You are on page 1of 47

IMPROVING CORPORATE GOVERNANCE SYSTEMS:

A STAKEHOLDER THEORY APPROACH


Steven M. Mintz
Visiting Professor of Accounting
Claremont McKenna College
steven.mintz@claremontmckenna.edu
Abstract
Corporate governance systems comprise the techniques used to protect the
interests of those that provide the resources essential to the operations of a business
entity. The shareholder approach that has traditionally been followed in the U.S.
emphasizes stockholder interests while the broader stakeholder approach that is followed
in Germany includes the interests of others, especially employees that have a role to play
in corporate governance. The purpose of this paper is to compare the two approaches so
that interested parties can better understand how the underlying systems are formed.
Recent changes in the U.S. brought about by the Sarbanes-Oxley Act have
improved governance systems. However, the need for additional change exists because
of a lack of shareholder representation in choosing members of the board of directors and
investment policies that threaten employee interests. The U.S. might benefit from
adopting some of the provisions in countries such as Germany and the UK that advance
shareholder democracy and employee participation in governance.

IMPROVING CORPORATE GOVERNANCE SYSTEMS:


A STAKEHOLDER THEORY APPROACH
Accounting scandals at companies such as Enron, WorldCom, Tyco, and
Adelphia illustrate the failure of corporate governance systems. In each case, senior
executives and board of director members did not live up to the legal standards
established by the courts and explained in the American Law Institutes (1994) Principles
of Corporate Governance: Analysis and Recommendations. These include the duty of
care and duty of loyalty standards. The former obligates top corporate officials to act
carefully in fulfilling the important tasks of monitoring and directing the activities of
corporate management while the latter requires a commitment to place the interests of
the corporation and its shareholders above self-interests and to not use [ones] corporate
position to make a personal profit or gain other personal advantage.
The purpose of this paper is to apply Stakeholder Theory to the relationships that
exist in a public corporation and evaluate the adequacy of corporate governance systems
in the U.S. Stakeholder Theory is a managerial conception of organizational strategy and
ethics (Donaldson and Preston 1995; Evan and Freeman 1993; Hill and Jones 1992;
Mitchell, Agle, and Wood 1997; Ortis 1997; Phillips 1997; Rowley 1997; and Marens
and Wicks 1999). According to Freeman and Phillips (2002), the central idea is that an
organizations success depends on how well it manages the relationships with key groups
such as creditors, employees, customers, suppliers, communities, and others that can
affect the realization of its purpose. The managers job is to maintain the support of all of
these groups, balancing their interests, while making the organization a place where
stakeholder interests can be maximized over time.

Following the Enron and WorldCom scandals, the regulators and courts in the
U.S. took steps to enhance corporate governance by: (1) adopting the Sarbanes-Oxley Act
of 2002; (2) fostering increased shareholder democracy by creating a mechanism for
long-term security holders with significant investments to participate meaningfully in
the proxy process for the nomination and election of directors (SEC 2003);
(3) establishing guidelines to increase expectations for independent action by board
members through recent decisions of the Chancery Court in Delaware where more than
50 percent of U.S. corporations are incorporated (New York Times 2004); and (4) by
applying standards in the Employee Income and Security Act (ERISA) that require
specific information on available investment options to relieve the plan sponsor of certain
liabilities associated with employee 401(k) or other retirement accounts.
The remainder of the paper is organized as follows. Section I describes the basic
tenets of agency theory that holds the fiduciary responsibility of corporate managers is to
the shareholder, and the implications of this theory for recognizing other stakeholder
interests. Section II provides an overview of the American Law Institutes (ALI)
Principles of Corporate Governance that reflects the common understanding of the key
legal relationships in the publicly-held corporation among the shareholders, directors, and
management. Section III evaluates stakeholder theory and issues related to employee
governance. Section IV identifies recent enhancements to corporate governance systems
in the U.S., the United Kingdom (UK), and Germany. The paper concludes with
recommendations to improve corporate governance systems in the U.S.
I.

AGENCY THEORY

Stakeholder theorists who argue for the primacy of shareholder interests typically

cite the famous dictum from Dodge Bros. v Ford that the corporation exists for
the benefit of the shareholders (Boatright 1994 and Goodpaster 1991) as evidence of a
restraint on the discretion of management. It follows from agency theory that the
fiduciary responsibility of corporate managers is to the shareholder. Shareholders receive
returns only after other corporate claimants have been satisfied. In other words,
shareholders have a claim on the corporations residual cash flows. Since the
shareholders claim is consistent with the purpose of the corporation to create new
wealth, and the shareholders are allegedly at greater risk than other claimants, agency
theorists reason that corporate directors are singularly accountable to shareholders
(Brickley et. al. 2001).
According to Hawley and Williams (1996), the central problem in corporate
governance then becomes to construct rules and incentives (that is, implicit or explicit
contracts) to effectively align the behavior of managers (agents) with the desires of the
principals (owners). However, the desires and goals of management and shareholders
may not be in accord and it is difficult for the shareholder to verify the activities of
corporate management. This is often referred to as the agency problem.
A basic assumption is that managers are likely to place personal goals ahead of
corporate goals resulting in a conflict of interests between stockholders and the
management itself. Jensen & Meckling (1976) demonstrate how investors in publiclytraded corporations incur (agency) costs in monitoring managerial performance. In
general, agency costs also arise whenever there is an information asymmetry between
the corporation and outsiders because insiders (the corporation) know more about a
company and its future prospects than outsiders (investors) do.

Overcoming the Agency Problem


The agency problem can never be perfectly solved and shareholders may
experience a loss of wealth due to divergent behavior of managers. Investigations by the
SEC and Department of Justice of twenty corporate frauds indicate that $236 billion in
shareholder value was lost between the time the public first learned of the fraud and
September 3, 2002, the measurement date. Of this amount, $140 billion (60 percent) is
attributable to the failures at Enron ($25 billion), WorldCom ($27 billion), Tyco ($84
billion), and Adelphia ($4 billion). Lucent claims the majority of the balance ($55
billion).
Textbooks in corporate finance (Brealey 2000; Keaney 2002; and Van Horne et.
al. 2000) can be used to identify a variety of possible solutions to the agency problem.
Aligning Managers Interests with Stockholders
One of the most common approaches is to tie managerial compensation to the
financial performance of the corporation in general and the performance of the
companys shares. Typically, this occurs by creating long-term compensation packages
and by the possibility to issue stock options related to the firms stock price. These
incentives aim at encouraging managers to maximize the value of shares.
Agency costs can occur if the board of directors fails to exercise due care in its
oversight role of management. Enrons board of directors did not properly monitor the
companys incentive compensation plans thereby allowing top executives to hype the
companys stock so that employees would add it to their 401(k) retirement plans. While
this was occurring the former CEO, Ken Lay, sold about 2.3 million shares for $123.4
million.

