Business, Government and Society MidTerm

Shareholders and Corporate Governance BUS 166, Week 10 Matthew Maguire [email protected] San José State University

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1. Who are shareholders?

2. Principles of good corporate governance

3. Executive compensation

4. Shareholder activism

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Who are shareholders?

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Ownership

In the United States, only about 1% of companies are publicly owned (i.e., shares traded on stock exchange). However, these companies provide around one-third of employment.

Many private companies also issue stock, though this stock cannot be traded on public exchanges and shareholders may be restricted from selling their shares to outsiders.

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Ownership

Prior to its initial public offering (IPO) in March 2019, Ly t had been a privately-owned company since its launch in June 2012.

Why do you think Ly t decided to go public? https://www.pbs.org/newshour/economy/makin g-sense/lyft-and-ubers-plans-to-go-publi c-explained

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Who are shareholders?

Shareholders = the legal owners of business corporations (also called stockholders or investors)

Types of shareholders: • Individual shareholders are people who directly own shares of stock issued by companies.

• Institutional investors — pension funds, mutual funds, insurance companies, and university endowments.

• Example: Tower Foundation at SJSU http://www.sjsu.edu/towerfoundation/about /financials/index.html

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Shareholder 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 decade earlier—see next slide.)

• In 2013, 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, about 24% of young households do so.

• Equity ownership is higher as income and education rises.

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Objectives of stock ownership

To produce a return greater than they could receive from alternative investments (e.g., bonds).

Shareholders make money when:

• the price of the stock rises (capital appreciation)

• they receive their share of the company’s earnings (capital dividends)

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Objectives of stock ownership

Shareholders are not a uniform group:

• Some seek long-term appreciation.

• Some seek short-term returns.

• Some seek capital gains.

• Some seek dividend income.

Some investors use stock ownership to achieve social or ethical objectives.

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Legal rights of shareholders

• To share in the profits of the enterprise if directors declare dividends.

• To receive annual reports of company earnings and company activities.

• To inspect the corporate books.

• To elect members of the board of directors.

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Legal rights of shareholders

To hold the directors and officers of the corporation responsible for their actions.

To vote on mergers, some acquisitions, and changes in the charter and bylaws.

To bring other business-related proposals before all shareholders.

To sell their stock.

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Securities and Exchange Commission (SEC)

Why is government regulation needed to protect shareholders?

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Securities and Exchange Commission (SEC)

• The major government agency charged with protection of shareholder interests. https://www.sec.gov

• Established in 1934, in the wake of the Great Depression.

• Mission: to protect shareholders’ rights by making sure that the stock markets are run fairly.

• Government regulation is needed because shareholders can be damaged by abusive practices.

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Securities and Exchange Commission (SEC)

Information transparency and disclosure:

• In recent years, management has tended to disclose more information to shareholders 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 before the financial crisis may have led investors to underestimate their risk.

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Securities and Exchange Commission (SEC)

Insider trading:

• Occurs when a person gains access to confidential information about a company’s financial condition and uses that information, before it becomes public knowledge, to buy or sell the company’s stock for a profit. https://markets.businessinsider.com/news/stocks/nfl-mychal-kendricks-faces-8-gam e-suspension-insider-trading-report-2018-10-1027672936

• It is illegal under SEC Act of 1934 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.

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Securities and Exchange Commission (SEC)

The S.E.C. also protects shareholders from fraud.

• PBS documentary on Bernard Madoff’s Ponzi scheme: https://www.pbs.org/wgbh/frontli ne/film/madoff/

• Documentary on accounting fraud at Enron, The Smartest Guys in the Room: http://watchdocumentaries.com/enron-the -smartest-guys-in-the-room//

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Principles of good corporate governance

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Corporate governance

Corporate governance = refers to the process by which a company is controlled, or governed.

The board of directors plays a central role in corporate governance.

• The board of directors is 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

• Boards 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).

What is the advantage of having more outside than inside directors?

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Boards of directors

• Board members are elected by shareholders at the annual meeting, where absent owners vote by proxy.

• Process is not truly democratic; board membership tends to be self-perpetuating.

• The board nominating committee, working with the CEO and chairman, develops a list of candidates.

• A ter final selection, the names of these individuals are placed on the proxy ballot.

• Alternative candidates are rarely presented.

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Principles of good governance

Key features of effective boards:

• Select outside directors to fill most positions.

