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McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 18

Corporate Governance
This chapter:

Discusses options backdating, just one type of recent


corporate scandals related to corporate governance.
Discusses corporate governance; how boards of
directors are structured, their duties, and reforms; and
issues associated with executive compensation.
Highlights the Sarbanes-Oxley Act by which Congress
responded to demands for reform.
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Backdating with Dr. McGuire


Opening Case
An option is the right to buy a share of company stock
at a fixed price on a later date.
Backdating occurs when options are granted on one
date, but priced as if they had been granted on a
historical date when the market price was lower.
Backdating is legal if it is revealed to shareholders,
but illegal if it is hidden.
William W. McGuire, the chairman and chief executive
of UnitedHealth Group, received twelve separate
option grants on days when the stock price fell to
yearly or quarterly lows. The odds of this were 1 to
200 million.
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Backdating with Dr. McGuire


Opening Case (continued)
SEC regulators told the company they were
investigating the matter, but Dr. McGuire seemed
untroubled.
Dr. McGuire denied that grant dates were picked
with the benefit of hindsight.
Investigators concluded the grants were likely
backdated
Dr. McGuire was forced to resign, pay a $7 million
fine, and disgorged of wrongful gains.
This is a tale of greed with a dose of justice at the end. It is
also a story of the flawed relationship among one companys
share owners, managers, and directors.
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What is Corporate
Governance?
The rules of corporate governance
define how power is distributed
among shareholders, boards of
directors, and managers and how
disputes are settled.
The nature of corporate governance
has changed dramatically over time.
Boards of directors evolved to
perform the critical role of monitoring
hired managers for the
shareholders.

Corporate
Governance
The exercise of
authority over
the members of
a corporate
community
based on formal
structures, rules,
and processes.

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The Corporate Charter


The corporate charter is the document that
authorizes formation of a corporation. It
specifies the rights and responsibilities of
stockholders, directors, and officers.
Directors have a fiduciary responsibility to
the shareholders.
U.S. corporations are chartered by the state
in which they incorporate.
States compete with one another to attract
the incorporation fees of large corporations.
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Flow of Authority in Corporate


Governance

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Federal Regulation
of Governance
Corporate governance laws have been primarily
the province of states, however, the Supreme
Court has said that the Constitution empowers
Congress to regulate corporations if it chooses.
Federal intervention generally comes in reaction to
conspicuous failures of governance and imposes
mandatory rules and restrictions.
Extensive intervention into corporate governance
came in the 1930s, the 1960s, and in 2003.

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Failure of Corporate Governance


at Enron
Enron enjoyed admiration and respect among
investors, managers of other companies, and the
public.
Government regulators uncovered multiple
instances of :
Juggling accounting records to inflate sales and profits
Hiding debt, concealing excessive CEO perks and
compensation in vague footnotes
Ignoring standard accounting and financial practices
Shredding documents to destroy incriminating records.

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Failure of Corporate Governance


at Enron (continued)
The boards Special Investigative
Committee did not place sole blame for
Enrons failure on its directors, but it
accused the board of failing to exercise it
oversight responsibility
A fundamental cause of the catastrophe
was the culture of the company.
In 2006 a federal jury found Chairman of the
Board Lay and CEO Skilling guilty of
conspiracy and fraud.
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The Sarbanes-Oxley Act


It holds management responsible for accurate
financial reports and strengthens the power
and responsibility of board audit committees.
A few of the acts provisions are:
Creates a five-member oversight board that has
authority over practices of accounting firms.
Prescribes rules to improve auditing.
Requires the CEO and CFO to sign and certify the
accuracy of annual and quarterly financial
statements.
Establishes heavy criminal penalties for violating its
provisions.
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Boards of Directors
The average corporate board had 11 members
although there is no set number.
Directors in large corporations are chosen after
being nominated by the board and approved by a
majority vote of shareholders.
Directors who are employees of the company are
called inside directors; those who are not employed
by the company are outside directors.
Boards are divided into committees.

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Duties of Directors
Laws impose two lofty duties on directors:
Represent the interests of stockholders
Exercise due diligence in the oversight of
corporate activity
Directors do not make day-to-day
decisions.
Boards exercise a very broad oversight.
Compensation varies substantially among
industries.
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Duties of Directors
(continued)
Some specific board functions:
Review and approve the corporations goals and
strategies.
Select the CEO, evaluate his or her performance,
and remove the CEO if necessary
Give advice and counsel to management.
Create governance policies for the firm, including
compensation policies
Nominate candidates to be presented to the
stockholders for election as directors
Exercise oversight of ethics and compliance
programs.
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Institutional Investors
and Governance
The growth of pension and mutual fund assets has
given institutional investors new power in corporate
governance.
Jesse Unruh formed the Council of Institutional
Investors (CII).
The CII endorsed a Shareholders Bill of Rights
demanding a voice in fundamental decisions
which could affect corporate performance and
growth.
Since then, institutional investors have been more
active in corporate governance issues.
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Percent of Equity Held


by Institutions

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Shareholder Resolutions
Shareholder resolutions cover a wide range of topics
and their focus has changed over time.
In the 1970s and 1980s they focused on corporate
social responsibilities such as automobile safety
and doing business in apartheid South Africa.
In recent years they focused on corporate
governance issues, especially the methods for the
election of directors and limits on executive
compensation.
Resolutions are voted on by all shareholders at the
annual meeting, by mail, or by Internet.

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Executive Compensation
A compensation committee of the board of
directors sets the pay and benefits of top
executives.
Elements of compensation include a combination of
the following.
Base salary
Annual cash incentives
Long-term stock-based incentives
Stock options
Performance shares
Restricted stock
Retirement plans
Perquisites
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Criticisms of CEO
Compensation
The size of extraordinary payouts
The compensation packages given to some newly hired
CEOs
The golden handshakes received by some CEOs when they
leave under fire.
An alleged bias in favor of boosting CEO compensation due
to the composition of the compensation committees.
Nonconformance with the interests of shareholders.
The number and misuse of stock option grants
The spread between executive pay and that of the average
worker.

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In Defense of CEO Pay


Congress has considerable responsibility for the boom in
stock options due to its 1993 legislation regarding the
expensing of CEO pay.
Stock options became a large part of compensation during a
period marked by long rises in stock markets.
Many large compensation packages were justified by the
gains of stockholders during their tenure.
Boards of directors point out that if they do not pay their
CEOs what executives in comparable companies get, they
stand to lose them.
Most managers do not get dramatically high salaries.

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Suggested Compensation
Reforms
Suggestions for compensation reform
include:
The SEC should require more data on
compensation in reports to shareholders.
Pay and performance relationship should
be revealed.
Bonuses should be tied to long-term
performance.
Shareholders should be able to vote on
executive compensation.
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Concluding Observations
Despite well-defined legal bonds between share
owners, boards of directors, and management,
there are many tensions between them.
Scandals revealed lax oversight of financial
strategies and reporting by many boards.
Many shareholders believe that boards have
allowed management compensation to exceed
reason.
The outlook is for more pressures and regulations
that tighten board oversight.

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