Controlling Management through Board of Directors Actions


The stockholders select the board of directors by electing its members. Managers
that are not pursuing stockholders best interest can be replaced since the board of
directors can hire and fire management. However, the accounting scandals taught us that
boards can be controlled by management or be inattentive to their oversight
responsibilities. For example, Andy Fastow, the now indicted former chief financial
officer (CFO) of Enron, directly or indirectly controlled many of the special purpose
entities that he set up. Yet, Enrons board waived the conflict of interest provision in the
companys code of ethics to enable Fastow to wear both hats.
Other problems exist when members of the board hold positions that should
require independence from management but conflicts exist. For example, the former
head of the executive compensation committee of the board of directors of WorldCom,
Stiles A. Kellett, Jr., granted $415 million in loans to former CEO Bernie Ebbers to cover
his personal indebtedness. Shortly thereafter, Kellett began using the companys Falcon
20F-5 jet and he received favorable lease terms without the full knowledge of the board.
Corporate Takeovers
If the companys share price drops too low due to poor management, takeovers
can take place either by a group of shareholders or another company. The result may be
to dismiss members of top management or scale down its responsibilities. For example,
the $49-billion all-stock takeover bid made by Comcast for Walt Disney Co. in February
2004, reflects the perception, in part created by Roy Disney, the nephew of the
companys co-founder, Walt Disney, that the company is not well managed.

The Disney board unanimously rejected the unsolicited tender offer because the
bid represented a 15 percent discount to its stock price at the time. Less than three weeks
after the rejection, at the companys annual meeting, shareholders owning 43 percent of
Disneys stock cast their votes in opposition to Michael Eisner. The board stripped him
of his job as chair although Eisner stayed on as Disneys CEO.
Financial Reports as a Monitoring Device
The financial reports can be used to mitigate the conflict between owners and
managers posited by agency theory. If owners perceive that accounting reports are
reliable, then management should be rewarded for their performance and for helping to
control agency monitoring costs.
Management has a stewardship responsibility to protect company assets. While
the management is responsible for the preparation of the financial reports, publiclyowned companies must hire independent auditors to render opinions on the fairness of the
presentations in the financial statements. The auditors fail in their oversight role when
they ignore managements manipulations of the financial statements or its unauthorized
use of company resources, as was the case in the accounting scandals.
Internal Controls
The internal control system consists of the policies and procedures established by
management to provide reasonable assurance regarding the achievement of objectives
related to: the reliability of financial reports; the effectiveness and efficiency of
operations; and compliance with applicable laws and regulations. The Sarbanes-Oxley
Act strengthens managements oversight role by requiring a report on internal controls.
This will be discussed in section four.

An important component of internal control is the processes in place to safeguard


company assets. As the recent scandals indicate, however, even the best internal control
system will fail if top management overrides the controls or the directors turn away from
their responsibilities. For example, top executives at Tyco and Adelphia used hundreds
of millions of dollars from interest-free loans for personal purposes. The board at each
company claimed to have been uninformed about the nature and purpose of the loans.
When the systems in place to provide checks and balances between the board,
management and shareholders fails as often as they did during the accounting scandals,
the time may be right to consider new approaches to corporate governance.
II. CORPORATE GOVERNANCE
The Encyclopedia about Corporate Governance points out that the concept of
corporate governance is poorly defined because it potentially covers a large number of
distinct economic phenomena resulting in different definitions based on ones own
special interest (www.encycogov.com). Typically, the phrase corporate governance
invokes a narrow consideration of the relationships between the firms capital providers
and top management, as mediated by its board of directors (Hart 1995). Shleifer and
Vishney (1997) define corporate governance as the process that deals with the ways in
which suppliers of finance to corporations assure themselves of getting a return on their
investment.
The shareholder model of corporate governance that underlies the principles
discussed in this section rely on the assumption that shareholders are entitled (morally,
not merely legally) to direct the corporation because their capital investments provide
ownership rights that are an extension of their natural right to own private property. On

the other hand, the stakeholder model that will be described in the next section views
corporate governance as more than simply the relationship between the firm and its
capital providers. On this view, corporate governance also implicates how the various
constituencies that define the entity serve, and are served by, the corporation.
A brief overview of ALIs Principles of Corporate Governance (The Principles)
follows.
The Objective and Conduct of the Corporation
The Principles take as a basic proposition that a business corporation through its
activities of producing and distributing goods and services and making investments,
should have as its objective the conduct of such activities with a view to enhancing
corporate profit and shareholder gain. This economic objective should be carried out
with a long-term perspective that generally depends on meeting the fair expectations of
constituency groups such as employees, customers, suppliers, and members of the
communities in which the corporation operates. Thus, the responsible maintenance of
these interdependencies gains recognition only within the larger context of enhancing
long-term value for the equity owners.
Corporate Structure
Given the impracticality of direct shareholder review and the constraints on the
efficacy of financial markets, the effectiveness of board operations and how committees
carry out independent responsibilities take on greater importance.
Role of Senior Executives
In the U.S., while the role of top manager typically is vested by the board in the
CEO, the Principles permit that function to be vested in a group of senior executives. For

example, in Germany, the management board operates collectively to carry out the
responsibilities of top management. A supervisory board oversees their efforts
primarily on behalf of the shareholders and employees. While the functioning of this
two-tier system will be explained later on, it is important to emphasize now that nothing
in the Law prevents U.S. corporations from considering such a structure.
Questions concerning a senior executives authority ordinarily come up in
disputes between the corporation and a third person arising out of a transaction between
the third person and an executive acting on the corporations behalf. In general,
questions concerning the authority of senior executives are decided under agency law by
examining whether the executive had either actual or apparent authority to act. A
discussion of these concepts is beyond the scope of the paper.
Functions and Powers of the Board of Directors
The primary function of the board of directors is the selection of the CEO and
concurrence with the CEOs selection of the companys top management team. This
includes monitoring the performance of the CEO, determining compensation, and
reviewing succession planning.
Other important responsibilities include: to select and recommend to shareholders
for election an appropriate slate of candidates for the board of directors; to evaluate board
processes and performance; to review the adequacy of systems to comply with all
applicable laws/regulations; and to review and, where appropriate, approve major
changes in and the selection of appropriate auditing and accounting principles to be used
in the preparation of the corporations financial statements. In practice, this function
often will be delegated to the audit committee.

Committees that Enhance Governance


Typically, there are three main committees that support the work of the board of
directors of a publicly-owned corporation including the audit committee, nominating
committee, and the compensation committee.
The independence of board decisions is enhanced by having a majority of the
directors free of any significant relationship with the corporations senior executives.
These outside directors should not have any close personal relationships with senior
executives and no consulting or other relationships with the corporation that provide a
significant portion of the directors income.
The audit committee should be composed of at least three independent members
who are neither employed by the corporation nor were so employed within the previous
two years. None of the directors on the nominating and compensation committees
should be officers or employees of the corporation and a majority should have no
significant relationship with the senior executives.
Audit Committee
The functions and powers of the audit committee relate to its relationship with the
external auditors and include:
(1) recommend the firm to be employed as the corporations external auditor and
review the proposed discharge of any such firm,
(2) review the external auditors compensation, the proposed terms of its
engagement, and its independence,
(3) serve as a communication link between the external auditor and the board,

(4) review the corporations annual financial statements, the results of the
external audit, the auditors report, and managements responses to audit
recommendations,
(5) review any significant disputes between management and the external auditor
that arose in connection with the preparation of those financial statements,
(6) consider, in consultation with the external auditor, the adequacy of the
corporations internal controls,
(7) consider major changes and other major questions of choice respecting the
appropriate auditing and accounting principles and practices to be used in the
preparation of the corporations financial statements, when presented by the
external auditor, a principal senior executive, or otherwise.
As explained in Section IV, the Sarbanes-Oxley Act adds additional requirements
that strengthen the role of the audit committee in corporate governance.
Nominating Committee
An independent nominating committee serves to implement and support the
oversight function of the board. Its primary responsibilities should include:
(1) recommend to the board candidates for all directorships to be filled by the
shareholders or the board,
(2) consider, in making its recommendations, candidates for directorships
proposed by the CEO and, within the bounds of practicality, by any other
senior executive or any director or shareholder,
(3) recommend to the board directors to fill the seats on board committees.

