AC 5690 Corporate Governance

Corporate Governance
 So Yean Kwack (Ph.D. in Accounting)
 Email: [email protected]
 Office: AC3 13-232
 Office hours: Wed, 10:00am-12:00pm
or by appointment (please send an e-mail)
 Corporate Governance
 Recommended textbook:
 Larcker, D., and Tayan, B. Corporate governance matters: A
closer look at organizational choices and their consequences, 2nd
edition, 2015, Pearson Education.
 Aim: understand the economic theories behind modern
corporate governance.
 Course Overview
 Coursework: 70%
 Mid-term quiz (25%) of two hours based on one or more
complex cases (open-book). Week 7 (Oct 20 Sat, 10am-12pm)
 Group presentations and participation (25%).
 Written report (20%) of substance & depth analyzing the
corporate governance structure of a publicly listed company.
 Examination: 30% (a closed-book 3-hour examination)
 Course Overview
 Pass both coursework and examination components in order to
pass the course.
 For illness or other circumstances related to assessment, please
refer to the University's Academic Regulations
 Students who fail to submit an assessment task (e.g., the written
report for the group project) on time will receive zero marks
on that task.
 Course Overview
 Group formation
 Form a group (5 students) and send e-mail prior to
week 4 for approval
 Indicate the section, and the group members’ student IDs and
names
 Choice of
 Case for case presentation
o Please send your first three choices of the cases which
will be posted on Canvas (first-come, first-served)
 Listed firm for written report
o Firms not in the case & not discussed in class
 Course Overview
 Group Case Presentation
 Format
 Front page: Indicate student name and ID, Program, and Section
 Each group will get 15 minutes to present and then we will have 5-10
minutes discussion.
 All members of the group needs to present
 Answer all the questions in the case
 Presented in class in weeks 11, 12 and 13
 Everyone should come to these weeks prepared to participate in
discussions
 Please e-mail your presentation slides 1 day before your presentation
and hand in the hard copy on the day of the presentation
 Will be peer-evaluated by your own group members (please hand in a
hard copy to me on the day of the presentation individually)
 Course Overview
 Group Written Report
 Content
 Basic background of that company
 Corporate governance structure
 Strengths and weaknesses of this structure
 Recommendations on improving this company’s corporate governance

 Grading Scheme for the Report

 Adequacy of the institutional background (25%)
 Clarity in describing the corporate governance structure (25%)
 Applicability and efficacy of the recommendations offered (25%)
 Critical application of theories covered in the course (25%)
 Course Overview
 Group Written Report
 Format
 Front page: Indicate student name and ID, Programme, and Section
 Provide reference
 Will be peer-evaluated by your own group members (please
hand in a hard copy to me in week 10 individually)
 Submit the written report of the analysis (both soft and hard
copy) by the end of week 10.
 Introduction to
Corporate Governance
 Business Organizations
 Sole proprietorship: one owner, unlimited liability,
limited life span (e.g., restaurant)

 Partnership: more than one owner but less than a

limited number (e.g., <20), unlimited or limited
liability (e.g., KPMG, law firms)

 Corporation: numerous owners, limited liability, double

taxation (e.g., IBM, HSBC)

 Corporations: the dominant form of business today

--In the U.S., they account for about 90% of total
business revenues.
 Modern Corporation
 Limited liabilities: a company’s liabilities are not its shareholders’
liabilities; the maximum loss a shareholder bear is the capital he or
she contributed to the corporation

 Transferability of interest: an investor can freely transfer his or her

shares; stock trading

 Legal personality: perpetual life, sue or be sued

 Modern Corporation
 Separation of ownership and control:

 ownership is dispersed
 shareholders: not directly participate in management
 board of directors: determine the overall direction
 Executives, who own little stake, control the companies

 Discussion: Is this true for Hong Kong companies?

 Shareholders

Shareholders

Board of
Directors

CEO

Operations Legal Risk Finance Treasury Purchasing Human Marketing

Management Suppliers Resources Sales
Alliances
 Agency Theory
 Jensen and Meckling (1976)

 Human beings are selfish and their objectives are to maximize

their own interest: No exception!

 Principal-agent relationship (agency relationship) : a contract

under which one or more persons (the principal) engage
another person (the agent) to perform some service on their
behalf which involves delegating some decision making
authority to the agent.
 Agency Theory
 Problem: The principal expects the agent to work to maximize the
principal’s welfare but the agent may take self-dealing actions, i.e.,
actions to increase her own interest but hurt the principle’s interest.
 Stockholders: the principal
 Executives: the agent
 Stockholders’ objective: maximize value of shares

 Adam Smith, the Wealth of Nations (1776) :

Being the managers of other people’s money rather than of their own, it
cannot well be expected that they should watch over it with the same
anxious vigilance with which the partners in a private co-partnery
frequently watch over their own.
 Agency Theory
 Executives self-interest actions
 Over pay themselves
 Shirk (i.e., not work hard)
 Over employ
 Consume excess perks
 Build empires
 Entrench (i.e., try to keep their own positions although they
know they are not suitable or capable)
 Agency Theory
 Evidence that executives’ self-interest behavior destroys
shareholders’ value
 Empire building: stock price declines upon the
announcements of acquisitions ;
 Entrenchment: stock price jumps upon the news of CEOs’
sudden deaths

 How to make sure managers to work for shareholders interest?

 We need corporate governance!

 Agency Theory
 Johnson, Magee, Nagarajan, and Newman, 1985

Stock Reaction to CEOs' Sudden Death

3.50%

3.00%

2.50%

2.00%

1.50%

1.00%

0.50%

0.00%
-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5
 Agency Theory
 Jensen and Meckling (1976): Page 6 – 7

“The problem of inducing an ‘agent’ to behave as if he were

maximizing the ‘principal’s welfare is quite general. It exists in all
organizations and in all cooperative efforts – at every level of
management in firms, in universities, in mutual companies, in
cooperatives, in governmental authorities and bureaus, in unions,
and in relationships normally classified as agency relationships
such as those common in the performing arts and the market for
real estate.”
 Agency Theory: Discussion Question

 How many principal-agent relationships exist in a

corporation?
 What is Corporate Governance?
 The process of supervision and control intended to ensure that the
company’s management acts in accordance with the interests of
shareholders (Parkinson, 1994).

 The governance role is not concerned with the running of the

business of the company per se, but with giving overall direction to
the enterprise, with overseeing and controlling the executive
actions of management and with satisfying legitimate expectations
of accountability and regulation by interests beyond the corporate
boundaries (Tricker, 1984).
 What is Corporate Governance?
 Corporate governance is the set of processes, customs, policies,
laws and institutions affecting the way in which a corporation is
directed, administered or controlled. Corporate governance also
includes the relationships among the many players involved (the
stakeholders) and the goals for which the corporation is governed.
The principal players are the shareholders, management and the
board of directors. Other stakeholders include employees,
suppliers, customers, banks and other lenders, regulators, the
environment and the community at large (Wikipedia).
 Maximize stakeholders’ value.
 What is Corporate Governance?
 Narrow definition in plain words:
Internal and external mechanisms used to motivate or monitor
managers to work for shareholders’ interest.
 Efficient Capital Regulatory
Markets Enforcement
Board Auditors

