Business & Society

Ethics, Sustainability & Stakeholder

Management
10th Edition

© 2018 Cengage 1
 Chapter 4
Corporate
Governance:
Foundational
Issues

© 2018 Cengage 2
 Learning Outcomes (1 of 2)
1. Link the issue of legitimacy to corporate
governance.
2. Discuss the problems that have led to the recent
spate of corporate scandals and problems in
corporate governance.
3. Discuss the principal ways in which companies can
improve corporate governance.
4. Discuss the role of shareholders and the idea of
strengthening shareholder voice. What are some of
the mechanisms that enable this?
5. Discuss the role of the SEC in protecting investors.
© 2018 Cengage 3
 Learning Outcomes (2 of 2)
6. Discuss the principal way in which shareholder
activists exert pressure on corporate
management to improve governance.
7. Discuss investor relations and the concept of
shareholder engagement.
8. Compare and contrast the shareholder-primacy
and the director-primacy models of corporate
governance. What are their strengths and
weaknesses? Which do you prefer and why?

© 2018 Cengage 4
 Chapter Outline
• Legitimacy and Corporate Governance
• Problems in Corporate Governance
• Improving Corporate Governance
• The Role of Shareholders
• The Role of the SEC
• Shareholder Activism
• Investor Relations and Shareholder Engagement
• An Alternative Model of Corporate Governance
• Summary
© 2018 Cengage 5
 Legitimacy
and Corporate Governance
Legitimacy -
• A condition that prevails when there is a
congruence between an organization’s
activities and society’s expectations.
Legitimation -
• A dynamic process by which a business
seeks to perpetuate its acceptance.

© 2018 Cengage 6
 Legitimacy
Micro Level of Legitimacy Macro Level of Legitimacy
Adapt operational methods Focus is on the corporate
to perceived societal system, the totality of
expectations. business enterprises.
Attempt to change societal Business has a fragile
expectations or norms to mandate, subject to
conform to firm’s practices. ratification.
Seek to enhance its Business exists solely
legitimacy by identifying because society has given
itself with others that have a it that right.
powerful legitimate base in
society.

© 2018 Cengage 7
 Corporate Governance -
• Refers to the method by which a firm is
being governed, directed, administered, or
controlled, and to the goals for which it is
being governed.
• Is concerned with the relative roles, rights,
and accountability of such stakeholder
groups as owners, boards of directors,
managers, employees, and other
stakeholders.

© 2018 Cengage 8
 Roles of Four Major Groups -
Shareholders -
• Own stock in the firm, giving them ultimate
control (the shareholder-primacy model).
Board of Directors -
• Govern and oversee management of the
business.
Managers -
• The individuals hired by the Board to manage
the business on a daily basis.
Employees -
• Hired to perform actual operational work.
© 2018 Cengage 9
Separation of Ownership from Control

© 2018 Cengage 10
 The Corporation’s
Hierarchy of Authority

© 2018 Cengage 11
 Problems in Corporate Governance
The Need for Board Independence:
Outside directors –
• are independent from the firm

Inside directors –
• have some tie to the firm
Board independence from management is
crucial to good governance.

© 2018 Cengage 12
Issues Surrounding Compensation

CEO Pay–Firm Performance Relationship

Excessive CEO Pay

Executive Retirement Plans & Exit Packages

Outside Director Compensation

Transparency; SEC Rules

© 2018 Cengage 13
 CEO Pay–
Firm Performance Relationship
Stock Options -
• Allows the recipient to purchase stock in the future
at the price it is today.
Backdating -
• Allows the recipient to purchase stock at yesterday’s
price, resulting in immediate wealth increase.
Spring-loading -
• Granting of a stock option at today’s price, but with
the inside knowledge that stock’s value is improving.
Bullet Dodging -
• Delaying of a stock option grant until right after bad
news.
© 2018 Cengage 14
 Excessive CEO Pay
Ratio of CEO pay to that of average worker -
• 1950, 20 to 1
• 2014, 216 to 1
Say on Pay
• Evolved from concerns over excessive
executive compensation.
Clawback provisions
• Compensation recovery mechanisms that
enable a company to recoup CEO pay,
typically in the event of a financial
restatement or executive’s misbehavior.
© 2018 Cengage 15
Executive Retirement Plans and

