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 Separation of management and ownership = 1. Potential for fiduciary lapses = 2. Conflicts of interest. Fiduciary lapses occur when management makes self-serving self-serving decisions.

Shareholders depend on directors to prevent fiduciary lapses. Corporate boards are an important part of governance. Boards have legal authority to dismiss poorly performing TMTs. Boards should be closely involved involved in major corporate decisions. 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 p pp proactive in their oversight role. 2. Boards were expected to END d dd duality in which the Board Chair is also the CEO.

Many investors believe the worldwide financial meltdown of 2009 was a confirmation of useless corporate boards. Governmental agencies from around the world began issuing a stream of new regulations related to corporate boards.But Not everyone is critical of Boards & TMTs!

Stewardship Theorists Stewardship Theorists believe: 1) TMTs can be trusted 2) They are capable and honest stewards of a firm’s resources. 3) No one understands or cares about the corporation more than those who actually manage it. DO NOT need 4) They DO NOT need independent board oversight. positive contribution 5) 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: Not all boards perform in the same way. Some Boards fulfill their fiduciary responsibility and 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 are likely to motivate directors to become more concerned about TMT decisions and actions. c. Dismal firm performance c. Dismal firm performance is likely to unnerve directors and encourage boards to get more deeply involved in decision-making. d. Government regulations d. Government regulations – new laws or more rigorous enforcement of existing laws is a strong motivator for changes in board behavior. e.g. Sarbanes-Oxley Act of 2002 (SOX)

BoardEnvironment PeerPressure Lawsuits Dismal Performance Regulation

a. Women positively a. Women – Women on corporate boards “ positively ” influences organizational citizenship. b. Professional expertise b. Professional expertise – 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 older boards. d. Committee membership changes d. Committee membership changes – When powerful committees such as executive compensation committees change, board power can shift from insiders to outsiders or vice versa. This could tame run-away executive compensation packages. Research has shown:

e. Inside/outside director ratio: Increasing o e. Inside/outside director ratio: Increasing outside board members intensifies challenges to CEO decisions. f. Board Size f. Board Size – As boards become larger they tend to display dysfunctional characteristics. g. CEO Tenure g. CEO Tenure – As the tenure of the Chief Executive Officer increases, so does the influence over the boards. h. Duality CEO is also h. Duality – Occurs when the CEO is also (COB). With duality board independence is diminished. i. Board interlocks i. Board interlocks occur when two or more corporate boards have common members (common control*). * Common control = two different firms influenced (controlled) by same individuals Some board interlocks are okay and others are illegal!

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

competing firms Interlocking directorates of competing firms 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.

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.

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.

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.

SOX: Contains substantial penalties associated with boards that fail to exercise due diligence. Makes it 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. Demands that 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.

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

 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.  Merger Activity: Review carefully the following site:  erind.pdf erind.pdf erind.pdf

Directors?