Chapter 9: Corporate
Governance: Foundational
Issues
Assoc. Prof. Le Thanh Tiep
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Icebreaker: What are the Powers of
Shareholders?
Divide in small groups and discuss: Are shareholder companies
democratic? Can all shareholders participate in the governance of the
company? How do shareholders exercise power?
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Chapter Objectives (1 of 2)
By the end of this chapter, you should be able to:
1. Link the issue of legitimacy to corporate governance.
2. Discuss the problems that have led to the recent spate of corporate scandals and
problems in corporate governance.
3. Discuss the principal ways in which companies can improve corporate governance.
4. Discuss the role of shareholders and the idea of strengthening shareholder voice.
What are some of the mechanisms that enable this?
5. Discuss the role of the Securities and Exchange Commission (SEC) in protecting
investors.
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Chapter Objectives (2 of 2)
6. Identify and discuss the principal ways in which shareholder activists exert
pressure on corporate management to improve governance.
7. Why are investor relations and shareholder engagement important? Discuss.
8. Compare and contrast the shareholder-primacy, director- primacy, and
stakeholder governance models of corporate governance. What are their
respective strengths and weaknesses? Which do you prefer and why?
9. In the realm of corporate governance, what should companies do to ensure
effective corporate social responsibility (CSR), sustainability, and business
ethics?
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Legitimacy and Corporate Governance
Legitimacy –
• A condition that prevails when there is a congruence between an
organization’s activities and society’s expectations.
Legitimation –
• A dynamic process by which a business seeks to perpetuate its
acceptance.
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Legitimacy
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Corporate Governance
Corporate Governance
Refers to the method by which a firm is being governed, directed,
administered, or controlled, and to the goals for which it is being
governed.
Is concerned with the relative roles, rights, and accountability of such
stakeholder groups as owners, boards of directors, managers, employees,
and other stakeholders.
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Roles of Four Major Groups
• Shareholders - Own stock in the firm, giving them ultimate control (the
shareholder-primacy model).
• Board of Directors - Govern and oversee management of the business.
• Managers - The individuals hired by the Board to manage the business
on a daily basis.
• Employees - Hired to perform actual operational work.
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The Corporation’s Hierarchy of Authority
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Precorporate versus Corporate Ownership
and Control
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Discussion Activity 9.1.1
What are the major criticisms of Boards of Directors? Which single
criticism do you find to be the most important? Why?
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The Importance of Board Independence:
Outside directors –
• Are independent from the firm.
Inside directors –
• Have some tie to the firm.
• Board independence from management is crucial to good governance.
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Issues Surrounding Compensation
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CEO Pay–Firm Performance Relationship
• Stock Options - Allows the recipient to purchase stock in the future at
the price it is today.
• Backdating - Allows the recipient to purchase stock at yesterday’s
price, resulting in immediate wealth increase.
• Spring-loading - Granting of a stock option at today’s price, but with
the inside knowledge that stock’s value is improving.
• Bullet Dodging - Delaying of a stock option grant until right after bad
news.
• Board independence from management is crucial to good governance.
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CEO Pay Controversy
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Executive Retirement Plans and Exit
Packages
Retirement packages
• Have come under scrutiny.
• George Hager Jr., retired and was given a $5.2 million “retention
payment by Genesis Healthcare at the height of the pandemic.
• In contrast, many of today’s workers do not have a retirement plan.
• Those who do generally have a defined contribution plan, rather than a
defined benefit plan.
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Outside Directors Compensation
• Paying board members is a recent idea.
• Today, outside board members are paid.
• From 2003-2015, their median pay rose about a third, from $175,800 to
$258,000.
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Transparency
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Governance Impact of the Market for
Corporate Control
Mergers and acquisitions -
• Expectation are that the threat of a possible takeover will motivate top
managers to pursue shareholder, rather than self-interest.
• But many corporate CEOs and boards go to great lengths to protect
themselves from takeovers, using:
• Poison pills (discourages a hostile takeover by making the firm
difficult to take on).
• Golden parachutes (firm agrees to pay key officers in the event of a
change in control of the corporation).
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Insider Trading
• The practice of buying or selling a security by someone who has access
to material information that is not available to the public.
• “Material Information” is information that a reasonable investor might
want to use, and is likely to affect the price of the firm’s stock.
• A “tipper” provides that information.
• A “tippee” receives the information.
• Executives and others who work for a firm may have inside information.
• Also those in relationships that include a duty of confidentiality may
have inside information, including spouses, parents, children, friends.
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Discussion Activity 9.2.1
Explain the evolution of corporate governance. What problems
developed? What are the current trends?
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Improving Corporate Governance (1 of 2)
Legislative Initiatives: Sarbanes–Oxley Act of 2002 (aka SOX or Sarbox)
• Limiting the nonauditing services an auditor can provide.
• Requiring auditing firms to rotate the auditors.
• Enhancing financial disclosure.