Compensation Committee
The compensation committee should be composed exclusively of directors who
are not officers or employees of the corporation, including at least a majority of members
who have no significant relationship with the senior executives. In carrying out its
oversight role, the committee should:
(1) review and recommend to the board, or determine, the annual salary, bonus,
stock options, and other benefits, direct and indirect, of the senior executives,
(2) establish and periodically review policies for the administration of executive
compensation programs and their operation to determine whether they are
properly coordinated;
(3) review new executive compensation programs including fixed and variable
salary payments, deferred compensation, bonus, profit-sharing, stock-option,
ERISA plans and benefits, retirement programs, and any other forms of
compensation,
(4) take steps to modify any executive compensation programs that yield
payments and benefits that are not reasonably related to executive
performance;
(5) establish and periodically review policies in the area of management
perquisites.
At WorldCom, the board did not meet its oversight responsibilities regarding
management perks. WorldComs former CEO, Bernie Ebbers, borrowed $415 million
from the company to help meet a margin call on bank loans that were collateralized with
WorldCom stock. The loan was not initially disclosed to all board members and those

that did know, like Stiles Kellett Jr., were bought-off with favors granted by Ebbers.
Compensation and the Agency Problem
Studies of executive compensation by financial economists indicate that there are
two different views on how the agency problem and executive compensation are linked.
The dominant view is that the design of compensation arrangements can help alleviate
the agency problem in publicly traded companies. Under this approach, which Bebchuk
and Fried (2003) label the optimal contracting approach, boards are assumed to design
compensation packages to provide managers with efficient incentives to maximize
shareholder value. However, as Bebchuk and Fried (73) point out, boards are also
subject to the agency problem and that can undermine their ability to address
effectively the agency problems in the relationship between managers
and shareholders.
Another approach to studying executive compensation, which Bebchuk and Fried
(2003) label the managerial power approach, views executive compensation not only as
a potential instrument for addressing the agency problem but also as part of the agency
problem itself. The very reasons for questioning the ability of optimal contracting to
explain compensation practices adequately also suggest that executives have substantial
influence over their own pay enabling them to extract rents. As a number of researchers
have recognized (Bertrand and Mullainathan 2001; and Blanchard et. al. 1994), some
features of pay arrangements seem to reflect managerial rent-seeking rather than the
provision of efficient incentives.
The managerial power approach predicts that pay will be higher and/or less
sensitive to performance in companies in which managers have relatively more power.

Holthausen and Larcker (1999) find that CEO compensation is higher under the
following conditions: when the board is large, which makes it more difficult for directors
to organize in opposition to the CEO; when more of the outside directors have been
appointed by the CEO, which could cause them to feel obligated to the CEO; and when
outside directors serve on three or more boards thereby having more demands on their
time. Finally, CEO pay is negatively related to the share ownership of the boards
compensation committee: doubling compensation committee stock ownership reduces
nonsalary compensation by 4-5 % (Cyert, Kang and Kumar 2002).
Researchers (Cyert, Kang and Kumar 2002; Core, Holthausen and Larcker 1999)
have found that CEO pay is 20-40 percent higher if the CEO holds the position of chair
of the board of directors. Recent reform legislation in the U.K. prohibits the same person
from holding both positions.
The presence of a large outside shareholder is likely to result in closer monitoring
(Shleifer and Vishney 1986), and it is likely to reduce top managers influence over their
compensation. Consistent with this observation, Cyert, Kang and Kumar (2002) find a
negative correlation between the equity ownership of the largest shareholder and the
amount of CEO compensation: doubling the percentage ownership of the outside
shareholder reduces non-salary compensation by 12-14 percent. Apparently, the larger
the equity interest the more involved is the shareholder.
A larger concentration of institutional shareholders might result in greater
monitoring and scrutiny of the CEO and the board. Examining CEO pay in almost 2000
firms during the period 1991-1997, Hartzell and Starks (2002) find that the more
concentrated is institutional ownership, the lower is executive compensation.

Checks and Balances to Control CEO Pay Packages


Concern over the rapidly increasing levels of CEO pay packages and widespread
use of stock-based compensation led to the passage of legislation in 1993, implemented
as Section 162(m) of the Internal Revenue Code, that capped the corporate tax
deductibility of top management compensation at $1 million per executive unless it
qualified as substantially performance-based. Rose and Wolfram (2000) conducted
research on CEO compensation at 1,400 publicly-traded U.S. corporations during the
1990s for the National Bureau of Economic Research and found that little evidence exists
to suggest that the deductibility limit has had significant effects on either overall
executive compensation levels or increased performance sensitivity of CEO pay.
Given the numerous exceptions to the cap on performance-based compensation, it
is not surprising that executive pay levels are far in excess of the $1 million limit. For
example, the limit applies only to the five named executive officers of the company as of
the end of the fiscal year. This creates the possibility of using post-retirement or deferred
compensation to mitigate the effect of the tax limits. Also, the exemption under Section
162(m) for qualified performance-based compensation means that companies may
continue to claim tax deductions in excess of $1 million for compensation under
shareholder-approved plans that link pay to objective measures of firm performance and
are administered by a committee of outside directors on the Board. Three-quarters of
all the companies studied by Rose and Wolfram (2000) qualified some type of
compensation for this exemption, and roughly 40 percent of the companies affected by
the pay cap qualified both bonus and stock option plans for exemption. Salary payments

are considered non-performance based by definition, and are therefore entirely subject to
the $1 million limit.
Increasing Shareholder Democracy
In response to concerns about the size of executive pay packages, institutional and
other influential shareholders have become more active in seeking a stronger role in the
director nominating process. New rules adopted at MCI (formerly known as WorldCom)
require the board to solicit director nominations from holders representing at least 15
percent of its shares. Marsh & McLennan Cos. agreed in March 2004 to nominate a
director recruited by institutional investors after months of negotiations (Solomon and
Lublin 2004).
The government joined the effort when on May 1, 2003, the SEC (Series Release
No. 34-47778) solicited public response on the adequacy of the proxy process with
respect to the nomination and election of directors. On July 15, 2003, the Commission
published on its website (www.sec.gov) a summary of the comments most of which
criticize the current process for the nomination and election of directors. Two particular
areas of concern are the nomination of candidates for election as directors and the ability
of security holders to communicate effectively with board members.
In response to these concerns, on October 14, 2003, the SEC proposed rule
amendments that would, under certain circumstances described below, permit
shareholders representing at least 5% of voting shares to put their own board nominees
alongside managements choices on a companys official ballot (Series Release No. 3448626). The proposed rules stop short of giving security holders the right to nominate
directors. Instead, the proposed requirements would apply only to those companies at

which one of two triggering events has occurred and would remain in effect for two years
after the occurrence of either or both events. These events include: (1) the withholding of
support for one or more directors from more than 35 percent of the votes cast; or (2) a
request by a security holder or group of security holders owning more than 1% of the
companys voting securities for one year, supported by more than 50 percent of the votes
cast, that the company become subject to the alternative nomination procedure.
Duty of Care and the Business Judgment Rule
An officer or director has a duty to the corporation to perform her functions in
good faith, in a manner that reasonably represents the best interests of the corporation,
and with the care and skill that an ordinarily prudent person would use under similar
circumstances. An officer or director is entitled to rely on information, opinion, reports
and financial statements prepared by management provided there is a reasonable belief
that the data is reliable and competent. If the officer or director has knowledge
concerning the matter that would render reliance unwarranted, a good faith presumption
does not exist absent further inquiry and investigation.
Where officers and directors are called upon to exercise their judgment or
discretion in making decisions, the business judgment rule comes into play. It requires
that such decisions be reasonably informed and rational, in the sense that a prudent
person would agree with the choice made, even though reasonable persons might differ
on the wisdom of the decision. On the other hand, the officers and directors are not
deemed guarantors of their business judgment, and the courts generally do not hold them
liable if a good-faith decision turns out to be unwise or unprofitable.

