Corporate Governance

1. Corporate Governance Chapter II

2. Chapter Objectives: • Identify the corporate governance developments in the post-SOX era. • Understand how corporate governance is designed . • Define corporate governance structure and its components of principles, functions, and mechanisms. • Illustrate how corporate governance has evolved from compliance function to a strategic Imperative. • Provide an overview of corporate governance aspects and principles. • List and define the seven essential corporate governance functions. • Identify significant improvements resulting from corporate governance reforms in the United States. • Become familiar with best practices of corporate governance. • Become familiar with corporate governance reporting and its components as well as corporate governance ratings.

3. Key Terms Corporate governance Effectiveness Corporate governance rating Oversight board External governance Mechanisms Integrated aspect Internal governance Transparency Mechanisms Oversight Stakeholder aspect Remuneration Shareholder Shareholder aspect Stakeholder

4. Definition of Corporate Governance The process affected by a set of legislative, regulatory, legal, market mechanisms, listing standards, best practices, and efforts of all corporate governance participants, including the company’s directors, officers, auditors, legal counsel, and financial advisors, which creates a system of checks and balances with the goal of creating and enhancing enduring and sustainable shareholder value, while protecting the interests of other stakeholders.

5. Aspects of Corporate Governance In the post-SOX era, corporate governance further evolved to the integrated aspects of meeting both compliance requirements and promoting a strategic business imperative. There are three aspects: shareholder aspect, stakeholder aspect, and an integrated aspect. Shareholder Aspect This aspect is based on the premise that shareholders provide capital to the corporations that exist for their benefit. Stakeholder Aspect Stakeholders are now becoming more engaged in a company performance on a variety of economic, governance, ethical, social and environment issues. Integrated Aspect Modern corporate governance emphasizes BOTH financial aspects of increasing shareholders’ value AND an integrated approach that considers the rights and interests of all stakeholders.

6. Corporate Governance Structure • Corporate governance is based on three interrelated components: corporate governance principles, functions and mechanisms.

7. Corporate Governance Principles HONESTY. Corporate communications with both internal and external audiences, including public financial reports, should be accurate, fair, transparent, and trustworthy. RESIELNCE.A resilient corporate governance structure is sustainable and enduring in the sense that it will easily recuperate from setbacks and abuses. RESPONSIVENESS. Effective corporate governance is responsive to the interests and desires of all stakeholders, as well as to emerging initiatives and changes in political, regulatory, social, and environmental issues. TRANSPARENCY. Transparency means that the company is not hiding relevant information, and disclosures are fair, accurate, and reliable.

8. What are the other principles upon which corporate governance structure should be developed?

9. They are the following: - Value-adding philosophy- Ethical conduct- Accountability- Shareholder democracy and fairness- Integrity of the financial reporting- Transparency - Independence

10. Corporate Governance Functions

11. OVERSIGHT FUNCTION. The board of directors should provide strategic advice to management and oversee managerial performance, yet avoid micromanaging. MANAGERIAL FUNCTION. The effectiveness of this function depends on the alignment of management’s interests with those of shareholders. COMPLIANCE FUNCTION. The set of laws, regulations, rules, standards, and best practices developed by state and federal legislators, regulators, standard-setting bodies, and professional organizations to create a compliance framework for public companies in which to operate and achieve their goals. INTERNAL AUDIT FUNCTION. Assurance and consulting services to the company in the areas of operational efficiency, risk management, internal controls, financial reporting, and governance processes. LEGAL AND FINANCIAL ADVISORY FUNCTIONS. Legal advice and assists the company, its directors, officers, and employees in complying with applicable laws and other legal obligations and fiduciary duties. EXTERNAL AUDIT FUNCTION. External auditors lend credibility to the company’s financial reports and thus add value to its corporate governance through their integrated audit of both internal control over financial reporting and financial statements. MONITORING FUNCTION. Shareholders, particularly institutional shareholders, empowered to elect and, if warranted, remove directors. Corporate Governance Functions

12. . Corporate Governance Mechanisms The corporate governance structure is shaped by internal and external governance mechanisms, as well as policy interventions through regulations. Both internal and external corporate governance mechanisms of the company have evolved over time to monitor, bond and control management.

13. Examples of internal governance mechanisms: - board of directors, particularly: - independent directors- audit committee- management - internal controls- internal audit functions

14. Examples of external mechanisms: - market for corporate control - capital market- labor market - federal and state statutes- court decisions- shareholders’ proposals- best practices of investors’ activists

15. Corporate Governance Reports To restore investor’s confidence after the collapse of the dotcom market, the economic downturn, reported financial scandals, and numerous earnings restatements of high-profile companies, several corporate governance reforms in the United States have been established, including SOX, SEC-related implementation rules, listing standards of national stock exchanges, auditing standards of the PCAOB, guiding principles of professional organizations (The Conference Board, Council of Institutional Investors, and National Association of Corporate Directors), and best practices.

