1. Chapter 12 Corporate Governance

2. What Is Corporate Governance? What do you think it is? “the institutions that design and monitor the rules used to make decisions in a firm, especially those involving compliance” alternative:“relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations”

3. Agency Theory can explain Focuses on the relationship between the principal and the agent the principal is the shareholder the agent is the firm’s management Principal tries to ensure that the agent acts in the principal’s interest through incentives and monitoring concern over separation of ownership and control control of the modern corporation passed from owners to managers because owners had become too dispersed for effective control (Berle and Means, 1932)

4. how are these disparate interests aligned? Incentives Compensation Monitoring Board of directors (internal) Market for corporate control (external)

5. The Board of Directors Shareholders exercise influence over managerial decision-making primarily through their election of the board of directors The board has primary responsibility for corporate governance Project details received by the board depend on the firm’s size, complexity, and the scale of the project Legal responsibilities of the board include duty of care, duty of loyalty, and the business judgment rule

6. The Board of Directors (cont’d) Board composition Inside directors: upper management, family members Outside (independent) directors: persons not employed by the firm or related to the firm by blood or commercial transactions Committees (composed of independent directors) Audit, compensation, and nominating Other committees that deal with various governance issues Finance, Executive, Risk, Strategy, Technology, others Lead director The chief independent director Chairs executive sessions of independent directors at board meetings

7. Duty of Care Defined as “the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances” Carries with it a requirement to develop knowledge related to the firm’s business May require the support of in-house and external experts and consultants Implies the duty to inquire into and remain informed about the firm’s ongoing activities Reduces the potential for management misbehavior

8. Duty of Loyalty Defined as a “duty in good faith to act in the best interests of the corporation” The firm’s interests must dominate conflicts between the interests of a director and the firm The firm’s interest is congruent with but not identical with shareholders Other constituencies – called stakeholders, e.g., local communities, labor, and suppliers - may be considered

9. Business Judgment Rule Underlies the “duty of care” obligation Acts as a “safe harbor” or protection when the duty of care is being questioned Shields directors from liability for taking reasonable actions on behalf of the firm that subsequently turn out badly Preserves directors’ willingness to take risks in investments in new products or markets

10. Did Sarbanes-Oxley make a difference? Rule 404 Requires a stringent and costly internal audit of the firm’s processes Problems in processes that had a material effect on the firm’s financial data had to be reported Most problems (in 2005) were in tax accounting, documentation, and personnel expertise Smaller firms were hurt more by this rule given the high fixed costs of adhering to it But in general, research has shown that after SOX: shareholders receive better information about firms listing shares on U.S. exchanges sends a stronger signal of financial strength

11. Are Better Governed Firms Higher Performers? Gompers, Ishii and Metrick (2003) showed that Investing in better governed firms and selling worse governed firms short resulted in an 8% return Better governed firms had fewer policies that impeded a takeover Worse governed firms had more of these policies

12. Anti-takeover Defenses Tactics for delaying hostile bidders Blank check Staggered board Special meeting Written consent Board and management protection Compensation plan Golden parachutes Liability and indemnification Voting rules Supermajority voting Other Fair price Poison pill

13. CEO Compensation Are CEOs paid too much? Possible determinants of CEO compensation: Firm size (revenues), Higher returns to shareholders, CEO influence on the board Research indicates that each is valid to some degree: Firm size is primary Controlling for size, compensation is weakly related to shareholder returns Controlling for size and performance, ingratiation behavior affects compensation

14. Table 12.3 What Predicts CEO Compensation in the Health Insurance Industry?

15. Quotes from “What’s Wrong with Executive Compensation,” (Elson, 2003) Roiter: Need to restore a greater liquidity in the market for corporate control Bachelder: Weren’t we saying in the 80’s to tie CEO compensation to the market in order to identify them with shareholders? We got what we asked for Bachelder: In trying to create independence between the CEO and board, you do not want to create an adversarial relationship Woolard: Compensation committees are really not independent Meyer: We need to tie the elements of executive compensation more closely to the organization’s mission and annual business performance and to long-term results England: Unfortunately options became just another form of currency, rather than an incentive to own shares

16. Quotes from “What’s Wrong with Executive Compensation,” (Elson, 2003) Roiter: If we turn to Congress or the courts to solve the problem with executive compensation, the cure may prove worse than the disease Roiter: I do think the answers lie in process changes Woolard: We need strong independent directors to hold CEOs’ feet to the fire, but they are hard to find; some of the few are stepping down to avoid the hassle Roiter: At least some executives are greedy, we have to assume that at least a fair segment of the CEO population will not exercise self-restraint Bachelder: We must be careful not to diminish the motivation for risk taking and entrepreneurship that drives so many leaders