Typically, judges do not like to substitute their judgment for that of top corporate
officials. Drexler, Black and Sparks (1991) point out in Delaware Corporate Law &
Practice (DCLP) that the business judgment rule in Delaware stands for nothing more
than the proposition that if officers and directors perform their management functions
properly they will not be held liable for losses caused by their decisions or failures to act,
nor will the courts otherwise interfere with their activities. Conversely, the rule provides
no shield against inadequate performance.
Duty of Loyalty and Fair Dealing
An officer or director is required to act as a trustee on behalf of the corporation
and its shareholders (Gottlieb v. Mckee 1954). This standard is generally met by
managing the corporation with unselfish loyalty and the utmost concern for the
corporation and its shareholders. An officer or director should not use her position to
make a personal profit or to gain an unfair advantage. Examples of situations that would
violate the fiduciary responsibilities of an officer or director include fraud, self-dealing,
misappropriation of corporate opportunities, improper diversions of corporate assets, and
similar matters involving potential conflicts between an officers or directors interest and
the corporations welfare.
Court Rulings on Officer and Board Responsibilities
Officers and directors are concerned about shareholder derivative litigation
because of the potential for personal liability. However, the corporation can indemnify
officers and directors by reimbursing them for losses and attorneys fees arising from
litigation in connection with their corporate duties. Delaware indemnification of
judgments or settlements from derivative suits alleging breach of duty of loyalty are

prohibited to avoid situations where plaintiffs could have their funds awarded (and paid
to the corporation by directors) paid back to the directors if the corporation provided
indemnification. The remaining option would then be to use any director-officer
insurance policies that had been purchased to provide financial protection.
Two recent decisions by the Chancery Court illustrate how it decides between the
applicability of the business judgment rule in the context of the effectiveness of the
corporate governance system.
In re the Walt Disney Company
The Chancery Court in May 2003 issued its decision which allowed a suit brought
by shareholders to proceed against directors of Disney regarding the approval of the $140
million compensation and severance package paid to former CEO, Michael Orvitz,
pursuant to that agreement. The shareholders allege that the directors failed to review
Orvitzs final employment contract that contained differences from a prior draft that was
reviewed. These differences included a non-fault termination clause that paid Orvitz
more than $38 million in cash and three million stock options. A key provision was
changed from the draft that linked the payment to Orvitz if Disney wrongfully terminated
him or he died or became disabled. The final version of the agreement, however, offered
Orvitz a non-fault termination as long as he did not act with gross negligence or
malfeasance.
The directors asserted the business judgment rule as a defense to the allegations.
However, the court denied the defendants motion to dismiss the suit stating that ample
evidence exists to go forward because the facts as alleged raise sufficient doubt that the
actions of the board were taken in good faith. The court also ruled that where a

director consciously ignores his or her duties to the corporation, thereby causing injury to
its stockholders, the directors actions are either not in good faith or involve intentional
misconduct.
In re Hollinger International Inc.
On February 26, 2004, the Delaware Chancery Court blocked Conrad Blacks
deal to sell his controlling interest in the newspaper company Hollinger International to
the Barclay brothers of Britain, ruling that the independent directors should be allowed to
try and sell the companys assets, which include The Daily Telegraph in London, The
Jerusalem Post and the Chicago Sun-Times.
The ruling by Vice Chancellor Leo E. Strine Jr. criticized Lord Blacks deal with
the Barclays conducted without knowledge of Hollingers board or its investment
bankers as cunning and calculated. Judge Strine wrote that Black who holds about
30 percent of the shares in the company but controls about 73 percent of the votes
repeatedly behaved in a manner inconsistent with the duty of loyalty he owed the
company.
The ruling represents a clear statement by the court for the importance of strong
independent directors even when there is a controlling shareholder. It is a victory for the
minority shareholders.
III.

STAKEHOLDER THEORY

The shareholder model of corporate governance relies on the assumption that


shareholders are morally and legally entitled to direct the corporation since their
ownership investment is an extension of their natural right to own private property. Berle
and Means (1932) point out that the notion the shareholders govern the corporation is

largely a fiction: Typically, executives have the greatest power. Etzioni (1998)
questions whether executives can and should be made more accountable and responsive
to some groups other than themselves, and which groups this should include.
Freemans (1984) seminal book on stakeholder theory posits that successful
managers must systematically attend to the interests of various stakeholder groups. This
enlightened self-interest position has been expanded upon by others (Donaldson and
Preston 1995 and Evan and Freeman 1983) who believe that the interests of stakeholders
have intrinsic worth irrespective of whether these advance the interests of shareholders.
Under this perspective, the success of a corporation is not merely an end in itself but
should also be seen as providing a vehicle for advancing the interests of stakeholders
other than shareholders.
Etzioni (682) supports the stakeholder view. He accepts the moral legitimacy of
the claim that shareholders have certain rights and entitlements because of their
investment, but he maintains that the same basic claim should be extended to all those
who invest in the corporation. This includes: employees (especially those who worked
for a corporation for many years and loyally); the community (to the extent special
investments are made that specifically benefit that corporation); creditors (especially
large, long-term ones); and, under some conditions, clients.
A prominent critic of stakeholder theory is Goodpaster (1991) who argues that a
multi-fiduciary stakeholder approach fails to recognize that the relationship between
management and stockholders is ethically different in kind from the relationship between
management and other parties (like employees, suppliers, customers, etc.) Goodpaster

contends that managers have many nonfiduciary duties to various stakeholders but their
fiduciary duties are only to shareholders.
Boatright (1994) suggests that the shareholder-management relation is not
ethically different and there is no reason in principle to adopt the distinction between
fiduciary and nonfiduciary duties and the distinction between shareholders and other
constituencies. He states that:
Many of the fiduciary duties of officers and directors are owed not to
shareholders but to the corporation as an entity with interests of its own,
which can, on occasion, conflict with those of shareholders. Further,
corporations have some fiduciary duties to other constituencies, such as
creditors (to remain solvent so as to repay debts) and to employees (in
the management of a pension fund) (403).
Goodpaster and Holloran (1994) dispute Boatrights contention that the
shareholder-management relation is not ethically different than the relations with other
stakeholders. Goodpaster and Holloran (425) point out that shareholder rights constrain
board actions and are central to the relationship of shareholder and board. These rights
include: the right to elect; the right of financial information; the right to put propositions
before shareholder meetings; and the right to management conduct that will not bias a
securities market. As is evident by the Delaware Chancery Court decisions cited earlier,
shareholders have retained the opportunity to bring offending directors (and officers) to
justice through the courts.
Orts and Strudler (2002) support Clarksons (1995) narrow conception of
stakeholder theory that claims some property or other asset must be at risk in a business

