Chapter 4 Business Ethics
Sarbanes-Oxley Act of 2002 (SOX)
*Amends securities laws to protect investors in public companies *Enhances public disclosure to require reporting of off-balance sheet transactions, and personal loans to executives *Limits the non-auditing services an auditor can provide to a firm it audits *Makes it unlawful for accounting firms to provide services where conflicts of interests exist *CEOs and CFOs must certify financials, and are held responsible for financial representations
Roles of Four Major Groups
*Shareholders - Own stock in the firm, giving them ultimate control (the shareholder-primacy model). *Board of Directors - Govern and oversee management of the business. *Managers - The individuals hired by the Board to manage the business on a daily basis. *Employees - Hired to perform actual operational work
An Alternative Model of Corporate Governance
*Shareholders* - Own stock in the firm, giving them ultimate control (the shareholder-primacy model). *Board of Directors* - Govern and oversee management of the business. *Managers* - The individuals hired by the Board to manage the business on a daily basis. *Employees* - Hired to perform actual operational work
CEO Pay- Firm Performance Relationship
Stock Options - Allows the recipient to purchase stock in the future at the price it is today. Backdating - Allows the recipient to purchase stock at yesterday's price, resulting in immediate wealth increase. Spring-Loading - Granting of a stock option at today's price, but with the inside knowledge that stock's value is improving. Bullet Dodging - Delaying of a stock option grant until right after bad news. **Alignment of incentives (stock options)
An Alternative Model of Corporate Governance cont.
The Anglo-American model of corporate governance is one of *shareholder primacy* A emerging perspective is a director-primacy model of *corporate governance* A *director-primacy* model is based on the concept of a corporation that is not owned, but is an independent legal entity that owns itself. *Boards are mediating hierarchs, responsible for balancing competing interests of stakeholders *Boards have a duty to shareholders, but boards are the ultimate decision-makers, whose duty is to the corporation
Board Member Liability
The Business Judgment Rule protects board members if: *they act in good faith, *making informed decisions that reflect the company's best interests, and not their own interests. Good Faith is central to the defense The argument in favor of the Business Judgment Rule is that Board members need to be free to take risks without fear of liability.
Macro Level of Legitimacy
Focus is on the corporate system, the totality of business enterprises. Business has a fragile mandate, subject to ratification. Business exists solely because society has given it that right.
Excessive CEO Pay
Generally viewed as overpaid Robert Nardelli became the poster boy for this view after he received $210 million when he was ousted from Home Depot by shareholders. Why does this happen? Generally regarded as a corp. governance problem Say on Pay Dodd-Frank Act *Evolved from concerns over excessive executive compensation. *Advisory vote by shareholders on senior executive pay. **Clawback provisions Compensation recovery mechanisms that enable a company to recoup CEO pay, typically in the event of a financial restatement or executive's misbehavior.
The Role of the SEC
*The SEC Is responsible for protecting investor interests. *Critics argue that the SEC is more focused on the needs of businesses than on that of investors. *The SEC failed to stop the Bernard Madoff Ponzi scheme before losing investors billions, although they had been warned of the scheme a decade earlier.
Red Flags Signaling Board Problems
1. Company has to restate earnings. 2. Poor employee morale. 3. Negative risk assessment from auditor. 4. Poor customer satisfaction track record. 5. Management misses strategic performance goals. 6. Company is target of employee lawsuits. 7. Stock price declines. 8. Quarterly financial results miss analysts' expectations. 9. Low corporate governance quotient rating.
Say on Pay Movement
1. Shareholder push to link pay to performance 2. Increasing use of "clawback" provisions where executives must return pay under some conditions
Transparency
1.Exec compensation packages may include deferred pay, Severance, pension benefits, & other perks over $10,000. 2.SEC Rules require disclosure of executive compensation 3.Such disclosures may have a moderating impact prior to implementation.
