Chapter 2 – Corporate Governance

Video 1 – The board of directors

What is a Board of Directors?

A group of individuals that are elected as representatives of stockholders to establish corporate

management-related policies and to make decisions on major issues.

How is the BoD structured? (Board structures in Europe)

 Unitary Board: One single agenda for the board.

 Two-tier board: Distinct meetings and agendas. Separated into a supervisory board
composed of the non-executives and an executive board composed of the executive
directors and the CEO.
 Mixed System: Distinct meetings and agenda. Some executives sit on both boards
(Chairman, CEO, and some executive directors).

Two-tier Boards

The management board

 Consists exclusively of executive management.

 Is charged with running the company daily and setting the corporate strategy for the
firm (consulting with the other board).

The supervisory board

 Includes ideally only independent and non-executive board members.

 Is charged with overseeing and advising the company’s management board.

There are usually formal meetings between the two boards, with formal presentations.

Board of Directors in Portugal

There are several different structures firms may use in their governance in Portugal:

They are set in the “Código das Sociedades Comerciais – sociedades anónimas”

 Can be composed of the Board of Directors and the Fiscal Board – Latin Model
 Can be composed of the Board of Directors (which includes auditing committee and
CPA) – Anglo-Saxon Model (the most prevalent today)
 Management Board, Supervisory Board, and CPA – Dualist Model (mimics what
happens in Central Europe).

The board’s responsibility

“Board members owe a duty to make decisions based on what ultimately is the best for the
long-term interests of shareholders.

In order to do this effectively, board members need a combination of three things:

independence, experience, and resources.”
Directors and Strategy

It is the directors’ responsibility to set an appropriate strategy, implement it, and revise it to
ensure its continuing relevance, and to provide leadership. A clear strategy and an eye open to
identifying potential opportunities are vital.

However, there is also a lot more operational stuff to do.

Other Board Functions

 Hire and evaluate management.

 Vote on major operational proposals.
 Vote on major financial decisions.
 Offer expert advice to management.
 Make sure the firm’s activities and financial condition are accurately reported to its
shareholders.

Board committees

The most common sub-committees include:

 Audit Committee
 Compensation Committee
 Nomination committee

Other sub-committees may include:

 Executive committee
 Finance committee
 Community relations committee
 Corporate governance committee
 Stock options committee
 Related parties committee

Board terms

“Shareholders should determine whether board members are elected annually, or whether the
company has adopted an election process that staggers the terms of board member elections.”

The way directors are elected can also have an impact on the probability of a firm being
acquired, via takeovers.

Non-executive directors

These are the ones that do not work at the company. This do not mean that they are
independent.

The Cadbury Report (UK, 1992) has influenced the development of many codes across the
world. It only covers 4 topics, but one of them is:

 The importance of, and contribution that can be made by, non-executive directors.

Western European Board regulations on independence

  The UK is very similar to the US in its emphasis on independent directors.
 The governance codes for the rest of the European countries do not explicitly require a
specific number or fraction of independent directors.
 The recommendations pertaining to director independence seem vague.
 Portugal has a good practice where the number of independent directors is greater
than the number of non-independent directors.

Rules for Independence: NASDAQ AND NYSE

 Not an employee (or immediate family).

 Direct compensation not higher than 125 000$ (or immediate family) except for certain
payments.
 Not an auditor, both internal or external (or immediate family) during the last three
years.
 Not an executive (or immediate family) in a firm where any of the present firm’s
executives served on the compensation committee during the last three years.
 Not executive or employee (or immediate family) in a firm with business relations > 1
million during the last 3 years.

Pros and Cons of board independence

Pros

1) Important monitors of managers

2) Providers of relevant expertise
3) Central to the effective resolution of agency problems

Cons

1) Too busy.
2) Sometimes lack of necessary expertise.
3) Do not have the right incentives to perform their duties effectively.

Are busy directors effective monitors?

 Growing literature shows that serving on multiple boards can be a source of both
valuable experience and reputational benefits for outside directors.

What are the costs?

 Results indicate busy boards display patterns associated with weaker Corporate
Governance: weaker profitability and lower sensitivity of CEO turnover to firm
performance.
 Departure of busy outside directors generates positive abnormal returns,
 Definition of busy: the majority of outside directors hold 3 or more directorships.

Is being a director worth it?

 Shareholders have become increasingly demanding of directors.

o Working longer hours.
o Taking more stock ownership in the firm.
o Challenging the CEO more often.
o Taking their duties more seriously.
 o 60 percent of nominated directors are turning down appointments.
 Compensation
o Averaging more than 50 000$ per year (S&P500).

Who are the directors? (profiling)

 Standard & Poor’s 500 firms have about 11 directors each.

 Experiences:
o 10 to 20 years of experience in a business leadership role.
o Be a current COO or CFO of a large company.
o Or be one of the top 15 executives at a large corporation.
 Typically, board make-up (in Fortune 1000 firms).
o 95% of firms have a retired executive serving as a director.
o 82% have an executive from another firm.
o 58% have an academic background.
o 58% have a former government official.
o 82% of boards have a woman as a director (now needs to be 100%).
o 76% have a member of an ethnic minority.