Exit Packages
Retirement packages –
• have come under scrutiny.
• $210 million to Robert Nardelli when he
was ousted from Home Depot.
• $125 million to outgoing Bank of America
CEO Ken Lewis.
• In contrast, many of today’s workers do
not have a retirement plan.
• Those who do generally have a defined
contribution plan, rather than a defined
benefit plan.
© 2018 Cengage 16
Outside Director Compensation -
• Paying board members is a recent idea.

• Today, outside board members are paid.

• From 2003-2015, their median pay rose

about a third, from $175,800 to $258,000.

© 2018 Cengage 17
 Transparency -

SEC Rules require disclosure of executive compensation.

Such disclosures may have a moderating impact prior to

implementation.

© 2018 Cengage 18
 Governance Impact of the
Market for Corporate Control

Mergers and acquisitions -

• Expectation is that the threat of a possible
takeover will motivate top managers to pursue
shareholder, rather than self-interest.
• But many corporate CEOs and boards go to great
lengths to protect themselves from takeovers,
using:
• poison pills (discourages a hostile takeover by making
the firm difficult to take on)
• golden parachutes (firm agrees to pay key officers in the
event of a change in control of the corporation)

© 2018 Cengage 19
 Insider Trading -
• The practice of buying or selling a security by
someone who has access to material information
that is not available to the public.
• “Material Information” is information that a
reasonable investor might want to use, and is likely
to affect the price of the firm’s stock.
• A “tipper” provides that information.
• A “tippee” receives the information.
• Executives and others who work for a firm may
have inside information.
• Also those in relationships that include a duty of
confidentiality may have inside information,
including spouses, parents, children, friends.
© 2018 Cengage 20
Improving Corporate Governance (1 of 2)
Legislative Efforts:
• Sarbanes-Oxley Act of 2002 (SOX) -
• Amends securities laws to protect investors in
public companies
• Enhances public disclosure to require reporting
of off-balance sheet transactions, and personal
loans to executives
• Limits the nonauditing services an auditor can
provide to a firm it audits
• Makes it unlawful for accounting firms to provide
services where conflicts of interest exist
• CEOs and CFOs must certify financials, and are
held responsible for financial representations
© 2018 Cengage 21
Improving Corporate Governance (2 of 2)
Changes in boards of directors -
• More Board diversity
• A greater ratio of outside board members
to inside board members
• Use of board committees to:
• Ensure that financials are not misleading
• Ensure that internal controls are adequate
• Follow-up allegations of irregularities
• Ratify the selection of an external auditor

© 2018 Cengage 22
 Red Flags Signaling Board
Problems
Ranking of Red Flags-
1. Company has to restate earnings.
2. Poor employee morale.
3. Adverse Sarbanes-Oxley 404 opinion
4. Poor customer satisfaction track record.
5. Management misses strategic performance goals.
6. Company is target of employee lawsuits.
7. Stock price declines.
8. Quarterly financial results miss analysts’ expectations.
9. Low corporate governance quotient rating.

© 2018 Cengage 23
 Steps to Take for Board Repair
Steps to Take -
1. Spread risk oversight among multiple committees
2. Seek outside help in identifying potential risks
3. Deepen involvement in corporate strategy
4. Align board size and skill mix with strategy
5. Pick compensation committee members who will
question the status quo
6. Use independent compensation consultants
7. Evaluate CEO on grooming potential successors
8. Know what matters to your investors

© 2018 Cengage 24
The Board’s Relationship with CEO
• Boards are responsible for monitoring CEO
performance and dismissing poorly
performing CEO
• Formerly, CEOs were protected; no more;
firings of CEOs are up significantly
• If CEO also serves as Chairman of the
Board, this duality can offer some
protection
• Activists have moved to separate CEO and
Board functions

