Chapter 4: Corporate Governance: Foundational Issues
Legitimacy and Corporate Governance
• Legitimacy helps to explain the role of a corporation’s charter, shareholders, board of
directors, management and employees all of which are part of the corporate governance
• Organizations are legitimate to the extent to which their goals and values are congruent
with the social system within which they function.
• Legitimation is a dynamic process by which business seeks to perpetuate its existence
• Legitimacy has to be considered at both the micro and macro level.
• At micro level- business achieving and maintaining legitimacy by conforming to societal
expectations. This can be done in different ways :
o First, they may adapt its methods of operating to conform to what it perceives to
be the prevailing standard.
o Second, a company may try to change the public’s values and norms to conform
to its own practices by advertising and other techniques.
o Thirdly, an organization may seek to enhance its legitimacy by identifying itself
with other organizations, peoples, values, or symbols that have powerful
legitimate base in the society.
• At macro level- refers to the corporate system that is the totality of business enterprises.
• In comparing both the levels, it is clear that, although specific organizations try to
perpetuate their own legitimacy, the corporate system as a whole rarely addresses the
issue at all. This is bad because powerful issues regarding business conduct clearly
indicate that such institutional introspection is necessary if business is to survive and
Purpose of Corporate Governance
• Governance comes from the Greek work ‘steering’. The way in which a corporation is
governed determines the direction in which it is steered.
• Corporate Governance refers to the method by which a firm is being governed, directed,
administered, or controlled and to the goals for which it is being governed. Components of corporate governance
Role of four major groups
• Overarching the groups is a Charter issued by the state. Giving the corporation the right
to exist and stipulating the basic terms of its existence.
• Shareholders are the owners of the corporation. They have control over the
corporation. They exercise this control be selecting the board of directors of the
• Large organizations with a large number of shareholders appoint board of directors to
govern and oversee the management of the business.
• The third group is the management, appointed by the board of directors to run the
company and manage it on a daily basis. The top management establishes the overall
policy. Middle and lower level carry out this policy and conduct daily supervision of
• Employees are those hired by the company to do the actual work.
Separation of ownership from control
• In the precorporate period, the owners were typically the managers themselves; thus the
system worked the way it was intended, with the owners also controlling the business.
• As the public corporation grew and stock ownership became widely dispersed, a
separation of ownership from control became the prevalent condition. This being the
case, the most effective control the owners could exercise was to appoint the board of
directors to look over the management.
• The problem with this was that the authority, power and control rested with the group
that had the most concentrated interest at stake- the management.
• The corporation did not function according to its designated plan with effective authority,
power and control flowing downwards from the owners.
• Factors that added to the managers power were the corporate laws and traditions that
gave the management control over the proxy process ( the method by which the
shareholders elected board of directors with like minded people who simply collected
their fees and deferred to the management on whatever it wanted).
Problems in Corporate Governance
1. The need for Board Independence • Board independence is a crucial aspect in good governance.
• Outside directors are independent from the firm and its top managers.
• They have no substantive relation to the firm or it’s CEO.
• Inside directors have ties with the firm.
• At times they are the top managers at het firm; at others, insiders are family members or
others with a professional or personal relationship to the firm or the CEO.
• Another problem is managerial control of board processes.
• CEOs can often control board perks such as director compensation and committee
assignments. Board members who rock the boat might find themselves left out in the
2. Issue surrounding Compensation
The CEO Pay-Firm Performance Relationship:
o Shareholders observed CEO pay rising when firm performance fell. Many executives
received staggering salaries, even while profits were falling, workers were being laid off,
and shareholder return was dropping.
o The SEC introduced stricter disclosure requirements in their effort to monitor CEO pay.
o The revised compensation rule was designed to provide shareholders with more
information about the relationship between firm performance and CEO compensation.
o Efforts to strengthen this relationship have centered on the use of stock options.
o Stock options are designed to motivate the recipient to improve the value of the firm’s
stock. An option allows the recipient to purchase stock in the future at the price it is
today. If stock value rises after granting of the option. The recipient will make money.
o But this has led to many abuses like:
o Stock option Backdating that occurs when the recipient is given the option of buying
stock at yesterday’s price, resulting in an immediate and guaranteed wealth increase.
o Spring loading is the granting of a stock option at today’s price but with the inside
knowledge that something good is about to happen that will improve the stock’s value.
o Bullet Dodging is the delaying of a stock option grant until right after bad news. o The last two involve the presence of insider trading which is a serious concern.
Excessive CEO pay
o CEO salaries have skyrocketed while worker salaries have waned.
o The CEO-worker pay ratio has rise from 42 to 1 in 1980 to 319 to 1.
o The Say on Pay movement that started in UK in 2000, evolved from concerns over
excessive executive compensation. It included the requirement to put a remuneration
report to a shareholder vote at each annual meeting.
o When the executive’s high level of pay results from dubious practices such as financial
misconducts or the exercising of options in a questionable way, shareholders have a
right to recover those funds. It is from a provision called Clawback provisions, which
are compensation recovery mechanisms that enable a company to recoup
compensation fund, typically in the event of a financial restatement or executive’s
Executive Retirement Plans and Exit Packages
o Executive retirement packages have traditionally flown under radar, escaping the notices
of shareholders, employees, and the public. Examples of GE chairman and CEO, CEO
of American Bank.
o Part of public’s frustration is that these CEO retirement packages stand in stark contrast
to the workers retirement packages. Many of the workers don’t even have retirement
packages today and many who have, are far more likely to have the less lucrative
defined contribution (that specify what will be put into the retirement fund).
Outside Director Compensation
o Apart from CEO compensation being an issue, director’s compensation is also a major
issue. Paying the board members is relatively a recent idea. A century ago it was illegal
to pay nonexecutive board members as they represented the shareholders, paying them
out of the company’s (shareholders) funds would be self-dealing. Transparency
o The SEC rules on complete disclosure are designed to address some of the obvious
problems by making the entire pay packages of top executives transparent.
o Tax Gross-up: reimbursing one for the taxes one would have to pay.
o Examples of CEO’s giving up their Tax Gross-up perks paid by the companies are given.
o Some experts express concern that the push for transparency is actually resulting in
o People argue that CEO’s are not paid excessively; they are paid according to their
responsibility and that excessive granting of stock options is clouding the data.
o Other issues are that transparency has made it easier for executives to compare their
pay to that of their peers and that has led these executives to compete for higher pay.
o Abuses such as backdating and spring loading have also been seen due to stock
3. The Governance Impact of the market for Corporate Control
• Mergers and Acquisitions are another form of corporate governance, one that comes
from outside the corporation.
• The merger, acquisition and hostile takeovers motivated many corporate CEO’s and
boards to go to greater lengths to protect themselves from these takeovers. Two
controversial practices were Poison pills and Golden Parachutes.
• Poison Pills- A poison pill is intended to discourage or prevent a hostile takeover.
Typically when a hostile suitor acquires more than a certain percentage of a company’s
stock, the poison pill provides that other shareholders be able to purchase shares, thus
diluting the suitor’s holding and making the acquisition prohibitively expensive.
• Golden Parachutes- It is a contract in which a corporation agrees to make payments to
key officers in the event of a change in the control of the corporation. Advocates argue
that these provide top executives with a