The McGraw-Hill Companies, Inc. 2006

1. The McGraw-Hill Companies, Inc. 2006 McGraw-Hill/Irwin

2. 8 Corporate Governance

3. Why Governance Fails • Separation of owners and managers • When managers hold little equity in the firm and shareholders are too dispersed to enforce value maximization, corporate assets may be deployed to benefit managers rather than shareholders • Managers’ interest may be growth, not earnings • Agency problems and self-interest

4. Why Governance Fails • Diversifying risk • Systematic risk (nondiversifiable) • Unsystematic risk (diversifiable) • Managerial risk aversion • Managerial self-preservation and entrenchment • Managerial enrichment • Agency problems and self-interest

5. Contextual Factors • Antitrust enforcement • Related diversification viewed unfavorably • Result was much unrelated diversification • Life cycles and free cash flow • Investing cash flow (new vs. mature firms) • Market pressures • Short-term focus by market • Pressure from market may tempt managers to cheat or “manage earnings” • May hold onto underperforming business units to avoid short-term costs of disposal

6. Contextual Factors • Executive compensation • Increased incentive to “manage earnings” (artificially inflate profits) • Disengaged shareholders • If shareholders are uninvolved • Governance deteriorates • Agency problems rise • Firms with more institutional investor ownership more likely to restate earnings or engage in accounting “improprieties”

7. Median CEO Pay In the United States $8 $7 $6 $5 $4 Median CEO Pay ($ million) $3 $2 $1 $0 1980 1985 1990 1995 2000 Equity-Based Pay Salary & Bonus Adapted from Figure 8.1: The Level and Composition of Median DEO Pay in the United States from1980 to 2001* (in 2001 dollars) *Chart taken directly from Brian J. Hall, “Six Challenges in Designing Equity-Based Pay,” NBER Working Paper No. 9887, July 2003.

8. Corporate Mismanagement • Golden parachute • Poison pill • CEO compensation • Empire building • Shareholder value may decrease following mergers • Manager-controlled firms may engage in more conglomerate acquisitions than owner-controlled firms and in general are more diversified

9. Changes in Governance Environment • Leveraged buyouts • Hostile takeovers • Institutional investors • No longer fragmented holdings by millions of individuals • Now indirect beneficial ownership through large pools of capital • Mutual funds • Corporate and governmental pension funds

10. Leveraged Buyout Market $90 350 $80 300 $70 250 $60 200 $50 Number of deals Median CEO Pay ($ million) $40 150 $30 100 $20 50 $10 $0 1981 1985 1990 1995 2000 2003 Value of deals ($ billions) Number of deals Adapted from Figure 8.2 The Leveraged Buyout Market, 1981–2003 ($ billions)

11. Changes in Governance Environment • Activism by institutional investors • May not loyally follow management’s lead in voting their shares • Are more activist, pressuring underperforming companies to change their strategies • May make specific policy recommendations • May lobby for the dismissal of CEOs • May engage in proxy fights with management to prevent the introduction of self-serving corporate policies

12. Changes in Governance Environment • Emergence of shareholder activists • Analyze company performance • Provide information to institutional investors for use in voting • Some shareholder activists wield considerable power in corporate governance

13. Changes in Governance Environment • Securities and Exchange Commission (SEC) • Made it easier for shareholders to initiate and fight proxy battles • Gave shareholders the right to • Challenge golden parachutes • Request detailed information regarding executive compensation • Pursue the formation of a shareholders’ independent advisory committee to work with directors on key issues

14. Legislation • Spectacular bankruptcies • Fraud on the part of firm executives • Less than optimal corporate governance practices on the part of firms’ boards • Enron and Worldcom bankruptcies in first four years of 2000 • Many retirees lost their life savings • Boards of these companies criticized heavily for not detecting the frauds

15. Legislation • Sarbanes-Oxley • CEOs and CFOs of the approximately 1,000 largest companies in the United States required to personally sign off on their company’s financial statements, certifying that they are true and accurate • New definition of “independent director” • New rules as to how audit firms are hired and what type of work they are allowed to perform • Board hotline to report fraud • Requires majority of a board’s directors to be independent

16. Role of the Corporate Board • Disengaged Directors • In theory and in law, boards of directors • Represent shareholders • Provide a critical check and balance on management • Boards often fail to act in the interests of shareholders • Board positions often filled by • Current and retired management • Business acquaintances and friends of the CEO • Representatives of banks and law firms that have a financial interest in the continuity of management

17. Role of the Corporate Board • Most directors do not see their role as • Protecting shareholders’ interests • Evaluating the performance of management • Most boards • Function largely as supportive audiences • Listening to the plans of CEOs • Occasionally offering advice and counsel • Board composition • More independent directors • Smaller stock options and grants for directors

18. Structure of Good Governance • The Sarbanes-Oxley bill requires • All members of audit and compensation committees be independent • Audit committees (not management) • Exclusive power to hire and fire the auditors • Auditor report directly to audit committee • Required to have a “financial expert” in the group • Hotline for employees and other individuals to report fraud anonymously

19. Limitations on the Boards’ Ability to Govern • Most firms have only one person fill two roles • Chief executive officer • Chairman of the board • That one person controls • Agenda • Flow of the discussion • Many directors • Have full-time responsibilities in other firms • Hold positions on other boards Available time and knowledge

20. Limitations on the Boards’ Ability to Govern • Directors often disagree regarding their roles • Goals have both long-term and short-term implications • Difficult to assess the interests of shareholders in goals that are adopted Available time and knowledge Lack of consensus about goals

21. Limitations on the Boards’ Ability to Govern • Directors have little accountability to shareholders • Shareholders have little input on the “slate” of directors • Performance of directors becomes opaque to the shareholders • Shareholders have no access to the directors’ votes Available time and knowledge Lack of consensus about goals Superior power of management

22. Role of the CEO • Some corporations have separated the roles of • CEO • Chairman of the Board • Creating corporate advantage • CEO has ultimate responsibility for firm’s performance • CEO’s primary task • Establishment or maintenance of corporate purpose • Corporate purpose is codified and implemented through corporate strategy