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Chapter 3

Corporate Governance

Ferrell, Thorne, Ferrell: Business in Society 7/e © 2021 Chicago Business Press. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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3-1 Define corporate governance

3-2 Describe the history and practice of corporate governance

3-3 Examine key issues to consider in designing corporate governance systems

3-4 Describe the application of corporate governance principles around the world

3-5 Provide information on the future of corporate governance

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What do you believe is the purpose of corporate governance?

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Governance

Stakeholders demand greater transparency in business.

Motives and actions must be clear, open for discussion, subject to scrutiny

Governance relates to the exercise of oversight, control, and authority

A board of directors should have final authority on decisions, including the ability to:

Approve corporate strategy

Provide financial oversight

Remove the CEO

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board of directors

a group of members who represent shareholders and oversee the firm’s operations and legal and ethical compliance

Oversight relates to a system of checks and balances that limit employees’ and managers’ opportunity to deviate from policies and codes of conduct

Accountability relates to how well of workplace decisions are aligned with a firm’s stated strategic direction

Control involves the process of auditing and improving organizational decisions and actions

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corporate governance

Formal system of oversight, accountability, and control for organizational decisions and resources

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Should be no conflict between maximizing profits and maintaining a stakeholder orientation

Firm’s are moving toward a balanced stakeholder model, see this approach will sustain the relationships necessary for long-term success

Obligations to balance stakeholder interest have been institutionalized in legislation that provides incentives for responsible conduct

shareholder

any person or entity that owns at least one share of a company’s stock

Both directors and officers of corporations are fiduciaries for the shareholders

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Fiduciaries

Persons placed in positions of trust who use care and loyalty in acting on behalf of the best interests of the organization

There is a duty of care, also called a duty of diligence, to make informed and prudent decisions

Duty of loyalty means that all decisions should be in the interests of the corporations and its stakeholders

Conflicts of interest exist when a person uses their position to obtain personal gain, usually at the expense of the organization

Insider trading is the act of purchasing or selling a public company’s security with access to nonpublic information about the company

Effective corporate governance creates compliance and values so that employees feel that integrity is at the core of competiveness

There should be oversight and authority for:

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Delegating tasks

Making difficult and sometimes controversial decisions

Balancing power throughout the firm

Maintaining social responsibility

How do you believe corporate governance has evolved over time in the U.S.?

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Late 1800s – Early 1900s

Less reason to talk about corporate governance because the owner of the firm was the same individual who made strategic decisions about the business

By the 20th Century

An increasing number of public companies and investors brought about a shift in the separation of ownership and control

Owner primarily bore the consequences (positive or negative) of decisions

History of Corporate Governance

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Since Mid-1900s

The approach to corporate governance has involved a legal discussion of principals and agents to the business relationship

Owners are “principals” who hire “agents,” the executives, to run the business

A key goal is to align the interests of principals and agents so that organizational value and viability are maintained

History of Corporate Governance

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Sarbanes-Oxley Act of 2002

Most significant piece of corporate governance reform at the time since the 1930s

CEOs and CFOs are required to certify that their quarterly and annual reports accurately reflect performance and comply with the requirements of the SEC

More independence of boards of directors

Protected whistle-blowers

Established a Public Company Accounting Oversight Board

History of Corporate Governance

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2000s

Corporate misconduct and the quest for short-term profits led the U.S. financial system to a near collapse during the last recession

Cause was a pervasive use of instruments like:

Credit default swaps

Risky debt like subprime lending

Corruption in major corporations

Government was forced to step in and bail out many financial firms

Board of directors should provide leadership for social responsibility initiatives

Some boards have been assuming greater responsibility for strategic decisions and have decided to focus on building more effective social responsibility

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How are corporate governance and social responsibility interrelated?

