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Corporate Governance: Foundational Issues



Chapter 4 Outcomes
1. Link the issue of legitimacy to corporate

2. Identify the best practices that boards of directors

can follow.

3. Discuss the problems that have led to the recent

spate of corporate scandals and the efforts that are currently underway to keep them from happening again.

4. Discuss the principle ways in which shareholder

activism exerted pressure on corporate management groups to improve governance.

Chapter 4 Outcomes (continued)

5. Discuss the ways in which managers relate to
shareholders and the issues arising from that relationship.

6. Discuss the issue of shareholder democracy, its

current state, and the trend for the future.

Chapter 4 Outline

Legitimacy and Corporate Governance

Problems in Corporate Governance

Improving Corporate Governance The Role of Shareholders Summary Key Terms Discussion Questions

Introduction to Chapter 4
Explore corporate governance and the ways in which
it has evolved.
Explain the concept of legitimacy and the part that corporate governance plays in establishing the legitimacy of business Explore how good corporate governance can mitigate problems created by separation of ownership

Legitimacy and Corporate Governance


A condition wherein there is a congruence between an organizations activities and societys expectations.


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

Legitimacy and Corporate Governance

Micro Level of Legitimacy 1. Adapt operational methods to
perceived societal expectations

Macro Level of Legitimacy 1. Focus is on the totality of

business enterprises

2. Attempt to change societal

expectations or norms to conform to firms practices

2. Subject to ratification 3. Existence is solely

because society has given it that right

3. Seek to enhance its

legitimacy by identifying itself with others that have a powerful legitimate base in society

The Corporations Hierarchy of Authority

State Charter Shareholders Board of Directors


Separation of Ownership from Control

Precorporate Period Corporate Period Shareholders (ownership)

Owners (ownership)

Managers (control)

Board of Directors

Management (control)

The Need for Board Independence

Inside Directors

Outside Directors


Issues Surrounding Compensation

CEO Compensation

Executive Retirement Plans

Outside Director Compensation


Issues Surrounding Compensation

1) the extent to which CEO pay is tied to firm performance

CEO Pay Controversy

2) the overall size of CEO pay


CEO Pay/Firm Performance Relationship

Stock Options
Allows the recipient to purchase stock in the future at the price it is today Allows the recipient to purchase stock at yesterdays price, resulting in immediate wealth increase Granting of a stock option at todays price, but with the inside knowledge that stocks value is improving




Excessive CEO Pay

Clawback Provisions

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


Impact of the Market for Corporate Control

Poison pill

Golden parachutes


Insider Trading

Insider Trading

The practice of obtaining critical information from inside a company and using that information for ones own personal financial gain


Improving Corporate Governance

Changes in boards of directors
board diversity Outside board directors

Use of board committees for:

audit nominating compensation public policy

Board should get tough with the CEO


Improving Boards and Board Members

Building a Better Board
Define the role the board intends to undertake Be explicit about their financial goals Widen the talent pool for directors Encourage constructive dissent Divide and delegate work to promote deeper analysis

Being a Better Board Member

Be willing to change management Be willing to do lots of homework Control the flow of information Meet outside of the CEOs sphere Dont sacrifice performance for collegiality

Figure 4-3

Use of Board Committees

Principal Responsibilities of an Audit Committee

1. To ensure that published financial statements are not


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.


Board Member Liability

Holds that courts should not challenge board members who act in good faith, making informed decisions that reflect the companys best interests. Board members need to be free to take risks without fear of liability.

Business Judgment Rule


Board Member Liability

In November 2006, the Delaware Supreme Court affirmed the Caremark Standard, which states that directors can only be held liable if: 1. The director utterly failed to implement any reporting or information system or controls, or 2. Having implemented such a system or controls, consciously failed to monitor or oversee its operations, disabling their ability to be informed of risks or problems requiring their attention.


Shareholder Democracy: Key Issues

The requirement that board members be elected by a majority of votes cast.

Majority Vote

Classified Boards

Boards that elect their members in staggered terms.

Shareholder Ballot Access

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

Shareholder Activism
Shareholder activism

Shareholder resolutions

Shareholder lawsuits


Investor Relations
Information filed at regular and frequent intervals that contains information that might affect investment decisions

Full Disclosure


Selected Key Terms

Legitimacy Legitimation Corporate governance Charter Shareholders Board of directors Management Employees Separation of ownership from control Proxy process Agency problems Inside directors Outside directors Stock options

Backdating Spring-loading Bullet-dodging Clawback provisions Tax gross-up Poison pill Golden parachute Insider trading Risk arbitrage Accounting Reform and Investor Protection Act of 2002 Sarbanes-Oxley Act Audit committee Nominating committee

Selected Key Terms

Compensation committee Public issues committee Public policy committee Business judgment rule Personal liability Majority vote Classified boards Shareholder ballot access The role of the SEC

Ordinary business
decisions Shareholder activism Corporate gadflies Shareholder resolutions Shareholder lawsuit Public Securities Litigation Reform Act of 1995 Full disclosure Transparency


Monitoring the Monitors

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

After interviews with board members failed to elicit the source of the leaks,
then board chairman Patricia Dunn engaged an outside licensed investigative firm to determine who had provided confidential information to the media. This firm used pretexting (conscious misrepresentation to obtain information) as one of their techniques for collecting the information. Investigators pretented to be the board members whose calls were being investigated. The source of the leaks was found; however, uproar ensued over the investigation. 1. Who should be responsible for taking action when a board member engages in problematic behavior? If the chairman is responsible, when should he or she involve the whole board? What are the costs of early full board involvement?

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

3. The law regarding pretexting is unclear. While it is illegal when used to obtain financial records, the use of pretexting in other situations-such as the phone records in this example-was not necessary against the law. Should it be?
4. How might things have evolved differently if the ethically rather than the legality of the practice had been the issue? Are the two synonymous or is there a difference?