Welcome to Class 7

1. Corporate Boards of Directors Welcome to Class 7 Chapter 4

2. History and overview of Corporate Boards

3. Early in the last century the majority of large corporations were owned and controlled by a small number of capitalists. Over time the stockholdings were dispersed to many beneficiaries. Beneficiaries were generally uninvolved in the firms so they passed control of operational decision-making to insiders with specialized expertise (management.) This meant a separationof managementfrom ownership. The separation gave rise to two different theories of implications: 1. Agency Theory 2. Stewardship Theory

4. AGENCY THEORY Separation of management and ownership created the potential for fiduciary lapses and conflicts of interest according to Agency Theory. Fiduciary lapses occur when management makes self-serving decisions without regard to shareholders.

5. Directors to the Rescue? Shareholders depend on its board of directors as a governance mechanism to protect against fiduciary lapses. Corporate boards are an important component of the governance structure. Boards have the legal authority to dismiss poorly performing TMTs. Boards are expected to be closely involved in major corporate decisions. Many boards ARE NOTfulfilling their responsibilities.

6. In the 1980s, frustrated by board refusal to challenge management decisions, investors began to DEMAND CHANGES. 1. Boards were expected to be more proactive in their oversight role. 2. Boards were expected to END dualityin which the Board Chair is also the CEO.

7. The worldwide financial meltdown of 2009 was considered by many analysts to be a confirmation of corporate board incompetence. Governmental agencies from around the world began issuing a stream of new regulations related to corporate boards.

8. STEWARDSHIP THEORY NOT SO FAST! Stewardship Theorists believe TMTs can be trusted as capable and honest stewards of a firm’s resources. The theory says no one understands or cares about the corporation more than those who actually manage it. They DO NOT need independent board oversight. Duality is believed to make a positive contributionto corporate governance.

9. Final Point on Theory There are fewerStewardship Theorists than there are Agency Theorists.

10. Studies of Corporate Boards reveal that not all boards perform in the same way. Some Boards fulfill their fiduciary responsibility appropriately and effectively while others do not. Transformational Motivators can alter the quality of Board performance: Primary Transformational Motivators are: 1. Board Environment 2. Board Re-Configuration

11. Transformational Motivators

13. (1) Board Environment a. Peer Pressureby other board members to conform to a new norms. b. Lawsuitsby shareholders or creditors – High profile lawsuits against corporations or corporate directors are likely to motivate directors to become more concerned about TMT decisions and actions.

14. c. Dismal firm performancein comparison to competitors is likely to unnerve directors and encourage them to get more deeply involved in decision-making. d. Government regulations– new laws or more rigorous enforcement of existing laws is perhaps the strongest motivator for changes in board behavior. The Sarbanes-Oxley Act of 2002 (SOX) is a more recent example.

16. (2) Board Reconfiguration a. Women– Ratio of women to men on the board changes – Increasing the representation of women on corporate boards has been shown to “positively” influence organizational citizenship (social responsibility). b. Professional expertise–Changing the configuration of professional expertise on boards has been shown to influence performance. Bankers and others with financial experience on corporate boards have been associated with stabilizing stock returns. c. Average age– Research found firms with younger boards tend to outperform those with older boards.

17. d. Committee membership changes– When membership on powerful committees such as executive compensation committees changes, board power shifts from insiders to outsiders or vice versa. e. Inside/outside director ratio: Ratio changes from inside to outside board members have been shown to make decisions more independent from CEO preferences.

18. f. Board interlocks(Interlocking Directorates) Board interlocks occur when two or more corporate boards of directors have one or more common members. Common control* of two or more competing corporations may result from interlocking directorates. The concern – potential unfair restriction of competition. Consequently, some interlocking directorates are subject to prohibition and regulation under the Clayton Antitrust Act. 15 U.S.C. §19 enacted in 1914. The antitrust rule against interlocking directorates was designed to prevent anti-competitive coordination between organizations. However, the Federal Trade Commission (FTC) seldom pursues violations unless a complaint is filed. * Common control = two different firms controlled by same individuals

19. g. Board Size– Studies have found as boards become larger the have a tendency to display dysfunctional characteristics. h. CEO Tenure– Research has shown that as the tenure of the Chief Executive Officer increases, so does the influence over the board – thus boards are likely to become less independent. i. Duality– CEO is also the board chair (COB) The TMTs tend to negate independent board oversight.

21. What is the greatest of the transformational motivators?

22. Sarbanes Oxley (SOX)

23. SOX: New Rules for Corporate Boards There are substantial penalties associated with boards that fail to exercise due diligence. SOX makes it easier to prosecute securities fraud, particularly financial fraud. SOX attempts to reassert board independence from corporate management. The Act places greater responsibility on senior management and directors, particularly independent directors. The independent directors on the audit committee are to be substantially more diligent in overseeing and monitoring the financial reporting process, establishing internal controls, and assuring performance transparency. SOX provides teeth for civil and criminal enforcement over the conduct of corporate boards.

24. Interlocking Boards

25. Board Interlocks Interlocks are a common practice in the United States and this has been a perpetual concern of the federal government. The U.S. Government has attempted to manage some of the more troubling aspects with antitrust laws. For example, as far back as 1890, the U.S. Government began weighing in on the issue by passing the Sherman Antitrust Act. However, none of these Acts make it illegal to sit on multiple boards of non-competing companies and as such, the practice of interlocking boards continues as a common practice.

26. Interlocking corporate boards are a source of concern for many shareholders and financial analysts. An interlock between two firms occurs when one or more of their directors sits on the other company's board. Although, it is usually legal except where the firms are direct competitors, investors often voice concerns about the practice for a variety of reasons.

27. Concerns of Interlocking Boards: 1. Potential for unfair, self-serving exchange of non-public information. 2. Sitting on too many boards = too little time for exercising due diligence in protecting the interests of shareholders. 3. Risk of addiction to the perks of multiple corporate boards – directors may measure their achievements by the number of boards they are on rather than by what they actually contribute.

28. Benefits of Interlocking Boards 1. The interlocking board member may be able to provide (legally of course) useful inside information about a particular market. 2. They may be uniquely qualified to interpret the conditions and environment surrounding the market in which the corporation wishes to diversify. 3. They may also be able to provide objective expertise about potential strategies and tactics for diversification process.

29. Summary… All corporate boards can be divided into two basic categories: (1) those that do something (proactive) and; (2) those that do nothing (sedate).

30. Proactive boardsquestion the actions and decision of management and are not afraid to insist that changes be made. Sedate boards Are frequently head bobbers, nodding in agreement with all proposals. They do not want to “rock-the-boat.” An integral element in performance assessment is determining whether a firm has a proactive or a sedate board.

31. Assessing a firm’s board begins with developing a directorship profile

32. Directorship profile should include • 1. Number of directors • 2. Number of insiders on the board • 3. Number of women on the board • 4. Number of educators on the board • 5. Number of outside directors with accounting/finance experience on the board • 6. Whether or not the company practices duality (CEO is also COB) • 7. Average age of board members • 8. Oldest board member • 9. Youngest board member • 10. Average tenure of board member • 11. Shortest tenure • 12. Longest tenure

33. End: Corporate Boards of Directors Directors?

34. Remember… • Next Class (Class 8) you meet with your individual teams. There will be no formal class meeting in the classroom but you are required to attend your team meeting. • Attendance will be taken by the team secretary. • Class 9 will be a comprehensive review • Class 10 will be Exam 1