1. 1 Corporate Governance: Foundational Issues Business and Society: Ethics and Stakeholder Management, 7e Carroll & Buchholtz Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved Prepared by Deborah Baker Texas Christian University Chapter 4

2. 2 1. Link the issue of legitimacy to corporate governance. 2. Identify the best practices that boards of directors can follow. 3. 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. 4. Discuss the principle ways in which shareholder activism exerted pressure on corporate management groups to improve governance. Chapter 4 Outcomes

3. 3 5. Discuss the ways in which managers relate to shareholders and the issues arising from that relationship. 6. Discuss the issue of shareholder democracy, its current state, and the trend for the future. Chapter 4 Outcomes (continued)

4. 4  Legitimacy and Corporate Governance  Problems in Corporate Governance  Improving Corporate Governance  The Role of Shareholders  Summary  Key Terms  Discussion Questions Chapter 4 Outline

5. 5 Introduction to Chapter 4  Explore corporate governance and the ways in which it has evolved. Explain the concept of legitimacy and the part that corporate governance plays in establishing the legitimacy of business Explore how good corporate governance can mitigate problems created by separation of ownership

6. 6 Legitimacy and Corporate Governance Legitimacy A condition wherein there is a congruence between anorganization’s activities andsociety’s expectations. Legitimation A dynamic process by which a business seeks to perpetuateits acceptance.

7. 7 Micro Level of LegitimacyMacro Level of Legitimacy Legitimacy and Corporate Governance 1. Adapt operational methods to perceived societal expectations 2. Attempt to change societal expectations or norms to conform to firm’s practices 3. Seek to enhance its legitimacy by identifying itself with others that have a powerful legitimate base in society 1. Focus is on the totality of business enterprises 2. Subject to ratification 3. Existence is solely because society has given it that right

8. 8 The Corporation’s Hierarchy of Authority State Charter Shareholders Board of Directors Management Employees Figure 4-1

9. 9 Separation of Ownership from Control Precorporate PeriodCorporate Period Owners (ownership) Managers (control) Owners (ownership) Managers (control) Shareholders (ownership) Board of Directors Management (control) Figure 4-2

10. 10 The Need for Board Independence Inside Directors Outside Directors

11. 11 Issues Surrounding Compensation CEO Compensation Executive Retirement Plans Outside Director Compensation http://www.aflcio.org/paywatch @

12. 12 Issues Surrounding Compensation 1) the extent to which CEO pay is tied to firm performance 2) the overall size of CEO pay CEO Pay Controversy CEO Pay Controversy

13. 13 CEO Pay/Firm Performance Relationship Stock Options Allows the recipient to purchase stockin the future at the price it is today Backdating Allows the recipient to purchase stockat yesterday’s price, resulting inimmediate wealth increase Spring-Loading Granting of a stock option at today’sprice, but with the inside knowledgethat stock’s value is improving Bullet-Dodging Delaying of a stock option grantuntil right after bad news

14. 14 Excessive CEO Pay Clawback Provisions Compensation recovery mechanismsthat enable a company to recoupexecutive compensation funds

15. 15 Impact of the Market for Corporate Control Poison pill Golden parachutes

16. 16 Insider Trading The practice of obtaining criticalinformation from inside a company andusing that information for one’s ownpersonal financial gain

17. 17 Improving Corporate Governance Sarbanes-Oxley Act of 2002 (SOX)  Limits the nonauditing services an auditor can provide  Requires auditing firms to rotate the auditors working with a specific company  Makes it unlawful for accounting firms to provide services where conflicts of interests exist

18. 18 Improving Corporate Governance  Enhances financial disclosure with requirements, such as: reporting off-balance sheet transactions prohibiting personal loans to executives and directors requiring auditors to assess and report upon internal controls  Audit committees must have at least one financial expert  CEOs and CFOs certify and are held responsible for financial representations  Whistle-blowers are afforded protection  Code of ethics disclosure Sarbanes-Oxley Act of 2002 (SOX)

19. 19 Improving Corporate Governance  Changes in boards of directors board diversity Outside board directors  Use of board committees for: audit nominating compensation public policy  Board should “get tough” with the CEO

20. 20 Improving Boards and Board Members Building a Better Board Define the role the board intends to undertake Be explicit about their financial goals Widen the talent pool for directors Encourage constructive dissent Divide and delegate work to promote deeper analysis Being a Better Board Member Be willing to change management Be willing to do lots of homework Control the flow of information Meet outside of the CEO’s sphere Don’t sacrifice performance for collegiality Figure 4-3

21. 21 Use of Board Committees 1. To ensure that published financial statements are not misleading. 2. To ensure that internal controls are adequate. 3. To follow up on allegations of material, financial, ethical, and legal irregularities. 4. To ratify the selection of the external auditor. Principal Responsibilities of an Audit Committee http://www.sec.gov @

22. 22 Board Member Liability Business Judgment Rule Business Judgment Rule Holds that courts should not challengeboard members who act in good faith,making informed decisions that reflectthe company’s best interests.Board members need to be free to takerisks without fear of liability. Holds that courts should not challengeboard members who act in good faith,making informed decisions that reflectthe company’s best interests.Board members need to be free to takerisks without fear of liability.

23. 23 Board Member Liability In November 2006, the Delaware Supreme Court affirmed the “Caremark Standard,” which states that directors can only be held liable if: 1.The director utterly failed to implement any reporting or information system or controls, or 2.Having implemented such a system or controls, consciously failed to monitor or oversee its operations, disabling their ability to be informed of risks or problems requiring their attention.

24. 24 Shareholder Democracy: Key Issues Majority Vote The requirement that board membersbe elected by a majority of votes cast. Classified Boards Boards that elect their members instaggered terms. Shareholder Ballot Access Provides shareholders with theopportunity to propose nominees forthe board of directors.

25. 25 Shareholder Activism Shareholder activism Shareholder resolutions Shareholder lawsuits

26. 26 Investor Relations Full Disclosure Information filed at regular andfrequent intervals that containsinformation that might affectinvestment decisions

27. 27  Legitimacy  Legitimation  Corporate governance  Charter  Shareholders  Board of directors  Management  Employees  Separation of ownership from control  Proxy process  Agency problems  Inside directors  Outside directors  Stock options  Backdating  Spring-loading  Bullet-dodging  Clawback provisions  Tax gross-up  Poison pill  Golden parachute  Insider trading  Risk arbitrage  Accounting Reform and Investor Protection Act of 2002  Sarbanes-Oxley Act  Audit committee  Nominating committee Selected Key Terms

28. 28  Compensation committee  Public issues committee  Public policy committee  Business judgment rule  Personal liability  Majority vote  Classified boards  Shareholder ballot access  The role of the SEC  Ordinary business decisions  Shareholder activism  Corporate gadflies  Shareholder resolutions  Shareholder lawsuit  Public Securities Litigation Reform Act of 1995  Full disclosure  Transparency Selected Key Terms