Investors Customers

Creditors Managers Suppliers

Analysts Unions

Regulators Media Accounting

Legal Tradition
Standards

Societal and Cultural Values

 Major Governance Mechanisms
 Executive incentives
 Used to align managers’ interest with shareholders’ so that
managers maximize their own interest when they maximize
shareholders’
 Short-term and long-term components
 Hard to design
 Performance measure issues
 Induce managers’ opportunistic behavior
 Major Governance Mechanisms
 Board of directors
 Elected by shareholders
 Supposed to work for shareholders
 Select and appoint executives, make strategic decisions
 Executives are usually board members as well
 Non-executive, independent directors are critical
 Major Governance Mechanisms
 Investor
 Shareholder rights
 Collective action problem
 Block shareholders
 Institutional investors
 Creditors
 Accounting and auditing
 Information asymmetry
 Financial reporting
 External auditors
 Major Governance Mechanisms
 Market for corporate control
 Hostile takeover
 A costly mechanism
 Anti-takeover strategies

 Legislation and regulations

 Regulatory bodies
 Security regulations
 Major Governance Mechanisms
 International corporate governance, and governance issues in
Hong Kong and China mainland
 Concentrated ownership
 Business group
 Family firms
 State control
 Political connections
 Stock Valuation
 If you hold a stock forever …
 What you receive: dividend payment (D)
 Suppose a company distributes all earnings (E) in form of
dividends to shareholders
 The rate of return you require (r)
 The price you are willing to pay

E1 E2 E3
P    ...
(1  r ) (1  r ) (1  r )
2 3
 Stock Valuation
 Stock price is determined by expected future performance and the
rate of return required by investors

 r: required rate of return to investors

cost of capital to a company

 Stock price changes if the expectation about future performance

or/and the required rate of return changes
 Is Governance Important?
 Gompers, Ishii, and Metrick (2003): governance and firm value
 Construct an index to measure the strength of corporate
governance for about 1500 largest firms in US
 Firms with strong governance have higher market valuation,
better stock returns, higher profits and sales growth, fewer
corporate acquisitions
 Beasley (1996): governance and financial fraud
 Examine financial statement fraud in the U.S.
 Outside directors matter
 Compared with companies without fraud, companies with
financial frauds tend to have
• A smaller portion of outside directors on the board
• Lower outside director equity ownership
• Longer director tenure
• Busier outside directors (i.e., their outsider directors on average hold
more directorships in other companies)
 Discussion Question
• Corporate governance – the more the better?

• What are the cost associated with corporate governance?

• What is the boundary of governance?

 Why there is separation of ownership and control in the first place?
 Investors have money but lack the ability to earn a return on
their money
 Professional managers have ability, vision and leadership, and
thus can help investors to manage money and earn a return
 Corporate governance: direct and control but not excessively
intervene in managers’ activities
 Corporate governance mechanisms are costly

 Need a balance!
 Enron: An Overview
 https://www.youtube.com/watch?v=Mi2O1bH8pvw
 Enron: An Overview
 Enron was once among 10 largest firms in the US
 It filed for bankruptcy protection in late 2001, which is the largest
bankruptcy case in the history until then
 A lot of accounting fraud and corporate governance weaknesses
were revealed
 Countries were shocked and began to examine their own
corporate governance
 The passage of Sarbanes-Oxley Act in US, the most significant
securities regulation since 1930s
 Enron: The Rise
1985 2000

No. of Employee 15,076 21,000

Business Coverage 4 > 40
12.1 65.5
Total assets (Billion)
<5 > 100
Sales (Billion)
59,200 49,000
Pipe line (Km)
- 18
Rank in ‘Fortune’ top 500
Reproduced from Akhigbe, Madura, and Martin (2005)
 Enron: The Collapse
• Aug 14, 2001, CEO Jeffrey Skilling resigned, citing ‘personal
reasons’.

• Oct 12, 2001, Enron disclosed a $638 million loss in its third
quarter for this fiscal year.

• Nov 8, 2001, Enron restated its financial statements to reduce

earnings by an additional $586 million over the past four years.
 Enron: The Collapse
• Enron announced it must pay $690 million in debt, with another
$6 billion by next year

• Nov 19, 2001, S&P downgraded Enron’s debt to ‘junk status’.

• Dec 2, 2001, Enron filed for the largest Chapter 11 bankruptcy
protection in U.S. history.

• Enron’s stock price at last close: 67 cents, total shareholder value

lost: $63 billion.
 Effects of November 2001 Restatements (Amounts in Millions)

1997 1998 1999 2000

Income As Reported 105 703 893 979

As Restated 77 570 645 880

Difference -28(-27%) 133(-19%) 248(-28%) 99(-10%)

Debt As Reported 10,938 13,051 14,622 23,213

As Restated 11,649 13,612 15,307 23,840

Difference 711(7%) 561(4%) 685(5%) 627(3%)

 Enron: Governance Issue
 It is revealed later that
 The CEO has unfettered power
 The internal audit committee did not function at all because of
serious conflicts of interest
• The chairman’s husband is a senate who receive substantial political
donation from Enron;
• A former committee member had a consulting contract with Enron
when he was on the committee
 External auditors had very close relationship with
management
 Enron: Discussion Questions
• Why executives in Enron had tried to overstate earnings and
understate liabilities?

• Is Enron’s demise avoidable?

• Why and How?
• Does governance matter?
 Enron: Long-term Impact
 Arthur Anderson, the auditor for Enron, was forced to close down
because of destroying documents related to Enron

 A global attention on corporate governance

 The passage of Sarbanes-Oxley Act which main provisions aim to

cure corporate governance weakness revealed in the Enron case
 Executives:
Incentives and Compensation
Labor Pool of CEO Talent
CEOs of Public U.S. Corporations
Number of CEOs > 6,000
Average tenure, with company 14 years
Average tenure, as CEO 5 years
% with 0-5 years as CEO 57%
% with 6-10 years as CEO 25%
% with 11-15 years as CEO 10%
% with 16+ years as CEO 8%
Prior to CEO: finance 22%
Prior to CEO: operations 20%
Prior to CEO: marketing 20%
Prior to CEO: engineering 5%
Prior to CEO: law 5%
Prior to CEO: consulting 4%

Spencer Stuart (2007)

Labor Pool of CEO Talent
CEOs of Public U.S. Corporations
Undergrad degree: engineering 21%

Undergrad degree: economics 15%

Undergrad degree: business 13%

Undergrad degree: accounting 8%

Undergrad degree: liberal arts 8%

MBA degree 40%

Military experience 7%

International work experience 34%

Same company entire career 19%

Spencer Stuart (2007)

 Evidence from the field

https://www.youtube.com/watch?v=RWBigA8R5oc
 Theory

 Conflicts in objectives between shareholders and executives

 Shareholders’ objective: maximize the value of their investments, and

expect executives to exercise efforts to achieve their objective

 Executives’ objective: maximize their own interest

 The actions executives take to maximize their own interest could destroy
shareholder value
 Theory
 Different risk attitudes between shareholders and executives:
executives are more risk-averse than shareholders
 Shareholders invest financial capital, and can easily diversify
their investments
 Executives cannot diversify their human capital investment
 Shareholders may prefer risky projects, while executives like
safe projects
• High risk, high return (e.g.: interest rate on bank deposit vs. yields on
corporate bonds)
 Theory
 To align executive and shareholder interests: a mechanism that
can increase executive interests when they exercise efforts to
create value for shareholders

 Incentive contract: reward executives based on firm performance

(short-term & long-term)

 Underlying assumption: firm performance is directly affected by

the level of efforts exercised by executives
 Inputs are not observable.
 Executive Compensation
 The compensation program serves three purposes.

 It must attract executives with the skills, experiences, and

behavioral profile necessary to succeed in the position.