Separation of Ownership from Control Contributes to Governance Problems
Agency problems develop when managers pursue self-interest over owner interest Separation of ownership and management is what leads to the agency problem
The Board's Relationship with CEO
Boards are responsible for monitoring CEO performance and dismissing poorly performing CEO Formerly, CEOs were protected; no more; firings of CEOs are up significantly If CEO also serves as Chairman of the Board, this duality can offer some protection to the CEO Activists have moved to separate CEO and Board functions
Issues Surrounding Compensation
CEO Pay-Firm Performance Relationship Excessive CEO Pay Executive Retirement Plans & Exit Packages Outside Director Compensation Transparency; SEC Rules **Excessive CEO pay can create an agency problem
Fraud Triangle
Leadership, culture, management controls The fraud triangle illustrates that the most important lessons from Enron lie in the way that a corporate culture championed by CEO Skilling overcame a sophisticated and widely lauded set of management controls and in the importance of carefully balancing the core concepts of leadership, organizational culture and control within organizations. Organization-wide fraud is only possible when these three variables are configured in a way that enables - and even fosters - manipulation and fails to prevent compliance failure. Leadership and culture out-weigh management controls
Legitimacy
Legitimacy - A condition that prevails when there is a congruence between an organization's activities and society's expectations. Legitimation - A dynamic process by which a business seeks to perpetuate its acceptance. Enron (& Sub-Prime Mortgage Crisis) - Placed into question the legitimacy of business and what legitimation steps needed to be taken.
Changes in boards of directors
More Board diversity A greater ratio of outside board members to inside board members Use of board committees to: Ensure that financials are not misleading Ensure that internal controls are adequate Follow-up allegations of irregularities Ratify the selection of an external auditor
The Need for Board Independence
Outside directors - are independent from the firm Inside directors - have some tie to the firm Board independence from management is crucial to good governance. **Problem with outside directors don't have the same expertise as inside
Outside Director Compensation
Paying board members is a recent idea. Today, outside board members are paid. From 2003-2010, their median pay rose about a third, from $175,800 to $233,800. Controversy over whether directors should be paid at all, and whether they are paid enough.
Corporate Governance
Refers to the method by which a firm is being governed, directed, administered, or controlled, and to the goals for which it is being governed. Is concerned with the relative roles, rights, and accountability of such stakeholder groups as owners, boards of directors, managers, employees, and other stakeholders. ENRON disaster is viewed first and foremost as a failure of corporate governance.
Executive Retirement Plans and Exit Packages
Retirement packages - have come under scrutiny. *$210 million to Robert Nardelli when he was ousted from Home Depot. *$125 million to outgoing Bank of America CEO, Ken Lewis In contrast, many of today's workers do not have a retirement plan. Those who do generally have a defined contribution plan, rather than a defined benefit plan.
The Corporation's Hierarchy of Authority
State Charter Shareholders Board of Directors Management Employees
The Role of Shareholders
The Shareholder Democracy Movement rises from the fact that although they are owners, shareholders may find that their votes are not counted. They seek: *A Majority Vote The requirement that board members be elected by a majority of votes cast, rather than by a plurality. *Banning Classified or Staggered Boards Electing members in staggered terms means that it might take 3 or more years to replace a board. *Proxy Access Would provide shareholders with the opportunity to propose nominees for the board of directors.
Investor Relations
A majority of corporate boards now communicate with their major investors Public corporations have obligations to current and potential shareholders, including Full disclosure (Transparency), and the duty to provide information that might affect investment decisions. Management is also responsible for communicating with shareholders. CEO Warren Buffet calls his annual shareholder meeting a "Woodstock weekend for capitalists."
Micro Level of Legitimacy
Adapt operational methods to perceived societal expectations. Attempt to change societal expectations or norms to conform to firm's practices. Seek to enhance its legitimacy by identifying itself with others that have a powerful legitimate base in society.
Mergers and acquisitions
Expectation is that the threat of a possible takeover will motivate top managers to pursue shareholder, rather than self-interest. But many corporate CEOs and boards go to great lengths to protect themselves from takeovers, using: **Poison Pills: Discourages a hostile takeover by making the firm difficult to take on **Golden Parachutes Company agrees to pay key officers in the event of a change in control of the corporation)
Insider Trading
The practice of buying or selling a security by someone who has access to material information that is not available to the public. "Material Information" is information that a reasonable investor might want to use, and is likely to affect the price of the firm's stock. A "tipper" provides that information A "tippee" receives the information Executives and others who work for a firm may have inside information Also those in relationships that include a duty of confidentiality may have inside information, including spouses, parents, children, friends.