Chapter 5 Corporate Governance Chapter Summary This chapter examines the challenges in maintaining an ethical culture within an organization. What policies and procedures should be put into place to ensure that the company conducts itself in an ethical manner, and what should be the consequences when evidence of unethical conduct is found? The chapter begins by explaining and defining corporate governance and how it should be organized in a firm. It discusses the roles and responsibilities of different executives, as well as major governance committees and the board of directors. Further, the two methodologies, “comply or explain” and “comply or else” are differentiated. Learning Outcomes After studying this chapter, the student should be able to: 1. Explain the term corporate governance. 2. Understand the responsibilities of the board of directors and the major governance committees. 3. Explain the significance of the “King I” and “King II” reports. 4. Explain the differences between the following two governance methodologies: “comply or explain” and “comply or else.” 5. Identify an appropriate corporate governance model for an organization. Extended Chapter Outline Frontline Focus “Incriminating Evidence” Questions 1. Which committee would have granted stock options to the senior management of Chemco Industries? Review Figure 5.1 on page 95 for more information on this. The compensation committee is staffed by members of the board of directors and its primary responsibility is to oversee compensation packages, including stock options, for the senior executives of the corporation. 2. The e-mail suggests that the CEO was well aware of what was going on at Chemco Industries. Do you think the board of directors was aware of the activities of senior management? Which committee would be responsible for monitoring ethical practices at Chemco? The board of directors may or may not have been aware of the activities of senior management, depending on the number of senior executives who serve on the board of directors. The committee responsible for monitoring the ethical practices at Chemco would be the corporate governance committee. This committee monitors the ethical performance of the corporation and oversees compliance with the company’s internal code of ethics as well as any federal and state regulations on corporate conduct. 3. What should Marco do now? Marco should approach David Collins about the e-mail and state that he found and is aware of this e-mail. It is unethical to delete any evidence, such as e-mails, that could be used to find justice. Marco must ask himself if it is more important to win/lose the case ethically or unethically. If David Collins does not address this issue, then Marco needs to bring up the matter in court. Learning Outcome 1: Explain the Term Corporate Governance. • The business world has seen an increasing number of scandals in recent years, and numerous organizations have been exposed for poor management practices and fraudulent financial reporting. • Corporate governance is the system by which business corporations are directed and controlled. o It is concerned with how well organizations meet their obligations to their stakeholders—their customers, their vendor partners, state and local entities, and the communities in which they conduct their business operations. • Corporate governance is about the way in which boards oversee the running of a company by its managers, and how board members are, in turn accountable to shareholders and the company. • Good corporate governance plays a vital role in underpinning the integrity and efficiency of financial markets. o Poor corporate governance weakens a company’s potential and at worst can pave the way for financial difficulties and even fraud. • If companies are well governed, they will usually outperform other companies and attract investors whose support can finance further growth. Learning Outcome 2: Understand the Responsibilities of the Board of Directors and the Major Governance Committees. • The owners of the corporation supply equity or risk capital to the company by purchasing shares in the corporation. o They are typically a fragmented group, including individual public shareholders, large blocks of private holders, private and public institutional investors, employees, managers, and other companies. • The board of directors is a group of individuals who oversee governance of an organization. o Elected by vote of the shareholders at the annual general meeting (AGM), the true power of the board can vary from institution to institution from a powerful unit that closely monitors the management of the organization, to a body that merely rubber- stamps the decisions of the chief executive officer (CEO) and executive team. o The directors are appointed to serve for specific periods of time. o The board is typically made up of inside and outside members—inside members hold management positions in the company, whereas outside members do not. • The audit committee is an operating committee staffed by members of the board of directors plus independent or outside directors. o The committee is responsible for monitoring the financial policies and procedures of the organization, specifically: ➢ Accounting policies ➢ Internal controls ➢ Hiring of external auditors • The compensation committee is an operating committee staffed by members of the board of directors plus independent or outside directors. o The committee is responsible for setting the compensation for the CEO and other senior executives. ➢ Typically, this compensation will consist of a base salary, performance bonus, stock options, and other perks. • The corporate governance committee is a committee (staffed by board members and specialists) that monitors the ethical performance of the corporation and oversees compliance with the company’s internal code of ethics as well as any federal and state regulations on corporate conduct. o It represents a more public demonstration of the organization’s commitment to ethical business practices. Learning Outcome 3: Explain the Significance of the “King I” and “King II” Reports. • While the issue of corporate governance has reached new heights of media attention in the wake of recent corporate scandals, the topic itself has been receiving increasing attention for over a decade. • In 1992, Sir Adrian Cadbury led a committee in Great Britain to address financial aspects of corporate governance in response to public concerns over directors’ compensation at several high-profile companies in Great Britain. • Two years after the release of the Cadbury report, attention shifted to South Africa, where Mervyn King, a corporate lawyer, former High Court judge, and the current governor of Bank of England, led a committee that published the “King Report on Corporate Governance” in 1994 o In contrast to Cadbury’s focus on internal governance, the King Report “incorporated a code of corporate practices and conduct that looked beyond the corporation itself, taking into account its impact on the larger community.” o “King I,” as the 1994 report became known, went beyond the financial and