Corporate Governance
Trouble results from
(leading to civil suits and penalties) or dishonesty (leading to criminal indictments and penalties).
A problem with stock options that are "under water"
(that is, market price is below strike price) is their reduced incentive effect. Another problem is how to value stock options at the grant date for financial accounting purposes.
The shareholders, either in person or by proxy
normally elect a slate of directors at an annual meeting. The existing board normally nominates an unopposed slate
The board hires and delegates
operational responsibility to the CEO
Internal control systems should report
timely information about critical successes and failures up the management chain to the board level at the appropriate degree of detail.
Weak boards sometimes delegate
too much decision authority to management, without adequate oversight.
It has three distinctive features
unlimited life, limited liability for its owners, and divisibility of ownership that permits transfer of ownership without disruption
The board profile consists of dimensions such as
1] independence meaning insiders versus outside directors, [2] perhaps retired executives of corporation, [3] perhaps major shareholders who hold large block of shares, [4] the company's lawyer, banker, consultant, customer, or supplier, [5] expertise in running a business or functional area such as accounting or financial management.
Good governance implies the following:
: [1] an effective board that carries out its responsibilities with integrity and competence, [2] the board hires a competent CEO, [3] the CEO a business in which the company can compete effectively and profitably and for which it has or can obtain the necessary resources, [4] the CEO creates a valid business concept encompassing customers, goods or services, means or processes; the CEO effectively implements the business concept; the company has systems to ensure that the company meets its obligations in compliance with laws and regulations and achieves full and timely disclosure.
The laws pertaining to corporations have seven goals
: to maintain competitive markets, regulate non-competitive markets, maintain a balance between capital and labor, ensure orderly capital markets, protect consumers from unsafe products and fraud, ensure equal access to employment, education, and housing, and protect the environment.
States issue and administer
Corporate Charters (especially Delaware)
The selection process depends on the surrounding circumstances.
Did the old CEO retire in due course? Did the old CEO suddenly quit? Was the old CEO terminated? Does the company normally promote from within? Will there be an outside search?
Defensive measures
In the event of a hostile takeover attempt, a poison pill provision forces outsiders to deal with the board rather appealing directly to shareholders. Under certain conditions, the provision allows existing shareholders to buy more shares at a low price. Staggered terms serve as a defensive measure.
Some questions when recruiting new board members
Is the candidate willing and able to make a meaningful commitment to the job of being a director? Does the candidate have unquestioned character and integrity? Can the candidate function effectively in a group?
Many companies prefer to use restricted stock rather than stock options
Restricted stock normally vests after three or five years. The vesting depends on whether the CEO stays with the company and/or whether performance goals are met. A problem is that restricted stock is taxable to the CEO at the time of vesting. Restricted stock acts like "golden handcuffs" that keep the CEO with the company.
The board also oversees
Results
the foundation for effective corporate governance
Securing the services of and retaining qualified, capable, and effective directors
Poor company performance over a long time period
Spells trouble for the board
The directors must represent
The best interests of the shareholders
For those competencies
There must be a match between a company's competencies and the resources that are
Board responsibilities include
[1] a fiduciary duty - act in the best interests of shareholders with integrity and competence, so as to enhance profit and shareholder gain within legal boundaries and taking into account ethical considerations, [2] duty of loyalty and fair dealing - directors should put interests of shareholders above personal interests, [3] duty not to entrench in case of poor performance by management and board, [4] duty of supervision with respect to monitoring management, including internal controls over financial reporting (handled by audit committee), [5] duty to deal with hostile takeover offers in shareholders' interest. *Business judgment rule - there is a presumption the board of directors properly acted absent evidence to the contrary.
Shareholders elect
a board of directors to represent them
Often a public company is organized as
a holding company with decentralized divisions or subsidiaries that report to a central parent organization
Financial results serve as
a key indicator of performance, so specific goals normally include target ROI or similar measures, as well as growth in earnings
The shareholders' annual meeting is
a major event for a public corporation, typically 90-120 days after the end of the fiscal year. Normally include approval of the independent auditor
Boards often give
a new CEO a bunch of stock options for incentive purposes. Stock options potentially link the CEO's incentives with long-term stock price. Sometimes stock options involve performance-based vesting, that is, long-term company goals must be met as a condition of vesting. Sometimes CEOS are required to hold their stock for a minimum period after exercising the option, in order to mitigate "pump and dump."
Usually CEO contracts include
a severance agreement on how much to pay the CEO if terminated under certain conditions.
Core competencies
are central to the successful implementation of the selected strategy
A CEO compensation package generally consists of
base salary, short-term incentives (based on profit or EPS, revenue growth, ROI or EVA, cash flow, or strategic measures such as market share), long-term incentives (including stock options, restricted stock, required stock purchases, stock appreciation rights, and maybe cash based on long-term performance), fringe benefits, and perks
Ineffective board organization and processess
can be problems
Morality and ethics
cannot be guaranteed by law or regulation
According to FAS 123R
companies must expense the value of stock options as part of compensation expense.
