TOPIC 4 (RESPONDING TO

PRIMARY
STAKEHOLDERS)
Part 1
Stockholder Rights and
Corporate Governance
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
 T4 P1: Key Learning Objectives
 Identifying different kinds of stockholders and
understanding their objectives and legal rights
 Knowing how corporations are governed and
explaining the role of the board of directors in
protecting the interests of owners
 Analyzing the function of executive compensation
and debating if top managers are paid too much
 Evaluating various ways stockholders can promote
their economic and social objectives
 Understanding how the government protects against
stock market abuses, such as fraudulent accounting
and insider trading

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Stockholders
 Stockholders (also called shareholders)
The legal owners of business corporations

 Types of stockholders
 Individual stockholders are people who directly own
shares of stock issued by companies (Main Street
investors)
 Institutions, such as pension funds, mutual funds,
insurance companies, and university endowments
• Called institutional investors (Wall Street
investors)

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Stockholders Trends
 In 2010, institutions accounted for 63% of the value of all
U.S. stocks, worth $15 trillion
 About eight times the value of institutional holdings
two decades earlier
 Slightly over half of all U.S. households own stocks,
either directly or indirectly through holdings in mutual
funds
 Older people are more likely to own stock, slightly less
than 40% of young households do so
 At all ages, equity ownership is higher as income and
education rises

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 Figure 14.2
Household versus Institutional
Ownership in the United States

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Objectives of Stock Ownership
 To produce a return greater than they could receive from
alternative investments
 Stockholders make money when the price of the stock rises (capital
appreciation) and when they receive their share of the company’s
earnings (called dividends)
 Bull markets (in which share prices rise overall) alternate with bear
markets (in which share prices fall overall)
 Although stock prices can be volatile, stocks historically have
produced a higher return over the long run than many other types
of investments (bond or money market)
 Some investors use stock ownership to achieve social or
ethical objectives
 Discussed further under “social investment”
 Companies which are new and with good prospects for rapid
growth, do not distribute dividends (stockholders are invested with
the goal of capital appreciation)
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 Major Legal Rights of
Figure 14.3 Stockholders

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Corporate Governance
 Corporate governance
 Refers to the process by which a company is
controlled, or governed

 Board of directors
 An elected group of individuals who have a legal
duty to establish corporate objectives, develop
broad policies, and select top-level personnel to
carry out these objectives and policies

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Boards of Directors
 Vary in size, composition, and structure to best serve the
interests of the corporation and shareholders
 Survey of governance practices in leading firms in the
Americas, Europe, and Asia Pacific:
 Average board size was 12 members
 Typically, 10 or 11 of these are outside directors (not managers of
the company) [Independent Directors]
 Work of the Board is done through committees:
 Typical committees: Compensation, Executive, Nominating, Audit
 Audit has key role to review financial reports, recommend outside
auditors, and oversee integrity of internal financial controls
(normally formed up by outside directors)

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Boards of Directors (Cont’)
 Board Structure in Europe is called two-tier
system, companies have two boards:
 Executive Board, formed up by CEO and other
internal managers
 Supervisory Board, made up outsiders and has an
independent chairperson
 Compensation committee staffed by outside
directors, help in administer and approve salaries
and other benefits of high level managers in the
company

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Boards of Directors (Cont’)
 Board members are elected by shareholders at the
annual meeting, where absent owners vote by proxy
 Process is not truly democratic, but tends to be self-
perpetuating (limited choices)
 The board nominating committee, working with the CEO and
chairman, develops a list of candidates. Once approved by the
Board, the names of these individuals are placed on the proxy
ballot. Because alternative candidates are often not presented,
the vote has little significance.
 Pilot Boards, see their role as actively guiding the company’s
strategic direction
 Watchdog Boards, see their role as assuring compliance with
the law and intervening in management decisions only if
something is clearly wrong
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Key Features of Effective Boards
 Select outside directors to fill most positions (truly
independent)
 Hold open elections for members of the board
 Appoint an independent lead director and hold
regular meetings without the CEO present (Non-
Executive Chairman of the Board)
 Align director compensation with corporate
performance
 Evaluate the Board’s performance on a regular
basis
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Improving Corporate Governance
Worldwide
 OECD (The Organization for Economic Cooperation and
Development), representing 36 nations, issued a revised set
of principles of corporate governance in 2004 to serve as a
benchmark for companies and policy makers worldwide
 The OECD 2009 report concluded that the financial crisis
affecting may of its member states had been caused to an
important extent by failures of corporate governance, and it called
for re-examination of the adequacy of these principles

 EU, South Africa, and India have worked hard to

modernize corporate governance practices, but progress
has been slow in emerging markets
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Executive Compensation
 Executive compensation is a key Board function
 An important mechanism for aligning the interests of the
corporation and its stockholders with those of its top
managers
 Many critics feel that this system is not working and
executive pay has become excessive
 Executive compensation in the U.S., by international
standards, is very high
 In 2011, the median total compensation of chief executives of the
largest corporations in the United States was $9.6 million
(including salaries, bonuses, benefits and stock options)
• Stock options is controversial subject on its own
• Put managers into the shoes of shareholders (align their
interest)

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 Figure 14.4
Relative Median Executive Compensation
in the United States and Selected European
Nations

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 Figure 14.5
Ratio of Average CEO Pay to Average
Production Worker Pay, 1990–2010