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Corporate social responsibility can be a difficult concept to define

Shareholder model–

Interpreted narrowly, a company can consider itself socially responsible if it generates returns for shareholders and provides jobs for employees

Stakeholder model–

A broad definition of social responsibility interprets the corporation as a vehicle for stakeholders and for public policy

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Shareholder Model of Corporate Governance

Focuses on improving the formal system of performance accountability between the top management and the shareholders

Stakeholder Model of Corporate Governance

A model where the business is accountable to all its stakeholders, not just the shareholders

Governance systems that consider stakeholder welfare in tandem with corporate needs and interests characterizes this approach

Has been criticized for its somewhat singular purpose and focus because there are other ways of “investing” in business

Shareholder model focuses on the primary stakeholder (the investor) whereas the stakeholder model incorporates a broader philosophy toward internal and external constituents

Although financial return is an important measure of success for all firms, the legal dimension of social responsibility is also a compulsory consideration

Ethical and philanthropic dimensions have not been traditionally mandated through regulation or contracts

Corporate Governance and Social Responsibility (cont.)

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What do you believe are key issues to consider when designing corporate governance systems?

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Today, board of directors are concerned primarily with monitoring the decisions made by managers on behalf of the company and…

Choosing top executives & assessing performance

Helping set strategic direction

Evaluating company performance

Developing CEO succession plans

Communicating with stakeholders

Maintaining legal and ethical practices

Ensuring that control & accountability mechanisms are in place

Evaluating the board’s own performance

Board of Directors

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Quality

Directors with competence and experiences that reflect some of the firm’s core issues should bring valuable insights to bear on discussions and decisions

Directors without direct industry or comparable executive experience may bring expertise on important issues such as:

Auditing	Executive compensation
Succession planning	Risk management to improve decision-making

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Performance

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As federal regulations increase and the latitude afforded boards of directors shrinks, boards are going to be faced with greater responsibility & transparency

Directors today are increasingly chosen for their proficiency and ability to bring different perspectives to strategic discussion

Performance

Rules promoted by the Sarbanes-Oxley Act & various stock exchanges now require:

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A majority of independent directors with no material relationship to the firm

Regular meetings between nonmanagement board members

No more than $120,000 in compensation for independent directors/year

Audit, compensation, governance, & nominating committees made up with only or majority of independent directors

A financial expert on the audit committee

Performance

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shareholder lawsuits

lawsuits brought against a key member of a company, like a director or executive, where a shareholder or group of shareholders is suing on behalf of the corporation

Shareholder Activism

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Shareholder Activism

Activism is a broad term that can encompass engaging in dialog with:

Engaging in dialogue with management

Attending annual meetings

Submitting shareholder resolutions

Bringing lawsuits

Other mechanisms designed to communicate shareholder interests to the corporation

Shareholder Activism

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shareholder resolutions

nonbinding, yet important, statements about shareholder concerns

A shareholder that meets certain guidelines may bring one resolution per year to a proxy vote of all shareholders at a corporation’s annual meeting

A proxy is an agent who is legally authorized to act on behalf of another person/party

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Investor Confidence

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Shareholders and other investors must have assurances that their money is being placed in the care of capable and trustworthy organizations

Primary stakeholders are expecting a solid return for their investment and they have additional concerns about social responsibility

Part of this trust relates to the perceived efficacy of corporate governance

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Internal Control & Risk Management

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Controls are used to:

Safeguard corporate assets & resources

Risk Management

Process used to anticipate and shield the organization from unnecessary or overwhelming circumstances

Protect the reliability of organizational information

Ensure compliance with regulations, laws, & contracts

While ensuring that executive leadership is taking the appropriate steps to move the organization and its strategy forward

Internal and External Audits

Auditing is the linchpin between risk and controls and corporate governance

Board of directors must ensure that the internal auditing function of the company is provided with:

Adequate funding

Up-to-date technology

Unrestricted access

Independence

Authority to carry out its audit plan

Board audit committee should be directly responsible for the selection, payment, and supervision of the company’s external audit

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(continued)

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(continued)

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Control Systems

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The area of internal control covers a wide range of company decisions and actions, not just the accuracy of financial statements and accounting records.

