0 Corporate Governance: Foundational Issues Chapter4 Professor Craig Diamond BA 385 October 14, 2009
0 Outline of Topics • Legitimacy and Corporate Governance • Problems in Corporate Governance • Improving Corporate Governance • The Role of Shareholders
A condition wherein an organization’s activities are • consistent with society’s • expectations. Legitimacy • A dynamic process by which a business seeks to perpetuate its acceptance. Legitimation 0 Legitimacy and Corporate Governance
0 Legitimacy and Corporate Governance Micro Level of Legitimacy Macro Level of Legitimacy • Adapt operational methods to perceived societal expectations • Attempt to change societal expectations or norms to conform to firm’s practices • Focus is on the totality of business enterprises • Existence is solely because society has given it that right
Corporate Governance • The word “governance” comes from the Greek word for steering.
State Charter Shareholders Board of Directors Management Employees 0 The Corporation’s Hierarchy of Authority Figure 4-1
Shareholders(ownership) Board ofDirectors Management(control) 0 Separation of Ownership from Control Precorporate Period Corporate Period Owners(ownership) Managers(control) Figure 4-2
Inside Directors Outside Directors 0 The Need for Board Independence Top managers Friends, family, or colleagues of top managers Firm’s hired lawyers, bankers Independent from the company and its top managers
1) the extent to which CEO payis tied to firm performance CEO Pay Controversy 2) the overall size of CEO pay 0 CEO Compensation Ratio of CEO pay to average worker pay: 1982 – 42:1 2006 – 411:1
Allows the recipient to purchase stockat yesterday’s price, resulting in immediate wealth increase Granting of a stock option at today’s price, but with the inside knowledge that stock’s value is improving Delaying of a stock option grant until right after bad news Stock Option Abuses Backdating Spring-Loading Bullet-Dodging 0 Stock Options
CEO Compensation • Executive Retirement Plans • Examples: • Richard Grasso, New York Stock Exchange • Jack Welch, General Electric
Compensation recovery mechanisms that enable a company to recoup executive compensation funds Clawback Provisions 0 Addressing Excessive CEO Pay 2007 SEC rules on disclosure of executive compensation – designed to increase transparency
Board/CEO Relationship • Boards are protecting CEOs less than they used to: • From 2005 to 2006, there was a 68% increase in turnover of CEOs and board members.
Director Compensation • Original idea – don’t pay board members anything • Keeps maximum independence • Board members increasingly want to be paid more • 1992: average board member worked 95 hrs/yr for a company. • In 2000, that number had increased to 173 hrs/yr. • Sarbanes-Oxley • Creating more accountability for Board members, which also causes them to want more compensation
0 Mergers & Acquisitions Poison pill Golden parachutes
The practice of obtaining criticalinformation from inside a company andusing that information for one’s ownpersonal financial gain Insider Trading 0 Insider Trading Examples: 1980s – wide spread scandals, 2003 – Martha Stewart
0 Improving Corporate Governance • Improves auditing and financial reporting: • 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 Accounting Reform and Investor Act of 2002 (Sarbanes-Oxley)
0 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 Accounting Reform and Investor Act of 2002 (Sarbanes-Oxley)
0 Improving Corporate Governance • Changes in boards of directors • Board diversity (make greater % of women and minorities) • Outside board directors • Use of board committees for: • Audit • Nominating (selecting Board members) • Compensation (for top management) • Public policy (stakeholder issues) • Board should “get tough” with the CEO
0 Use of Board Committees Principal Responsibilities of an Audit Committee • To ensure that published financial statements are not misleading. • To ensure that internal controls are adequate. • To follow up on allegations of material, financial, ethical, and legal irregularities. • To ratify the selection of the external auditor.
Holds that courts should not challenge board members who act in good faith,making informed decisions that reflectthe company’s best interests. Board members need to be free to take risks without fear of liability. BusinessJudgment Rule 0 Board Member Liability
0 Board Member Liability • In November 2006, the Delaware Supreme Court affirmed the “Caremark Standard,” which states that directors canonly be held liable if: • The director utterly failed to implement any reporting or information system or controls, or • 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.
The requirement that board membersbe elected by a majority of votes cast. Boards that elect their members instaggered terms. Provides shareholders with the opportunity to propose nominees forthe board of directors. Majority Vote Classified Boards ShareholderBallot Access 0 Shareholder Democracy: Board Elections
Originated from activism of 1960s Shareholder resolutions Shareholder lawsuits 0 Shareholder Activism
Information filed at regular and frequent intervals that contains information that might affectinvestment decisions FullDisclosure 0 Investor Relations