The board also advises and gives
consent with respect to selection of business and strategies
It is a good idea to have a
contingency succession plan in case of unexpected CEO turnover. For example, the plan might allow for an interim CEO
The nominating process is usually managed by
controlling shareholders or the existing board through its nominating or governance committee.
To thwart hostile takeovers
corporations use staggered terms of three or four years
a hierarchy of stakeholders:
customers, employees, supplies, community, and ownership. Steps that satisfy each stakeholder group in principle maximizing ownership's best interest.
The board
delegates most decisions to management
Exhibit 4-2
details the activities of an effective board
Corporations indemnify
directors against liability for legal acts (but not illegal acts such as fraud)
INternal politics or personal conflicts
do not help board effectiveness
Sometimes directors are
drawn into unfortunate situations. Individuals should do due diligence before joining the board.
Risks include
economic cycles, failure of major customers, disruptive technological innovations, reduced cash flow related to lower revenues and higher costs, and failure to meet debt covenants.
Committee chairs also need to be
effective leaders
Weak boards usually result from
excessive influence by a domineering CEO
Most boards have multiple committees
executive committee, compensation committee, audit committee, nominating and governance committee, committee of outside directors.
The board of directors is responsible
for governing the affairs of a public corporation
Board size varies
from approximately 8 to 16 depending on maturity, complexity, and industry of corporation. There should a breadth of expertise but not so many people as to create coordination problems
A key events for stock options are
granting of option, vesting of option after holding period of maybe three or four years, exercise of option at the strike price within period of maybe 10 years or less, holding of stock, and sale of stock
A good relationship between the board and CEO includes the following
hiring a CEO who is the right fit for the company; developing mutually agreeable goals; aligning CEO incentives with the best interests of shareholders; mutual agreement on the kinds of issues and decisions on which the board should "advise and consent;" board members stay up to date about the company's activities; the board holds management accountable and is willing to intervene when necessary (but not to the point of micromanaging).
Entrenchment
is another symptom of weak boards. Term limits are one solution.
*The board has a compensation committee consisting of
independent directors to do this task. There must be a written charter for the compensation committee. The committee has to submit an annual report to the SEC in the proxy statement or 10K.
A director should always act with
integrity. A major source of trouble is ignorance on the part of the director. Another source of trouble is lack of independence on the part of the director. Conflicts of interest arise when a director has the potential to profit from a decision at the expense of shareholders. Failure to execute duty of care can happen for busy directors. Another source of trouble for directors is any form of insider trading.
Evaluating the CEO's performance
is a major board responsibility. There should a formal evaluation every year, and continuous informal evaluation.
A competency
is a set of organizational capabilities that are needed to function in a given business.
An annual report including audited financial statements
is distributed ahead of the meeting, along with a proxy statement that discloses the business to be discussed at the meeting
Corporate governance
is known as This system of authoritative direction
Removal of the serving director
is nearly impossible
Selecting the CEO
is the biggest decision made by the board
The board meeting
is the centerpiece of board activities.
The best practice for an independent nominating committee
is to lead the search for new directors
The most difficult decision for a board
is whether to replace the CEO
Mistakes can result from
lack of effective board leadership, especially when the CEO is also board chair.
Most corporations buy
liability insurance (D&O coverage) for directors.
Most options are nonqualifying
meaning that the gains are taxed as ordinary income rather than as capital gains.
Directors also must be concerned about
risk management, which goes beyond having adequate insurance coverage
The board chairman
runs the meeting and sets the agenda
Distinctive competencies
set the business apart from competitors.
The proxy statement also
solicits proxy votes from those who will not attend - selected directors or officers execute the proxy votes
The corporation's secretary
takes minutes of the meeting. Upon approval, the minutes are the official record of the board meeting.
Typically, the stock option is worthless if
the CEO leaves the firm before exercising it
In designing CEO compensation
the board wants to attract and retain the right people, find the right alignment of CEO performance and shareholders' interests in the short run and long run, and use tax-efficient methods.
Board members must understand the business with reasonable proficiency. Things to understand include
the company's business concept/model and competitive environment. Is the company's competitive advantage based on cost or differentiation?
The bylaws stipulate
the list of corporate officers
In the 20th century
the publicly owned corporation emerged as the dominant legal form for business enterprises.
A board would not want to set up incentives that lead to excessive risk taking
the results of which may not be apparent for many years.
A number of factors affect such board meetings
the tone set by the board's leader, time limitations, asymmetry of information between management and board (board members need to ask probing questions), and attention to the future and not just past performance.
Some factors to consider are
the value of the CEO to the company, company resources, absolute company performance, relative company performance, achievement of non-financial goals, external parity with comparable CEOs, and internal parity with respect to other top executives in the company.
Corporate laws
vary by state
A key provision is
whether the CEO is also the chairman of the board. About 85 percent of U.S. corporations use this dual role, despite concern about too much CEO influence and monitoring of performance. A related issue is whether to include any other inside executives on the board, which by definition weakens the board's independence.