16. Sources of Corporate Governance

17. SOX was signed into law on July 30, 2002, to reinforce corporate accountability and rebuild investor confidence in public financial reports. It was designed to: (1) establish an independent regulatory structure for the accounting profession, (2) set high standards and new guiding principles for corporate governance, (3) improve the quality and transparency of financial reporting, (4) improve the objectivity and credibility of audit functions and empower the audit committee, (5) create more severe civil and criminal remedies for violations of federal securities laws, (6) increase the independence of securities analysts. Sarbanes-Oxley Act of 2002

18. SARBANES-OXLEY ACT Of 2002 SOX provisions, SEC-related rules, and listing standards influence corporate governance structure in at least three ways: • Auditors, analysts, and legal counsel are now brought into the realm of internal governance as gatekeepers. • Legal status and fiduciary duty of company directors and officers (audit committee and CEO) have been more clearly defined and, in some instances, significantly enhanced. • Certain aspects of state corporate law were preempted and federalized (For example, Section 402 of SOX prohibits loans to directors and officers, whereas state law permits such loans).

19. Cost Benefit Of Sarbanes- Oxley A 2007 survey of 2000 corporate executives reveals that: (1) The compliance costs of SOX for the second consecutive year declined substantially; (2) The cost dropped 23 percent in 2006; (3) Total compliance costs decreased to an average of $2.9 million per company in 2006, which is down 35 percent from the $4.51 million average costs in 2006; (4) There was no significant change in audit fees; (5) The majority of surveyed executives (78 percent) reported that the costs to comply with section 404 still outweigh any benefits. More manageable and cost-effective Section 404 compliance is currently being addressed by the SEC and the PCAOB.

20. NYSE Corporate Governance Rules: Section 303A Independent Directors Listed companies must have a majority of independent directors. Independence Tests Companies must identify which directors are independent (have no material relationships with the company) and disclose the basis for that determination. Executive Sessions The nonmanagement directors of each listed company must meet at regularly scheduled executive sessions without management. Nominating/Corporate Governance Committee Listed companies must have a nominating/corporate governance committee composed entirely of independent directors. The nominating committee must have a written charter.

21. NYSE Corporate Governance Rules: Section 303A (Cont) Compensation Committee Listed companies must have a compensation committee composed entirely of independent directors. Audit Committee Listed companies must have an audit committee that satisfies the requirements of Rule 10A-3 under the Exchange Act. Audit Committee Additional Requirements The audit committee must have a minimum of three members. In addition to any requirement in Rule 10A.3(b)(1), all audit committee members must satisfy the requirements for independence set out in Section 303A.02. Shareholder Approval of Equity Compensation Plans The shareholders must be given the opportunity to vote on all equity-compensation plans and material revisions thereto, with limited exemptions defined by the NYSE corporate governance rules.

22. NYSE Corporate Governance Rules: Section 303A (Cont) Corporate Governance Guidelines Listed companies must adopt and disclose corporate governance guidelines that address certain subjects. Code of Business Conduct and Ethics Listed companies must adopt and disclose a code of business conduct and ethics for directors, officers, and employees, and promptly disclose any waivers of the code for directors or executive officers. Foreign Private Issuer Disclosure Listed foreign private issuers must disclose any significant ways in which their corporate governance practices differ from those followed by domestic companies under NYSE listing standards.

23. NYSE Corporate Governance Rules: Section 303A (Cont) Certification Requirements Each listed company CEO must certify to the NYSE each year that he or she is not aware of any violation by the company of NYSE corporate governance listings standards, qualifying the certification to the extent necessary. Each listed company must submit an executed Written Affirmation annually to the NYSE and promptly report any material incompliance with application of Section 303A. Public Reprimand Letter The NYSE may issue a public reprimand letter to any listed company that violates an NYSE listing standard. Web Site Requirement Listed companies must have and maintain a publicly accessible Web site. Source: NYSE Corporate Governance Rules: Section 303A. Available at: www.nyse.com/pdfs/finalcorpgovrules.pdf.