 It must be sufficient to retain these individuals, so they do not

leave for alternative employment.
 It must motivate them to perform in a manner consistent with
the strategy and risk-profile of the organization and discourage
self-interested behavior.
 Elements of Compensation
 Base salary
 Determined ex ante
 Not vary with ex post performance
 Average US $975,000 for CEOs in largest U.S. firms in 2004
 Cash bonus
 Receive at the end of a fiscal year
 Awarded for short-term performance, e.g., earnings,
earnings growth
 Average US $1.5m for CEOs in largest U.S. firms in 2004
 Elements of Compensation
 Equity-based (long-term) compensation

 Stock options: average option-based compensation realized for

CEOs in largest U.S. firms in 2004 is US $2.7m

 Restricted stock: restricted in transferability, the average

restricted stock grant is $1m in 2004
 Performance units (shares): Performance units are similar to a
longer-term version of the annual bonus. The average
performance shares is a little less than $1m in 2004.
 How to Determine Executive
Compensation
 The compensation committee recommends compensation of the
CEO and other executive officers.

• Packages are approved by independent directors of the full board.

Shareholders ratify equity-based compensation.

• Details are disclosed in the annual proxy.

 How to Determine Executive
Compensation
 Most boards benchmark CEO pay against a peer group of
companies comparable in size, industry, and/or geography.

 Common practice targets cash compensation (salary + bonus) at

50th percentile and long-term pay at the 75th percentile.
 What is the impact on the salary next year?

 There are potential drawbacks to benchmarking:

 Is based on size rather than value creation.
 Recall ‘Empire building” argument
 Is highly dependent on companies included in peer group.
 The CEOs can influent the choices of peer group.
 How to Determine Executive
Compensation
 Compensation consultants

 Most companies use a third-party consultant to advise on

compensation levels and program design.

 Compensation consultants might be subject to conflicts of interest

if they provide other services to the company, such as benefits
consulting or pension asset management
 Once again, CEOs have great influence over the choice of compensation
consultants.
 Pay Inequity

 There is a large pay differential between the pay granted to the

CEO and the pay granted to other senior executives.

 On average, the CEO earns 1.8 times the pay of the 2nd highest
officer. The 2nd highest earns 1.2 times the 3rd.

 (+) Might reflect relative value creation of these jobs.

 (+) Pay inequity provides incentive for promotion.

 (-) Might reflect management entrenchment.

 (-) Discourages executives who feel they are not paid fairly.
 Pay Inequity
 The press often cites the ratio of CEO pay to that of the average
employee as a sign of excessive compensation.
 Dodd-Frank Act requires companies to disclose the ratio of CEO pay
to average employee pay in proxy statements

 This figure varies greatly with methodology. It has been calculated

as either 180, 300, 400, or 500 in recent years.

 It also varies with industry, size, location, and measurement

period.

 It is difficult to interpret. Does it reflect relative value creation,

scope of job, or expendability of the position?
 Short-Term Incentives
 Short-term incentives offer an annual payment (usually cash) for
achieving predetermined performance objectives.
 The size of the bonus is expressed in terms of a target, with a
minimum and maximum level.
 The board should consider the following:
 How difficult are the performance targets?
 Does the plan encourage a short-term focus?
 Does management defer investments to achieve targets?
 Are earnings deferred after maximum targets are met?
 Are earnings manipulated to increase payouts?
 Short-Term Incentives
 Accounting income is usually used to measure short-term
performance

 Advantages: more precise and controllable, relative to stock

prices

 Disadvantages: not sensitive to managers’ efforts to improve long-

term performance
 Investment myopia
 Short-Term Incentives
Absolute Measures Ratios and Growth Rates
Sales Sales growth rate
EBITDA EBITDA/Sales
Growth rate of EBITDA
NOPAT NOPAT/Sales
Growth rate of NOPAT
Net income Net income/Sales
Return on equity
Return on capital
Growth rate of NI
Earnings per share Growth rate of EPS
EBITDA per share Growth rate of EBITDA per share
Cash flow per share Growth rate of cash flow per share
Assets Assets turnover
Capital Capital turnover
Stock price Growth rate in price
Market capitalization Growth rate in market value
 Short-Term Incentives
 Too much weight on short-term performance may induce
undesirable managers’ behavior

 Some expenditures which would increase earnings in the long

term might be cut by managers: e.g., research & development
expenditure, advertising expenditure

 Earnings management: e.g., earnings inflation, take a big bath

 Restricted Stocks
 Common stocks given to executives that include a limitation that
requires a certain length of time to pass or a certain goal to be
achieved before the stock can be sold: e.g., executives may receive
a grant of shares that requires 10 years to pass before they can sell
those shares.

 Restricted stock is increasingly used in U.S., from 12% of total

long-term incentives in 2002 to 23% in 2004
 Performance Shares
 A company’s stocks given to executives only if certain
performance criteria are met, such as earnings per share targets

 Similar to cash bonus, it rewards past performance

 Similar to other long-term compensation forms, it can motivate

managers to maximize long-term value of stocks because
performance shares can become more valuable

 It is increasingly used and accounts for about 20% of long-term

incentives in 2004 in U.S.
 Executive Stock Options
 Option: a right not an obligation

 Executive stock options (ESOs) are issued by a firm to executives;

such options give executives the right but not the obligation to buy
a certain number of stocks from the firm at a pre-determined
price in a certain time period
 Executive Stock Options
 Terminologies
 Strike price (exercise price): the price to purchase a share
 At-the-money option: the strike price equals the market price
of stocks;
 In-the-money option: the strike price is below the market
price
 Out-of-the-money option: the strike price is higher than the
market price
 ESOs are usually granted at the money
 Executive Stock Options
 Payoff to executives at the expiration date of options
Max [(market price of stocks – strike price), 0]

 The higher the stock price on the exercising day, the larger the
payoff to executives.

 Thus, executives might have strong incentives to work hard to

improve performance, which will lead to higher stock prices.
 Executive Stock Options
Example: strike price = $20/share

Payoff for Exercising Options

30

25

20 Out of the money In the money

15

10

0
0 5 10 15 20 25 30 35 40
-5

-10

-15

-20 At the money

-25

-30
 Executive Stock Options
 Advantages to use stock options as incentives
 Align managers’ interest with shareholders’
 Reduce managers’ myopic behavior and encourage them to
maximize long-term shareholders’ wealth
 Encourage managers to take risk (e.g., invest in risky projects
that could bring huge profits to shareholders)
 Firms do not need to pay a large amount of cash to attract
excellent managers: e.g., we more often observe that growing,
high-tech firms grant options to their executives and
employees.
 Executive Stock Options
 Disadvantages

 Stock price is affected by many other factors not controllable

to managers (2/3 of stock price movement is explained by the
market- and industry-wide factors): e.g., bad but lucky
managers in bull markets, good but unfortunate managers in
bear markets

 Encourage managers to take excessive risks: theoretically, the

higher the risk (volatility), the larger the options’ value
 Manipulation of Equity Grants
 Equity ownership might encourage executives to manipulate
equity grants to extract incremental value.
 Manipulate the timing of grants.
• Delay grant date to occur after a stock price decline.
• Bring grant forward to occur before expected rise.
 Manipulate the timing that information is released.
• Delay the release of favorable information until after grant date.
• Bring forward release of unfavorable information to precede grant date.
 In both cases, the executive seeks to maximize value by taking
actions not in the interest of shareholders.
 Manipulation of Equity Grants
● When equity awards are granted on a random basis, there is no
discernable pattern in the stock price around the grant.
● A “V-shaped pattern” around the grant date suggests manipulation
might be taking place.

● There is considerable evidence that this occurs.

Reproduced from Heron and Lie (2007), Figure 3
 Manipulation of Equity Grants
● Stock option backdating is the practice where insiders
retroactively change the grant date to correspond with a relative
low in the company share price.

● When practice was discovered in 2006, more than 120 companies

were implicated. Abuses stemmed back to 1981.