regulatory accountability upon which the Cadbury report had focused and took a more integrated approach to the topic of corporate governance, recognizing the involvement of all the corporate stakeholders—the shareholders, customers, employees, vendor partners, and the community in which the corporation operates— in the efficient and appropriate operation of the organization. • Even though King I was widely recognized as advocating the highest standards for corporate governance, the committee released a second report eight years later—referred to as “King II,” which formally recognized the need to move the stakeholder model forward and consider a triple bottom line as opposed to the traditional single bottom line of profitability. o The triple bottom line recognizes the economic, environmental, and social aspects of a company’s activities. o In the words of the King II report, companies must “comply or explain” or “comply or else.” Learning Outcome 4: Explain the Differences between the Following Two Governance Methodologies: “Comply or Explain” and “Comply or Else.” • “Comply or explain” is a set of guidelines that require companies to abide by a set of operating standards or explain why they choose not to. o The Cadbury report argued for a guideline of comply or explain, which gave companies the flexibility to comply with governance standards or explain why they do not in their corporate documents. o The vagueness of what would constitute an acceptable explanation for not complying, combined with the ease with which such explanations could be buried in the footnotes of an annual report (if they were even there at all) raised concerns that comply or explain would not do much to help corporate governance. o The string of financial scandals that followed the report led many critics to argue that comply or explain offered no real deterrent to corporations. o The answer, they argued, was to move to a more aggressive approach of comply or else. • “Comply or else” is a set of guidelines that require companies to abide by a set of operating standards or face stiff financial penalties. o The Sarbanes-Oxley Act of 2002 incorporates this approach. Learning Outcome 5: Identify an Appropriate Corporate Governance Model for an Organization. • When corporations reach out to consultants, or are approached by consultants with new solutions to maximize the effectiveness of their corporate governance, the issues of finding an accepted benchmark and a comparative measure of one company’s corporate governance versus another’s inevitably arise. o Acronyms typically feature prominently in these measurement frameworks. ➢ For example, INSEAD, the European business school, offers the “CRAFTED” principles of governance—“good corporate governance is a culture and a climate of Consistency, Responsibility, Accountability, Fairness, Transparency, and Effectiveness that is Deployed throughout the organization.” ➢ The application of a commonly accepted numerical scoring template remains frustratingly elusive. ➢ The CRAFTED principles appear to be fairly self-explanatory, and, when questioned, most boards of directors would no doubt offer their wholehearted support for them. • If the board is to serve its purpose in setting the operational tone for the organization, it should be comprised of members who represent professional conduct in their own organizations. o Proper authority should be granted, so that the board members can fulfill their responsibilities of oversight, guidance, and approval to the best of their abilities. • Unfortunately, the CRAFTED principle of transparency is often foregone in favor of tightly managed information flow by the executive leadership of the organization; and the appointments to the board more often reflect the trading of professional favors and quid pro quo agreements than the utilization of the best available skills and experience. • The board must be willing to work with the executive leadership to provide feedback and guidance in a detailed and timely manner. • Running a company of any size requires constant evaluation of risk-versus-reward scenarios. o The corporate governance model assumes that the board of directors and executive leadership work together in making those evaluations. • Walter Salmon, a longtime director with over 30 years of boardroom experience, in a 1993 Harvard Business Review article, recommended a checklist of 22 questions to assess the quality of a board of directors. o If the board answers yes to all 22 questions, it is an exemplary board. o Even with a board that passes all the tests and meets all the established criteria, ethical misconduct can still come down to the individual personalities involved. • There is more to effective corporate governance than simply maintaining a checklist of items to be monitored on a regular basis. o Simply having the mechanism in place will not, in itself, guarantee good governance. • While media coverage of corporate scandals has tended to concentrate on the personalities involved, we cannot lose sight of the fact that corporate governance is about managers fulfilling a fiduciary responsibility to the owners of their companies. o A fiduciary responsibility is ultimately based on trust, which is a difficult trait to test when a company is hiring a manager or to enforce once that manager is in place. o A commitment to good corporate governance makes a company both more attractive to investors and lenders, and more profitable. Life Skills Governing your Career This Life Skills box discusses how an organization’s board of directors is designed to be both an advisory group and a governing body. The board is a team of people that businesspeople can count on for advice and guidance. Many successful businesspeople acknowledge that developing a dream team of advisers has been critical to their business and personal success in life. Being willing to reach out to others and seek their advice and guidance on a regular basis, they believe, has helped them prepare for important decisions and plan for long-term career choices. Progress ✓Questions 1. Define corporate governance. Corporate governance is the system by which business corporations are directed and controlled. 2. Explain the roles of a corporate governance committee. The corporate governance committee is staffed by board members and specialists. It monitors the ethical performance of the corporation and oversees compliance with the company’s internal code of ethics as well as any federal and state regulations on corporate conduct. 3. Explain the role of the board of directors. The board of directors is a group of individuals who oversee governance of an organization. Elected by vote of the shareholders at the annual general meeting (AGM), the true power of the board can vary from institution to institution from a powerful unit that closely monitors the management of the organization to a body that merely rubber-stamps the decisions of the chief executive officer (CEO) and executive team. 4. What is an outside director? The board of directors is typically made up of inside and outside members—inside members hold management positions in the company, whereas outside members do not. The term outside director can be misleading because some outside members may have direct connections to the company as creditors, suppliers, customers, or professional consultants. 5. Which two scandals greatly increased the attention paid to the 1992 Cadbury Report? In 1992, Sir Adrian Cadbury led a committee in Great Britain to address financial aspects of corporate governance in response to public concerns over directors’ compensation at several high-profile companies in Great Britain. The subsequent financial scandals surrounding the Bank of Credit and Commerce International (BCCI) and the activities of publishing magnate Sir Robert Maxwell generated more attention for the committee’s report than was originally anticipated. 6. Explain the “right balance” that Cadbury encourages companies to pursue. At the heart of the Cadbury Committee’s recommendations is a Code of Best Practice designed to achieve the necessary high standards of corporate behavior. By adhering to the Code, listed companies will strengthen both control over their businesses and their public accountability. In so doing, they will be striking the right balance between meeting the standards of corporate governance now expected of them and retaining the essential spirit of enterprise. 7. Explain the difference between the King I and King II reports. The King I report went beyond the financial and regulatory accountability upon which the Cadbury report had focused and took a more integrated approach to the topic of corporate governance, recognizing the involvement of all of the corporation’s stakeholders—the shareholders, customers, employees, vendor partners, and the community in which the corporation operates—in the efficient and appropriate operation of the organization. The King II report formally recognized the need to move the stakeholder model forward and consider a triple bottom line as opposed to the traditional single bottom line of profitability. The triple bottom line recognizes the economic, environmental, and social aspects of a company’s activities. 8. Explain the difference between “comply or explain” and “comply or else.” The comply or explain is a set of guidelines that require companies to abide by a set of operating standards or explain why they choose not to. The comply or else is a set of guidelines that require companies to abide by a set of operating standards or face stiff financial penalties. 9. What is the argument in favor of merging the roles of chairman and CEO? The argument in favor of merging the roles of chairman and CEO is one of efficiency—by putting the leadership of the board of directors and the senior management team in the hands of the same person, the potential for conflict is minimized and, it is argued, the board is given the benefit of leadership from someone who is in touch with the inner workings of the organization rather than an outsider who needs time to get up to speed. 10. What is the argument against merging the roles of chairman and CEO? The argument against merging the roles of chairman and CEO is an ethical one. Governance of the corporation is now in the hands of one person, which eliminates the checks and balances process that the board was created for in the first place. As time passes, the CEO slowly populates the board with friends who are less critical of the CEO’s policies and more willing to vote larger and larger salary and benefits packages. With a rubber-stamp board in place to authorize every wish, the CEO now becomes a law unto himself or herself. The independence of the board is compromised, and the power of the stockholders is minimized. The CEO can pursue policies that are focused on maintaining a high share price in the short term without any concern for the long-term stability of the organization. 11. Explain the difference between a short-term and long-term view in the governance of a corporation. In the short-term view in the governance of a corporation, the CEO focuses on the numbers for the next quarter. In the long-term view in the governance of a corporation, the CEO focuses on the numbers for the next five or more years. 12. Is it unethical to populate your board of directors with friends and business acquaintances? Why or why not? Students’ answers will vary but majority of the students may say that populating the board of directors with friends and business acquaintances is unethical. It will create a conflict of interest. Friends and business acquaintances will be less critical of the CEO’s policies and more willing to vote larger and larger salary and benefits packages. It is much harder for a friend or business acquaintance to say no to the CEO than an outsider who has no stake in the organization. 13. Briefly discuss the CRAFTED principles for effective corporate governance. Good corporate governance is a culture and a climate of Consistency, Responsibility, Accountability, Fairness, Transparency, and Effectiveness (CRAFTED) that is deployed throughout the organization. The CRAFTED principles appear to be fairly self-explanatory, and, when questioned, most boards of directors would no doubt offer their wholehearted support for them. Unfortunately, the CRAFTED principle of transparency is often foregone in favor of tightly managed information flow by the executive leadership of the organization. 14. Select your top six from Walter Salmon’s “22 Questions for Diagnosing Your Board” and defend your selection. Students’ answers will vary. Numerous responses can be expected as long as supported with justification. For example: • Are there three or more outside directors for every insider? This is important because outsiders create a more diverse board and provide the checks and balances that a board is supposed to have. • Does your audit committee, not management, have the authority to approve the partner in charge of auditing the company? This is important because this eliminates management from choosing and therefore eliminates the situation of conflict of interest. • Do outside directors annually review succession plans for senior management? This is important because outside directors are chosen by the owners of the corporation and should be held responsible for reviewing succession plans of senior management. • Is there a way for outside directors to alter the meeting agenda set by your CEO? A corporation’s CEO already has a great deal of power. When combining this power with being chair of the board, there needs to be a method in place through which outsiders can intervene. • Do the outside directors meet without management on a regular basis? Meeting on a regular basis without management provides an atmosphere in which persuasion by management’s interests are not present. • Is the performance of each of your directors periodically reviewed? Evaluation is an important task of any committee or organization. 