ACCT4007

Corporate Governance

Topic 5
Management Function
(Part A) 1
 Agenda

 Overview of management function

 Categories of management responsibilities
 Functions of Corporate Officers
 Executive Compensation

2
 Overview of Management Function

 Top management team:

 Led by CEO
 Supported by CFO and other senior executives

Example: Apple
 What is the composition of Apple’s top management
team?

3
 Overview of Management Function

 CG is needed to:
 Avoid concentration of power in the hands of manage
ment
 Appropriately balance power-sharing authority between
shareholders, boards of directors, and management
 Under the oversight of the board, management is fully res
ponsible for acting in the best interests of shareholders
and other stakeholders for all managerial functions.

4
 Categories of Management Responsibilities

1) Operating process
 Mainly involve strategic decisions made by management to improv
e efficiency of operations, so as to generate profits and create share
holder value
a) Operating activities
 Designing products and services
 Marketing and delivering products
 Invoicing products
 Servicing customers
b) Investing activities
 Investing in both human and capital resources
b) Financing activities
 Funding investments and expenditures through internal funds, issuing
stocks or debts
5
 Categories of Management Responsibilities

2) Financial reporting process

 Management should report both financial and nonfinancial i

nformation that assist investors to predict future cash flows
from operating, investing, and financing activities.
 Management is responsible for integrity and quality of all int
ernal and external financial and nonfinancial reports.
 True and fair presentation of financial position and results
of operations
 No manipulation to exaggerate earnings or misstate asset
s, liabilities, expenses, or revenues

6
 Categories of Management Responsibilities

3) Compliance process

 Compliance with all applicable laws, regulations, and stand

ards (including environmental, social, and ethical standards a
nd best practices)

7
 Functions of Corporate Officers

 Competent and ethical corporate officers (C-Suites)

 Chief Executive Officer (CEO)
 Chief Financial Officer (CFO)
 Chief Risk Officer (CRO)
 Others
◇ Chief Development Officer (CDO)
◇ Chief Governance/Compliance Officer
◇ Chief Operating Officer (COO)
◇ …

8
 Functions of Corporate Officers
Chief Executive Officer (CEO)

 Leader of managerial function

 All other senior executives look to CEO for direction and gui
dance
 Personal attributes, ethical values, and professional char
acteristics of CEO:
 In line with values, visions, and strategic plans of the boar
ds and shareholders
 Vital for long-term survival and success and stakeholder val
ue creation

9
 Functions of Corporate Officers
Chief Executive Officer (CEO)

 Key challenges faced by CEO

 (1) Fiduciary duty
◇ Duty of loyalty: Act solely for the benefit of the company
and its shareholders
◇ Duty of due care
 (2) Duality
◇ A challenge to establish a right power-sharing balance b
etween CEO, directors, and shareholders

10
 Functions of Corporate Officers
Chief Executive Officer (CEO)

 Key challenges faced by CEO

 (3) Succession planning
◇ In cases of CEO turnovers, departures, and retirements

Effective CEO succession plan is vital to:

 Sustainable performance of the company

 Effectiveness of corporate governance

 Better performance of current CEO

 Smoother transition

 Success of new CEO

11
 Functions of Corporate Officers
Chief Executive Officer (CEO)

 Key challenges faced by CEO

 (4) Financial knowledge
◇ Sufficient knowledge and understanding of financial risks, inter
nal control, and financial reporting

Example: WorldCom
 Many CEOs of companies where accounting frauds have occurred
claimed that they knew nothing of the financial malfeasance.
 However, CEOs’ pleas of innocence are not valid arguments of
defense in the lawsuits.
 A defense of CEO ignorance about financial fraud did not prevail in
the WorldCom trial when its former CEO Bernard J. Ebbers was found
guilty of securities fraud, false regulatory filings, and conspiracy.
12
 Functions of Corporate Officers
Chief Executive Officer (CEO)

 Key challenges faced by CEO

 (5) Self-serving
◇ Conviction for self-serving and engagement in fraud, cons
piracy, and filing false financial reports
 Greatly damaged integrity and reputation of CEOs.
 High demand for competent, ethical, and accountabl
e CEOs.

13
 Functions of Corporate Officers
Chief Executive Officer (CEO)

 Key challenges faced by CEO

 (5) Self-serving

Examples:
 WorldCom: Bernard Ebbers, the Former CEO, got 25 years in prison
for his involvement with one of the largest corporate frauds in U.S.
history.
 Parmalat: Calisto Tanzi, the founder and CEO of the Italian dairy and
juice giant that collapsed in an $18 billion fraud, stands trial for the
alleged market securities violations.
 Tyco International: Dennis Kozlowski, the former chairman and
CEO, was convicted of fraud, conspiracy, and grand larceny charges.