firm to be considered a valid stakeholder. Narrow stakeholder theory avoids the problem
of the broader view that identifies anyone as a stakeholder who can affect or is affected
by the achievement of the organizations objectives (Freemen 1984).
According to Orts and Strudler (220), narrow stakeholder theory is consistent
with a theory of the firm that includes direct participants in a business for example,
employees and creditors as well as shareholders and other equity owners of an
enterprise. Under this perspective, stakeholders would not include groups just because
their economic interests are affected by the corporation (government and members of the
community).
The narrow theory emphasizes that insiders have meaningful claims for purposes
of stakeholder analysis. This perspective will be used is Section V to develop
recommendations to improve employee governance. While creditor claims also are valid,
the creditors have protections such as contractual rights to receive principal and interest
payments and the use of debt covenants to protect their interests. Moreover, creditors
have access to bankruptcy law to force action by the corporation. On the other hand,
employees have to rely on others such as trustees that administer their 401(k) plans.
Corporate Constituency Statutes
In whose interests should corporations be governed? The traditional view in
American corporate law has been that the fiduciary duties of corporate directors run to
the shareholders of the corporation. The debate that began shortly after Berle and Means
(1932) wrote The Modern Corporation and Private Property flared up again in the 1980s
as states began to pass corporate constituency statutes. These statutes allow corporate
officers and directors to take into account the interests of a variety of corporate

stakeholders in carrying out their fiduciary duties to the corporation. The statutes suggest
that a corporation may be run in the interests of groups other than shareholders.
McDonnell (2002) points out that while the statutes seem to have appeal to
advocates of employee involvement in corporate governance, they were passed in
response to the takeover wave of the eighties, and critics charge their main effect is to
entrench incumbent managers. McDonnell believes (2) they are a poor substitute for
direct employee involvement in corporate governance because constituent groups cant
sue under the statutes.
Employee Participation in Decision Making
The contractarian point of view, which has found its way into corporate law
scholarship through the infusion of economic thought, challenges the long-standing belief
that shareholders have a right to expect that their property will be managed in their
interest. The contractarian view portrays the corporation as a nexus of contracts between
various parties which interact through the corporation, potentially including employees,
customers, suppliers, creditors, local communities, and the state and national economies.
According to this perspective, the corporation is merely a convenient legal fiction which
may help structure these interactions.
Greenfield (1998) recognizes that employees have a stake in the long-term
success of the corporation. In that regard the shareholders are not the only residual
claimants. Employees possess skills and knowledge which are specific to their
particular corporation and may be of limited value if they were to become employed
elsewhere. Moreover, employees care about a wide range of decisions within
corporations.

According to some proponents of the contractarian view (Carney 1993; Narveson


1992), workers should be able to bargain for participation rights in corporate decisionmaking in the same way that they bargain for health benefits or paid vacation days. Thus,
according to the argument, the competitive marketplace itself guarantees fair treatment
and autonomy for workers. The fact that workers do not possess participation rights
shows not that their autonomy is jeopardized but only that they are not sufficiently
interested in co-determination to be willing to pay for the privilege.
McCall (2001) examines the relative impact of participation and property rights
on the shared foundational value of fairness. If workers are given strong participation
rights, it might be presumed that workers would gain greater guarantees that their
interests will be considered fairly. Even though owners might suffer some loss of profits
returned as dividends if workers were better able to protect their interests (e.g., better
environmental controls), the exercise of co-determination rights provides a fairer
distribution of accumulated profits than would be the case under traditional arrangements
where management alone determines the distribution.
Employee Rights to Participate
On September 30, 2003, the U.S. District Court in Houston issued the first
substantive decision in the Enron ERISA litigation (Tittle v Enron Corp.). The class
action lawsuit includes all 20,000 former Enron workers who were participants in or
beneficiaries of Enron Corporation Savings Plan, (401(k) Plan) from January 20, 1998,
through December 2, 2001, and who made or maintained investments in Enron stock. It
also includes participants of the Enron Stock Ownership Plan or Cash Balance Plan.

Enron employees sued the trustee, the administrative committee, various


corporate officers, and the outside directors of Enron, alleging that they had breached
their fiduciary duties under ERISA by failing to disclose the companys true financial
condition and by continuing to invest plan assets in Enron stock. The court decision
allows most of the fiduciary claims to proceed.
When employees own corporate stock through their retirement plan or a separate
employee stock ownership plan (ESOP), their right to participate in decision-making
takes on a new dimension. Indeed, employees have an ethical right to participate based
on their years of service and retirement investments, both of which are at risk. Under
these circumstances, the employees should not have to bargain for participation rights.
They should be granted those rights based on their ownership interest.
Employees do not have a legal right to participate in the oversight of retirement
plans. Instead, they rely on plan trustees to meet their fiduciary obligations under
ERISA. Employees also expect that plan administrators and corporate officials will
provide all the information they have a right to expect as owners of corporate stock.
Employee Governance
McDonnell (2000) supports employee governance as a way to ensure that
corporations are governed in part in the interests of employees. He identifies three
approaches: employee share ownership; electing employee representatives to the board of
directors; and employee involvement in quality circles, work councils, or the like.
OConnor (1993) points out that employee governance may be an effective commitment
device to induce employees to devote the time to learn information and procedures
specific to the company.

McDonnell (2000, 13-14) identifies a variety of advantages of employee


governance, most of which relate to the knowledge they gain in the workplace. For
example, employees learn through their efforts how to improve processes and how
effective managers are in meeting their objectives. As a result, employee involvement in
corporate governance can work as a potentially powerful additional mechanism to control
managerial opportunism and to direct the corporation towards greater efficiency.
Boatright (2004, 16) addresses whether employee governance conflicts with
shareholder governance and concludes these two forms of governance are not conflicting.
Instead, they are complementary and mutually beneficial. The strength of shared
governance is that the two groups make decisions on matters where they have superior
information and an incentive to increase the value of the firm. He also believes that
their respective forms of governance support the needs of each group to protect their
firm-specific assets and to satisfy their risk preferences.
IV.

GOVERNANCE IN THE U.S., UK AND GERMANY

U.S. -- Sarbanes-Oxley Act of 2002


The Sarbanes-Oxley Act was adopted by Congress and signed into law by
President Bush in August 2002, as a response to the accounting scandals at Enron and
WorldCom. The following discussion emphasizes the major provisions of the Act that
affect public companies. These can be divided into three groups based on whether they
affect the responsibilities of top corporate officials or board members, the audit
committee, or the preparation of financial reports.
Top Corporate Officials and Board Members
1.

The CEO and CFO must certify in a statement that accompanies the audit report

the appropriateness of the financial statements and disclosures and that they fairly
present, in all material respects, the operations and financial condition of the
company. A violation of this provision must be knowing and intentional to give
rise to liability.
2. Management should make an assessment of internal controls and disclosed its
findings in an internal control report that the auditors will review.
3. It is unlawful for any officer or director of a public company to take any action to
fraudulently influence, coerce, manipulate, or mislead any auditor engaged in the
performance of an audit for the purpose of rendering the financial statements
materially misleading.
4. If a company is required to prepare a restatement due to material
noncompliance with financial reporting requirements, the CEO and CFO must
reimburse the company for any bonus or other incentive-based or equity-based
compensation received during the 12 months following the issuance of the noncompliant document and any profits realized from the sale of securities of the
company during that period.
5. Officers and directors are prohibited from buying or selling company stock during
blackout periods when employee sales and purchases are restricted. Any profits
resulting from such sales can be recovered from the offending party by the
company. If the company fails to bring a lawsuit or prosecute diligently, a lawsuit
to recover the profit may be instituted by an owner of company securities.
[It is worth noting that Enron employees were locked-out during a ten day period
when the stock price was declining about $10 per share.]

