Business and Society Chapter Notes

Chapter 4

Corporate Governance: Foundational Issues

LEARNING OUTCOMES

After studying this chapter, you should be able to:

  1. Link the issue of legitimacy to corporate governance.
  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 principal ways in which shareholder activism exerted pressure on corporate management groups to improve governance.
  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.

TEACHING SUGGESTIONS

INTRODUCTION – In this chapter, the authors explore corporate governance and the ways in which it has evolved. They first examine the concept of legitimacy and the part that corporate governance plays in establishing the legitimacy of business. They then explore how good corporate governance can mitigate the problems created by the separation of ownership and control and examine some of the specific challenges facing board members today.

KEY TALKING POINTS – In some sense, discussing corporate governance may seem a bit premature for business students, especially at the undergraduate level. Most of the students will not have direct contact with board members of publicly-traded companies and their issues for quite some time. However, the issues are highly relevant to them in many ways. Some undergraduates plan to start their own business upon graduation and need to understand the mechanics and obligations of corporate formation. Further, when starting their own business, many will operate as owner-managers. They need to understand their various roles in the corporate form, as well as their legal obligations to other investors should they serve as directors.

Further, as citizens, they should be concerned with the legitimacy of corporations and understand the power that they hold. The 2008 financial crisis illustrates how breakdowns in corporate governance can create legitimacy problems for business. As investors, they should realize the impact that boards and CEOs have on the firm and be aware of the relationship between the board and senior management. They will, in all likelihood, understand the theoretical relationship—the board oversees management activity and has authority over managers. The reality, that the power structure is inverse to the theory, may come as quite a surprise. Most students will not be familiar with the proxy process and the agency problems that exist with the corporate form.

As workers, they should be aware of the issues surrounding executive compensation. Executives are often in the enviable position of setting their own compensation plans, with the board providing only rubber stamp approval in some cases (although compensation committees of publicly-traded companies now are required to explain and justify executive compensation). An attitude of self-enrichment at the top of the organization can have grave consequences for the rest of the employees (e.g., Enron, Tyco, WorldCom, etc.). Furthermore, they need to understand how different compensation elements (including stock options) impact their personal financial situation.

As the authors point out, boards are making an effort to wrest control back from management. In addition to the steps pointed out in the textbook, there are many efforts to “create” better board members, through education and research. The National Associate of Corporate Directors works to improve corporate governance in companies ranging from Fortune 100 companies to small, over-the-counter, closely held, and private firms ( Jeffrey Sonnenfeld, a professor at YaleUniversity, is well known for his “CEO College.” He has written several articles about the CEO position and board of directors. Two of his articles are:

Sonnenfeld, J. A. Good governance and the misleading myths of bad metrics.Academy of Management Executive, Feb 2004, Vol. 18 Issue 1, p108.

Sonnenfeld, J. A. What Makes Great Boards Great.Harvard Business Review, Sep 2002, Vol. 80 Issue 9, p106.

Students also may be interested in finding out more about the issue of executive compensation. Two excellent websites provide a wealth (no pun intended) of information about the topic. The AFL-CIO (an umbrella labor organization) provides Executive Pay Watch information at The Institute for Policy Studies and United for a Fair Economy jointly produce an annual report on CEO pay entitled Executive Excess. The most recent report, for 2008, is available at

Students also may want to explore the stock option backdating scandals from a few years ago. Various federal agencies, including the Department of Justice, the IRS and the SEC, became involved in the investigation of over 200 companies implicated in the controversy. This is an example of how breakdowns in corporate governance can lead to serious problems for a company. Essentially, backdating occurred in many cases due to governance oversights or intentional fraudulent acts. Many companies lacked the internal governance structures necessary to prevent both inadvertent and intentional backdating problems. Students can review a list of implicated companies at WSJ Options Scorecard

PEDAGOGICAL DEVICES – In this chapter, instructors may utilize a combination of:

Cases:

The Benefit Corporation: Making a Difference while Making Money

The Waiter Rule: What Makes for a Good CEO?

Family Business

Ethics in Practice Cases:

Monitoring the Monitors

Spotlight on Sustainability:

Linda Fisher, Chief Sustainability Officer for DuPont

Power Point slides:

Visit for slides related to this and other chapters.