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Executive Compensation: Is it
Justified?
 Arguments of proponents of high executive pay
 Well-paid managers are simply being rewarded for outstanding
performance
 High salaries provide an incentive for innovation and risk-taking
 Not many individuals are capable of running today’s large,
complex organizations

 Arguments of critics of high executive pay

 Inflated executive pay hurts the ability of U.S. firms to compete
with foreign rivals (money that initially can be used for business
investment, increase stockholder dividends or pay workers more)
 Multimillion dollar salaries cause resentment, sap the commitment
of hardworking lower and midlevel employees
 As many extravagantly compensated executives preside over
failure as they do over success

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Executive Compensation Reform
 Has been the subject of shareholder pressure
 Some companies have changed the way they structure
executive pay, e.g., by tying pay more directly to company
performance
 Small number of companies set multiple of executive pay
versus others workers
 Government regulations
 Under U.S. rules, corporations must disclose top 5
executives’ compensation and the rationale for it
 The say-on-pay provisions of the Dodd-Frank Act, which
went into effect in 2011, require public companies to hold
shareholder votes on executive compensation at least once
every three years
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Shareholder Activism – Rise of Institutional Investors
 As shown earlier, holdings (stakes held by institutional investors,
such as mutual funds, pension funds, endowment funds) have
increased significantly; have become more assertive in
promoting interests of their members
 Have large blocks of stock so not easy to sell if become
dissatisfied, therefore strong incentive to work to change
management policy (cannot sell then change)
 Council of Institutional Investors (CII)
 Represents institutions and pension funds with investments
collectively exceeding $3 trillion in holdings
 Developed a Shareholder Bill of Rights (this council has urged their
members to view their proxies as assets, voting them on behalf of
shareholders rather than automatically with management)
 Research shows involvement of institutional investors can
improve company performance
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Shareholder Activism – Social Investment
 Social investment (Social Responsibility Investment)
 Refers to the use of stock ownership as a strategy for promoting
social objectives; also called social responsibility investment
 This can be done in 2 ways: (1) through selecting stocks according
to various social criteria; (2) by using the corporate governance
process to raise issues of concern
 Social screening of stock
 Some stock purchasers choose stocks based on social or
environmental criteria, called social screens
 In 2010, $3.1 trillion in the United States was invested in mutual
funds or pensions using social responsibility as an investment
criterion (to do investment)
 Rapid growth in similar funds in Europe and beyond
 Shareholders wishing to choose stocks based on social,
environmental or governance criteria often turn to screened funds
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Shareholder Activism – Social
Responsibility Shareholder Resolutions
 Social responsibility shareholder resolutions
 A resolution on an issue of corporate social responsibility placed
before stockholders for a vote at the company’s annual meeting
 Has been a significant rise in social responsibility
shareholder resolutions in recent years – about 400 were
sponsored or supported in 2011
 Sponsorship is often from a coalition of groups, like Interfaith Center
on Corporate Responsibility (groups of institutional investors that
formed up their alliance which main concern on CSR)
 Resolutions can be about social issues, not company’s
ordinary business
 In 2011, such resolutions garnered, on average, 21 percent
of votes cast, an all-time high (started to gain popularity)

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Shareholder Activism –
Shareholder Lawsuits
 If owners think they or their company have been damaged
by actions of company officers or director, they have right
to bring lawsuits (either on personal basis or on behalf of
the company – derivative lawsuit)

 Can be initiated to check abuses, for example insider

trading, inadequate stock buyout price, or timely
disclosure of material information

 The outcome can be very expensive for companies

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Securities and Exchange Commission
(SEC) [Securities Commissions]
 Government agency charged with protection of stockholder
interests
 Established in 1934 in the wake of the Great Depression
 Mission is to protect stockholders’ rights by making sure that
the stock markets are run fairly and that investment information
if fully disclosed
 Unlike more government agencies, generates revenue to pay
for its own operations (revenue refers to fees from companies
listed in the major stock exchanges)
 Two areas calling for regulatory attention are: (1) protecting
stockholders from fraudulent financial accounting; (2) from
unfair trading by insiders
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SEC – Information Transparency and
Disclosure
 Giving stockholders more and better company information
is one of best ways to safeguard investor interests
 In recent years, management has tended to disclose more
information than ever before to stockholders and other
interested people
 Although the overall trend has been to greater
transparency, some observers felt that a lack of disclosure
about complex financial instruments (example like
mortgage-backed securities) that became common in the
mid-2000s may have led investors to underestimate their
risk
 Enactment of Sarbanes-Oxley Act
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 SEC - Insider Trading
 Insider trading
 Occurs when a person gains access to confidential information
about a company’s financial condition and then uses that
information, before it becomes public knowledge, to buy or sell the
company’s stock
 Is illegal under SEC Act of 1934, meaning against the law
to:
 Steal nonpublic information and use it to trade a stock
 Trade a stock based on a tip from someone who had an obligation
to keep quiet
 Pass information to others with an expectation of gain
 Insider Trading laws are important in order for investors to have
full confidence in the fundamental fairness of the stock markets
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Stockholders and the Corporation
 Stockholders have become an increasingly powerful
and vocal stakeholder group in corporations
 Provide capital
 Monitor corporate performance
 Assure the effective operation of stock markets
 Bring new issues to the attention of management

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