one or more roles.

Corporate Documents Articles of incorporation (sometimes called “corporate charter”) – very general document; filing date marks birth of corporation. By-laws – very detailed document; describes rights and responsibilities of corporate personnel. Statement of information by domestic stock corporation – pre-printed form provides basic information about corporation; must be filed annually.

Corporate Governance Scandals Enron – see pages Tyco International, Adelphia Communications and WorldCom – see page 595. These scandals led to the passage of the Sarbanes- Oxley Act of 2002 (“SOX”), which imposed many requirements for corporate oversight and accountability – see pages SOX has caused many executives to decline appointments to other companies’ boards of directors since these executives (1) need to spend much more time fulfilling SOX requirements and (2) want to avoid being held liable under SOX if other companies have problems.

Executive Compensation Executive compensation based on –Free market – what competitors pay their executives; need to pay market price to attract good executives. –Individual and company performance. –Aligning interests of executives with shareholders in long-term value creation.

Executive Compensation cont. What makes up the compensation package? –Base salary – usually capped at $1M (amount IRS allows as tax-deductible). –Annual cash incentives – bonuses often based on meeting financial targets. –Long-term stock-based incentives – stock options, performance shares, restricted stock (see pages ). –Retirement plans. –Perquisites (“perks”) – extra “executive lifestyle” benefits (e.g., parking, financial services, use of corporate condo or luxury box at Honda Center).

Criticisms of Executive Compensation Extraordinary payouts – see examples on page 607. Large amounts paid to executives who are new to the company. Lucrative golden handshakes given even if executive leaves under bad circumstances. Compensation committees made up of friends or others inclined to approve generous compensation packages. Executive compensation levels not in shareholders’ best interests. Stock option grants too lavish. Misuse of stock option grants (e.g., backdating).

Defenses of Executive Compensation Congress effectively imposed $1M limit on salary; led to widespread use of stock options to attract executives. Stock options became popular during time of long rises in stock market. Justified by shareholder gains. Must pay market value or will lose executives. In reality, most executives do not earn lucrative compensation packages.

Case Study – Walt Disney Co. and Michael Ovitz See Brehm v. Eisner (In re Walt Disney Co. Derivative Litigation), 906 A.2d 27 (Del. 2006) – basically, board of directors has very broad authority to make decisions for corporation due to business judgment rule. This case goes for 37 pages so only read the summaries and headnotes at the beginning; see next slide for important points.

Case Study – Walt Disney Co. and Michael Ovitz cont. Facts – Walt Disney Co. (“Disney”) hired Ovitz as president for 5 years but Ovitz worked for only 14 months before termination without cause; severance payout = $130 million. Issue – Did Ovitz and Disney board of directors breach their fiduciary duties to the shareholders and commit waste? Result – Delaware courts said “no” to both.

Case Study – Walt Disney Co. and Michael Ovitz cont. Delaware law presumes directors acted properly unless shown otherwise. Even grossly negligent conduct is not a breach of fiduciary duties if conduct done in good faith. Fiduciary must act with “true faithfulness and devotion to the corporation and its shareholders” – conscious misconduct required for breach of fiduciary duties (see next slide).

Case Study – Walt Disney Co. and Michael Ovitz cont. How to show directors’ failure to act in good faith? –Acting with purpose other than that of advancing corporation’s best interests. –Acting with intent to violate applicable positive law. –Intentionally failing to act despite known duty to act (conscious disregard for duty). No waste unless contract so one-sided that no businessperson of ordinary, sound judgment could conclude corporation has received adequate consideration (“rare, unconscionable case”).