15. Research a recent case of poor corporate governance and document how the company in question “had all its governance boxes checked. Students’ answers will vary. Some of them may give the example of Enron. Enron separated the roles of Chairman (Kenneth Lay) and Chief Executive Officer (Jeffrey Skilling)—at least until Skilling’s surprise resignation. The company maintained a roster of independent directors with flawless résumés. It maintained an audit committee consisting exclusively of nonexecutives. However, the true picture was a lot less appealing. Many of the so-called independent directors were affiliated with organizations that benefited directly from Enron’s operations. The directors enjoyed substantial “benefits” that continued to grow as Enron’s fortunes grew. Their role as directors of Enron, a Wall Street darling, guaranteed them positions as directors for other companies—a career package that would jeopardize if they chose to ask too many awkward questions and gain reputations as troublemakers. 16. Provide three examples of evidence that good corporate governance can pay off for organizations. Student answers may vary. Possible answers may include: • A Deutsche Bank study of Standard & Poor’s 500 firms showed that companies with strong or improving corporate governance outperformed those with poor or deteriorating governance practices by about 19 percent over a two-year period. • A Harvard-Wharton study showed that if an investor purchased shares in U.S. firms with the strongest shareholder rights and sold shares in the ones with the weakest shareholder rights, the investor would have earned abnormal returns of 8.5 percent per year. o The same study also found that U.S.-based firms with better governance have faster sales growth and was more profitable than their peers. • In a 2002 McKinsey survey, institutional investors said they would pay premiums to own well- governed companies. Premiums averaged 30 percent in Eastern Europe and Africa and 22 percent in Asia and Latin America. Ethical Dilemma 5.1 – 20/20 Hindsight 1. How did SIB’s status as an “offshore bank” facilitate Stanford’s alleged fraud? Students’ responses will vary. As an “offshore bank”, Stanford International Bank (SIB) SIB operated outside of U.S. banking regulations. This facilitated Stanford’s alleged fraud. With a reputed $8.5 billion in assets, the bank took money from depositors by an unusual route. No loans were ever made by the bank, although it did claim to have a traditional stock and bond trading department. Clients deposited funds by purchasing certificates of deposits (CDs) that offered above average interest rates in return for reduced liquidity. Once deposited with SIB, customer funds took 60 days to be returned. The above average interest rates proved irresistible to investors in the United States and Latin America—over $8 billion was invested in SIB CDs by over 20,000 investors. 2. Why would investors be willing to sacrifice immediate access to the funds they deposited with SIB? The investors were willing to sacrifice immediate access to the funds they deposited with Stanford International Bank (SIB) because the certificates of deposit (CDs) offered above average interest rates in return for reduced liquidity. Once deposited with SIB, customer funds took 60 days to be returned. The above average interest rates proved irresistible to investors in the United States and Latin America. 3. What elements were missing from the governance structure of Stanford Financial Group? The case doesn’t talk about the following elements of the governance structure: • The board of directors • The audit committee • The compensation committee • The corporate governance committee The chief financial officer (CFO) of Stanford International Bank (SIB), James Davis, was Stanford’s college roommate. The chief investment officer of Stanford Financial Group (SFG), Laura Pendergest-Holt, had no financial services or securities experience, and claimed to have limited knowledge of “the whereabouts of the vast majority of the bank’s multi-billion investment portfolio” according to the Securities Exchange Commission (SEC). Other senior corporate officers included Stanford family members, friends, and business associates with cattle ranching and car sales companies in Texas. Such people are less critical of the chief executive officer’s (CEO’s) policies and more willing to vote larger and larger salary and benefits packages. The independence of the board of directors is compromised, and the power of the stockholders is minimized. 4. What was the basis of Stanford’s defense? Stanford continued to profess his innocence by claiming that he was wrong to trust the integrity of his chief financial officer (CFO), James Davis. Therefore, he did not have knowledge of the missing funds. As for the collapse of his financial empire and his inability to repay investors, Stanford blamed the SEC for using him as a “scapegoat” after failing to catch Bernard Madoff, and for the “ripple effect” of its indictment that prompted regulatory agencies around the world to freeze the assets of his multiple investment companies. He said there was no money missing, there never was a Ponzi scheme, and there never was an attempt to defraud anybody. 5.2 – A Spectacular Downfall 1. Which stakeholders were impacted by Thain’s leadership at Merrill Lynch? The stakeholders who were impacted by Thain’s leadership at Merrill Lynch included but were not limited to the stockholders, employees and customers at Merrill Lynch and Bank of America, purchasers of the toxic assets, investors, and insurance companies. 2. Where were the failures in corporate governance in this case? Students’ responses will vary. The failures in corporate governance included but were not limited to a lack of internal expenditure oversight by the board of directors, the auditors (internal and possible external), and the accounting department. The board of directors needs to take a long and hard look at the amount of power and authority that senior executives possess at the financial institutions. A system of dual control is an interesting topic that could spark future debate in reference to corporate executive accountability in the financial sector. 3. Is there any evidence of good corporate governance in this case? Students’ responses will vary. Students should note that Thain achieved commendable accomplishments in his field. Good corporate governance was evident when Ken Lewis of Bank of America terminated Mr. Thain. Another important consideration in this case is how CIT hired Mr. Thain and their positive outlook about his employment with the company. 4. If you were a shareholder of CIT, how would you feel about the appointment of John Thain as chairman and CEO? Students’ responses will vary. Some shareholders would feel optimistic about his new employment venture with their company. However, other shareholders may choose to leave and not be associated with the outcome of his current or future leadership. Frontline Focus “Incriminating Evidence”—Marco Makes a Decision Questions 1. What could Marco have done differently here? Student answers will vary. Marco could have gone public with this news and been recognized as a whistleblower. As a whistleblower, he would have gotten the chief executive officer (CEO) of Chemco, the senior managers, David Collins, and probably anyone assigned to the Chemso case fired. Although this seems like a drastic strategy to take, this would send a message to all those acting unethically and it would eliminate these people from destroying Chemco permanently. 2. What do you think will happen now? Student answers will vary. Because Marco shredded the evidence, Chemco will most likely win the lawsuit and continue to act unethical and “massage the numbers” when needed. Having gotten away with this, Chemco may also begin making more unethical choices. 3. What will be the consequences for Adam, David Collins, and Chemco Industries? Student answers will vary. If other evidence is found, then David Collins, the chief executive officer (CEO) of Chemco, and Marco will be fired and struggle to be hired in any other firm, if at all. Marco could have saved himself by “doing the right thing,” but is now at risk of being associated with the unethical practices of the firm and David Collins. Key Terms Audit Committee: An operating committee staffed by members of the board of directors plus independent or outside directors. The committee is responsible for monitoring the financial policies and procedures of the organization—specifically the accounting policies, internal controls, and the hiring of external auditors. Board of Directors: A group of individuals who oversee governance of an organization. Elected by vote of shareholders at the annual general meeting (AGM), the true power of the board can vary from institution to institution from a powerful unit that closely monitors the management of the organization, to a body that merely rubber-stamps the decisions of the chief executive officer (CEO) and executive team. Compensation Committee: An operating committee staffed by members of the board of directors plus independent or outside directors. The committee is responsible for setting the compensation for the CEO and other senior executives. Typically, this compensation will consist of a base salary, performance bonus, stock options, and other perks. “Comply or Else”: A set of guidelines that require companies to abide by a set of operating standards or face stiff financial penalties. “Comply or Explain”: A set of guidelines that require companies to abide by a set of operating standards or explain why they choose not to. Corporate Governance: The system by which business corporations are directed and controlled. Corporate Governance Committee: Committee (staffed by board members and specialists) that monitors the ethical performance of the corporation and oversees compliance with the company’s internal code of ethics as well as any federal and state regulations on corporate conduct. Review Questions NOTE: Some questions allow for a number of different answers. Below are some suggestions. 1. Why do corporations need a board of directors? Student responses will vary. Corporations need board of directors to oversee the governance in an organization. Typically, the stockholders of the organization elect the board of directors. The corporation needs the board of directors because an organization’s board of directors is also designed to be both an advisory group and a governing body. 2. What is the value of adding “outside directors” to your board? Student responses will vary. Outside directors are beneficial because they can bring their outside skills or knowledge to the organization. Outside directors can also eliminate bias in an organization. 3. Which is more important to effective corporate governance: an audit committee or a compensation committee? Why? Student responses will vary. Some of them may say that both the committees are effective for corporate governance. The audit committee is responsible for monitoring the financial policies and procedures at the organization. They monitor the accounting policies, internal controls, and they hire the external auditors. The compensation committee is responsible for setting the compensation for the chief executive officer (CEO) and other senior executives. The audit committee is one of the key safeguards of the organization because this system of corporate governance helps to defend the organization against fraud and incompetence. 4. Many experienced senior business executives serve on multiple corporate boards. Is this a good thing? Explain your answer. Student responses will vary. A senior business executive that serves on multiple corporate boards can bring experience and knowledge to a corporation. For example, if the organization has a unique situation, the business executive will have the knowledge and experience to offer guidance or assistance to rectify the issue. However, a senior business executive that serves on multiple corporate boards could become very busy. As a result, the board member may not have the time it takes to be effective in the organization. In certain cases it could be considered a conflict of interest. 5. Many of Enron’s “independent” directors were affiliated with organizations that benefited directly from Enron’s operations. How would you address this clear conflict of interest? Student responses will vary. Students should address the ethical issues that relate to Enron’s “independent” directors. They were guaranteed other positions at organizations and the organizations they were affiliated with benefited directly from Enron’s operations. It is important for directors to have a strong and ethical fiduciary responsibility to the organization. The “independent” directors at Enron crossed that line and entered into an unethical situation. 6. Outline the corporate governance structure of the company you work for (or one you have worked for in the past). Student responses will vary. • Board of Directors: Oversees company management and makes high-level decisions. • CEO/President: Manages day-to-day operations. • Executive Leadership Team: Includes senior leaders like CFO, COO, etc. • Committees: Audit, compensation, and risk management committees that focus on specific areas. • Shareholders: Provide input and vote on major decisions during annual meetings. Review Exercises 1. Who would most likely have intervened to terminate the senior team over issues of conduct? Student responses will vary. The board of directors would be the governing group of the organization and would have the authority to fire these executives. 2. Give some examples of the kind of ethical misconduct that could have led to the termination of the entire senior leadership of GlobalMutual. Student responses will vary. Some examples of ethical misconduct would be the collaboration of these executives in practices such as falsifying financials or reports, or selling of stock when company is performing poorly while still portraying great health to the public. 3. Was it a good idea to fire them all at the same time with no detailed explanation? Student responses will vary. If each of these executives were involved in the same unethical conduct then firing them all at the same time would be justified. However, the public, especially shareholders, has a right to know about the misconduct that was committed. 