© 2018 Cengage 25
 Board Member Liability -
• The Business Judgment Rule protects
board members if:
• they act in good faith
• making informed decisions
• that reflect the company’s best interests,
and not their own interests.
• Good Faith is central to the defense
• The argument in favor of the Business
Judgment Rule is that board members
need to be free to take risks without fear
of liability.
© 2018 Cengage 26
 The Role of Shareholders
The Shareholder Democracy Movement arises from
the fact that although they are owners,
shareholders may find that their votes are not
counted. They seek:
A Majority Vote
• The requirement that board members be elected
by a majority of votes cast, rather than by a
plurality.
Banning Classified or Staggered Boards
• Electing members in staggered terms means that
it might take 3 or more years to replace a board.
Proxy Access
• Would provide shareholders with the opportunity
to propose nominees for the board of directors.
© 2018 Cengage 27
 The Role of the SEC -
• The SEC is responsible for protecting
investor interests.
• Critics argue that the SEC is more focused
on the needs of businesses than on that of
investors.
• The SEC failed to stop the Bernard Madoff
Ponzi scheme before investors lost billions,
although they had been warned of the
scheme a decade earlier.

© 2018 Cengage 28
Shareholder Activism

History of Shareholder activism

Shareholder resolutions

Shareholder lawsuits

© 2018 Cengage 29
 Investor Relations and
Shareholder Engagement -
• A majority of corporate boards now
communicate with their major investors
• Public corporations have obligations to
current and potential shareholders, including
Full disclosure (Transparency), and the duty
to provide information that might affect
investment decisions.
• Management is also responsible for
communicating with shareholders.
• CEO Warren Buffett calls his annual
shareholder meeting a “Woodstock weekend
for capitalists.”
© 2018 Cengage 30
 An Alternative Model of
Corporate Governance
• The Anglo-American model of corporate
governance is one of shareholder primacy
• A emerging perspective is a director-primacy
model of corporate governance
• A director-primacy model is based on the
concept of a corporation that is not owned,
but is an independent legal entity that owns
itself.
• Boards are mediating hierarchs, responsible for
balancing competing interests of stakeholders
• Boards have a duty to shareholders, but boards
are the ultimate decision-makers, whose duty is to
the corporation
© 2018 Cengage 31
 Key Terms (1 of 2)
• Accounting Reform and • Corporate responsibility
Investor Protection Act of committee
2002 • Corporate sustainability
• Agency problems committee
• Anglo-American model • Council of Institutional
• Audit committee Investors (CII)
• Backdating • Director-primacy model
• Board of directors • Dodd-Frank Wall Street
• Bullet-dodging Reform and Consumer
• Business judgment rule Protection Act
• CEO duality • Employees
• Charter • Fragile mandate
• Classified boards • Full disclosure
• Clawback provisions • Golden parachute
• Compensation committee • Information asymmetry
• Continental-European • Inside directors
Model • Insider trading
• Corporate gadflies • Legitimacy
• Corporate governance • Legitimation
© 2018 Cengage 32
 Key Terms (2 of 2)
• Majority vote • Say on Pay movement
• Management • Separation of ownership
• Material information from control
• Nominating committee • Shareholder activism
• Out-of-pocket liability • Shareholder democracy
• Outside directors • Shareholder-Director
• Pay-ratio disclosure rule exchange
• Personal liability
• Shareholder engagement
• Poison pill
• Ponzi scheme • Shareholder lawsuit
• Private Securities • Shareholder resolutions
Litigation Reform Act of • Shareholders
1995 • Spring-loading
• Proxy access • Stock options
• Regulation FD (fair • Tax gross-up
disclosure) • Team-production model
• Restricted stock • Tippee
• Risk committees • Tipper
• Sarbanes-Oxley Act (SOX) • Transparency
© 2018 Cengage 33