14
 Functions of Corporate Officers
Chief Executive Officer (CEO)

Question: Determine how the following situations could affect

the power of a CEO.
 CEO serves as chair of the board
 CEO serves on board committees
 CEO tenure
 Independent directors on the board
 Interlocking directors
 Directors hired after CEO assumes office (“co-opted directors”)

15
 Functions of Corporate Officers
Chief Financial Officer (CFO)

 A major CG participant involved in internal control, financial

reporting, and strategy execution.
 Ensure the effectiveness of ICFR and quality of both interna
l and external financial reports
 Assist the board in strategic decision making
[Internal control: To be discussed in Topic 6A]

16
 Functions of Corporate Officers
Chief Risk Officer (CRO)

 Oversee the overall strategies of ERM (Enterprise risk man

agement) in identifying and managing risks
 Oversee proper implementation and compliance of policies
related to various risks (e.g., financial risk, operational risk, e
tc.)
[Risk management: To be discussed in Topic 6B]

17
 Executive Compensation

 The board and its compensation committee should develop

an effective, rewarding, and reasonable executive comp
ensation program tailored to achieve the company’s missio
n and strategic goals.
 The program should align with industry considerations a
nd be subject to approval by shareholders through advi
sory say-on-pay votes.

18
 Executive Compensation
Objectives

 Attract and retain talented management

 Pay-for-performance linkage
 An integral component of monitoring function of CG
 An important way for shareholders to assess the perform
ance of executives
 Establishment of attainable, reasonable, and objective p
erformance target and proper payout structure to rew
ard executives for outstanding performance

19
 Executive Compensation
Objectives

Example: Apple’s Proxy Statement

 What is the philosophy of Apple’s executive
compensation design?

20
 Executive Compensation
Concerns about weak pay-for-performance linkage
 MSCI’s 2016 report (Marshall and Lee, 2016)

Reference: Marshall, R., and L. Lee. Are CEOs Paid for Performance? Evaluating
the Effectiveness of Equity Incentives. MSCI ESG Research, July 2016. 21
 Executive Compensation
Concerns about weak pay-for-performance linkage

 MSCI’s 2016 report (Marshall and Lee, 2016)

 For a sample of firms included in the MSCI USA Index, the cor
relation between CEO compensation and total shareholder ret
urns is consistently negative (although small) during 2005-201
4.
Reference: Marshall, R., and L. Lee. Are CEOs Paid for Performance? E
valuating the Effectiveness of Equity Incentives. MSCI ESG Research, J
uly 2016.

22
 Executive Compensation
Concerns about weak pay-for-performance linkage

 Wall Street Journal article by Francis and Lublin (2016)

 None of the top-ten highly paid CEOs in S&P500 firms is among
the top-ten best performers in 2015.
Reference: Francis, T., and J. Lublin. 2016. CEO Pay Shrinks 4.6% but Off
ers Weak Reflection of Performance. Wall Street Journal, June 2, 2016.

23
 Executive Compensation
Compensation components

 Salary
 Set at a level that reflects responsibilities, tenure, and capabilities.
 Comparable with peer companies
 Annual cash incentive pay (bonus)
 Reward superior performance that meets or exceeds predetermined
annual performance targets
 Long-term incentive pay (LTIP)
 Grants of stocks and stock options (rights to buy stocks in the future)
 Reward superior long-term performance to align interests of executiv
es and shareholders

24
 Executive Compensation
Compensation components

 Severance payments
 Provided only in the event of wrongful termination, death, or dis
ability under non-control change situations.
 Not for poor performance, failure to renew a contract, or resign
ation under pressure.
 Change-of-control payments
 Best practice recommends no change-of-control payments whe
n the company is acquired.

25
 Executive Compensation
Compensation components

 Retirement arrangements
 Pension plans and supplemental retirement packages

 Clawback provision
 Executives need to repay incentive compensation to the compa
ny if they engage in corporate scandals or fraudulent financial a
ctivities that cause restatements of financial statements or signi
ficant harm to the company.

26
 Executive Compensation
Compensation components

Example: Apple’s Proxy Statement

 What are the components of executive compensation in
Apple?
 Are severance payments provided to Apple’s executives?
 Are retirement benefits provided to Apple’s executives?
 Is there any clawback provision in Apple?

27
 Executive Compensation
Typical performance metrics

 Accounting metrics
 Revenue
 Earnings per share (EPS)
 Return on assets (ROA) or Return on equity (ROE)
 Cash flow: operating cash flow, free cash flow

 Total shareholder return (TSR)

 Typically for evaluating long-term performance and for LTIP pay
outs
 Limitation: Stock price fluctuations may not be associated with t
he performance of executives
28
 Executive Compensation
Typical performance metrics
 Economic profit or economic value added (EVA)
 Incorporate cost of capital
◇ Net operating profit minus cost of capital
 Rarely used
 Operational metrics
 Customer satisfaction
 Reserve replacement for oil and gas exploration companies
 …
 Qualitative factors
 Achievement of strategic goals
 CSR indicators
 … 29
 Executive Compensation
Typical performance metrics

Example: Apple’s Proxy Statement

 What performance measure are used by Apple to evaluate
executives?
 Does Apple use peer benchmarking?
 What is the policy of using corporate jet by CEO?

30
31