Chapter 13

Corporate Governance in the

Twenty-First Century
OBJECTIVES

1 Explain what is meant by corporate governance

2 Describe how corporate governance relates to
competitive advantage and understand its basic
principles and practices
3 Identify the roles of owners and different types
of ownership profiles in corporate governance
4 Describe how boards of directors are structured
and the roles they play in corporate governance
5 Explain and design executive incentives as a
corporate governance device
6 Describe how the market for corporate control is
related to corporate governance
7 Compare and contrast corporate governance
practices around the world

2
SUNBEAM
Al Dunlap’s mgmt. philosophy
1. Shareholders are most important
corporate constituents
2. Most corporations have bloated
bureaucracies
3. Drastic layoffs are usually needed
to save failing companies
4. Layoffs should be quick,
one-time events
5. CEOs should be rewarded like
stars when they perform well
and fired when they do not
6. Board members should have
significant personal investments
in the company
Results
• Costs slashed
Early • Stock doubled in first month
success • Market cap rises from $1.1
billion to $5 billion
• With R&D budgets cut, new
product development hampered
Signs
of problems
• Growth fails to meet targets
• Company accused of “channel
stuffing”
• Board fines Dunlap
Failure • He looses his stock options
• Sunbeam stock is delisted
3
CORPORATE GOVERNANCE

In a broader perspective, governance determines how all

stakeholders influence the corporation:

Share holders

Corporate governance Board Management

The system by which
organizations,
particularly business Corporation
corporations, are
directed and controlled
by their owners Employees Society

Environment

4
CORPORATE GOVERNANCE IMPACTS PERFORMANCE

The Italian stock Companies of the STAR

exchange started exchange consistently
a new exchange out perform their
called STAR for counterparts on the
small and mid- regular exchange (e.g.,
sized companies during 2004 STAR firms
that followed achieved returns 24.5%
strict governance greater than their
prescriptions counter parts)

5
EARLY WARNING SIGNS OF PROBLEMS WITH KRISPY KREME

Source: M. Maremont and R. Brooks, “Fresh Woes Batter Krispy Kreme; Doughnut Firm to Restate Results, Delay SEC Filing; Shares Take a 15% Tumble,” Wall
Street Journal (Eastern edition), January 5,2005.p.A3 6
AGENTS AND PRINCIPALS

• When interests are virtually

identical, the agency
problem is small: executives
Principal Agents do what is in principals’ best
s interests
Shareholders Act on behalf
of a firm of principals • However interests often do
in managing not overlap. Then agents
the firm may act to detriment of
principals and visa-versa
(e.g., executives raise
salaries and reduce returns)

7
EXAMPLES OF CODES OF GOVERNANCE

What is the Can the same Is disclosure required

recommendation executive be both if the company does
on director CEO & Is auditor rotation not comply with the
Country independence? chairperson? required? recommendations?

Brazil CVM As many as possible Split recommended Not addressed No

Code (2002)

Russia CG Code At least one-quarter Split required by law Not addressed No

(2002)

Singapore CG At least one-third Split recommended Not addressed Yes

Committee
(2001)

United Kingdom Majority Split recommended Periodic rotation of Yes

Cadbury Code1 lead auditor

United States Substantial majority Separation is one of Recommended3 No

Conference three acceptable
Board and alternatives
CalPers (2003)2

1. In 2003, a Combined Code made further additions to the code, but these basic principles remain
2. Just one of several codes in existence in the United States
3. The Sarbanes-Oxley Act requires that the lead audit partner be rotated every 5 years; changing audit firm after 10 years of continual relationship or if former audit
partner is employed by the company 8
SOME NEW COMPLIANCE RULES FROM SARBANES-OXLEY

• Auditors must list the non-audit services they are unable to perform
during an audit
• A one-year waiting period for audit-firm employees who leave an
accounting firm to become an executive for a former client
• Transactions and relationships that are off the balance sheet but that may
affect financial status must now be disclosed
• Personal loans from a corporation to its executives are now largely
prohibited
• Research analysts for securities firms must now file conflict of interest
disclosures. For instance, analysts must report whether they hold any
securities in a company or have received corporate compensation
• Brokers and dealers must disclose if the public company is a client
• Altering, destroying, concealing, or falsifying records or documents with
the intent to influence a federal investigation or bankruptcy case is
subject to fines and up to 20 years of imprisonment