LECTURE OUTLINE

  1. LEGITIMACY AND CORPORATE GOVERNANCE
  2. The Purpose of Corporate Governance
  3. Components of Corporate Governance
  4. Roles of Four Major Groups
  5. Separation of Ownership from Control
  1. PROBLEMS IN CORPORATE GOVERNANCE
  2. The Need for Board Independence
  3. Issues Surrounding Compensation
  4. The CEO Pay/Firm Performance Relationship
  5. Excessive CEO Pay
  6. Executive Retirement Plans and Exit Packages
  7. Outside Director Compensation
  8. Transparency
  9. The Governance Impact of the Market for Corporate Control
  10. Poison Pills
  11. Golden Parachutes
  12. Insider Trading Scandals
  1. IMPROVING CORPORATE GOVERNANCE
  2. Sarbanes-Oxley Act
  3. Changes in Boards of Directors
  4. Board Diversity
  5. Outside Directors
  6. Use of Board Committees
  7. The Board’s Relationship with the CEO
  8. Board Member Liability
  1. THE ROLE OF SHAREHOLDERS
  2. Shareholder Democracy
  1. THE ROLE OF THE SEC
  1. SHAREHOLDER ACTIVISM
  2. The History of Shareholder Activism
  3. Shareholder Resolutions
  4. Shareholder Lawsuits
  1. INVESTOR RELATIONS
  1. SUMMARY

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

Students should recognize that their answers to these discussion questions should be well reasoned and supported with evidence. Although some answers will be more correct than others, students should be aware that simplistic answers to complex questions, problems, or issues such as these will never be “good” answers.

  1. Corporations at their inception were run by owner-managers who retained full responsibility for all functions of the enterprise. As corporations grew (the availability of limited liability was a significant impetus in this process), owners’ roles became more investor than owner. Berle and Means, in The Modern Corporation and Private Property, refer to this change as moving from active property to passive property. In this process, the functions of managing the business were divorced from the ownership function, leaving managers effectively in charge of the organization. As “ownership” became more diluted among many investors, shareholders soon lost any pretense of control over the firm. Even the board of directors, designed to oversee the company’s operations for the investors, became subservient to management, as many directors have financial, relationship and other ties to management, making it difficult for many directors to make decisions independent of management. Exacerbating this final problem is the proxy process, which effectively turns over to management even the selection of directors. What this means in practice is that managers choose their own bosses and then tell the bosses what to do.

Congress, various regulatory agencies and shareholders of public companies took a critical look at the inherent agency problems present in the corporate form as a result of the scandals that erupted in the early 2000s. As Sarbanes-Oxley, the New York Stock Exchange and the NASDAQ ramped up independence requirements for publicly-held companies, a new trend emerged for publicly-held boards. Many board members became more active, taking some control back from management. More independent board members began serving on the boards of public companies, as well as the audit and nominating committees. Private companies began to follow suit, as creditors, lenders and shareholders considered the implementation of an independent board the best practices for all companies. Directors also began spending more time on their duties. However, while boards became more independent and more focused on corporate responsibilities, corporations are still effectively controlled by management in the vast majority of cases. Furthermore, the increased focus on corporate governance had an unintended effect: many individuals quit board positions or refused appointments in light of the increasing legal hassles associated with regulatory investigations and shareholder lawsuits.

  1. The major criticisms of boards of directors center on their effectiveness. Boards are less effective than they should be because too many members are inside directors, they often do not put enough time into their positions, they may be paid too much money for the work they do, and they may become “yes men” to the CEO.

The inability to exercise independence is perhaps the most important criticism, especially in light of the fact that board members have a legal obligation to act in the best interest of shareholders. When directors are unable to separate themselves from management, they run the risk of violating their fiduciary duties. In some cases, board members, acting in concert with management, pursue their own best interests rather than the company’s best interests, which may result in shareholder losses and personal liability for the directors involved.

  1. Governance failures like Enron happen primarily because the power relationship between the board and top management is inverse. Although the board should have authority over top management, the reverse is generally true. Members of top management select who will be on the board and continuing to hold a seat is dependent upon rubber stamping top management’s decisions. For example, members of the board of directors of Enron waived provisions of the company’s code of conduct so that Andy Fastow could serve as CFO for Enron and as general partner for certain limited partnerships (which were established for the benefit of Enron). This was an inherent conflict of interest. Board members were willing to approve the waiver as the company was a Wall Street darling at the time. Further, Enron board members were bringing in large fees for their service to the board. Consequently, the board members did not want to displease and/or disagree with management, as the loss of the board seat could mean a significant loss of income for these individuals.

