Chapter 18 Corporate Governance This chapter:  Discusses options backdating, just one type of recent corporate scandals related to corporate governance.  Discusses corporate governance; how boards of directors are structured, their duties, and reforms; and issues associated with executive compensation.  Highlights the Sarbanes-Oxley Act by which Congress responded to demands for reform. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Backdating with Dr. McGuire Opening Case  An option is the right to buy a share of company stock at a fixed price on a later date.  Backdating occurs when options are granted on one date, but priced as if they had been granted on a historical date when the market price was lower.  Backdating is legal if it is revealed to shareholders, but illegal if it is hidden.  William W. McGuire, the chairman and chief executive of UnitedHealth Group, received twelve separate option grants on days when the stock price fell to yearly or quarterly lows. The odds of this were 1 to 200 million. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Backdating with Dr. McGuire Opening Case (continued)  SEC regulators told the company they were investigating the matter, but Dr. McGuire seemed untroubled.  Dr. McGuire denied that grant dates were picked with the benefit of hindsight.  Investigators concluded the grants were “likely backdated”  Dr. McGuire was forced to resign, pay a $7 million fine, and disgorged of wrongful gains. This is a tale of greed with a dose of justice at the end. It is also a story of the flawed relationship among one company’s share owners, managers, and directors. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

What is Corporate Governance?  The rules of corporate governance define how power is distributed among shareholders, boards of directors, and managers and how disputes are settled.  The nature of corporate governance has changed dramatically over time.  Boards of directors evolved to perform the critical role of monitoring hired managers for the shareholders. Corporate Governance The exercise of authority over the members of a corporate community based on formal structures, rules, and processes. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

The Corporate Charter  The corporate charter is the document that authorizes formation of a corporation. It specifies the rights and responsibilities of stockholders, directors, and officers.  Directors have a fiduciary responsibility to the shareholders.  U.S. corporations are chartered by the state in which they incorporate.  States compete with one another to attract the incorporation fees of large corporations. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Flow of Authority in Corporate Governance Re-label as Figure 18.3 McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Federal Regulation of Governance  Corporate governance laws have been primarily the province of states, however, the Supreme Court has said that the Constitution empowers Congress to regulate corporations if it chooses.  Federal intervention generally comes in reaction to conspicuous failures of governance and imposes mandatory rules and restrictions.  Extensive intervention into corporate governance came in the 1930s, the 1960s, and in McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Failure of Corporate Governance at Enron  Enron enjoyed admiration and respect among investors, managers of other companies, and the public.  Government regulators uncovered multiple instances of :  Juggling accounting records to inflate sales and profits  Hiding debt, concealing excessive CEO perks and compensation in vague footnotes  Ignoring standard accounting and financial practices  Shredding documents to destroy incriminating records. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Failure of Corporate Governance at Enron (continued)  The board’s Special Investigative Committee did not place sole blame for Enron’s failure on its directors, but it accused the board of failing to exercise it oversight responsibility  A fundamental cause of the catastrophe was the culture of the company.  In 2006 a federal jury found Chairman of the Board Lay and CEO Skilling guilty of conspiracy and fraud. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

The Sarbanes-Oxley Act  It holds management responsible for accurate financial reports and strengthens the power and responsibility of board audit committees.  A few of the act’s provisions are:  Creates a five-member oversight board that has authority over practices of accounting firms.  Prescribes rules to improve auditing.  Requires the CEO and CFO to sign and certify the accuracy of annual and quarterly financial statements.  Establishes heavy criminal penalties for violating its provisions. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Boards of Directors  The average corporate board had 11 members although there is no set number.  Directors in large corporations are chosen after being nominated by the board and approved by a majority vote of shareholders.  Directors who are employees of the company are called inside directors; those who are not employed by the company are outside directors.  Boards are divided into committees. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Duties of Directors  Laws impose two lofty duties on directors:  Represent the interests of stockholders  Exercise due diligence in the oversight of corporate activity  Directors do not make day-to-day decisions.  Boards exercise a very broad oversight.  Compensation varies substantially among industries. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Duties of Directors (continued)  Some specific board functions:  Review and approve the corporation’s goals and strategies.  Select the CEO, evaluate his or her performance, and remove the CEO if necessary  Give advice and counsel to management.  Create governance policies for the firm, including compensation policies  Nominate candidates to be presented to the stockholders for election as directors  Exercise oversight of ethics and compliance programs. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Institutional Investors and Governance  The growth of pension and mutual fund assets has given institutional investors new power in corporate governance.  Jesse Unruh formed the Council of Institutional Investors (CII).  The CII endorsed a Shareholders Bill of Rights demanding a voice in “fundamental decisions which could affect corporate performance and growth.  Since then, institutional investors have been more active in corporate governance issues. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Percent of Equity Held by Institutions Insert Figure 18.4 McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Shareholder Resolutions  Shareholder resolutions cover a wide range of topics and their focus has changed over time.  In the 1970s and 1980s they focused on corporate social responsibilities such as automobile safety and doing business in apartheid South Africa.  In recent years they focused on corporate governance issues, especially the methods for the election of directors and limits on executive compensation.  Resolutions are voted on by all shareholders at the annual meeting, by mail, or by Internet. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Executive Compensation  A compensation committee of the board of directors sets the pay and benefits of top executives.  Elements of compensation include a combination of the following.  Base salary  Annual cash incentives  Long-term stock-based incentives  Stock options  Performance shares  Restricted stock  Retirement plans  Perquisites McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Criticisms of CEO Compensation  The size of extraordinary payouts  The compensation packages given to some newly hired CEOs  The golden handshakes received by some CEOs when they leave under fire.  An alleged bias in favor of boosting CEO compensation due to the composition of the compensation committees.  Nonconformance with the interests of shareholders.  The number and misuse of stock option grants  The spread between executive pay and that of the average worker. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

In Defense of CEO Pay  Congress has considerable responsibility for the boom in stock options due to its 1993 legislation regarding the expensing of CEO pay.  Stock options became a large part of compensation during a period marked by long rises in stock markets.  Many large compensation packages were justified by the gains of stockholders during their tenure.  Boards of directors point out that if they do not pay their CEOs what executives in comparable companies get, they stand to lose them.  Most managers do not get dramatically high salaries. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Suggested Compensation Reforms  Suggestions for compensation reform include:  The SEC should require more data on compensation in reports to shareholders.  Pay and performance relationship should be revealed.  Bonuses should be tied to long-term performance.  Shareholders should be able to vote on executive compensation. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved

Concluding Observations  Despite well-defined legal bonds between share owners, boards of directors, and management, there are many tensions between them.  Scandals revealed lax oversight of financial strategies and reporting by many boards.  Many shareholders believe that boards have allowed management compensation to exceed reason.  The outlook is for more pressures and regulations that tighten board oversight. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved