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. 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

4. 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:

5. 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)

6. EARLY WARNING SIGNS OF PROBLEMS WITH KRISPY KREME Source: M. Maremont and R. Brooks, “Fresh Woes Batter Krispy Kreme; Doughnut Firm to Restate Results, Delay SEC Filing; Shares Take a 15% Tumble,” Wall Street Journal (Eastern edition), January 5,2005.p.A3

7. 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)

8. 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

9. SOME NEW COMPLIANCE RULES FROM SARBANES-OXLEY • Auditors must list the non-audit services they are unable to perform during an audit • A one-year waiting period for audit-firm employees who leave an accounting firm to become an executive for a former client • Transactions and relationships that are off the balance sheet but that may affect financial status must now be disclosed • Personal loans from a corporation to its executives are now largely prohibited • Research analysts for securities firms must now file conflict of interest disclosures. For instance, analysts must report whether they hold any securities in a company or have received corporate compensation • Brokers and dealers must disclose if the public company is a client • Altering, destroying, concealing, or falsifying records or documents with the intent to influence a federal investigation or bankruptcy case is subject to fines and up to 20 years of imprisonment

10. OWNERSHIP STRUCTURE VARIES Source: Company annual reports

11. ROLES AND ACTIONS OF BOARD OF DIRECTORS

12. EFFECTS OF CEO FIRINGS Source: M.wiersema, “Holes at the Top: Why CEO Firings Backfire,” Harvard Business Review 80;12 (2002), 70-77

13. 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

14. 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

15. 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

16. 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

17. CEO PAY COMPARISON

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

23. Germany • China • Two-tier board system • Only recently started a securities market • Management board manages the enterprise • Majority of listed companies started off as state-owned enterprises • Supervisory board appoints, supervises, and advises members of the management board • State ownership remains high across all industries CORPORATE GOVERNANCE IN GERMANY AND CHINA

24. Chiquita • Dole • Del Monte • Sales 2004($ millions) • 2,613 • 4,773 • 2,171 • The Chiquita board set objectives as: • Delivery of quality products to consumers • Quality returns to shareholders • Transform Chiquita into a global player • Net income ($ millions) • 96 • 84 • 134 • CEO salary($ thousands) • 950 • 810 • What is appropriate? • CEO bonus($ thousands) • 1,368 • 870 • CEO total Compensation($ thousands) • 4,387 • 7,394 HOW WOULD YOU DO THAT? – CHIQUITA • How should Chiquita compensate its new CEO? Source: Company annual reports

25. SUMMARY 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