Failures like Enron also happen when the lines between the external auditor, management and the audit committee are blurred. Sarbanes-Oxley attempts to address this corporate governance failure by implementing independence requirements for the audit committee and forcing the audit committee to take ownership over the oversight of the external auditor.

To remedy this situation, board members will have to be stronger and stand up to top management. It also will require institutional investors to select board members who will provide leadership and take back control of the organization. Robert Greenleaf spoke forcefully of the need for strong leadership from directors (he used the word trustees) in Servant Leadership. Finally, there has to be a clear delineation between the roles of management, the external auditor and the board.

  1. Several suggestions for improving corporate governance have been made. Most center on board composition and performance. Recommended changes in who sits on boards include more outside directors, more women, and more people of color. Suggestions for changes in activities include more active participation by board committees and getting tougher with CEOs.

The relationship between the external auditor, management and the board also is a key element to better corporate governance. Since many investors view the external auditor as the “watchdog” of their investment, it is important that any inappropriate ties between the external auditor, management and the board are eliminated.

  1. Companies can become more responsive to shareholders by fully disclosing their activities and by placing the owners’ interests above the managers’ (although this is probably unreasonable to expect from anyone on a consistent basis). There is a significant danger in focusing on shareholders’ interests, though. Concentrating on this one narrow topic can easily translate into forgetting about other stakeholders such as employees or the community.

While boards are becoming more responsive to shareholders in general, many boards are still criticized for their executive compensation practices. Many shareholders believe that boards approve compensation packages for executives due to board member/management relationships rather than as a result of management performance. A few years ago, the SEC implemented new rules regarding executive compensation disclosure. While the SEC stressed that its objective was not wage controls, it did indicate that it wanted to focus on wage clarity. Specifically, the SEC had concerns that companies were using existing proxy statement disclosure rules to avoid disclosure of certain compensation elements. The rules require companies to disclose a total compensation figure for its top executives. In connection with the increased focus on this corporate governance issue, shareholder activism over executive compensation has risen dramatically in the last few years. Both shareholder proposals and proposed legislation have contained initiatives to give shareholders a “Say on Pay.” Specifically, many shareholders want to see executive pay tied to performance and want the right to approve compensation packages. If strides are to be made in this area, shareholders must continue to hold board members accountable for the pay packages that they approve.

GROUP ACTIVITY

Group Activity 1 - Public Disclosure of Corporate Governance Issues

Divide the students into groups of four to five students. Have the students select a publicly-traded company. The instructor should explain how publicly-traded information can be obtained from Edgar ( Specifically, students should learn how to obtain a company’s annual report (Form 10-K) and proxy statement (Form Def 14A). Students should be encouraged to review these documents to get a better understanding of the company’s corporate governance structure. The instructor may want to have the students answer specific questions related to the company’s corporate governance structure, using the company’s annual report and proxy statement. The following are sample questions:

How many shareholders hold common stock according to the company’s annual report?

What is the date of record for determining shareholders entitled to receive notice and to vote at the annual meeting?

How are directors elected? What are the voting requirements for the election of directors? How would a shareholder propose a candidate for nomination to the board of directors?

Who serves on the board of directors? What are their qualifications?

How many directors are independent? Indicate which directors are “inside” directors and which directors are “outside” directors. Is this an appropriate mix? Are there any obvious conflicts of interest?

What board committees does the company have? Describe the function(s) of each committee as described in the company’s proxy statement.

Who is the audit committee financial expert? What are his or her qualifications?

What internal controls framework does the company use?

Did management determine that the internal control over financial reporting was effective?

Did the auditor find that management’s assessment of the effectiveness of the company’s internal controls was fairly stated?

Where will the company disclose waivers to the Code of Ethics for the Senior Officers?

Students should be encouraged to assess the corporate governance structure of the group’s selected company and note any deficiencies or suggestions that they may have for improvement in a short presentation to the entire class.

Group Activity 2 – Executive Compensation

Divide the students into groups of four to five students. Have the students select a publicly-traded company. The instructor should explain how publicly-traded information can be obtained from Edgar ( Specifically, students should learn how to obtain a company’s annual report (Form 10-K) and proxy statement (Form Def 14A). Students should be encouraged to review these documents (specifically the proxy statement) to get a better understanding of the company’s compensation structure, philosophy and objectives. The instructor may want to have the students answer specific questions related to executive compensation, using the company’s annual report and proxy statement. The following are sample questions: