Chapter 13 Corporate Governance in the Twenty-First Century

1. Chapter 13Corporate Governance in the Twenty-First Century

2. OBJECTIVES 1 • Explain what is meant by corporate governance 2 • Describe how corporate governance relates to competitive advantage and understand its basic principles and practices 3 • Identify the roles of owners and different types of ownership profiles in corporate governance 4 • Describe how boards of directors are structured and the roles they play in corporate governance 5 • Explain and design executive incentives as a corporate governance device 6 • Describe how the market for corporate control is related to corporate governance 7 • Compare and contrast corporate governance practices around the world

3. CORPORATE GOVERNANCE AT HEWLETT-PACKARD • Corporate Governance in Action: • A new business term is coined – • Pretexting: approaching a company under the pretext of being someone else.

4. Results • Costs slashed • Stock doubled in first month • Market cap rises from $1.1billion to $5 billion • Earlysuccess • With R&D budgets cut, newproduct development hampered • Growth fails to meet targets • Company accused of “channel stuffing” • Signsof problems • Board fines Dunlap • He looses his stock options • Sunbeam stock is delisted • Failure SUNBEAM • Al Dunlap’s mgmt. philosophy • Shareholders are most important corporate constituents • Most corporations have bloated bureaucracies • Drastic layoffs are usually neededto save failing companies • Layoffs should be quick,one-time events • CEOs should be rewarded likestars when they perform welland fired when they do not • Board members should have significant personal investmentsin the company

5. CHAINSAW AL • “The last dirty secret in the corporate world is how directors live off the fat of a business that is not their employer. I started a revolution by insisting that Scott directors be paid only in stock.” • - Al Dunlap

6. Corporate governance • Share holders • The system by which organizations, particularly business corporations, are directed and controlled by their owners • Board • Management • Corporation • Employees • Society • Environment CORPORATE GOVERNANCE • In a broader perspective, governance determines how all stakeholders influence the corporation:

7. CORPORATE GOVERNANCE IMPACTS PERFORMANCE • The Italian stock exchange started a new exchange called STAR for small and mid-sized companies that followed strict governance prescriptions • Companies of the STAR exchange consistently out perform their counterparts on the regular exchange (e.g., during 2004 STAR firms achieved returns 24.5% greater than their counter parts)

8. Agents • Principals • Shareholders of a firm • Act on behalfof principalsin managingthe firm AGENTS AND PRINCIPALS • When interests are virtually identical, the agency problem is small: executives do what is in principals’ best interests • However interests often do not overlap. Then agents may act to detriment of principals and visa-versa (e.g., executives raise salaries and reduce returns)

9. As many as possible • Split recommended • Not addressed • No • At least one-quarter • Split required by law • Not addressed • No • At least one-third • Split recommended • Not addressed • Yes • Majority • Split recommended • Periodic rotation of lead auditor • Yes • Substantial majority • Separation is one of three acceptable alternatives • Recommended3 • No EXAMPLES OF CODES OF GOVERNANCE • What is the recommendation on director independence? • Can the same executive be both CEO & chairperson? • Is disclosure required if the company does not comply with the recommendations? • Is auditor rotation required? • Country • Brazil CVM Code (2002) • Russia CG Code (2002) • Singapore CG Committee (2001) • United Kingdom Cadbury Code1 • United States Conference Board and CalPers (2003)2 • In 2003, a Combined Code made further additions to the code, but these basic principles remain • Just one of several codes in existence in the United States • The Sarbanes-Oxley Act requires that the lead audit partner be rotated every 5 years; changing audit firm after 10 years of continual relationship or if former audit partner is employed by the company

10. INSTITUTIONAL ACTIVISM ON THE RISE CalPERS known for their institutional activism TIAA-CREF Corporate Governance Team

11. ROLES AND ACTIONS OF BOARD OF DIRECTORS

12. STAGGERED BOARDS • A • turn over • at once • the entire • Board does not • are • staggered so • Board • elections • Nearly 2/3 of boards today are • considered staggered.

13. Phantom • Active • Phantom boards have no involvement in the strategic management process of the firm. • The public (and major stakeholders) have higher expectations for board involvement today. BOARD INVOLVEMENT

14. Incentivealignment can solvesuch problems • Conflicts of interest can arise • Agents • Principals • Example: • A company receives a buy-out offer • Shareholders (principals) would benefit because price assures a good return on investment • Management (agents) resists because they may lose their jobs • Boards can include “golden parachute” provisions in manager’s compensation packages INCENTIVE ALIGNMENT

15. HOW WOULD YOU DO THAT? – DENDRITE INTERNATIONAL • Dendrite’s challenge: • Dendrite’s solution: • How can Dendrite better align managementincentives with shareholders? • 20 senior-most executives must own 15,000 to 100,000 shares of stock • Must be common sharesnot options • Must be achieved within 5 years • Executives may elect to receive incentive compensation in stock instead of cash

16. EXECUTIVE STOCK OWNERSHIP IN 2004 • Largest 250 companies withstock ownership guidelines • Number ofcompanies • Percent ofcompanies • Percent increase from 2001 to 2004 • Executives • 142 • 57 • 58 • Directors • 123 • 49 • 127 Source: Adapted from Fredrick W. Cook & Co., Inc., “Stock Ownership Policies: Prevalence and design of Executive and Director Ownership Policies Among the Top 250 Companies,” www.fecook.com/surveys.html (accessed Nov 29, 2005), Sep 2004

17. Oldest form of incentive pay. Board can evaluate executives’ performance along multiple dimensions and allocate a year-end cash award • Annual bonus plans • An employee receives the right to buy a set number of shares of company stock at a later date for a predetermined price • Stock options • More recent forms of incentive compensation. Long-term bonuses linked to performance over several years. May help executives avoid short-term myopia and focus on long-term • Other long-termincentives INCENTIVE COMPENSATION

18. HIGHEST PAID CEOs Source: Company annual reports and ExecComp Service of Thomson Financial

19. EXECUTIVE PAY TRENDS Source: U.S. Bureau of Labor Statistics

20. Share holders • Elect • Example: • Example: • Corporate raiders such as T. Boone Pickens, CarI Icahn, Ted Turner and Michael Milken • Oracle engaged in 18-month battle to gain control of PeopleSoft • Board • Corporate control: • Hires/fires • The right to choose the members of the board of directorsof a company andto control all major decisions madeby a company • Top management • Directs • Corporation THE MARKET FOR CORPORATE CONTROL

21. POOR CORPORATE GOVERNANCE, A WORLD-WIDE PROBLEM • Recent examples of scandal-ridden non-U.S. multinationals • Netherlands Ahold Group (grocery stores) • Italy’s Parmalat (dairy and food products) • France’s Vivendi (entertainment) • French-Belgian Firm ELF (petroleum)

22. CORPORATE GOVERNANCE: U.S VS. JAPAN • U.S • Japan • Owner-managerrelationship • Adversarial • Co-operative • Manager andshareholderrelationship • Through a Keiretsu (group of interlockingcompanies) • Through onecompany • Ownershipconcentration • Control function • Monitoring function