Chapter 4Chapter 4Corporate Corporate

Governance: Governance: Foundational Foundational

IssuesIssues

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Corporate Governance

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.

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The Corporation’s Hierarchy of Authority

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State Charter

Shareholders

Board of Directors

Management

Employees

The Need for Board Independence

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•Outside directors – independent from the firm

•Inside directors – have some tie to the firm

Board independence is crucial to good governance

Issues Surrounding Compensation

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Issues Surrounding Compensation (continued)

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1) Shareholder push to link pay to performance

1) Shareholder push to link pay to performance

2) Increasing use of “clawback” provisions where executives must return pay under some

conditions

2) Increasing use of “clawback” provisions where executives must return pay under some

conditions

CEO PayControversy

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.

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Excessive CEO Pay

Ratio of CEO pay to average worker is 319 to 1 (down from 531 to 1 in 2000).

Say on Pay • Evolved from concerns over excessive

executive compensation.• Began in the United Kingdom in 2002 with

regulations on pay.

Clawback provisions• Compensation recovery mechanisms that

enable a company to recoup compensation funds, typically in the event of a financial restatement or executive’s misbehavior.

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Executive Retirement Plans and Exit Packages

Retirement packages have come under scrutiny.• Robert Nardelli received $210 million

when he was ousted from Home Depot by shareholders.

• Contrast to most workers, many of whom to do have a retirement plan.

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Outside Director Compensation

• Paying board members is a recent concept.

• Controversy over whether directors should be paid at all, and whether they are paid enough.

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Insider Trading

The practice of obtaining criticalinformation from inside a company and

using that information for one’s ownpersonal financial gain.

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Improving Corporate Governance: Sarbanes-Oxley Act of 2002 (SOX)

• 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

• CEOs and CFOs certify and are held responsible for financial representations

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Improving Corporate Governance: Sarbanes-Oxley Act of 2002 (SOX)

(continued)

• 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• Whistle-blowers are given protection• Code of ethics disclosure

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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

The board should “get tough” with the CEO.

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Ranking of Red Flags Signaling Board Problems

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Steps to Take for Board Repair

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Board Diversity

Board diversity is lacking•Only around 15% of directors in U.S. are women.

•Sixty-six Fortune 500 firms have no female board members.

•Hispanics, Asian Americans and African Americans also under-represented.

•Diverse boards are also less likely to fall prey to groupthink because they have a range of perspectives.Is a global problem.

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Use of Board Committees

Principle Responsibilities of an Audit Committee

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.

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Other Board Committees

Nominating committee•Is composed of outside directors.•Has the responsibility of selecting competent, objective board members.Compensation committee•Evaluates executive performance and recommending terms and conditions of employment.Public issues committee (Public policy committee)•Responds to public or social issues.•Deals with areas in which public or ethical issues are present.

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Board Member Liability

Business judgment 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.

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Board Member Liability (continued)

The “Caremark Standard,” which heightened concerns over personal liability, states that directors can be held personally 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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The Role of the SEC

• Is responsible for protecting investor interests.

• Critics argue that the SEC is more focused on businesses than on investors.

SEC failed to catch the Bernard Madoff Ponzi scheme before losing investors billions.

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Investor Relations

Full disclosure (Transparency)•Information filed at regular and frequent intervals that contains information that might affect investment decisions.

Management is responsible for communicating with shareholders.

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