Corporate Governance:
Foundational Issues
Chapter
4
Prepared by Deborah Baker
Texas Christian University
Business and Society: Ethics and Stakeholder Management, 7e • Carroll & Buchholtz
Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved
1
Chapter 4 Outcomes
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 principle ways in which shareholder
activism exerted pressure on corporate management
groups to improve governance.
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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.
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Chapter 4 Outline
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Legitimacy and Corporate Governance
Problems in Corporate Governance
Improving Corporate Governance
The Role of Shareholders
Summary
Key Terms
Discussion Questions
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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
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Legitimacy and Corporate Governance
Legitimacy
Legitimation
A condition wherein there is a
congruence between an
organization’s activities and
society’s expectations.
A dynamic process by which a
business seeks to perpetuate
its acceptance.
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Legitimacy and Corporate Governance
Micro Level of Legitimacy
Macro Level of Legitimacy
1. Adapt operational methods to
1. Focus is on the totality of
perceived societal
expectations
2. Attempt to change societal
expectations or norms to
conform to firm’s practices
business enterprises
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
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The Corporation’s
Hierarchy of Authority
State Charter
Shareholders
Board of Directors
Management
Employees
Figure 4-1
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Separation of Ownership from Control
Precorporate Period
Owners
(ownership)
Managers
(control)
Corporate Period
Shareholders
(ownership)
Board of
Directors
Management
(control)
Figure 4-2
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The Need for Board Independence
Inside Directors
Outside Directors
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Issues Surrounding Compensation
CEO Compensation
Executive Retirement Plans
Outside Director Compensation
@
http://www.aflcio.org/paywatch
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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
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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
Bullet-Dodging
Granting of a stock option at today’s
price, but with the inside knowledge
that stock’s value is improving
Delaying of a stock option grant
until right after bad news
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Excessive CEO Pay
Clawback
Provisions
Compensation recovery mechanisms
that enable a company to recoup
executive compensation funds
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Impact of the Market
for Corporate Control
Poison pill
Golden parachutes
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Insider Trading
Insider Trading
The practice of obtaining critical
information from inside a company and
using that information for one’s own
personal financial gain
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Improving Corporate Governance
Sarbanes-Oxley Act of 2002 (SOX)
 Limits the nonauditing services an auditor can provide
 Requires auditing firms to rotate the auditors working with
a specific company
 Makes it unlawful for accounting firms to provide services
where conflicts of interests exist
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Improving Corporate Governance
Sarbanes-Oxley Act of 2002 (SOX)
 Enhances financial disclosure with requirements, such as:
• reporting off-balance sheet transactions
• prohibiting personal loans to executives and directors
• requiring auditors to assess and report upon internal controls
 Audit committees must have at least one financial expert
 CEOs and CFOs certify and are held responsible for
financial representations
 Whistle-blowers are afforded protection
 Code of ethics disclosure
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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
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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 CEO’s sphere
Don’t sacrifice performance for collegiality
Figure 4-3
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Use of Board Committees
Principal Responsibilities of an Audit Committee
1. To ensure that published financial statements are not
misleading.
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.
@
http://www.sec.gov
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Board Member Liability
Business
Judgment
Rule
Holds that courts should not challenge
board members who act in good faith,
making informed decisions that reflect
the company’s best interests.
Board members need to be free to take
risks without fear of liability.
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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.
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Shareholder Democracy: Key Issues
Majority Vote
Classified Boards
Shareholder
Ballot Access
The requirement that board members
be elected by a majority of votes cast.
Boards that elect their members in
staggered terms.
Provides shareholders with the
opportunity to propose nominees for
the board of directors.
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Shareholder Activism
Shareholder activism
Shareholder resolutions
Shareholder lawsuits
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Investor Relations
Full
Disclosure
Information filed at regular and
frequent intervals that contains
information that might affect
investment decisions
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Selected Key Terms
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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
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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
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Selected Key Terms
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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
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decisions
Shareholder activism
Corporate gadflies
Shareholder resolutions
Shareholder lawsuit
Public Securities Litigation
Reform Act of 1995
Full disclosure
Transparency
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