• Requiring that audit committees have at least one financial expert.
• CEOs/ CFOs be held responsible for financial representations of the
company.
• Requiring that corporations adopt a code of ethics.
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Improving Corporate Governance (2 of 2)
Legislative Initiatives: The Dodd–Frank Wall Street Reform and
Consumer Protection Act
• Covers 16 major areas of reform affecting:
• Banks
• Credit card companies
• Credit rating agencies
• Insurance companies
• Hedge funds
• Futures trading
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The Role of the SEC
• The SEC is responsible for protecting investor interests.
• Critics argue that the SEC is more focused on the needs of businesses
than on that of investors.
• The SEC failed to stop the Bernard Madoff Ponzi scheme before
investors lost billions, although they had been warned of the scheme a
decade earlier.
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Changes in Boards of Directors
• More board diversity.
• A greater ratio of outside board members to inside board members.
• Use of board committees to:
• Ensure that financials are not misleading.
• Ensure that internal controls are adequate.
• Follow-up allegations of irregularities.
• Ratify the selection of an external auditor.
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Red Flags That Signal Board Problems and
Steps to Take for Board Repair
Red Flags Steps to Take for Board Repair
1. Company has to restate earnings 1. Spread risk oversight among multiple committees
2. Poor employee morale 2. Seek outside help in identifying potential risks
3. Adverse Sarbanes-Oxley 404 or Dodd-Frank opinion 3. Deepen involvement in corporate strategy
4. Poor customer satisfaction track record 4. Align board size and skill mix with strategy
5. Management misses strategic performance goals 5. Revamp executive compensation
6. Company is target of employee lawsuits 6. Pick compensation committee members who will question
the status quo
7. Stock price declines 7. Use independent compensation consultants
8. Quarterly financial results miss analysts’ expectations 8. Evaluate CEO on grooming potential successors
9. Low corporate governance quotient rating 9. Know what matters to your investors
Sources: “What Directors Think 2015,” SpencerStuart (February 2015), [Link] accessed March 7, 2021. Joanne S. Lublin, “Corporate Directors Give
Repair Plan to Boards,” The Wall Street Journal (March 24, 2009), B4; “What Directors Think 2015,” SpencerStuart (February 2015), [Link]
accessed March 7, 2021; Joanne S. Lublin, “Corporate Directors Give Repair Plan to Boards,” The Wall Street Journal (March 24, 2009), B4.
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The Board’s Relationship with the CEO
• Boards are responsible for monitoring CEO performance and dismissing
poorly performing CEO.
• Formerly, CEOs were protected; no more; firings of CEOs are up
significantly.
• If CEO also serves as Chairman of the Board, this duality can offer
some protection.
• Activists have moved to separate CEO and Board functions.
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Board Member Liability
• The Business Judgment Rule protects board members if:
• They act in good faith.
• Making informed decisions.
• That reflect the company’s best interests, and not their own
interests.
• Good faith is central to the defense.
• The argument in favor of the Business Judgment Rule is that board
members need to be free to take risks without fear of liability.
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Discussion Activity 9.3.1
How do companies lose legitimacy? Explain how governance failures
could happen? How might they be avoided?
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Discussion Activity 9.3.2
Outline the major suggestions that have been set forth for improving
corporate governance. In your opinion, which suggestions are the most
important? Why?
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The Role of Shareholders
• The Shareholder Democracy Movement arises from the fact that although
they are owners, shareholders may find that their votes are not counted.
• They seek:
• A Majority Vote: The requirement that board members be elected by a
majority of votes cast, rather than by a plurality.
• Banning Classified or Staggered Boards: Electing members in staggered
terms means that it might take 3 or more years to replace a board.
• Proxy Access: Would provide shareholders with the opportunity to
propose nominees for the board of directors.
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Shareholder Activism
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Discussion Activity 9.4.1
How does shareholder activism change the practices of business and
corporate governance?
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Investor Relations and Shareholder
Engagement
• A majority of corporate boards now communicate with their major
investors.
• Public corporations have obligations to current and potential
shareholders, including full disclosure (Transparency), and the duty to
provide information that might affect investment decisions.
• Management is also responsible for communicating with shareholders.
• CEO Warren Buffett calls his annual shareholder meeting a “Woodstock
weekend for capitalists.”
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An Alternative Model of Corporate
Governance
• The Anglo-American model of corporate governance is one of
shareholder primacy.
• A emerging perspective is a director-primacy model of corporate
governance.
• A director-primacy model is based on the concept of a corporation
that is not owned, but is an independent legal entity that owns itself.
• Boards are mediating hierarchs, responsible for balancing competing
interests of stakeholders.
• Boards have a duty to shareholders, but boards are the ultimate
decision-makers, whose duty is to the corporation.
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Discussion Activity 9.6.1
Discuss the pros and cons of the shareholder-primacy and director-
primacy, and shareholder governance models of corporate governance.
Which do you prefer and why?
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