6. Generally, it is unlawful for a public company to extend credit to any director or


executive officer. [The CEOs at WorldCom, Tyco and Adelphia abused their
authority in granting themselves hundreds of millions of dollars of loans without
the approval of the board of directors.]
Audit Committee
1. Each member of the audit committee of the board must be independent of the
public company defined as: Not receiving, other than for service on the board,
any consulting, advisory, or other compensatory fee from the issuer, and as not
being an affiliated person of the issuer or any of its subsidiaries.
2. The audit committee is required to be directly responsible for the appointment,
compensation and oversight of the auditors including resolution of disagreements
between management and the auditors regarding financial reporting, and the
auditors must report such disagreements directly to the audit committee.
3. The audit committee should establish procedures for the receipt, retention and
treatment of complaints received by the company regarding accounting, internal
accounting controls, or auditing matters and any confidential, anonymous
submission by employees of the company of concerns regarding questionable
accounting or auditing matters.
4. The board must notify the SEC of pending investigations involving potential
violations of the securities laws, and coordinate its investigation with the SEC
Division of Enforcement.
Financial Reporting
1. Each report that is required to be prepared in accordance with GAAP must

reflect all material correcting adjustments that have been identified by the
auditors.
2. Each annual and quarterly financial report must disclose all material off-balance
sheet transactions and other relationships with unconsolidated entities that may
have a material current or future effect on the financial condition of the issuer.
[By some accounts Enron created more than 3,000 special purpose entities that
were kept off the books of the company to hide debt and inflate profits.]
While it may be too early to know if the Act will positively influence corporate
governance in the U.S., a survey of 310 senior executives around the world conducted by
the Economist Intelligence Unit and sponsored by KPMG (2003) indicates strong support
for recent U.S. efforts to improve corporate governance.
Germany

U.K.

U.S.

7%

16%

71%

7%

6%

23%

1. Which of the following countries


has done most to improve standards
of corporate governance over
the past year?
2. Which of the following countries
has the farthest to go in improving
standards of corporate
governance?

These results seem to suggest that the Germans and British are farther along than
Americans in developing effective corporate governance mechanisms.

United Kingdom
The collapse of BCCI in the late 1980s, that caused a financial panic spanning
four continents and engulfing the Bank of England, was the impetus for the 1992 Report
of the Committee on the Financial Aspects of Corporate Governance (Cadbury
Committee). The Committee investigated accountability of the Board of Directors to
shareholders and society. The report and associated Code of Best Practices made
recommendations to improve financial reporting, accountability, and board of director
oversight.
The Cadbury Committee recommendations for disclosure of directors
emoluments led to the Greenbury Report in 1995 that established extensive disclosures
on directors remuneration to be found in the annual reports of UK companies. The
Hempel Report in 1998 confirmed much of the work of Cadbury and Greenbury and it
led to The Combined Code on Corporate Governance (Code) (2003). Compliance with
this Code is a Stock Exchange requirement.
The Code requires that the annual report of a major UK company should contain a
report from the Remuneration Committee, a statement on Corporate Governance, a
statement on internal controls, a statement on the going concern status of the company,
and a statement of the directors responsibilities. The following is a list of requirements
that differ from those in effect enacted in the U.S.
1.

The chair of the board should meet with non-executive directors without the
executives present.

2. Led by the senior independent director, the non-executive directors should meet
without the chair present at least annually to appraise her performance and on

such other occasions as are deemed appropriate.


3. The roles of the chair and CEO should be separated. The division of
responsibilities should be clearly established, set out in writing, and agreed by the
board.
4. At least half of the board, excluding the chair, should comprise non-executive
directors determined by the board to be independent.
5. The board should appoint one of the independent non-executive directors to be the
senior independent director. The senior independent director should be available
to shareholders if they have concerns that have not been alleviated by top
company officials.
6. Shareholders should be invited specifically to approve all new long-term incentive
arrangements and significant changes to existing schemes unless prohibited by the
Listing Rules.
7. The Listing Rules require a statement to be included in the annual report relating
to compliance with the Code. Some of the important provisions follow.
a. An explanation from the directors of their responsibility for preparing the
accounts and a statement by them about their reporting responsibilities;
b. A statement from the directors that the business is a going concern, with
supporting assumptions or qualifications as necessary;
c. A report that the board has conducted a review of the effectiveness of the
groups system of internal controls;
d. A separate section describing the work of the audit committee in
discharging its responsibilities;

e. Where the board does not accept the audit committees recommendation
on the appointment, reappointment or removal of an external auditor, a
statement of the audit committee explaining the recommendation and the
reasons why the board has taken a different position; and
Of particular note is the requirement that UK directors have responsibilities that,
in the U.S., are the sole purview of management including the preparation of financial
statements and review of internal controls. Also, the Listing Rules require a Corporate
Governance Report to be included in the annual report and there must be a Statement of
Compliance whether the company meets the provisions of the Combined Code on
Corporate Governance.
Germany
According to Schmidt (2003), German corporate governance is shaped by a legal
tradition that dates back to the 1920s and regards corporations as entities which act not
only in the interests of their shareholders, but also serve other stakeholder interests. The
German conception of corporate governance reflects the legal rights and arrangements
that underlie how decision-making rights are distributed in a company. This broader
view encompasses the product markets, the markets for capital and labor, and any
informal organizational arrangements which may exist and function alongside the formal
structures. The German system of corporate governance builds on insider relationships
while the U.S. system relies on external participation.
Codetermination
Germany has a strong employee codetermination program. Work councils have

extensive participation rights, and employees are also represented in the corporate
boardroom. These two features contrast with the market or shareholder-oriented
approach to corporate governance in the U.S. (Jackson et. al., 2004).
The distinguishing characteristic of German corporate governance is the two-tier
board of directors system. The two-tier system of governance creates different rights and
obligations for members of each board that are set out in the German Stock Corporation
Act and the German Corporate Governance Code.
The management board is charged with managing the enterprise for the benefit of
a wide array of interests. The supervisory board, whose members are elected by the
shareholders at the annual meeting, does not have the formal right to give specific
instructions to members of the management board, but management is required to report
to the supervisory board at regular intervals. Since two of the major functions of the
supervisory board are to appoint and dismiss the members of the management board and
to determine management remuneration, it is safe to conclude that in its decisions the
management board will tend to give due consideration to the positions of the supervisory
board (Schmidt, 9).
Schmidt (9-11) identifies three groups of powerful and influential stakeholders on
the supervisory board. The first are shareholders that own large blocks of stock (25
percent or greater) that give it the power to veto important decisions. The most likely
blockholder is another business enterprise. The second group of blockholders is
wealthy families, often those of the companys founder. The third are financial
institutions, especially the big commercial banks (Deutsche Bank, Dresdner Bank,