● Stock option backdating largely stopped following Sarbanes Oxley,

which requires that grants be reported in two days.
 Monsanto Inc.
(Definitive Proxy Statement
http://www.sec.gov/Archives/edgar/data/1110783/0001206774
09002291/monsanto_def14a.htm)
 Core principles
 Align management interests with those of shareholders
 Encourage employees to behave like owners
 Promote creativity, innovation, and reasonable risk-taking
 Reward for results rather than on the basis of seniority, tenure,
or other entitlement
 Comparable to similar companies
…
 Role of management: the Compensation Committee considers
inputs from CEO and other executives
 Role of consultant
 The Committee: Frederic W. Cook & Co.
 The management team: Towers Perrin

 Comparable companies

 Key components: base salary, cash annual incentive awards, and

stock-based long-term incentive awards
 How are different components awarded?
 Base salary: comparable to similar companies, adjusted for
inflation
 Annual incentive plan (AIP): based on short-term
performance such as growth in net sales, EPS, and cash flow
 Long-term incentive: stock options

 Summary compensation
 Do Incentive Contracts Work?
 Rajgopal and Shevlin (2002)

 Examine the effect of the adoption of stock options as a

compensation for CEOs on CEOs’ risk taking in the oil and
gas industry

 Option-based compensation plans indeed encourage CEOs to

take risks: more exploration activities; less hedging activities
after option grant
 Executive Compensation
in Hong Kong
 Discussion question

Why are stock options relatively uncommon among

Hong Kong companies?
 Family firms: executives are often large shareholders
 Most firms operate in traditional industries

Example:
 Li Ka-shing controls 43.33% of Cheung Kong stocks (0001)
 He receives $10,000 from Cheung Kong every year
 Link to the 2013 annual report:
http://doc.irasia.com/listco/hk/ckh/annual/2013/ar2013.pdf
(page 127)
 Grasso Event: Are CEOs Overpaid?
 Dick Grasso: Former CEO of New York Stock Exchange (NYSE)
 The compensation in 2001:
Salary: $ 1,400,000
Annual Incentive: $16,100,000
Capital Accumulation Plan: $ 8,050,000
Special Payment: $ 5,000,000
Total: $30,550,000
 In addition, he received $139.5 million payout on his retirement
plan.
 Grasso Event
 Is he over-paid?
 As early as in 1991, the former Chairman of Coca-Cola, Roberto Goizueta
got pay of $86m, including a record of $80m stock grants. He defended his
1991 pay in AGM and was interrupted 4 times – by thunderous applause.
Shareholders were happy – under his management, Coke stock had
increased by 1300%.
 Almost at the same time, executives of the top 3 auto makers were
together paid $5.3m and they were blamed for taking too much…because
their combined loss totaled $7.5b in a year.

 The issue: not how much but how!

 Grasso Event

 How to assess?

 Comparable to peers?

 Sensitive to performance?

 Determined independently from the CEO?

 Grasso Event
 If NYSE is considered as a financial institution …
 Grasso Event
 If NYSE is considered as a regulatory agency …
 Grasso Event
 Grasso was paid more than $76 million from 1999 through 2002 –
more than 1/3 of the exchange’s net income in that period.

 NYSE is a non-for-profit institution similar to a regulatory agency.

 The chair of compensation committee then argued that Grasso
was worth every dime, in part for getting the markets running
after the Sep.11 terrorist attacks.
 Grasso Event

 NYSE is a regulatory agency and it urges listed firms to improve

corporate governance but it is revealed that NYSE itself has bad
governance …

 The chair of the compensation committee is Mr. Grasso’s

long-time friend
 Grasso Event-Takeaways
 Can a good performance or a performance improvement justify
huge bonuses to a CEO?
 Rising tides lift all boats …
 Lucky managers in bull markets all get good pay although they
may not all exercise efforts to improve performance
 CEOs should be compensated for their efforts
 Need a benchmark to calculate relative performance
 The former HP CEO, Carly Fiorina, can collect full amount of
cash award in a three-year period only if HP stock has
outperformed at least half of the companies in the S&P 500 at
the end of the third year
 https://www.youtube.com/watch?v=PnyT3ukfLBQ
 Directors:
Duties & Effectiveness
 History of Boards

 In the early age of shareholding companies, when directors met

 Sat on stools around a long board placed across two sawhorses
 The leader sat in a chair
 That group was named ‘the board’
 The leader was named ‘chair-man’

 Society for Establishing Useful Manufactures (SUM), 1791

 The structure is similar to today’s typical boards
 The board has 13 directors
 A committee of inspectors: similar to the audit committee today
 Board Duties

 Fiduciary duty: directors must place shareholders’ interest above their own
interest
 Duty of loyalty: a director must demonstrate unyielding and undivided
loyalty to shareholders
 Duty of care: a director must exercise due diligence in making decisions

 Business judgment rule: as long as directors act with all loyalty and exercise
due care, the court will not second guess their decisions
 The process is more important than the consequences
 Allow directors to make decisions without the fear of being prosecuted
 “Why CEOs Need to Be Honest with
Their boards” (Jan 14, 2008, The WSJ)
 Discussion Questions:

1. Why are CEOs often reluctant to inform directors of bad news

promptly?

2. Why did the retired judge, Mr. Walsh, rule in favor of the company
(i.e., Kinder Morgan Inc.)?
 Responsibilities
• The board of directors has a dual mandate:
• Advisory: consult with management regarding strategic and
operational direction of the company.
• Oversight: monitor company performance and reduce agency
costs.

• Effective boards satisfy both functions.

• The responsibilities of the board are separate and distinct from

those of management. The board does not manage the company.
OECD Principles of Corporate Governance:
“The corporate governance framework should ensure the strategic guidance of
the company, the effective monitoring of management by the board, and the
board’s accountability to the company and the shareholders.”
OECD (2004)
 Responsibilities
Selected advisory and oversight responsibilities:

• Approve the corporate strategy

• Test business model and identify key performance measures
• Identify risk areas and oversee risk management
• Plan for and select new executives
• Design executive compensation packages
• Ensure the integrity of published financial statements
• Approve major asset purchases
• Protect company assets and reputation
• Represent the interest of shareholders
• Ensure the company complies with laws and codes
 Independence
• Boards are expected to be independent:
• Act solely in the interest of the firm.
• Free from conflicts that compromise judgment.
• Able to take positions in opposition to management.

• “Independence” is defined according to regulatory standards.

• However, independence standards may not be correlated with true

independence.

• Requires a careful evaluation of board member’s biography,

experience, previous behavior, and relation to management.
 Operations of the Board
• Presided over by chairman: sets agenda, schedules meetings,
coordinates actions of committees.

• Decisions made by majority rule.

• To inform decisions, board relies on materials prepared by

management.

• Periodically, independent directors meet outside presence of

management (“executive sessions”).
Directors report spend 20 hours per month
on board matters while a typical meeting
lasts 7 hours

NACD (2014)
 Board Committees
• Not all matters are deliberated by the full board. Some are
delegated to subcommittees.

• Committees may be standing or ad hoc, depending on the issue at

hand.

• All boards are required to have audit, compensation,

nominating/governing committees.

• On important matters, the recommendations of the committee

are brought before the full board for a vote.
 Audit Committee
Responsibilities of the audit committee include:
• Oversight of financial reporting and disclosure
• Monitor the choice of accounting policies
• Oversight of external auditor
• Oversight of regulatory compliance
• Monitor internal control processes
• Oversight of performance of internal audit function
• Discuss risk management policies

Audit committees meet on average 8 times

per year, for 2.7 hours each.
NACD(2014)
 Compensation Committee
Responsibilities of the compensation committee include:

• Set the compensation for the CEO

• Advise the CEO/BOD on compensation for other executive
officers
• Set performance-related goals for the CEO
• Determine the appropriate structure of compensation
• Monitor the performance of the CEO relative to targets
• Hire consultants as necessary
Compensation committees meet on average 6
times per year, for 2.7 hours each.

NACD(2014)
 Nominating/Governance Committee
Responsibilities of the nominating/governance committee include:

• Identification of qualified individuals to serve on the board

• Selection of nominees to be voted on by shareholders
• Hiring consultants as necessary
• Determine governance standards for the company
• Manage the board evaluation process
• Manage the CEO evaluation process
• CEO succession planning
Nominating/governance committees meet on
average 8 times per year, for 1.8 hours each.
NACD(2014)
 Specialized Committees
• Executive • Science & technology
• Finance • Legal
• Corporate social • Ethics / compliance
responsibility • Mergers & acquisitions
• Strategic planning • Employee benefits
• Investment • Human resources /
• Risk management development
• Environmental policy
Prevalence of specialized committees:
• Finance: 31%
• Corporate social responsibility: 11%
• Science & technology: 8%
• Legal: 6%
• Environment: 8%
Spencer Stuart (2013)
 Director Terms
• Two main election regimes:
• Annual election: Directors are elected to one-year terms.
• Staggered board: Directors are elected to three-year terms, with
one-third of board standing for reelection every three years.

• Staggered (Classified) boards are an effective antitakeover protection.

• Staggered (Classified) boards may also insulate or entrench
management.
Prevalence of staggered boards:

• Approximately half of all publicly traded

companies have a staggered board.

• Small companies are more likely to have a

staggered board than large companies.
SharkRepellent (2009)
 Director Elections
• In most companies, directors are elected on a one-share, one-vote basis.
• Shareholders may withhold votes but not vote against.
• Four main voting regimes:
• Plurality: directors who receives most votes is elected, even if a majority
is not obtained.
• Majority: director must achieve majority to be elected, otherwise must
tender resignation.
• Cumulative: shareholders can pool votes, and apply to selected candidates
(rather than one vote each).
• Dual class: different classes of shares carry different voting rights
(disproportionate to economic interest).
• Typically, only one slate of directors is put forth for election; in a contested
election, a dissident slate is also put forth.
 Market for Directors
• Among public corporations in the U.S.:

• Total number of directors: 50,000

• Average tenure on board: 7 years
• Average mandatory retirement age: 72

• Directors tend to retire voluntarily.

• Only 2 percent of directors who step down are dismissed or

not reelected.
 Director Recruitment Process
• Director recruitment is a responsibility of the nominating/
governance committee.
• Identify needs of company.
• Identify gaps in director capabilities.
• Identify potential candidates, either through director
networks or with professional recruiter.
• Rank candidates in order of preference.
• Meet with each candidates successively and offer job.
• Put before shareholders for a vote.

• Director recruitment differs from CEO recruitment in that

candidates are ranked in order before interviews take place
 Director Compensation
• Compensation must be sufficient to attract, retain, and motivate
qualified directors.

• Compensation covers time directly spend on board matters, cost

to keeping schedule flexible to address urgent issues, and financial
and reputational risk from corporate scandal or lawsuit.
Revenues Revenues
(median)
> $20 bn $1 - $2.5 bn
Annual Retainer $ 80,000 $45,000

Committee Fees 10,500 16,200

Non-Retainer Equity 105,800 57,800

Total Director Comp $229,900 $132,600

% Equity 45% 46%

Hewitt (2010)
 Director Compensation
• Companies pay fees for serving on committees.
• Fees are intended to compensate for time, expertise, and potential
risk of committee role.
Revenues Revenues
(median)
> $20 bn $1 - $2.5 bn
Audit Retainer $10,000 $ 10,000
Audit Meeting Fee 2,000 1,500
Audit Chair 20,000 12,500
Comp Retainer $ 9,500 $ 5,000
Comp Meeting Fee 2,000 1,500
Comp Chair 15,000 8,250
Nom/Gov Retainer $ 9,000 $ 5,000
Nom/Gov Meeting Fee 2,000 1,500
Nom/Gov Chair 10,000 7,500
Hewitt (2010)
 Removal of directors
• Companies may replace a director for a variety of reasons.
(+) Requires new skills and capabilities on the board
(+) Company wants to refresh the board
(+) Director wishes to retire
(+) director reaches mandatory retirement age

(-) Director is negligent or performing below expectation

(-) Director has irresolvable disagreement with other directors or
management

 Shareholders often do not know the real reason the director leaves
the board
 Removal of directors
• Process
• Board does not have power to remove other board members
• Wait to replace at annual meeting
• Encourage to resign
• Shareholders have limited rights to remove directors
• Pass special resolution if they can demonstrate cause
• Vote for removal if election is by majority voting
• How does this affect accountability?
 Board Structure
• Boards are often described in terms of their salient structural
features: size, independence, committees, diversity, etc.
• Do these attributes have an impact on the board’s ability to
monitor and advise the corporation?
• Do companies with certain structural features perform better/
worse than those who lack them?
• A determination of how to structure the board should be based on
rigorous statistical evidence.
• At the same time, it should allow for situational differences across
companies.
 Board Structure
The Board of Directors of the Average Large
U.S. Corporation

Number of directors 11
Number of meetings per year 8
Independent directors 85%
Independent chairman 25%
Dual chairman/CEO 55%
Lead director 90%
Independent audit committee 100%
Independent comp committee 100%
Independent nom/gov committee 100%
Average age 63
Mandatory retirement 72%
Mandatory retirement age ~72
Female directors 18%
Boards with at least one female
93%
director

Spencer Stuart(2013)
 Chairman of the Board
• The chairman is the liaison between the board and management,
and between the board and shareholders.

• The chairman presides over the board, schedules meetings, sets

the agenda, and distributes materials in advance.

• The chairman leads the discussion of important items, including

strategy, risk, performance, compensation, succession, and
mergers.

• The chairman shapes the timing and manner in which items are
discussed and therefore is critical to the governance system.
 Chairman of the Board
Should the chairman be independent?

• (+) Clear separation from management.

• (+) Clear authority to speak on behalf of the board.
• (+) Eliminates conflicts.
• (+) CEO has more time to run the company.

• (-) Artificial separation if dual Chairman/CEO is effective.

• (-) Difficult to recruit new CEO that expects to hold both jobs.
• (-) Complicates decision making.
• No research evidence that an independent chairman
improves or destroys shareholder value.

• Decision to separate should be based on situation.

Boyd (1995); Brickley, Coles and Jarrell (1997)
 Independent Directors
• Independent directors are those who “have no material
relationship” with the company (as defined by the NYSE).

• A director is not independent if director or family member has, in

the last three years:
• Served as an executive of the listed firm.
• Earned compensation > $120,000 from the firm.
• Served as an internal or external auditor of firm.
• Served as executive at another firm where CEO of listed firm
was on compensation committee.
• Served as executive of another firm whose business with the
listed firm is greater of $1 million or 2% of revenue.
 Independent Directors
Independent judgment is critical to the advisory
and monitoring functions of the board.

• (+) Offer objective evaluation of company and management.

• (+) Allow for arms-length negotiation of compensation.
• (+) Make decisions solely in the best interest of the company.
• (-) Less informed about company than insiders
• (-) Directors who meet NYSE standards may not be independent.
• (-) Social ties may compromise judgment.
• (-) Only effective if they are qualified and engaged.
• Outside directors improve some governance outcomes, such as M&A premiums.

• Their effectiveness depends on their cost of acquiring information about the firm.

• True independence of judgment may differ from regulatory independence.

Cotter, Shivdasani, and Zenner (1997); Duchin, Matsusaka, and Ozbas (2010); Hwang and Kim (2009)
 Independent Committees
• Committees of the board deliberate topic-specific issues that are
critical to the oversight of the company.

• Directors are selected to committees based on their qualifications

and domain expertise (generally).

• The audit, compensation, and nominating/governance committees

are required to be independent (Sarbanes Oxley).

• Specialized committees (strategy, finance, technology, and

environmental, etc.) have no independence requirements and may
include executive officers.
 Independent Committees
Are committees more effective when they are independent (either
majority or 100%)?

• (+) Objective advice and oversight.

• (+) Less susceptible to being co-opted by management.
• (-) Decision making may suffer.
• (-) Independent directors have a “knowledge gap.”
• (-) Management brings important firm-specific knowledge.
• Some evidence that independent audit committees improve earnings
quality. 100% independence is no better than majority independence.

• Specialized committees benefit from insider knowledge.

• The independence of a committee should depend on its function.

Klein (2002); Kliein (1998)
 Busy Boards
• “Busy” director: director holds multiple board seats (generally 3 or
more).

• “Busy” board: a majority of directors are busy.

Total unique directors 29,089

Directors with:

1 board seats 24,144

2 board seats 3,583
3 board seats 1,020
4 board seats 254 Potentially busy
directors
5 or more 88
Corporate Board Member and PricewaterhouseCoopers (2009)
 Busy Boards
Are busy directors better or worse corporate monitors?

• (+) Bring important experiences from other directorships.

• (+) Broad social and professional networks.
• (+) May have high integrity (reason they are in demand).
• (-) May be too busy to properly monitor.
• (-) May be less available at critical moments.
• Companies with busy boards tend to have worse long-term
performance and worse oversight.

• Busy boards are less likely to fire an underperforming CEO.

• Busy boards award higher compensation.

Fich and Shivdasani (2006); Core, Holthausen, and Larcker (1999)

 Interlocked Boards
Interlocked boards: the CEO of Firm A sits on the board of Firm B,
while the CEO of Firm B sits on the board of Firm A.
• (+) Creates a network between companies.
• (+) Facilitates the flow of information and best practices.

• (-) Creates a dynamic of reciprocity.

• (-) Can compromise objectivity and weaken oversight.
• Network connections generally improve corporate performance.

• Effects are most pronounced among companies that are newly

formed, have high growth potential, or in need of a turnaround.

• At the same time, interlocking leads to decreased monitoring (less

to terminate underperforming CEO; award higher compensation).

• Companies must balance trade-off.

Larcker, So, and Wang (2010); Hallock (1997); Nguyen-Dang (2009)

 Board Size
Board size tends to be correlated with company revenue.
• Small companies (<$10 million): 7 directors, on average.
• Large companies (>$10 billion): 11 directors, on average.

• (+) Large boards have more resources.

• (+) Allow for greater specialization.

• (-) Greater cost (compensation, scheduling conflicts, etc.).

• (-) Slow decision making.
• Larger boards tend to provide worse oversight (when company
size is held constant).

• Large “complex” firms (those with multiple business segments)

benefit from larger board size while large “simple” firms do not.
Yermack (1996); Coles, Daniel, and Naveen (2008)
 Diverse Boards
Do diverse boards provide better advice and oversight?
• (+) Broader array of knowledge, experience, and perspective.
• (+) Lessens “groupthink” (premature consensus).
• (+) Encourages healthy debate.

• (-) Diverse groups exhibit lower teamwork.

• (-) May lead to “tokenism.”
• Evidence on the relation between diversity and corporate performance is largely
inconclusive.

• Modest evidence that female representation improves governance quality.

• Diversity for the sake of meeting arbitrary quotas is clearly detrimental (the cost of
inexperience outweighs the potential benefits).

• Mentoring and development improves director qualification.

 Summary of Evidence
Structural Attribute Findings from Research
Independent Chairman No evidence
# of Outside/Independent
Mixed evidence
Directors
Independence of Committees Evidence for audit committee
Busy Boards Negative impact
Positive on performance
Interlocked Boards
Negative on monitoring
Negative impact (unless company
Board Size
is “complex”)
Diversity Mixed evidence
 Case: Yin Guangxia
 Yin Guangxia: an example of an inefficient board

 A listed company in China mainland

 It inflated sales by more than RMB1 billion between 1997 and 2001, and
earnings by more than RMB0.77 billion

 The accounting fraud is first revealed by a financial media

 After the fraud is revealed, its stock price declines 10% each day for 15
consecutive trading days

 It was named as ‘China’s Enron’

 The fraud was so obvious but the board did not detect its
presence:
• Even if the company operates at its full capacity, and 24hrs/day, it cannot
produce enough products for reported sales;
• The selling price is unbelievably high;
• Tax refund for foreign sales is not received by the company
  Most members in both the board of director and the board of
supervisor are former government officials: they lack both
incentives and expertise to monitor managers
Name Background
Zhang, Jisheng (Chairman of the Ministry of Science and Technology
board)
Kong, Xiang-ping (Executive VP) Policy Research Office of Industrial Department
Yu, Du (Chairman of Yinchuan City Health Bureau
Supervisory Board)
Wen, Dunai (Supervisory board) Yinchuan City Health Bureau,Yinchuan City Arbitration
Commission
Wade,Yuyan Zhongning County Committee
Zhao,Yinsheng Industrial Science and Technology Department
Li, Wei Ningxia Securities Co., Ltd.
Wang,Yucai (VP) Yinchuan City Industrial Development Bureau, Department of
Commerce Ningxia Finance Department
Liu,Yunkang (Supervisory board) Sichuan Provincial Department of Commerce
 Another Board
 Background of board members
 Former dean of the Stanford Business School
 Former chairman of US Commodity Futures Trading Commission
 A former member of UK House of Lords and House of Commons,
and former UK Energy minister
 Ronnie C. Chan: Chairman, Hang Lung Group
 Former and current presidents of University of Texas M.D. Anderson
Cancer Center
 CEOs or chairmen of several other big companies: Alliance Capital
Management, Comdisco, Inc., Belco Oil and Gas Corp., Gulf and
Western Industries Inc., Winokur Holdings Inc., Portland General
Electric

 Looks good? An efficient board?

 Case: Lehman Brothers
 Failed during the financial crisis in 2008
 Board of directors
(https://www.sec.gov/Archives/edgar/data/806085/0001104659070137
60/a07-5283_1def14a.htm)
 10 directors : 8 were independent according to NYSE rules
 CEO was the chairman
 Age: average of 68 (cf. 61 at average large corporation)
 Diverse professional background (current and former CEOs, executives from
both for-profit and nonprofit sectors)
 Not overly busy
 Compensated with a mix of equity

 How does the board of directors look?

 Case: Lehman Brothers
 Some red flags?
 Absence of financial services expertise
 Absence of current business experience
 No current CEOs of major public corporation
 Former CEOs were well into retirement

Were professional experiences of board members relevant for

understanding the increasing complexity of financial markets?
Why directors from non-profit sector?
Too old?
 Case: Lehman Brothers
 Were the directors really engaged in monitoring the management?
 CEO Richard Fuld was “aggressive, confrontation, blunt” and tended to
isolate himself from colleagues
 Committee composition
 E.g. The theatrical producer was appointed to audit committee and the finance & risk
committee
 E.g. Finance & risk committee met only twice during the year
 E.g. Executive committee appeared to be more active than the full board or the
committees
 Was the committee structured properly?
 Was oversight quality compromised?
 Conclusion
 It is easy to achieve the letter of good governance but it is difficult
to achieve the spirit or the reality of good corporate governance.

 Corporate governance is about making sure that the right questions

are asked and the right checks and balances are in place, and not
about superficial construct
Governance Role of Shareholders
 Shareholder Type

 Individual investors

 State

 Institutional Investors: mutual funds, pension

funds, insurance companies, banks, foundations
etc.
 Institutional ownership is mostly an indirect individual
ownership: the majority of institutions’ beneficiaries are
individuals
 Shareholder Right

 Elect directors

 Approve charter amendment

 Approve merger & acquisitions

 Ratify executive compensation and the

appointment of external auditors
 Shareholder Right

Discussion question:

 Have you ever attended any shareholder meetings? Why

did you attend or not attend?

 Will you attend the shareholder meetings?

 Limitations
• Indirect influence. Shareholders do not have direct control
over the corporation. They influence the firm by:
• Communicating their concerns.
• Withholding votes from directors.
• Waging a proxy contest to elect an alternative board.
• Voting against company proxy items.
• Sponsoring their own proxy items.
• Selling their shares.
 Free-rider Problem

 Shareholder monitoring: cost and benefit

 A shareholder must bear all costs associated with its

action to monitor managers

 The benefit brought by monitoring, however, is shared

by all shareholders
 Free-rider Problem

 Dispersed ownership and free-rider problem

 The ownership of large modern corporations is so

dispersed that almost no shareholders own a significant
amount of shares in any company

 The cost of monitoring usually outweighs the benefit

 Free-rider problem (collective action problem): small

shareholders takes no action and hopes that the others can
monitor management; as a result, nobody monitors.
 Class Action Lawsuit
 A form of lawsuit in which one or more named
plaintiffs, on behalf of a proposed class, brings to
court against a business entity and/or its executives

 The proposed class must consist of a group of

individuals that have suffered a common injury
caused by the defendants: e.g., shareholders who were
misled by fraudulent disclosures to buy or sell stocks

 Originated and prevalent in the U.S.

 Advantages: the associated costs are shared by all
shareholders, so are benefits
 The attorney fee is paid only the case is successful
 The judge determines how much the lawyers should
be paid (usually 30% of the total compensation)
 The net compensation is paid to the proposed class
on an equal basis.

 Case: Tyco International

http://securities.stanford.edu/filings-case.html?id=102326

 Top 10 class action lawsuits:

http://www.cnbc.com/id/35988343
 Block Shareholders
 Block shareholder: a shareholder who owns a
significant portion of shares (e.g., 5%+) and thus
can exercise significant influence over the control of
the company.

 Block shareholder can exercise effective monitoring

 The benefit they obtain could outweigh the
monitoring cost they bear
 They have incentives to collect information and
exercise efforts
 They have significant influence over voting outcome
 Block Shareholders
 Evidence on the role of large shareholders in
exercising corporate governance

 Poorly performing firms with large shareholders

are more likely to be taken over

 Managers of poorly performing firms with large

shareholders are more likely to be fired

 Discretionary spending, such as advertising and

entertainment expenses, is less in firms with large
shareholders

 Firms with large shareholders have higher turnover

of directors
 Large Creditors
 The role of banks in corporate governance

 Have the ability to collect information

 Interest payment reduces free cash flow available to

managers

 Have the rights to seize assets or liquidate the firms

if firms cannot meet the requirements to pay interest
or return principle
 Large Creditors
 Evidence about governance by large creditors

 The announcement of new or renewed bank

loan has a positive impact on stock prices,
while public bond issues have no positive
effect

 Acquisitions financed by bank loans are

associated with positive stock returns for
bidders at the announcements
 Institutional Investors

 Mutual funds
 Hedge funds

 Public pension funds

 Private pension funds

 Commercial and Investment Banks

 Insurance companies

 Foundations and endowments

 Institutional Investors
 The rise of institutional investors
Shareholders of Stocks by Investor Type (USA)
1970 2002

non-US investors
3% non-US
mutual funds
other 5% pensions
investors
1% 9% 11% mutual funds
insurance
19%
companies other
3% 3%

bank trusts
10%

pensions
households &
21%
nonprofit
organizations
insurance
36%
households & companies
nonprofit 8%
organizations
69% bank trusts
2%

Reproduced from Kim & Nofsinger, 2007, Page 96

 Institutions are not All the Same
1. Investment horizon. Long-term investors might tolerate
volatility if they believe value is being created. Short-term
investors might prefer that management focus on quarterly
earnings and stock price.
2. Objectives. Mutual funds might care primarily about economic
returns. Other funds might emphasize how results are achieved
and the impact on stakeholders.
3. Activity level. Passive investors might focus on index returns
and pay less attention to individual firms. Active investors might
care greatly about individual outcomes.
4. Size. Large funds can dedicate significant resources to
governance matters. Small funds lack these resources.
 Proxy Voting
• A primary method for shareholders to influence the corporation is
through the proxy voting process.

• Each year, shareholders are asked to vote on a series of corporate

matters, either in person at the annual meeting or through the annual
proxy.

• Institutional investors are required by SEC regulation to vote all items

on the proxy and to disclose their votes to investors.

•Institutional investors vote “for” a proposal 90% of the time when

management recommends a vote in favor.

• They vote “against” 62% of the time when management is “against.”

ISS Voting Analytics (2009)
 Proxy Voting
• Management proposals are those sponsored by the company, including
the election of directors, ratification of the auditor, approval of equity-
compensation plans, say-on-pay, anti-takeover protections, and bylaw
changes.

• Shareholder proposals are those sponsored by investors. They

generally relate to compensation, board structure, antitakeover
protections, and bylaw changes.

• Companies may exclude shareholder proposals if they violate the law,

deal with management functions, involve dividends, or involve other
substantive matters.
•33% of shareholder proposals relate to compensation; 20% are board-
related (e.g., proposal to require an independent chairman).

• Union funds and individual activists sponsor > 80% of proposals.

Gillan and Starks (2007)
 Proxy Advisory Firms
Many institutions rely on the recommendations of a third-party advisory
firm to assist them in voting the proxy.
• (+) Proxy firms examine all issues on the proxy.
• (+) Small investors lack the resources to do this in-house.
• (+) Large investors might want a second opinion.
• (-) No evidence that their recommendations increase value.
• (-) Guidelines tend to apply a one-size-fits-all approach.
• (-) Proxy firms might not have sufficient staff or expertise.
•The largest proxy advisory firms are Institutional Shareholder Services (ISS) and
Glass Lewis, whose clients manage $25 trillion and $15 trillion in equities.

• An unfavorable recommendation from ISS can reduce support by 14% to 20%.

•No evidence that recommendations lead to improved performance. Some evidence

that ISS recommendations for option exchanges lead to worse outcomes.

Bethel and Gillan (2002); Larcker, McCall and Ormazabal (2011)

 Shareholder Activism
• Utilize shareholder rights to pressure the company in which
they invest

• (+): Reduce agency problem

• (+): Prevent management entrenchment
• (+): Prevent complacency by pressuring management to pursue S/H
interests first

• (-): Takes management/board attention away from important matters

• (-): Used to boost short-term stock prices
 Activist Investors
• An activist investor is a shareholder who uses an ownership
position to actively pursue governance changes. Examples
might include:
• Union-backed pension funds.
• Socially responsible investment funds.
• Hedge funds that take an active position.
• Individual investors with strong personal beliefs.

• Activist investors play a prominent role in the governance

process, sometimes for the better and sometimes not.
 Pension Funds
• Public pension funds manage retirement assets on behalf of state,
county, and municipal government employees.

• Private pension funds manage retirement assets on behalf of trade union

members.

• Pensions are active in the proxy voting process. However, their

activism has not been shown to have a positive impact on shareholder
value or governance outcomes.

•Companies that are the target of activism by CalPERS experience marginal

excess stock price returns following the announcement; no excess returns or
improvement in operating performance is discernable over the long term.

• The AFL-CIO is likely to vote against directors at companies in the middle of a

labor dispute, particularly when the AFL-CIO represents the workers.
Barber (2007); Agrawal (2010)
 Socially Responsible Funds
• Socially responsibility funds cater to investors who value specific
objectives and want to invest only in companies whose practices are
consistent with those objectives.

• Examples include fair labor practices, environmental sustainability, and

the promotion of religious or moral values.

• These funds are visible in the proxy process, although it is only one tool
they use to influence corporate behavior; proxy items sponsored by
these funds generally do not receive majority support.

•Shareholders submitted 410 resolutions relating to social and environmental

objectives in 2008. Of these, 202 came to a vote. On average, they received
support from 5% to 10% of shareholders.

•Research is mixed on whether socially responsible funds succeed in their dual

objective of achieving market returns and advocating social mission.
ISS (2009); Geczy, Stambaugh, and Levin (2005); and Renneboog, Ter Horst, and Zhang (2008)
 Activist Hedge Funds
• Hedge funds are private pools of capital that engage in a variety of
trading strategies to generate excess returns.

• Hedge funds are known for their high fee structure. They face pressure
from clients to generate superior performance to justify these fees.

• Pressure to perform might encourage activism.

•Activist hedge funds target companies with high ROA and cash flow, but below
market price-to-book ratios and stock price performance.

•Activist hedge funds accumulate an initial position of 6.3%; many coordinate

their actions with other funds (“wolf pack strategy”).

• Target companies realize positive excess returns following the announcement.

•A majority of hedge funds achieve the stated objective of their activism (such
as replacing the CEO, sale of company, or increased share buybacks); however,
target companies do not exhibit superior long-term operating performance.

Brav, Jiang, Thomas, and Partnoy (2008); Klein and Zur (2009)
 Shareholder Democracy
• In recent years, there has been a push by Congress, the SEC, and
others to increase the influence that shareholders have over
governance systems (“shareholder democracy”).

• Advocates of shareholder democracy believe that it will make

board members more accountable to shareholder concerns, such
as excessive compensation, risk management, and board
accountability.

• Elements of shareholder democracy include:

• Majority voting in uncontested elections.
• Investor right to nominate directors (“proxy access”).
• Investor vote on executive compensation (“say on pay”).
 Majority Voting
• Shareholder advocates believe that plurality voting lowers governance quality
by insulating directors from investors.

• They advocate a stricter standard—majority voting—under which directors

must receive 50% of the votes to be elected.

• The impact of majority voting on governance is unclear. Dissenting votes are

often issue-driven and not personal to the director (e.g., withhold votes for
directors on comp committee to protest CEO compensation levels).

• This might inadvertently work to remove directors who bring important

strategic, operational, or risk qualifications.

•More than 80% of the largest 100 companies in the U.S. use majority
voting. However, only 46% of all U.S. companies use majority voting.
Sterling Sherman (2010); NACD (2009)
 Proxy Access
• Historically, the board of directors has had sole authority to nominate
candidates whose names appear on the proxy.

• Following Dodd-Frank, shareholders or groups of shareholders owning

3% or more of a company’s shares for at least 3 years are eligible to
nominate up to 25% of the board.*

• Proxy access (or the threat of proxy access) is likely to increase the
influence of activist investors over boards.

• The market reacts negatively to proxy access regulation, and

the reaction is most negative among companies that are most
likely to be affected.

•Only 11% of directors believe that proxy access is likely to

improve corporate governance.
Larcker, Ormazabal, and Taylor (forthcoming); Boardmember.com (2010).

* This rule has been challenged in court.

 Say on Pay
• Shareholders are given an advisory (nonbinding) vote on executive or
director compensation.

• Variations of “say on pay” have been enacted in the U.S., U.K.,

Netherlands, Australia, Sweden, Norway and India.

• Under Dodd-Frank, companies are required to hold a nonbinding say-

on-pay vote at least every 3 years.
•Research indicates that say-on-pay votes outside the U.S.
have not reduced executive compensation levels; it has been
shown to change the structure of pay contracts.

•Evidence in the U.S. suggests that capping or regulating

executive pay results in less efficient contracts and negatively
affects shareholder wealth.
Ferri and Maber (2009); Larcker, Ormazabal, and Taylor (2011)
 Case: Honeywell 1989
 Incorporated in 1927
 Design and manufacture of thermostats and other electronic
control devices for buildings, aircraft, and other industrial
applications
 After World War II, diversified into weapons and computer
industries
 1986: Recorded accounting loss
 Went through restructuring
 Consolidated basic controls business
 Sold most of computer business
 Purchased Sperry Aerospace Group from Unisys for $1.03 billion
 Price too high?
 Later Honeywell sued Unisys charging that it had misrepresented Sperry’s
worth
 Case: Honeywell 1989
 Late 70’s and 80’s:
 Growth in assets (from $2.8 billion in 1978 to $5.3 billion in
1989)
 Enhanced reputation for benevolence among its workers and
other stakeholders
 BUT productivity and stock returns below industry average
 October 21, 1988
 Q3 loss of $22.2 million
 According to October 24, 1988 WSJ’s “Heard on the Street” :
‘size of the loss staggered some analysts and investors and the
management lost credibility on Wall Street’
 Case: Honeywell 1989
 December 1988
 Loss exceeded $400 million due to restructuring write-off
 Analysts questioned internal controls
 Late 1988
 Dissatisfaction among Honeywell shareholders, including
takeover investors who increased their stakes
 Case: Honeywell 1989
 February 1989 board meeting
 Directors voted to propose 2 antitakeover amendments to
firm’s charter at the shareholder meeting
 Classify the 12 member BOD into three groups, only one of which would
come up for reelection in any year
 Deny any outsider the opportunity to gain control at one annual
meeting
 Eliminate shareholders’ right to act by written consent
 No shareholder action can be taken without calling a shareholders’
meeting
 Management mailed proxy materials on 23 March
Was the management trying to insulate itself?
 Case: Honeywell 1989
 After proposal, North American Partners, L.P. (NAP) took
action
 Worked with ISS
 Brought CalPERS and PennPSERS to cosponsor the dissident
solicitation (these three had 4.4% of the stock) ensuring that
NAP will pay all costs
 After the CEO refused the shareholder requests, filed proxy
materials with the SEC
 April 28: distributed proxy materials
 Started making calls to vote against management’s proposals
 Case: Honeywell 1989

Source: Nuys (1993)

 Case: Honeywell 1989
 May 12, 1989: Management defeated
 Proposal supported by majority of shares voting
 But failed to receive support from 50% of the shares
outstanding

 July 24, 1989: announce reorganization

 Success: CAR was over 35% from mailing of management’s
proxy to completion of restructuring program in 1990
 Case: Honeywell 1989
 Effects of solicitation
 Case: Honeywell 1989
 Discussion question:
Do you think Honeywell would have committed to
restructuring before NAP came along ?
 Case: Honeywell 1989
 Structure of BOD
 Edson W. Spencer (former CEO) was on board during the
countersolicitation
 Every board member in 1989 was elected during Spencer’s
term as chairman
 Did this friendship made the directors reluctant to force any
changes to the policies?
 Nine institutions with commercial relationship (e.g. banks,
insurance companies) had board members or other employees
who sat on Honeywell’s BOD
 Conflict of interests?
 Conclusion
• In theory, shareholders should be in a strong position to
influence the structure of governance systems.

• In practice, shareholders have limited influence, and in

some cases they have conflicting agendas.

• Regulators have attempted to increase the influence of

shareholders by mandating elements of “shareholder
democracy.”

• However, shareholders tend to react negatively to these

regulations. A positive impact on governance quality has
not yet been demonstrated.