4. How are the stakeholders of GlobalMutual likely to react to this news? Explain your answer. Student responses will vary. The stakeholders are most likely to be concerned and confused as to what misconduct was committed by the three executives. The firing of these three important executives will create another struggle for the organization because they must replace these people and get the new people up to date regarding the operations and issues. This will most likely be difficult for the company and cause a trickle-down effect for the stakeholders. However, if the executives were guilty of unethical practices, stakeholders should feel that this was the best thing to do to prevent further disruption in the organization. Internet Exercises 1. Review the website of the International Corporate Governance Network (ICGN) at www.icgn.org. a. What is the ICGN’s stated mission? According to the website, the ICGN is a global membership organization of around 600 leaders in corporate governance based in 50 countries with a mission to raise standards of corporate governance worldwide. b. How can this organization affect corporate governance in the business world? The ICGN’s mission is to raise standards of corporate governance worldwide. In doing so, the ICGN encourages cross-border dialogue at conferences and influences corporate governance public policy through ICGN Committees. It promotes best practice guidance, encourages leadership development and keeps its members informed on emerging issues in corporate governance through publications and the ICGN website. This will ultimately have some effect on corporate governance in the business world. c. The ICGN offers “best practice” guidance in several areas. Select one, and summarize how that guide contributes to the general discussion on corporate governance. Students’ responses are expected to vary. Some of the ideas areas are corporate objective (sustainable value creation), corporate boards (directors as fiduciaries, effective board behavior, responsibilities of the board, composition and structure of the board, skills and experience, etc.), corporate culture (culture and ethical behavior, integrity, codes of ethics and conduct, bribery and corruption, employees share dealing, etc.), risk management (effective and appropriate risk management, dynamic management process, board oversight, comprehensive approach, disclosure), remuneration (alignment with long term, link to value-creation, pay for non- executive directors, transparency, share ownership, etc.), etc. 2. Review the annual report of a Fortune 100 company of your choice. Who serves on the board of directors for the company? Are there any designated “outside” directors? On how many other boards do those “outside” directors serve? What does the company gain from having these “outside” directors on the board? Students’ responses will vary. Microsoft's Board of Directors includes several external directors, such as Reid Hoffman and Penny Pritzker. These outside directors bring diverse expertise and perspectives, enhancing governance and decision-making Team Exercises 1. Chairman and/or CEO. Divide into two teams. One team must prepare a presentation advocating for the separation of the roles of chairman and CEO. The other team must prepare a presentation arguing for the continued practice of allowing one corporation executive to be both chairman and CEO. Student responses will vary. Advocating the separation of the roles of chairman and CEO, students will need to emphasize that this allows the CEO to focus on his/her duties to the company and its shareholders, while allowing the chairperson and board to monitor his/her actions. The separation allows for checks and balances and eliminates one person having too much power and a possible conflict of interest. The argument against separation is one of efficiency. Allowing the CEO to also be the chairman creates a more efficient board because the leader of the organization (CEO) is already aware of the organization’s operations and functions. If the chairman is someone different, then he or she must be brought up to speed before accurately conducting his or her duties. 2. Compensation. You serve on your organization’s compensation committee, and you are meeting to negotiate the retirement package for your CEO who is retiring after a very successful 40-year career with your organization—the last 20 as CEO, during which time the company’s revenues grew more than fourfold and gross profits increased by over 300 percent. Divide into two teams, arguing for and against the following compensation package being proposed by the CEO’s representative: • Unlimited access to the company’s New York apartment. • Unlimited use of the corporate jet and company limousine service. • Courtside tickets to New York Knicks games. • Box seats at Yankee Stadium. • VIP seats at the French Open, U.S. Open, and Wimbledon tennis tournaments. • A lucrative annual consulting contract of $80,000 for the first five days and an additional $17,500 per day thereafter. • Reimbursement for all professional services—legal, financial, secretarial, and IT support. • Stock options amounting to $200 million. Student responses will vary. Arguments for the recommended compensation package may include the point that the successful career and dedication that this CEO has had with the organization deserves to be rewarded. He or she has grown the company’s revenues more than fourfold and increased gross profits by over 300 percent. This is also someone who will still represent the company in consulting and through his or her connections when networking; therefore, keeping him or her satisfied and happy with the organization will, ultimately benefit the organization. Arguments against this recommended package is the cost of all the benefits—tickets to sporting events, reimbursements, etc. Also, one must consider the opportunity cost and how these items will indirectly affect the company. For example, the stock options amounting to $200 million dollars is going to result in less capital from investors buying the shares. Also, the new CEO and other executives may need or have access to the New York apartment and corporate jet, so this will create a conflict of interest or possibly a problem between these people. 3. An appropriate response. You sit on the board of directors of a major airline that just experienced a horrendous customer service event. A severe snowstorm stranded several of your planes and caused a ripple effect throughout your flight schedule, stranding thousands of passengers at airports across the country and keeping dozens of passengers as virtual hostages on planes for several hours as they waited for departure slots at their airport. The press has covered this fiasco at length and is already calling for a passenger bill of rights that will be based primarily on all the things your airline didn’t do to take care of its’ passengers in this situation. Your CEO is the founder of the airline, and he has been featured in many of your commercials raving about the high level of customer service you deliver. The board is meeting to review his continued employment with the company. Divide into two teams and argue the case for and against terminating his employment as a first step in restoring the reputation of your airline. Student responses will vary. Arguments for the CEO’s termination may include the points that the unhappy and unsatisfied customers have tarnished the reputation of the organization, as well as the trust of the public. Also, due to the incident and the coverage of the situation, the public will expect some kind of punishment or expression of fault to show that the organization is committed to satisfying its customers. Arguments against termination of the CEO may include the point that everyone makes mistakes and the response to the situation needs to be taken into consideration. The CEO is also the founder of the airline and has provided quality customer service throughout his career. 