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2. Chapter 4 Corporate Governance: Foundational Issues
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3. Learning Outcomes
Link the issue of legitimacy to corporate governance.
Identify the best practices boards of directors can follow.
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.
Discuss the principle ways in which shareholder activism exerted pressure on corporate management groups to improve governance.
Discuss the ways in which managers relate to shareholders and the issues arising from that relationship.
Compare and contrast the shareholder-primacy and director-primacy models of corporate governance. What are their respective strengths and weaknesses? Which do you prefer and why?
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4. Chapter Outline Legitimacy and Corporate Governance
Problems in Corporate Governance
Improving Corporate Governance
The Role of Shareholders
The Role of the SEC
Shareholder Activism
Investor Relations
An Alternative Model of Corporate Governance
Summary
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5. Legitimacy and Corporate Governance
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.
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6. 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.
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7. Roles of Four Major Groups -
Shareholders -
Own stock in the firm, giving them ultimate control (the shareholder-primacy model).
Board of Directors -
Govern and oversee management of the business.
Managers -
The individuals hired by the Board to manage the business on a daily basis.
Employees -
Hired to perform actual operational work
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8. The Corporation’s Hierarchy of Authority
State Charter
Shareholders
Board of Directors
Management
Employees
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9. Shareholders (ownership)
Separation of Ownership from Control Contributes to Governance Problems
Corporate Period
Precorporate Period
Shareholders (ownership)
Board of Directors
Management (control)
Owners (ownership)
Managers (control)
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10. The Need for Board Independence
Outside directors –
are independent from the firm
Inside directors –
have some tie to the firm
Board independence from management is crucial to good governance.
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11. Issues Surrounding Compensation
CEO Pay-Firm Performance Relationship
Executive Retirement Plans & Exit Packages
Transparency; SEC Rules
Excessive CEO Pay
Outside Director Compensation
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12. 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.
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13. Excessive CEO Pay Say on Pay Clawback provisions
Ratio of CEO pay to that of average worker -
1980, 42-1
2000, 531-1
2011, 380 to 1
Say on Pay
Evolved from concerns over excessive executive compensation.
Clawback provisions
Compensation recovery mechanisms that enable a company to recoup CEO pay, typically in the event of a financial restatement or executive’s misbehavior.
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14. CEO Pay Controversy Say on Pay Movement
1. Shareholder push to link pay to
performance
2. Increasing use of “clawback”
provisions where executives
must return pay under some
conditions
Say on Pay
Movement
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15. Executive Retirement Plans and Exit Packages
Retirement packages –
have come under scrutiny.
$210 million to Robert Nardelli when he was ousted from Home Depot.
$125 million to outgoing Bank of America CEO, Ken Lewis
In contrast, many of today’s workers do not have a retirement plan.
Those who do generally have a defined contribution plan, rather than a defined benefit plan.
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16. Outside Director Compensation -
Paying board members is a recent idea.
Today, outside board members are paid.
From , their median pay rose about a third, from $175,800 to $233,800.
Controversy over whether directors should be paid at all, and whether they are paid enough.
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17. Transparency - Exec compensation packages may include deferred pay,
Severance, pension benefits, & other perks over $10,000.
SEC Rules require disclosure of executive compensation
Such disclosures may have a moderating impact
prior to implementation.
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18. Governance Impact of the Market for Corporate Control
Mergers and acquisitions -
Expectation is that the threat of a possible takeover will motivate top managers to pursue shareholder, rather than self-interest.
But many corporate CEOs and boards go to great lengths to protect themselves from takeovers, using:
poison pills (discourages a hostile takeover by making the firm difficult to take on)
golden parachutes (firm agrees to pay key officers in the event of a change in control of the corporation)
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19. Insider Trading -
The practice of buying or selling a security by someone who has access to material information that is not available to the public.
“Material Information” is information that a reasonable investor might want to use, and is likely to affect the price of the firm’s stock.
A “tipper” provides that information
A “tippee” receives the information
Executives and others who work for a firm may have inside information
Also those in relationships that include a duty of confidentiality may have inside information, including spouses, parents, children, friends.
