Chapter 14: Stockholder Rights and Corporate Governance

Chapter 14 Stockholder Rights and Corporate GovernanceCopyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinCh. 14: Key Learning ObjectivesIdentifying different kinds of stockholders and understanding their objectives and legal rightsKnowing how corporations are governed and explaining the role of the board of directors in protecting the interests of ownersAnalyzing the function of executive compensation and debating if top managers are paid too muchEvaluating various ways stockholders can promote their economic and social objectivesUnderstanding how the government protects against stock market abuses, such as fraudulent accounting and insider trading14-*StockholdersStockholders (also called shareholders) The legal owners of business corporations Types of stockholdersIndividual stockholders are people who directly own shares of stock issued by companiesInstitutions, such as pension funds, mutual funds, insurance companies, and university endowmentsCalled institutional investors14-*Stockholders TrendsIn 2010, institutions accounted for 63% of the value of all U.S. stocks, worth $15 trillionAbout eight times the value of institutional holdings two decade earlierSlightly over half of all U.S. households own stocks, either directly or indirectly through holdings in mutual funds Older people are more likely to own stock, slightly less than 40% of young households do soAt all ages, equity ownership is higher as income and education rises14-*Household versus Institutional Ownership in the United StatesFigure 14.214-*Objectives of Stock OwnershipTo produce a return greater than they could receive from alternative investmentsStockholders make money when the price of the stock rises (capital appreciation) and when they receive their share of the company’s earnings (called dividends) Bull markets (in which share prices rise overall) alternate with bear markets (in which share prices fall overall)Although stock prices can be volatile, stocks historically have produced a higher return over the long run than many other types of investments Some investors use stock ownership to achieve social or ethical objectives Discussed further under “social investment”14-*Major Legal Rights of StockholdersFigure 14.314-*Corporate GovernanceCorporate governanceRefers to the process by which a company is controlled, or governedBoard of directorsAn elected group of individuals who have a legal duty to establish corporate objectives, develop broad policies, and select top-level personnel to carry out these objectives and policies14-*Boards of Directors Vary in size, composition, and structure to best serve the interests of the corporation and shareholders Survey of governance practices in leading firms in the Americas, Europe, and Asia Pacific:Average board size was 12 members Typically, 10 or 11 of these are outside directors (not managers of the company) Work of the Board is done through committees:Typical committees: Compensation, Executive, Nominating, AuditAudit has key role to review financial reports, recommend outside auditors, and oversee integrity of internal financial controls 14-*Boards of Directors Board members are elected by shareholders at the annual meeting, where absent owners vote by proxyProcess is not truly democratic, but tends to be self-perpetuatingThe board nominating committee, working with the CEO and chairman, develops a list of candidates. Once approved by the Board, the names of these individuals are placed on the proxy ballot. Because alternative candidates are often not presented, the vote has little significance. 14-*Key Features of Effective BoardsSelect outside directors to fill most positionsHold open elections for members of the boardAppoint an independent lead director and hold regular meetings without the CEO presentAlign director compensation with corporate performanceEvaluate the Board’s performance on a regular basis14-*Improving Corporate Governance WorldwideOECD, representing 30 nations, issued a revised set of principles of corporate governance in 2004 to serve as a benchmark for companies and policy makers worldwideThe OECD 2009 report concluded that the financial crisis affecting may of its member states had been caused to an important extent by failures of corporate governance, and it called for re-examination of the adequacy of these principlesEU, South Africa, and India have worked hard to modernize corporate governance practices, but progress has been slow in emerging markets14-*Executive CompensationExecutive compensation is a key Board functionAn important mechanism for aligning the interests of the corporation and its stockholders with those of its top managersMany critics feel that this system is not working and executive pay has become excessiveExecutive compensation in the U.S., by international standards, is very highIn 2011, the median total compensation of chief executives of the largest corporations in the United States was $9.6 million (including salaries, bonuses, benefits and stock options)Stock options is controversial subject on its own14-*Relative Median Executive Compensation in the United States and Selected European Nations Figure 14.414-*Ratio of Average CEO Pay to Average Production Worker Pay, 1990–2010Figure 14.514-*Executive Compensation: Is it Justified?Arguments of proponents of high executive payWell-paid managers are simply being rewarded for outstanding performanceHigh salaries provide an incentive for innovation and risk-takingNot many individuals are capable of running today’s large, complex organizationsArguments of critics of high executive payInflated executive pay hurts the ability of U.S. firms to compete with foreign rivalsMultimillion dollar salaries cause resentment, sap the commitment of hardworking lower and midlevel employees As many extravagantly compensated executives preside over failure as they do over success14-*Executive Compensation ReformHas been the subject of shareholder pressureSome companies have changed the way they structure executive pay, e.g., by tying pay more directly to company performanceSmall number of companies set multiple of executive pay versus others workersGovernment regulationsUnder U.S. rules, corporations must disclose top 5 executives’ compensation and the rationale for itThe say-on-pay provisions of the Dodd-Frank Act, which went into effect in 2011, require public companies to hold shareholder votes on executive compensation at least once every three years14-*Shareholder Activism – Rise of Institutional InvestorsAs shown earlier, holdings have increased significantly; have become more assertive in promoting interests of their membersHave large blocks of stock so not easy to sell if become dissatisfied, therefore strong incentive to work to change management policyCouncil of Institutional InvestorsRepresents institutions and pension funds with investments collectively exceeding $3 trillion in holdingsDeveloped a Shareholder Bill of RightsResearch shows involvement of institutional investors can improve company performance14-*Shareholder Activism – Social InvestmentSocial investmentRefers to the use of stock ownership as a strategy for promoting social objectives; also called social responsibility investment Social screening of stockSome stock purchasers choose stocks based on social or environmental criteria, called social screensIn 2010, $3.1 trillion in the United States was invested in mutual funds or pensions using social responsibility as an investment criterion Rapid growth in similar funds in Europe and beyond14-*Shareholder Activism – Social Responsibility Shareholder ResolutionsSocial responsibility shareholder resolutionsA resolution on an issue of corporate social responsibility placed before stockholders for a vote at the company’s annual meetingHas been a significant rise in social responsibility shareholder resolutions in recent years – about 400 were sponsored in 2011Sponsorship is often from a coalition of groups, like Interfaith Center on Corporate ResponsibilityResolutions can be about social issues, not company’s ordinary businessIn 2011, such resolutions garnered, on average, 21 percent of votes cast, an all-time high 14-*Shareholder Activism – Shareholder LawsuitsIf owners think they or their company have been damaged by actions of company officers or director, they have right to bring lawsuitsCan be initiated to check abuses, for example insider trading, inadequate stock buyout price, or timely disclosure of material informationThe outcome can be very expensive for companies 14-*Securities and Exchange Commission (SEC)Government agency charged with protection of stockholder interestsEstablished in 1934 in the wake of the Great DepressionMission is to protect stockholders’ rights by making sure that the stock markets are run fairly and that investment information if fully disclosedUnlike more government agencies, generates revenue to pay for its own operations14-*SEC – Information Transparency and DisclosureGiving stockholders more and better company information is one of best ways to safeguard investor interestsIn recent years, management has tended to disclose more information than ever before to stockholders and other interested peopleAlthough the overall trend has been to greater transparency, some observers felt that a lack of disclosure about complex financial instruments that became common in the mid-2000s may have led investors to underestimate their risk14-*SEC - Insider TradingInsider tradingOccurs when a person gains access to confidential information about a company’s financial condition and then uses that information, before it becomes public knowledge, to buy or sell the company’s stockIs illegal under SEC Act of 1934, meaning against the law to:Steal nonpublic information and use it to trade a stockTrade a stock based on a tip from someone who had an obligation to keep quietPass information to others with an expectation of gain14-*Stockholders and the CorporationStockholders have become an increasingly powerful and vocal stakeholder group in corporations Provide capitalMonitor corporate performanceAssure the effective operation of stock marketsBring new issues to the attention of management14-*