24. Global Convergence in Corporate Governance • There are no globally accepted corporate governance reforms and best practices. • Differences are mainly driven by the country’s statutes, corporate structures, and culture. • The United States and United Kingdom operate under common law with the purpose of aligning the interests of management with those of shareholders compared to countries under code law (e.g., Germany) to protect the rights of minority shareholders. • Corporate governance reforms in the United States are typically regulator-led and established by the SEC to protect investors, whereas reforms in the United Kingdom are normally shareholder-led, indicating that investors are responsible for safeguarding their interests. 21

25. Corporate and Capital Structure • Corporate governance in a dispersed share ownership (US) is designed to align the interests of management with those of shareholders. • In a concentrated ownership (Germany) corporate governance creates a right balance between the interests of minority and majority shareholders. • The primary purpose of corporate governance in the US is to enhance shareholder value creation while protecting the interests of other stakeholders (creditors, employees, suppliers, customers, government); in Germany, the focus is more on protecting creditors as banks play an important role in financing companies. 22

26. The Board System • In one-tier boards in the US, directors are elected to oversee management in running the company. • In the two-tier board system in Germany, the supervisory board advises, appoints, and supervises the management board in managing the operation of the company. • In Japan, companies operate through a complex system of committees, and these committees oversee and run the company. • Cultural and political differences can also influence corporate governance as some cultures are more collective and risk averse than others (e.g., Germany compared to US). 23

27. UK Corporate Governance vs. U.S. Corporate Governance

28. Corporate Governance in Germany German corporate governance is characterized by the two-tier board of director system, which creates different rights and obligations for directors of each board as specified in the German Stock Corporation Act and the German Corporate Governance Code. The two-tier board of directors system consists of the management board and the supervisory board. Two recent laws, namely, UMAG and KapMuG, were established to promote protection for German shareholders. The two laws are intended to enhance shareholder democracy in Germany and provide protection for investors.

29. Convergence in Corporate Governance The following issues should be resolved to facilitate global convergence in corporate governance: Reconcilable corporate governance principles are: (1) the majority of directors must be independent, nonexecutive directors; (2) members of the audit, compensation, and nomination committees must be independent; (3) nonexecutive, independent directors do not receive compensation or fees other than their director fees; (4) the audit committee, composed of truly independent directors, oversees financial reporting, internal controls, and audit activities; (5) the audit committee is directly responsible for the appointment, retention, and compensation of the external auditor.

30. MNC usually have parent-subsidiary structure. The parent-subsidiary corporate governance structure is shaped by both the host and home countries’ legal, political, cultural, and regulatory systems; the business practices and historical patterns of countries; the global capital, labor, and managerial markets; global institutional investors; and the boards of directors. When the subsidiary is wholly owned by the parent company and is managed automatically (independently) by a management who has little if any ownership interest in the MNC or the subsidiary, then the effectiveness of parent-subsidiary corporate governance becomes more crucial in monitoring and controlling managerial actions. http://sciencestage.com/v/18401/mark-to-market-accounting-accounting-rules-post-crisis-reform-and-fair-value-accounting-bob-pozen.html , Video . Corporate Governance In Multinational Corporations

31. Corporate Governance Reporting Corporate Governance Reporting (CGR) entails assessing the quality and effectiveness of the organization’s corporate governance and reporting findings to interested stakeholders, including the board of directors, executives, auditors, regulatory agencies, and shareholders. Corporate Governance Reporting: (1) Disclose all relevant information about the effectiveness of the company’s corporate governance. (2) Focus on the company’s sustainability performance. (3) Provide transparent information about the company’s performance and its impacts on all stakeholders. (4) Assess the company’s responsiveness to the needs of its stakeholders.

32. Conclusion Corporate governance participants must structure the process to ensure the goals of both shareholder value creation and stakeholder value protection for public companies. The corporate governance structure is shaped by internal and external governance mechanisms, as well as policy interventions through regulations. Corporate governance mechanisms are viewed as a nexus of contracts that is designed to align the interests of management with those of the shareholders. The effectiveness of both internal and external corporate governance mechanisms depends on the cost–benefit trade-offs among these mechanisms and is related to their availability, the extent to which they are being used, whether their marginal benefits exceed their marginal costs, and the company’s corporate governance structure.

33. Conclusion There are three aspects of corporate governance: the shareholder aspect, the stakeholder aspect, and the integrated aspect. Corporate governance structure should be based on the principles of value-adding philosophy, ethical conduct, accountability, shareholder democracy and fairness, integrity of financial reporting, transparency, and independence. A well-balanced operation of the seven corporate governance functions—oversight, managerial, compliance, internal audit, legal and financial advisory, external audit, and monitoring— can contribute toward effective corporate governance. Corporate governance effectiveness is defined as the extent to which the company’s corporate governance is achieving its objectives in three categories: (1) promoting efficient and effective operational, financial, and social performance; (2) creating shareholder value while protecting the interests of other stakeholders (employees, suppliers, customers, and creditors); and (3) ensuring the integrity, quality, reliability, and transparency of financial reporting.