Video 2 – Women on Boards

In Europe, there is a growing number of companies searching for women with qualifications,
talent, and tact to serve as outside/non-executive directors.

This is in part due to legislative reforms. For example, in 2003 Norway passed a law requiring
companies to fill 40% of board seats with women by 2008 and threatened to shut down firms
that did not comply. Spain has now passed a similar law; the deadline is 2005.

In Portugal and Spain, it is mandatory to have 30% of women on the board since 2020.

Outlook of women on boards

The percentage of women is still low, below 50%. Differences persist, however, there has been
a progressive change.

ESG Performance and diversity have a positive correlation with companies’ performance.

Teams with women are more likely to lead companies to excel financially.

EU Directive

 To address the considerable imbalance between women and men in economic

decision-making at the highest level, the European Commission submitted a proposal
for a directive on gender balance among non-executive directors of companies listed
on stock exchanges in November 2012.
 The proposal set the aim of a minimum of 40% of non-executive members of the
under- represented sex on company boards, to be achieved by 2020 in the private
sector and by 2018 in public-sector companies. Companies would have to make
appointments on the basis of pre-established, clear and neutral criteria. If candidates
were equally qualified, advantage would be given to the under-represented sex.
 Member States would require companies to issue annual reports on the composition
of their boards and impose sanctions in the event of negative evaluations.
  The directive would not apply to SMEs. Companies that had not reached the 40 %
target would be required to continue to apply the procedural rules, as well as to
explain what measures they intended to take to reach it. For Member States that chose
to apply the objective to both executive and non-executive directors, a lower target (33
%) would apply.

Board Tenure

The average time on the board varies a lot across jurisdictions.

Succession plans for boards.

BusinessWeek (2017) reports that although many boards understand the need for succession
planning all too often, they do not do it very well:

 Estimates suggest that only about half of boards have CEO success plans in place.
 Just 16% of directors report that their board is effective at CEO succession planning.
 Yet selecting the right CEO is critical to performance and sustainability.

Companies may fail, but directors are in demand

“In our corporate system the directors are supposed to be in charge, not the CEO, yet they
rarely get any of the blame because they’re typically dominated by the CEO” – John Gillespie

Many directors of failed financial institutions have kept the other director posts they had
before the financial crisis.

E.g.: Marsha Evans (former Lehman director) continues to serve as a director of Weight
Watchers, Huntsman and Office Depot ($500,000 in 2009).

What is a good board (?)

 Given the assumption that all public firms have experienced and successful experts
serving on their boards, a good board.
 Not all countries share the U.S.’s emphasis on independent directors.
 Companies in different countries also seem to have differing views on board size.

Potential Problems with Boards

 For many boards the chairman is also the firm’s CEO.

 “When the CEO is also the chairman, management has de control. Yet the board is
supposed to be in charge of the management. Checks and balances have been thrown
to the wind.”
 So-called outside board members might have some sort of business or personal tie to
the CEO.
 Directors do not have a significant vested interest in the firm. They might take it as a
light part time.
 Some directors may be overextended.
 Some directors do not have the expertise to be a board member.
 Some boards are too large.
Video 3 – Incentives and Compensation

Potential Managerial Temptations

 A good manager should put the needs of other stakeholders before his own.
 However, if shareholders cannot effectively monitor managers’ behavior, then
managers may be tempted to put their needs first, even at the expense of
shareholders.
 Vast literature on the so-called managerial theory of the firm, dating from the works of
Olver Willamson in the 1960s.
 Executives may take self-serving actions:
o Not working hard enough (low effort).
o Hiring friends (cronyism).
o Determination of excessive perks (company cars and jets, expense accounts).
o Empire building. Making things big is not necessarily more valuable.
o Take no risks to avoid being fired.
o Have a short-run horizon.
o Insider trading.

Solutions to the agency problem

 Executive incentives:
o Align executives and shareholders' incentives and goals.
o Tie an executive’s wealth to the wealth of shareholders.
o Executive compensation contract with equity incentives to align interests.
 An alternative way to solve the agency problem is to increase effective punishment:
o Former CEO of Worldcom was sentenced to 25 years of prison.
o Former CFO of Enron was sentenced to 6 years of prison.

Types of Executive Compensation

 Base salary – Base salary is usually determined through benchmarking.

 The compensation committee of the board of directors surveys peer CEO salaries.
Creates rules on trying to make the CEO salary compatible with equally complex
companies.
 Benchmarking may increase median salary over time.
o Increased role of peer group.
o Compensation consultants to help set compensation.

 Cash Bonuses – At the end of every year, executives often receive cash bonuses.
 The value of the bonus is usually based on the firm accounting performance over the
past year.
o Earnings per share, EBIT
o Return on assets, Economic-Value Added.
 Minimum performance threshold and cap.
 Is awarding bonuses better than giving large raises?
o Bonuses are one-time rewards for past realized performance.
o Increases in salaries are permanent additions for future unrealized
performance.
  Compensations lags/average performance over a given period is a solution that many
times is applied by companies.