Commerzbank and Hypo-Verinsbank). Typically, employee representatives make up


half of the representatives of the supervisory board.
A potential problem in the German system of corporate governance is the dual
obligation of members of the supervisory board. On the one hand they are obliged to act
in the best interests of the company while on the other they have a certain amount of
leeway to further the interests of their specific constituencies. This mixture of shared and
divergent or even conflicting interestsraises the question of how the supervisory board
can influence and monitor the management board at all (Schmidt, 11).
Another concern is the impact of industrial relations on shareholder value. Since
the 1990s, the German experience has been one of diffusion of shareholder value without
undermining the core institutions of German industrial relations, namely codetermination
and collective bargaining. Likewise, strong labor has not prevented the emergence of
shareholder value in Germany.
While one might expect Germanys emphasis on employee rights in corporate
governance to increase agency costs, Jackson et. al. (41) argue this might not be the case
because work councils may work in coalition to promote greater accountability and
thereby actually decrease agency costs by monitoring managerial pay, fighting for
transparency,and also siding with shareholders in corporate restructuring.
Accounting, Financial Reporting, and Auditing
The German Stock Corporation Act and the German Commercial Code establish
the regulations for the preparation of financial statements. The Act also details audit
requirements. Table 1 compares these provisions and demonstrates how the operational
functions of the management board in Germany are carried out primarily by management

executives in the U.S. The functions of the supervisory board are similar to audit
committee responsibilities in the U.S.
Place Table 1 Here
A comparison of requirements in Germany and the U.S. indicates significant
differences exist in two areas. First, the Germans rely on a consensus approach to
decision making primarily through the efforts of the supervisory board. Second,
employee participation informs decision making through representation on the
supervisory board and the influence of works councils on management board functions.
SUMMARY AND RECOMMENDATIONS
The Sarbanes-Oxley Act began the process of evaluating corporate governance
mechanisms in the U.S. New requirements imposed on public companies include:
increasing the number of independent members on the board; strengthening the oversight
of financial reporting by the audit committee; requiring the CEO and CFO to certify the
financial statements and internal controls; developing effective communication links
between the external auditor and the audit committee; and restricting the ability of
corporate officials to approve self-serving actions that might be detrimental to the best
interest of investors and the public good. This section of the paper outlines additional
steps that are needed to further the goal of improving corporate governance systems
including:
(1) Ensure compliance with the best practices of corporate governance;
(2) Enhance shareholder democracy;
(3) Better protect the investment and retirement rights of employees; and
(4) Foster employee participation in a more representative and effective

governance process.
Compliance with Best Practices
The compliance report required by the Listing Rules in the UK ensures that
constituency groups are informed how the principles of the Combined Code on Corporate
Governance have been applied. The following provisions of the Sarbanes-Oxley Act
should be addressed in a compliance report that would be included in the annual filing of
financial statements with the SEC.
1. Certification of the financial statements. This would be an informational item
reminding the public of the responsibilities of top management for the accuracy
and reliability of the financial statements.
2. Managements report on internal controls. This also is an informational item
since the report appears elsewhere in the annual filing.
3. Audit committee responsibilities. A description of these responsibilities should
include the independence of committee members, its oversight of the financial
reporting process, and any important communications with the external auditors
that reflect managements receptivity to recommended changes in the accounting
principles and financial reporting practices.
4. Management Remuneration. The following issues should be addressed in the
compliance report or in a separate report made by the compensation committee.
a. Whether there have been any loans to top executives during the year;
b. Any other form of compensation or business relationship with top
executives that might qualify as a related party transaction; and

c. A description of the compensation paid to the five named executive


officers under section 162(m) of the Internal Revenue Code. This should
include an analysis of compensation that qualifies as substantially
performance-based.
Shareholder Democracy
Previously cited research indicates that certain steps can be taken to limit CEO
compensation packages and control agency costs. The following recommendations
should help to achieve those goals by strengthening governance systems.
1. Separate out the dual roles of chair of the board and CEO. This feature that has
been adopted in the UK seems to be gaining support in the U.S. as the Disney
experience illustrates.
2. Recognize the right of stockholders to nominate directors. The SEC proposal
makes it easier for shareholders who are dissatisfied to nominate their own
candidates but it does not recognize it as a basic right a right that should exist by
virtue of the shareholders ownership interest in the corporation.
3. Give shareholders a more direct role in board oversight. Shareholder
representatives should be given the right to become actively involved in
overseeing how the company is run by being allocated a number of seats on the
supervisory board that would appoint the executive board as explained below.
Protecting the Rights of Employees
A new board-level committee should be formed to protect retirement rights of the
employees. The Employee Development and Retirement committee would have the
following responsibilities:

1. Train employees to serve on the supervisory board. Since the designated


representatives may not be familiar with board processes and oversight
responsibilities, an on-going training and development program might help to
facilitate effective participation. Laws that regulate corporate activities can
change over time and the committee should educate representatives to their
changing responsibilities.
2. Oversee the performance of retirement plans. The committee should monitor the
performance of investment managers or other fiduciaries in charge of corporate
pension plans and 401(k) retirement plans. This would include developing an
investment policy statement that provides a clear road map of how investment
decisions are made and monitoring investment performance.
3. Monitor compliance with regulations. The committee should oversee compliance
with ERISA laws and any other regulations that might affect retirement plans
such as the blackout period restrictions under Sarbanes-Oxley.
Employee Participation in Corporate Governance
A two-tier board system should be established, such as the one in Germany, to
facilitate employee participation in decision-making, help to manage the information
flow, and improve board efficiency.
Supervisory Board
The supervisory board should include an equal number of shareholder and
employee representatives. A minority of the total membership should be divided equally
between insiders and outsiders. The primary responsibilities of the board should be to:
1. Appoint and dismiss members of the management board;

2. Determine management remuneration;


3. Review and approve the compliance report;
4. Review and approve accounting principles and the financial statements;
5. Work with the external auditors on matters relating to the financial reports; and
6. Establish committees as needed to carry out these and other responsibilities
including the nominating committee, remuneration committee, audit committee,
and employee development and retirement committee.
Management Board
Representation on the management board should consist of members of top
management, including the CEO, CFO, and chief operating officer. Other members
should be independent of management. An independent member of the board should
serve as its chair. The primary responsibilities of the management board would include:
1. Prepare the financial statements and management report;
2. Monitor the internal control system including risk assessment;
3. Report to the supervisory board on operational strategies and major questions
about corporate planning, financial and investment activities, and human resource
issues;
4. Report to the supervisory board the profitability of the business particularly the
return on equity;
5. Report to the supervisory board on business development.
Shareholders are concerned about good corporate governance because of its
connection to their expected returns. Employees consider employee governance to be an
essential component of security and retirement planning. Managements goal should be

to develop the systems that enhance employee participation and contribute toward
improving long-term share value.
A dual board approach to corporate governance adds needed checks and balances
to help ensure the integrity of the process and monitor whether the corporation pursues its
strategic objectives in an ethical manner. A corporate governance system based on these
principles would build on the positive changes already made since Sarbanes-Oxley, and it
better represents the interests of those who provide the capital and labor inputs so
essential to success.