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20. Improving Corporate Governance (1 of 2)
Sarbanes-Oxley Act of 2002 (SOX) -
Amends securities laws to protect investors in public companies
Enhances public disclosure to require reporting of off-balance sheet transactions, and personal loans to executives
Limits the nonauditing services an auditor can provide to a firm it audits
Makes it unlawful for accounting firms to provide services where conflicts of interests exist
CEOs and CFOs must certify financials, and are held responsible for financial representations
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21. Improving Corporate Governance (2 of 2)
Changes in boards of directors -
More Board diversity
A greater ratio of outside board members to inside board members
Use of board committees to:
Ensure that financials are not misleading
Ensure that internal controls are adequate
Follow-up allegations of irregularities
Ratify the selection of an external auditor
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22. Red Flags Signaling Board Problems
Ranking of Red Flags-
1. Company has to restate earnings.
2. Poor employee morale.
3. Negative risk assessment from auditor.
4. Poor customer satisfaction track record.
5. Management misses strategic performance goals.
6. Company is target of employee lawsuits.
7. Stock price declines.
8. Quarterly financial results miss analysts’ expectations.
9. Low corporate governance quotient rating.
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23. Steps to Take for Board Repair
Spread risk oversight among multiple committees
Seek outside help in identifying potential risks
Deepen involvement in corporate strategy
Align board size and skill mix with strategy
Revamp executive compensation
Pick compensation committee members who will question the status quo
Use independent compensation consultants
Evaluate CEO on grooming potential successors
Know what matters to your investors
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24. The Board’s Relationship with CEO
Boards are responsible for monitoring CEO performance and dismissing poorly performing CEO
Formerly, CEOs were protected; no more; firings of CEOs are up significantly
If CEO also serves as Chairman of the Board, this duality can offer some protection
Activists have moved to separate CEO and Board functions
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25. Board Member Liability -
The Business Judgment Rule protects board members if:
they act in good faith,
making informed decisions
that reflect the company’s best interests, and not their own interests.
Good Faith is central to the defense
The argument in favor of the Business Judgment Rule is that Board members need to be free to take risks without fear of liability.
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26. The Role of Shareholders
The Shareholder Democracy Movement rises from the fact that although they are owners, shareholders may find that their votes are not counted. They seek:
A Majority Vote
The requirement that board members be elected by a majority of votes cast, rather than by a plurality.
Banning Classified or Staggered Boards
Electing members in staggered terms means that it might take 3 or more years to replace a board.
Proxy Access
Would provide shareholders with the opportunity to propose nominees for the board of directors.
© 2015 Cengage Learning

27. The Role of the SEC -
The SEC Is responsible for protecting investor interests.
Critics argue that the SEC is more focused on the needs of businesses than on that of investors.
The SEC failed to stop the Bernard Madoff Ponzi scheme before losing investors billions, although they had been warned of the scheme a decade earlier.
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28. Shareholder resolutions
Shareholder Activism
Shareholder activism
Shareholder resolutions
Shareholder lawsuits
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29. Investor Relations -
A majority of corporate boards now communicate with their major investors
Public corporations have obligations to current and potential shareholders, including Full disclosure (Transparency), and the duty to provide information that might affect investment decisions.
Management is also responsible for communicating with shareholders.
CEO Warren Buffet calls his annual shareholder meeting a “Woodstock weekend for capitalists.”
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30. An Alternative Model of Corporate Governance
The Anglo-American model of corporate governance is one of shareholder primacy
A emerging perspective is a director-primacy model of corporate governance
A director-primacy model is based on the concept of a corporation that is not owned, but is an independent legal entity that owns itself.
Boards are mediating hierarchs, responsible for balancing competing interests of stakeholders
Boards have a duty to shareholders, but boards are the ultimate decision-makers, whose duty is to the corporation
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31. Key Terms (1 of 2)
Accounting Reform and Investor Protection Act of 2002
Agency problems
Anglo-American model
Audit committee
Backdating
Board of directors
Bullet-dodging
Business judgment rule
CEO duality
Charter
Classified boards
Clawback provisions
Compensation committee
Corporate gadflies
Corporate governance
Director-primacy model
Dodd-Frank Wall Street Reform and Consumer Protection Act
Employees
Fragile mandate
Full disclosure
Golden parachute
Information asymmetry
Inside directors
Insider trading
Legitimacy
Legitimation
Majority vote
Management
Material information
Nominating committee
© 2015 Cengage Learning

32. Key Terms (2 of 2) Out-of-pocket liability Outside directors
Personal liability
Poison pill
Ponzi scheme
Private Securities Litigation Reform Act of 1995
Proxy access
Regulation FD (fair disclosure)
Sarbanes-Oxley Act (SOX)
Say on Pay movement
SEC Rule 10b5-1
SEC Rule 10b5-2
Separation of ownership from control
Shareholder activism
Shareholder democracy
Shareholder lawsuit
Shareholder resolutions
Shareholders
Spring-loading
Stock options
Tax gross-up
Team-production model
Tippee
Tipper
Transparency
© 2015 Cengage Learning