4. Ideal corporate governance. Divide into groups of three or four. Each group must map out its ideal model for corporate governance of an organization—for example, the number of people on the board of directors; separate roles of chairman and CEO, inside and outside directors, and employee representation on the board. Prepare a presentation arguing for the respective merits of each model and offer evidence of how each model represents the best interests of all the organization’s stakeholders. Student responses will vary. Students will need to justify the number of people on the board of directors. A smaller board may not be as efficient as a larger board. The number of inside and outside directors will vary and must also be justified. Outside directors are important to prevent situations of conflict of interest. Separation of the chairman and CEO can be argued as an ethical issue or an efficiency issue. Thinking Critically 5.1 – Hewlett-Packard: Pretexting 1. Was the CNET story sufficient justification for the HP board’s actions? Why or why not? Students’ responses will vary. Many of them will say that there is no sufficient justification for acting in the manner in which HP’s board and Patricia Dunn acted. HP’s board and Dunn acted in an unethical manner by hiring private investigators to spy on board members and encouraging those detectives to use all means necessary to identify the source of leaks, including taking the step of hiring contractors to pretext cell phone records of the individuals they were investigating. After all, pretexting is illegal in California. Moreover, they had not got the clearance to carry out such actions from the California Attorney General’s Office, the Justice Department, or the Securities and Exchange Commission (SEC). 2. HP Chairwoman Patricia Dunn defended the actions of the board by arguing that HP’s higher standards of corporate integrity justified such aggressive actions as pretexting. Do their higher standards make the behavior of the board more or less ethical? Explain. Students’ responses will vary. Many of them will say that having high standards does not mean the board should be acting in unethical ways to uncover other unethical conduct. The investigation by the board was still in violation of the laws (pretexting is illegal in California); therefore, even though this investigation was to uphold the ethical standards, it does not justify the actions taken. If the board members are willing to act unethically in this situation, they may act unethically in other future situations. 3. Does the fact that HP’s legal advisors approved the actions of Dunn and her board beforehand clear them of all responsibility in this case? Why or why not? Students’ responses will vary. Many of them will say that the fact that HP’s legal advisors approved the actions of Dunn and her board beforehand doesn’t clear them of all responsibility in this case. Each of these individuals was contributing to the unethical practices in some way and should all be held accountable. After all, pretexting is illegal in California. Moreover, they had not got the clearance to carry out such actions from the California Attorney General’s Office, the Justice Department, or the Securities and Exchange Commission (SEC). 4. Does pretexting match the founding principles of “The HP Way”? Students’ responses will vary. Many of them will say that the high standards and legacy of HP, known as “The HP Way” does not justify pretexting. High standards should include acting in an ethical and legal manner, which the board did not adhere to when pretexting. 5. The board voted to dismiss Patricia Dunn in light of her indictment—was that the right decision? Why or why not? Students’ responses will vary. Many of them will say that especially after the story was uncovered by the news, the public is going to expect some punishment. Dismissing Dunn was the right thing to do because she was simply using HP’s high standards as an excuse to justify her actions even though they were unethical. Someone willing to rationalize and act in an unethical manner should be sitting on any board of directors. 5.2 – SocGen 1. Who are the stakeholders in this case? Students’ responses will vary. Many of them will say that the stakeholders of this case include Nick Leeson from Barings Bank PLC and all the employees with the organization, all shareholders of Barings, Jerome Kerviel of SocGen, his coworkers and executives at SocGen, and France. Unethical decisions affect many people and most of the time, people who take such unethical decisions do not think of how these affect others. 2. What did Kerviel do wrong? Students’ responses will vary. Many of them will say that Kerviel should not have placed the series of bets on European futures that resulted in a $7.9 billion loss for SocGen. 3. What did SocGen do wrong? Students’ responses will vary. Many of them will say that SocGen did not have the proper functional financial department in place that would be responsible for ensuring all trades. SocGen should have had controls in place over all transactions, especially those amounting to billions of dollars. 4. Identify the ethical violations that occurred in this case. Students’ responses will vary. Many of them will say that in Barings Bank PLC, Nick Leeson was able to manipulate and use his back office knowledge to hide the size of the trades he was placing on the Japanese stock market. In SocGen, Kerviel was engaging in unauthorized trades. 5. Would the outcome have been different if Kerviel’s trades in European futures had worked out? Students’ responses will vary. Many of them will say that the outcome would not have been different if Kerviel’s trades in European futures had worked out because it was found that Kerviel was engaging in unauthorized trades since 2005. He was placing the corporation in high risk and acting in an unethical manner. 6. What actions could SocGen have taken to prevent such large losses? Students’ responses will vary. Many of them will say that SocGen should not have allowed an inexperienced midlevel trader to trade without supervision. In all cases, whether Kerviel was experienced or not, SocGen should have had the proper controls in place over all transactions. Had they had these controls, Kerviel would have been caught and this loss would have never become an issue. 