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Corporate Governance: Foundational Issues

Chapter 4

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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

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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)

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Legitimacy and Corporate Governance

Problems in Corporate Governance

Improving Corporate Governance

The Role of Shareholders

Summary

Key Terms

Discussion Questions

Chapter 4 Outline

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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

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Legitimacy and Corporate Governance

LegitimacyA condition wherein there is a congruence between an organization’s activities and society’s expectations.

LegitimationA dynamic process by which a business seeks to perpetuate its acceptance.

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Micro Level of Legitimacy Macro 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

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The Corporation’s Hierarchy of Authority

State CharterState Charter

ShareholdersShareholders

Board of DirectorsBoard of Directors

ManagementManagement

EmployeesEmployees

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Separation of Ownership from Control

Precorporate Period Corporate Period

Owners(ownership)

Managers(control)

Owners(ownership)

Managers(control)

Shareholders(ownership)

Shareholders(ownership)

Board ofDirectors

Board ofDirectors

Management(control)

Management(control)

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The Need for Board Independence

Inside Directors

Outside Directors

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Issues Surrounding Compensation

CEO CompensationCEO Compensation

Executive Retirement PlansExecutive Retirement Plans

Outside Director CompensationOutside Director Compensation

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Issues Surrounding Compensation

1) the extent to which CEO payis tied to firm performance

1) the extent to which CEO payis tied to firm performance

2) the overall size of CEO pay2) the overall size of CEO pay

CEO PayControversy

CEO PayControversy

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CEO Pay/Firm Performance Relationship

Stock OptionsAllows the recipient to purchase stockin the future at the price it is today

BackdatingAllows the recipient to purchase stockat yesterday’s price, resulting in immediate wealth increase

Spring-LoadingGranting of a stock option at today’s price, but with the inside knowledge that stock’s value is improving

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Excessive CEO Pay

Clawback Provisions

Compensation recovery mechanisms that enable a company to recoup executive compensation funds

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Impact of the Market for Corporate Control

Poison pillPoison pill

Golden parachutesGolden parachutes

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Insider Trading

Insider Trading

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

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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

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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

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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 Principal Responsibilities of an Audit Committee

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Board Member Liability

BusinessJudgment

Rule

BusinessJudgment

Rule

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.

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.

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Board Member Liability

In November 2006, the Delaware Supreme Court affirmed the “Caremark Standard,” which states that directors canonly 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.

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Shareholder Democracy: Key Issues

Majority VoteThe requirement that board membersbe elected by a majority of votes cast.

Classified BoardsBoards that elect their members instaggered terms.

ShareholderBallot Access

Provides shareholders with the opportunity to propose nominees forthe board of directors.

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Shareholder Activism

Shareholder activismShareholder activism

Shareholder resolutionsShareholder resolutions

Shareholder lawsuitsShareholder lawsuits

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Investor Relations

FullDisclosure

Information filed at regular and frequent intervals that contains information that might affectinvestment decisions

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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

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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

Monitoring the Monitors

Boards members are typically disciplined by not being re-elected through shareholders vote. While shareholder vote can sometimes address firm performance issues, it is unlikely to be effective in addressing less public issues in a timely fashion. The Hewlett-Packard(HP) board found itself dealing with this type of problem when the details of confidential board discussions were being leaked to the press. Details of the firm’s strategies as well as its CEO hiring deliberations had been made public, but it was unclear who on the board was supplying the information.

After interviews with board members failed to elicit the source of the leaks, then board chairman Patricia Dunn engaged an outside licensed investigative firm to determine who had provided confidential information to the media. This firm used “pretexting” (conscious misrepresentation to obtain information) as one of their techniques for collecting the information. Investigators pretented to be the board members whose calls were being investigated. The source of the leaks was found; however, uproar ensued over the investigation.

1. Who should be responsible for taking action when a board member engages in problematic behavior? If the chairman is responsible, when should he or she involve the whole board? What are the costs of early full board involvement?

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2. One complaint lodged was that HP provided board member’s home phone numbers to investigators. Was this out of line? Do board members have a responsibility to provide certain basic information, or was their privacy breached when their home phone numbers were given? A board member whose phone records proved he was not involved in any leaks still resigned the board in protest that his privacy was invaded by the pretexting. Was he right?

3. The law regarding pretexting is unclear. While it is illegal when used to obtain financial records, the use of pretexting in other situations-such as the phone records in this example-was not necessary against the law. Should it be?

4. How might things have evolved differently if the ethically rather than the legality of the practice had been the issue? Are the two synonymous or is there a difference?

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