Table 1
A Comparison of Responsibilities for Financial Reporting Oversight
Financial Reporting Item

Responsible Board

Germany*
U.S.
_______________________________________________________________________
Prepare financial statements
Management Board
Management
Assess propriety and
appropriateness of
accounts

Supervisory Board

Audit Committee

Prepare management report

Management Board

Management

Legal requirement to approve


financial statements

Supervisory Board

Audit Committee

Review and approval of quarterly


financial reports

Supervisory Board

Audit Committee

Internal control system

Management Board

Management

Risk early recognition system


(going concern evaluation)

Management Board

External auditors

Appointment of auditors

Supervisory Board

Audit Committee

Role of the external audit

Support Supervisory Board


and
Perform a control function
In the public interest

Protect public interest

*The source for the financial reporting and other requirements in Germany is the Institut
der Wirtschaftsprufers (German equivalent of the AICPA) issues paper Financial
Reporting, Auditing and Corporate Governance (2003).
________________________________________________________________________

REFERENCES
Bebchuk, L.A. and J. M. Fried. 2003. Executive compensation as an agency problem.
Journal of Economic Perspectives 17 (3): 71-92.
Berle, A. A., Jr. and G. C. Means. 1932. The Modern Corporation and Private Property.
New York, NY: MacMillan.
Bertrand, M. and S. Mullainathan. 2001. Are CEOs rewarded for luck? The Ones
without principles are. Quarterly Journal of Economics. 16 (3): 901-932.
Blanchard, O. J., F. Lopze-de-Silanes, and A. Shleifer. 1994. What do firms do with cash
windfalls? Journal of Financial Economics. 36 (3): 337-360.
Boatright, J. R. 1994. Fiduciary duties and the shareholder-management relation: Or,
whats so special about shareholders? Business Ethics Quarterly 4 (4): 393-407.
Boatright, J. R. 2004. Employee governance and the ownership of the firm. Business
Ethics Quarterly 14 (1): 1-21.
Brealey, R. and S. C. Myers. 1989. Principles of Corporate Finance. New York, NY:
McGraw-Hill.
Brickley, J. C. W. Smith, Jr., and H. L. Zimmerman. 2001. Managerial Economics and
Organizational Architecture, New York, NY: McGraw-Hill.
Clarkson, M. B. E. 1995. A stakeholder framework for analyzing and evaluating
corporate social performance. Academy Management Review 20: 90-107.
Core, J. E., R. W. Holthausen, and D. E. Larcker 1999. Corporate governance, chief
executive compensation, and firm performance. Journal of Financial Economics
51 (3): 371-406.
Cyert, R., S. H. Kang, and P. Kumar. Corporate governance, takeovers, and topmanagement compensation: Theory and evidence. Management Science. 48:4:
453-469.
Dalton, D. R. and C. M. Daily. 2001. Director stock compensation: An invitation to a
conspicuous conflict of interests? Business Ethics Quarterly 11 (1): 89-108.
Donaldson, T. and L. E. Preston. 1995. The stakeholder theory of the corporation:
Concepts, evidence, and implications. Academy of Management Review 20 (1):
65-91.
Drexler, Black & Sparks. 1991. Delaware Corporation Law & Practice. New York,
NY: Matthew Bender.

Economist Intelligence Unit. 2003. Corporate governance: Business under Scrutiny. A


white paper. The Economist.
Etzioni, A. 1998. A communitarian note on stakeholder theory. Business Ethics
Quarterly 8 (4): 679-691.
Evan, W. M. and R. E. Freeman. A stakeholder theory of the modern corporation:
Kantian Capitalism. In T. L. Beauchamp and N. E. Bowie. Ethical Theory and
Business. Englewood Cliffs, NJ: Prentice Hall, 1993.
Fama, E. 1980. Agency problems and the theory of the firm. Journal of Political
Economy. 88: 975-990.
Financial Services Authority. 2003. The Combined Code on Corporate Governance.
London, England.
Freeman, R. E. 1984. Strategic Management. Boston, MA: Pitman.
German Government Commission. The Combined Code on Corporate Governance.
2003. German Justice Ministry.
Goodpaster, K. E. 1991. Business ethics and stakeholder analysis. Business Ethics
Quarterly 3 (1): 62-75.
Goodpaster, K. E. and T. E. Holloran. 1994. In defense of a paradox. Business Ethics
Quarterly 4 (4): 423-429.
Hart, O. 1995. Firms, Contracts, and Financial Structure. Cambridge, England: Oxford
University Press.
Hartzell, J. C. and L. T. Starks. 2002. Institutional investors and executive compensation.
A working paper.
Hawley, J.P., J. E. Core and D. F. Larcker. 1999. Corporate governance, chief executive
officer compensation, and firm performance. Journal of Financial Economics 51
(3): 321-354.
Hill, C. W. L. and T. M. Jones. 1992. Stakeholder-agency theory. Journal of
Management Studies 29: 131-154.
Hollinger International Statement on Delaware Court Order. March 4, 2004
(www.hollingerinternational.com).
In re The Walt Disney Company Derivative Litigation. 825 A.2d 275, 2003 WL
21267266 (Del. Ch.).

Institut der Wirtschaftsprufer, 2003. Financial Reporting, Auditing and Corporate


Governance. Dusseldorf, Germany.
Jackson, G., M. Hopner, and A. Kurdlebusch. 2004. Corporate governance and
employees in Germany: Changing linkages, complementarities, and tensions.
Discussion paper. RIETI.
Jensen, Michael C. and W. H. Meckling. 1976. Theory of the firm: Managerial behavior,
agency costs and ownership structure. Journal of Financial Economics 3: 305360.
Marens, R. and A. Wicks. 1999. Getting real: Stakeholder theory, managerial practice,
and the general irrelevance of fiduciary duties owed to shareholder. Business
Ethics Quarterly 9 (2): 273-293.
McDonnell, B. H. 2002. Public law and legal theory research. Research Paper No. 02-13.
Paper series. University of Minnesota Law School.
Mitchell, R. K., B. R. Agle, and D. J. Wood. 1997. Toward a theory of stakeholder
identification and salience: Defining the principle of who and what really counts.
Academy of Management Review 22 (4): 853-886.
McCall, J. J. 2001. Employee voice in corporate governance: A defense of strong
participation rights. Business Ethics Quarterly 11 (1): 195-213.
Narveson, J. Democracy and economic rights. In Paul, E. F. Economic Rights
Cambridge, MA: Cambridge University Press, 1992.
OConnor, M. A. 1991. Restructuring the corporations nexus of contracts: Recognizing a
fiduciary duty. North Carolina Law Review. 60.
Orts, E. W. 1998 . Shirking and sharking: A legal theory of the firm. Yale Law and
Policy Review 16: 252-275, 1999.
Ort, E. W. and A. Strudler. The ethical and environmental limits of stakeholder theory.
Business Ethics Quarterly 12 (2): 215-233.
Phillips, R. A. 1997. Stakeholder theory: A principle of fairness. Business Ethics
Quarterly 7 (1): 51-66.
Ross, S. A., R. W. Westerfield, and J. Jaffe. 2002. Corporate Finance. New York, NY:
McGraw-Hill.
Rowley, T. 1997. Moving beyond dyadic ties: A network theory of stakeholder
influences. Academy of Management Review 22 (4): 889-910.

Schmidt, R.H. 2003. Corporate governance in Germany: An economic perspective. A


working paper. Center for Financial Studies an der Johann Wolfgang GoetheUniversitat (www.ifk-cfs.de).
Securities and Exchange Commission (SEC). 2003. Security Holder Director
Nominations. 17 CFR Parts 240, 249 and 274, File No. S7-19-03. Washington,
D.C., Government Printing Office.
__________. 2003. Roundtable Discussion on the Proposed Security Holder Director
Nominations Rules. Series Release No. 34-47778. Washington, D.C.
Government Printing Office.
Shleifer, A. R. W. Vishny. 1997. A survey of corporate governance. Journal of
Finance. 52: 737-782.
Solomon, D. and J. S. Lublin. 2004. Democracy looks for an opening in the boardroom.
Wall Street Journal. (March 22): A1.
The American Law Institute (ALI). 1994. Principles of Corporate Governance:
Analysis and Recommendations. St. Paul, MN: ALI Publishers.
The Encyclopedia about Corporate Governance. What is corporate governance.
(www.encycogov.com).
Tittle v. Enron Corp. 22245394, 2003 WL (U.S. District Court, S.D. TX.)