Chapter 14

Stockholder Rights and Corporate Governance

Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Ch. 14: Key Learning Objectives Identifying different kinds of stockholders and

understanding their objectives and legal rights Knowing how corporations are governed and

explaining the role of the board of directors in protecting the interests of owners

Analyzing the function of executive compensation and debating if top managers are paid too much

Evaluating various ways stockholders can promote their economic and social objectives

Understanding how the government protects against stock market abuses, such as fraudulent accounting and insider trading

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Stockholders Stockholders (also called shareholders)

The legal owners of business corporations Types of stockholders

Individual stockholders are people who directly own shares of stock issued by companies

Institutions, such as pension funds, mutual funds, insurance companies, and university endowments

• Called institutional investors

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Stockholders Trends In 2010, institutions accounted for 63% of the value of all

U.S. stocks, worth $15 trillion About eight times the value of institutional holdings

two decade earlier Slightly 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 so

At all ages, equity ownership is higher as income and education rises

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Household versus Institutional Ownership in the United States

Figure 14.2

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Objectives of Stock Ownership To produce a return greater than they could receive

from alternative investments Stockholders 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”

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Major Legal Rights of StockholdersFigure 14.3

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Corporate Governance Corporate governance

Refers to the process by which a company is controlled, or governed

Board of directors An 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 policies

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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, Audit Audit has key role to review financial reports, recommend outside

auditors, and oversee integrity of internal financial controls

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Boards of Directors Board members are elected by shareholders at the

annual meeting, where absent owners vote by proxy

Process is not truly democratic, but tends to be self-perpetuating The 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.

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Key Features of Effective Boards Select outside directors to fill most positions Hold open elections for members of the board Appoint an independent lead director and hold

regular meetings without the CEO present Align director compensation with corporate

performance Evaluate the Board’s performance on a regular basis

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Improving Corporate Governance Worldwide OECD, representing 30 nations, issued a revised set of

principles of corporate governance in 2004 to serve as a benchmark for companies and policy makers worldwide The 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 principles

EU, South Africa, and India have worked hard to modernize corporate governance practices, but progress has been slow in emerging markets

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Executive Compensation Executive compensation is a key Board function

An important mechanism for aligning the interests of the corporation and its stockholders with those of its top managers

Many critics feel that this system is not working and executive pay has become excessive

Executive compensation in the U.S., by international standards, is very high In 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 own

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Relative Median Executive Compensation in the United States and Selected European Nations

Figure 14.4

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Ratio of Average CEO Pay to Average Production Worker Pay, 1990–2010

Figure 14.5

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Executive Compensation: Is it Justified? Arguments of proponents of high executive pay

Well-paid managers are simply being rewarded for outstanding performance

High salaries provide an incentive for innovation and risk-taking Not many individuals are capable of running today’s large,

complex organizations

Arguments of critics of high executive pay Inflated executive pay hurts the ability of U.S. firms to compete

with foreign rivals Multimillion 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 success

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Executive Compensation Reform Has been the subject of shareholder pressure

Some companies have changed the way they structure executive pay, e.g., by tying pay more directly to company performance

Small number of companies set multiple of executive pay versus others workers

Government regulations Under U.S. rules, corporations must disclose top 5 executives’

compensation and the rationale for it The 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 years

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Shareholder Activism – Rise of Institutional Investors

As shown earlier, holdings have increased significantly; have become more assertive in promoting interests of their members Have large blocks of stock so not easy to sell if become

dissatisfied, therefore strong incentive to work to change management policy

Council of Institutional Investors Represents institutions and pension funds with investments

collectively exceeding $3 trillion in holdings Developed a Shareholder Bill of Rights

Research shows involvement of institutional investors can improve company performance

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Shareholder Activism – Social Investment

Social investment Refers to the use of stock ownership as a strategy for

promoting social objectives; also called social responsibility investment

Social screening of stock Some stock purchasers choose stocks based on social or

environmental criteria, called social screens In 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 beyond

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Shareholder Activism – Social Responsibility Shareholder Resolutions Social responsibility shareholder resolutions

A resolution on an issue of corporate social responsibility placed before stockholders for a vote at the company’s annual meeting

Has been a significant rise in social responsibility shareholder resolutions in recent years – about 400 were sponsored in 2011 Sponsorship is often from a coalition of groups, like Interfaith Center

on Corporate Responsibility Resolutions can be about social issues, not company’s

ordinary business In 2011, such resolutions garnered, on average, 21 percent

of votes cast, an all-time high

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Shareholder Activism – Shareholder Lawsuits If owners think they or their company have been

damaged by actions of company officers or director, they have right to bring lawsuits

Can be initiated to check abuses, for example insider trading, inadequate stock buyout price, or timely disclosure of material information

The outcome can be very expensive for companies

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Securities and Exchange Commission (SEC)

Government agency charged with protection of stockholder interests

Established in 1934 in the wake of the Great Depression

Mission is to protect stockholders’ rights by making sure that the stock markets are run fairly and that investment information if fully disclosed

Unlike more government agencies, generates revenue to pay for its own operations

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SEC – Information Transparency and Disclosure Giving stockholders more and better company

information is one of best ways to safeguard investor interests

In recent years, management has tended to disclose more information than ever before to stockholders and other interested people

Although 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 risk

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SEC - Insider Trading Insider trading

Occurs 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 stock

Is illegal under SEC Act of 1934, meaning against the law to: Steal nonpublic information and use it to trade a stock Trade a stock based on a tip from someone who had an

obligation to keep quiet Pass information to others with an expectation of gain

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Stockholders and the Corporation Stockholders have become an increasingly powerful

and vocal stakeholder group in corporations Provide capital Monitor corporate performance Assure the effective operation of stock markets Bring new issues to the attention of management

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