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MGMT 1040 Chapter Notes -Takeover, Insider Trading, Good Governance


Department
Management
Course Code
MGMT 1040
Professor
William(bill) Woof

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Chapter 4: Corporate Governance: Foundational Issues
Legitimacy and Corporate Governance
Introduction
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
system.
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 :
oFirst, they may adapt its methods of operating to conform to what it perceives to
be the prevailing standard.
oSecond, a company may try to change the public’s values and norms to conform
to its own practices by advertising and other techniques.
oThirdly, 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
prosper.
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.

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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
company.
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
operative employees.
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

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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
cold.
2. Issue surrounding Compensation
The CEO Pay-Firm Performance Relationship:
oShareholders 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.
oThe SEC introduced stricter disclosure requirements in their effort to monitor CEO pay.
oThe revised compensation rule was designed to provide shareholders with more
information about the relationship between firm performance and CEO compensation.
oEfforts to strengthen this relationship have centered on the use of stock options.
oStock 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.
oBut this has led to many abuses like:
oStock 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.
oSpring 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.
oBullet Dodging is the delaying of a stock option grant until right after bad news.
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