The board should have ultimate oversight of the integrity of the internal control system.

Smaller private companies and nonprofit organizations are less likely to have invested in a complete system.

Risk Management

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Most corporate leaders greatest fear is discovering serious misconduct or illegal activity somewhere in their organization

Whole concept of risk management involves recognizing the possibility of a misfortune that could jeopardize or even destroy the corporation

Risk is always present within organizations, so executives must develop processes for remedying or managing its effects

Risk Management

There are at least 3 ways to consider how risk poses either a potential negative or positive concern for organizations:

Risk can be categorized as a hazard

Focused on minimizing negative situations (fraud, injury, or financial loss)

Risk may be considered an uncertainty that needs to be hedged through quantitative plans and models

Type of risk is best associated with the term risk management

Risk also creates the opportunity for innovation and entrepreneurship

Management can be criticized for taking too much risk AND not taking enough risk

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Executive Compensation

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Dodd-Frank Act included measures to rein in overcompensation:

A “say-on-pay” mandate requiring shareholders to vote on their company’s compensation policies

“Compensation committee independence” requiring board members in charge of determining compensation to be independent from the company’s management

Some argue that executives deserve the rewards that follow from strong company performance, because they assume so much risk on behalf of the company

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Executive Compensation

An increasing number of corporation boards are imposing performance targets on the stock and stock options they include in their CEOs’ pay package

Corporate plans that base compensation on the achievement of several performance goals, including profit and revenue, are intended to align the interests of owners with management

Overall, CEOs’ compensation is decreasing, indicating a possible change in the ways executives are compensated

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As globalization continues to increase, how do you think it is affecting corporate governance?

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Increased globalization

Enhanced electronic communications

Economic agreements and zones

Reduction of trade barriers

Created opportunities for firms around the world to conduct business with both international consumers and industrial partners

Propel the need for greater homogenization in corporate governance principles

As financial, human, and intellectual capital cross borders, business, social, and cultural concerns arise

Corporate Governance Around the World

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The Organization for Economic Electronic Co-operation and Development (OECD)

Forum for governments to discuss, develop, and enhance economic and social policy, issued a set of principles intended to serve as a global model for corporate governance

Purpose of OECD Corporate Governance Principles if to formulate minimum standards of:

Fairness

Transparency

Accountability

Disclosure

Responsibility for business practice

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The OECD Corporate Governance Principles cover many specific best practices, include:

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Ensuring the basis for an effective corporate governance framework

Rights of shareholders to vote and influence corporate strategy

Greater number of skilled, independent members on boards of directors

Fewer techniques to protect failing management & strategy

Wider use of international accounting standards

Better disclosure of executive pay and remuneration

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Best practices may vary slightly from country to country because of unique factors such as:

Market structure

Government control

Role of banks and lending institutions

Labor unions

Other economic, legal, and historical factors

What do you believe the future of corporate governance holds for firms, managers, boards, & governments?

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Future of Corporate Governance

To pursue social responsibility, organizations must consider issues of control and accountability

The cost of governance

The benefits of a strong approach to corporate governance outweigh its cost

Positive return benefits the industrial competitiveness of entire nation

Lack of good governance can lead to insular and selfish motives

As nations with large economies embrace responsible governance principles, it becomes more difficult for nations and firms that do not abide by such principles to compete in these lucrative markets

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Future of Corporate Governance

The future of corporate governance is directly linked to the future of social responsibility:

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Business leaders & managers will need to embrace governance as an essential part of effective performance

Governments have a key role to play in corporate governance

Other stakeholders may become more willing to use governance mechanisms to influence corporate strategy or decision-making

Future of Corporate Governance

Key issue going forward will be the board’s ability to align corporate decisions with various stakeholder interests

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Future will require that business leaders have a different set of skills & attitudes, including the ability to:

Balance multiple interests

Handle ambiguity

Manage complex systems & networks

Create trust among stakeholders

Improve processes so that leadership is pervasive throughout the organization