9
OWNERSHIP STRUCTURE VARIES

Source: Company annual reports 10

ROLES AND ACTIONS OF BOARD OF DIRECTORS

11
EFFECTS OF CEO FIRINGS

Source: M.wiersema, “Holes at the Top: Why CEO Firings Backfire,” Harvard Business Review 80;12 (2002), 70-77
12
INCENTIVE ALIGNMENT

Conflicts of interest can arise

Incentive
alignment can solve
Principal Agents such problems
s

Example:

• A company receives a buy-out

offer Boards can include
• Shareholders (principals) would “golden parachute”
benefit because price assures a provisions in
good return on investment manager’s
compensation
• Management (agents) resists packages
because they may lose their
jobs

13
HOW WOULD YOU DO THAT? – DENDRITE INTERNATIONAL

Dendrite’s challenge: Dendrite’s solution:

How can Dendrite better align  20 senior-most executives must

management own 15,000 to 100,000 shares of
incentives with shareholders? stock
 Must be common shares
not options
 Must be achieved within 5 years
 Executives may elect to receive
incentive compensation in
stock instead of cash

14
EXECUTIVE STOCK OWNERSHIP IN 2004

Largest 250 companies with

stock ownership guidelines

Number of Percent of Percent increase

companies companies from 2001 to 2004

Executives 142 57 58

Directors 123 49 127

Source: Adapted from Fredrick W. Cook & Co., Inc., “Stock Ownership Policies: Prevalence and design of Executive and Director
Ownership Policies Among the Top 250 Companies,” www.fecook.com/surveys.html (accessed Nov 29, 2005), Sep 2004 15
INCENTIVE COMPENSATION

Oldest form of incentive pay. Board can evaluate executives’

Annual bonus
performance along multiple dimensions and allocate a year-
plans
end cash award

An employee receives the right to buy a set number of shares

Stock options
of company stock at a later date for a predetermined price

More recent forms of incentive compensation. Long-term

Other long-term
bonuses linked to performance over several years. May help
incentives
executives avoid short-term myopia and focus on long-term

16
CEO PAY COMPARISON

17
HIGHEST PAID CEOs

Source: Company annual reports and ExecComp Service of Thomson Financial 18

EXECUTIVE PAY TRENDS

Source: U.S. Bureau of Labor Statistics 19

THE MARKET FOR CORPORATE CONTROL

Share holders

Elect
Corporate control: Example:

The right to choose Board • Corporate raiders such

the members of the as T. Boone Pickens,
board of directors CarI Icahn, Ted Turner
Hires/fires
of a company and and Michael Milken
to control all major • Oracle engaged in 18-
decisions made Top management
month battle to gain
by a company control of PeopleSoft
Directs

Corporation

20
POOR CORPORATE GOVERNANCE, A WORLD-WIDE PROBLEM

Recent examples of scandal-ridden non-U.S. multinationals

• Netherlands Ahold Group (grocery stores)

• Italy’s Parmalat (dairy and food products)

• France’s Vivendi (entertainment)

• French-Belgian Firm ELF (petroleum)

21
CORPORATE GOVERNANCE: U.S VS. JAPAN

U.S Japan

Owner-manager
Adversarial Co-operative
relationship

Manager and Through a Keiretsu

Through one
shareholder (group of interlocking
company
relationship companies)

Ownership
Control function Monitoring function
concentration

22
CORPORATE GOVERNANCE IN GERMANY AND CHINA

Germany China

• Two-tier board system • Only recently started a

securities market
• Management board • Majority of listed
manages the enterprise companies started off as
state-owned enterprises
• Supervisory board • State ownership remains
appoints, supervises, and high across all industries
advises members of the
management board

23
HOW WOULD YOU DO THAT? – CHIQUITA

How should Chiquita compensate its new CEO?

Chiquita Dole Del Monte

Sales 2004 2,613 4,773 2,171

The Chiquita board set
($ millions)
objectives as:
1. Delivery of quality Net income 96 84 134
products to ($ millions)
consumers CEO salary 950 810
2. Quality returns to ($ thousands)
shareholders What is
CEO bonus 1,368 870
appropriate?
3. Transform Chiquita ($ thousands)
into a global player
CEO total 4,387 7,394
Compensation
($ thousands)

Source: Company annual reports 24

SUMMARY

1 Explain what is meant by corporate governance

2 Describe how corporate governance relates to
competitive advantage and understand its basic
principles and practices
3 Identify the roles of owners and different types
of ownership profiles in corporate governance
4 Describe how boards of directors are structured
and the roles they play in corporate governance
5 Explain and design executive incentives as a
corporate governance device
6 Describe how the market for corporate control is
related to corporate governance
7 Compare and contrast corporate governance
practices around the world

25