5.3 – “Off-Label Marketing” 1. Why would illegal marketing activities feature so frequently in the pharmaceutical industry? At what point would they be considered endemic? Students’ responses will vary. Many of them will say that, it is difficult to keep track of all the drugs that are being developed. This makes it difficult for the authorities to test them properly before granting the launch. Moreover, most pharmaceutical companies are eager to cash in on the first mover advantage. This prompts them to adopt a short-cut method rather than checking and rechecking whether the drug actually works. All these make illegal marketing activities frequent in the pharmaceutical industry. 2. Why would pharmaceutical companies choose to continue such practices even when it is made clear that they are illegal? Students’ responses will vary. Many of them will say that most pharmaceutical companies are eager to cash in on the first mover advantage. This prompts them to adopt a short-cut method rather than checking and rechecking whether the drug actually works. 3. What should the respective boards of directors be doing here? How should they be held accountable? Students’ responses will vary. Many of them will say that the boards of directors should be the ones who take it upon themselves to be involved in each step of the drug development and testing process. This will keep them in the loop. Moreover, they will not be able to cite ignorance as an excuse. As they represent the company, it makes sense that they should be fined, penalized, or held accountable if the drugs not perform well or produce unwarranted side-effects. 4. Critics argue that fines are too affordable. In other words, a $1 billion fine for activities that generate several billion dollars in illegal sales simply becomes a cost of doing business. Should fines be more punitive? How much would be enough? Students’ responses will vary. Many of them may say that the fines should be increased. The fine should vary from a case-to-case basis. The monetary fine may be set at half of the expected returns. Along with that some prison time should also be included. Specifically, repeat offenders must serve a prison sentence. This will work as a deterrent for other companies in the business. 5. Is the payment of a monetary fine sufficient restitution for these offences? Why or why not? Students’ responses will vary. Many of them may say that monetary fine does not seem to be sufficient resolution for these offences because a $1 billion fine for activities that generate several billion dollars in illegal sales simply becomes a cost of doing business. Adding a prison sentence to the monetary fine levied may work as a stronger deterrent for likely offenders. 6. How could this apparently endemic problem be approached differently? Students’ responses will vary. Many of them may say that a central laboratory may be set up where all pharmaceutical companies developing a new drug are bound to carry out the drug development process. This way they can be closely monitored. Some may say that the monetary fine should be set at half of the expected returns so that drug companies would consider and reconsider before adopting a short-cut. Copyright © 2013 The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5 Corporate Governance 5-2 Corporate Governance • The system by which business corporations are directed and controlled • Good corporate governance - Plays a vital role in underpinning the integrity and efficiency of financial markets • Poor corporate governance - Weakens a company’s potential and leads to financial difficulties 5-3 What Does Corporate Governance Look Like? • Owners - Supply equity or risk capital to the company by purchasing shares in the corporation • Board of directors: Group of individuals who oversee governance of an organization • Audit committee: Operating committee staffed by members of the board of directors plus independent or outside directors 5-4 What Does Corporate Governance Look Like? • Compensation committee: Operating committee staffed by members of the board of directors plus directors • Corporate governance committee: Monitors the ethical performance of the corporation and oversees compliance with the company’s internal code of ethics as well as any federal and state regulations on corporate conduct 5-5 Figure 5.1 - Governance of the Modern Corporation Source: Adapted from Fred R. Kaen, A Blueprint for Corporate Governance (New York: AMACOM, 2003). 5-6 In Pursuit of Corporate Governance • King I report advocates the highest standards for corporate governance • Took a more integrated approach to the topic of corporate governance, recognizing the involvement of all the corporation’s stakeholders 5-7 In Pursuit of Corporate Governance • King II report • Formally recognized the need to move the stakeholder model forward and consider a triple bottom line as opposed to the traditional single bottom line of profitability • Successful governance in the world in the 21st century requires companies to adopt an inclusive and not exclusive approach 5-8 Two Governance Methodologies • Comply or explain • Set of guidelines that require companies to abide by a set of operating standards or explain why they choose not to • Comply or else • Set of guidelines that require companies to abide by a set of operating standards or face stiff financial penalties 5-9 The Chairman and The CEO • Disregard the corporate governance model by merging the roles of chief executive officer (CEO) and chairman of the board into one individual 5-10 The Chairman and The CEO Advantages of merging • Potential for conflict is minimized • Board given the benefit of leadership from someone who is in touch with the inner workings of the organization Disadvantages of merging • Governance of the corporation is with one person, which eliminates the checks and balances the process that the board was created for in the first place • Independence of the board is compromised, and the power of the stockholders is minimized 5-11 Effective Corporate Governance • European business school INSEAD emphasizes corporate governance as an organizational culture issue through CRAFTED principles • Consistency • Responsibility 5-12 Effective Corporate Governance • Accountability • Fairness • Transparency • Effectiveness • Deployed through the organization 5-13 The Dangers of a Corporate Governance Checklist • There is more to effective corporate governance than simply maintaining a checklist of items to be monitored on a regular basis • Having the mechanisms in place will not guarantee good governance 5-14 A Fiduciary Responsibility • Corporate governance is about managers fulfilling a fiduciary responsibility to the owners of their companies • Fiduciary responsibility is based on trust 5-15 A Fiduciary Responsibility • Key safeguards • Properly constituted boards • Separation of the functions of chairperson and CEO • Audit committees • Vigilant shareholders • Financial reporting and auditing systems Solution Manual for Business Ethics Now Andrew Ghillyer 9780073524696, 9781260262513
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