• Hold more open elections for members of the board (i.e., allow more proxy access).

• Appoint an independent lead director (i.e., not the CEO).

• Align director compensation with corporate performance.

• Evaluate the board’s performance on a regular basis.

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Executive compensation

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Executive compensation

Setting executive compensation is a key function of the board.

• The emergence of the modern, publicly held corporation in the late 1800s effectively separated ownership and control.

• This development gave rise to the agency problem: as hired agents, managers might act to benefit themselves, rather than owners.

• Executive compensation is an important mechanism for aligning the interests of the corporation and its shareholders with those of its top managers.

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Executive compensation

• Many critics feel that this system is not working and executive pay has become excessive. https://www.asyousow.org/report/th e-100-most-overpaid-ceos-2019

• Executive compensation in the U.S., by international standards, is very high.

• In 2014, the median total compensation of chief executives of the largest corporations in the United States was $17.6 million.

• Stock options (i.e., the right to buy stock at a set price) is a controversial subject on its own—see next slide.

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Executive compensation

Pay-for-performance approaches:

• If compensation is tied to the stock price, will executives work harder to improve results for the company—results that will also benefit shareholders and/or employees?

• In 2014, 54% of executive pay was performance-based.

• Critics warn that unscrupulous executives may become so fixated on their performance pay that they will do anything to increase the stock price, even if this involves unethical actions.

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Median executive compensation

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Ratio of CEO pay to worker pay

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Are such high levels of executive pay justified?

In favor of high executive pay:

• Well-paid managers are simply being rewarded for outstanding performance.

• High salaries provide an incentive for innovation and risk-taking.

• High compensation reflects a shortage of labor; necessary to attract top talent.

• Not many individuals are capable of running today’s large, complex organizations.

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Are such high levels of executive pay justified?

Against high executive pay:

• Inflated executive pay hurts the ability of U.S. firms to compete with foreign rivals.

• High executive pay causes mid- and lower-level employees to feel they are not receiving their fair share.

• Empirical evidence finds weak relationship between executive pay and company success.

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Government rules on executive compensation

• Under U.S. rules, corporations must disclose top five 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 non-binding shareholder votes on executive compensation at least once every three years.

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Shareholder activism

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Shareholder activism

Rise of institutional investors:

• Holdings have increased significantly; have become more assertive in promoting interests of their members.

• Have large blocks of stock not easy to sell if become dissatisfied.

• Strong incentive to work to change management policy.

• Council of Institutional Investors — represents institutions and pension funds with investments collectively exceeding $3 trillion in holdings. https://www.cii.org/general_members

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Shareholder activism

Rise of institutional investors:

• Research shows involvement of institutional investors can improve company performance.

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Shareholder activism Social investment (also called socially responsible investment or impact investment):

• Refers to the use of stock ownership as a strategy for promoting social, environmental, and governance objectives. https://www.ussif.org/sribasics

• Can be done in two ways:

• Through selecting stocks according to various social criteria (stock screening).

• By using the corporate governance process to raise issues of concern (shareholder resolutions and lawsuits).

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Shareholder activism Stock screening:

• A growing number of mutual funds and pension funds use social screens to select companies in which to invest. https://www.calvert.com/what-is-your-impact.php

• In 2014, $6.6 trillion in the United States was invested in mutual funds or pensions using social responsibility as an investment criterion.

• Socially responsible investing has rapidly grown in Europe and beyond.

• Social criteria may also be used when selling stocks. 35 / 38

Shareholder activism Shareholder resolutions:

• A resolution on an issue of corporate social responsibility placed before shareholders for a vote at the company’s annual meeting. https: //www.asyousow.org/resolutions-tracker/

• Resolutions can be about social issues, not company’s ordinary business.

• Significant rise—about 400 were sponsored in 2015 by faith-based institutions, individual shareholders, unions, etc.

• In some cases, managers enter into a dialogue with shareholder activists and resolve an issue before the election.

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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 a right to bring lawsuits. https://www.law.com/nationallawjournal/2018/07/25/report-shareholder-lawsuits-being-filed-a

t-record-pace-and-theyre-getting-bigger/?slreturn=20180931183631

• Shareholder lawsuits maybe initiated to check abuses (e.g., insider trading; inadequate stock buyout price; timely disclosure of material information).

• The outcome can be very expensive for companies. 37 / 38

Shareholders and the corporation

Shareholders 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.

• Play a very important role in making the business system work.

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