 Stock options – The most common form of market-oriented incentive pay to align
managers’ goals with shareholders’ goals.
 Executive has the right to buy shares at a fixed price (strike price):
o Have asymmetric incentives: profit if the stock price goes up but no loss if stock
price goes down.
o Strike is usually the current stock price – at the money.
o American options with expiration typically in 10 years.
 Vesting period (options exercisable) conditional on:
o Time elapsed.
o Performance.

 Stock grants
 Restricted stock – stock of the company that includes limitation to sell (time elapsed,
performance goal).
 Performance shares – stock is given only if performance criteria are met.
 It is an alternative of long-term incentive compensation.
o Does not have asymmetric incentives.

 Other forms of compensation

 Perks: club membership, financial advisors, office renovations, luxury cars and
chaffeurs, personal travel.
 Retirement: pensions, keeping perks after leaving the firm.
 Golden parachutes.
 Golden coffins (life insurance and bonus when people pass away).
 Company loans.

Graphs

The US compensation grew substantially in the 1990s and has remained high. The fixed
compensation has not changed a lot, the variable compensation is the one that has been
increasing.

The share of each component is sector-sensitive, but the pattern is fairly general.

CEO-to-worker compensation ratio grew until the early 2000s and stabilized remaining still very
large.

CEO compensation is beating valuation growth, and the UK data has been showing that.

UK's upward trend regardless of stock performance clearly shows that some things are not
functioning well.
Problems with incentives

 The CEO might forego increasing dividends in favor of using cash to try to increase the
stock price.
 CEOs have a tendency to pick a higher-risk business strategy.
 CEOs may try to time stock price movements to match the time horizons of their stock
options (manipulation can reduce earnings after the target year).
 Stock prices are affected by company performance but also by many other factors
beyond its control – relative performance evaluation (RPE).
 Stock options may be too far underwater to motivate the manager effectively –
repricing and backdating.

Video 4 – The rise of compensation

There are essentially two schools of thought on why top executive pay has soared over time:

 Rent-extraction view – Managerial power

o Powerful CEOs set their own pay, at least indirectly.
o Blames corporate governance for failing to monitor the payments to the CEOs.
o Boards are captured by the CEO.
 Market-based view.
o Free-market outcome of breakthroughs in technology and globalization that
enhanced the productivity of talented individuals. General skills became
increasingly important.
o CEO pay is tied to performance.
o CEO tenures have declined (6 years).
o CEO turnover is more closely tied to performance in the 2000s – the job is
riskier.
o Similar trends in compensation in Wall Street, sports, and layer firms.
 Gabaix and Landier (2007) (market view):
o Sixfold increase in CEO pay in the US between 1980 and 2003-
o Can be explained by the six-fold market capitalization of the average company
over the same period.
o The bigger the firm
 The more difference CEO talent can make.
 And the bigger the size of groups competing for CEO talent.
o Strong positive relation between CEO pay and firm size.

CEO compensation around the world

Fernandes, Ferreira, Matos, and Murphy (2011): “Are US CEOs paid more?”

 Uses data across 14 countries with mandated disclosure.

 CEO total (and equity) pay in the US is 2x of pay outside the US.
 There is a US premium after controlling for firm characteristics, ownership, and board
structure, that has been declining:
o In 2006 only 26% declined from 60% in 2003 to only 14% in 2008.
o Only 10% in 2006 if we further risk-adjust pay.
 No pay differences among firms exposed to international and US capital, product and
labour market.
Graphs

 The US compensation is tilted towards the variable compensation part. The non-US
countries the fixed part is more relevant.
 Higher elasticity relative returns, sales growth, and other values.

Recent Regulation trends

SEC Enhanced Disclosure Rules 2006:

 Companies are required to disclose a Summary Compensation Table:

o Total Column
o For the CEO, the CFO, and the 3 most highly compensated executive officers
than the CEO and the CFO whose total compensation exceeds 100 000$.
 Performance graph for easy visual comparison of a comparison of a company’s
performance relative to its peers and the market.
 In Portugal you need to disclose all the executives' compensation.

SEC Rule 2009:

 Enhanced disclosure about risk, compensation and corporate governance.

o So that shareholders are better able to evaluate the leadership of public
companies.
o Require a company to provide information about how its overall employee
compensation policies create incentives that can affect the company’s risk and
the management of its risk.
o Firms need to report the value of options when they are awarded (aggregate
grant date fair value), instead of annual accounting charge.

Say on pay:

 The US tried to pass this rule but did not go through.

 However, in other countries like the UK and the Netherlands, shareholders have a
binding vote on remuneration.
o Evidence from the UK suggests that say on pay is effective in removing
excessive perks and increasing sensitivity of pay to poor performance.
o Companies that have had their proposals voted down include Philips, Royal
Dutch Shell, and Heineken.

EU Action Plan 2003:

 Disclosure of compensation policies in annual reports.

 Disclosure of details of the remuneration of individual directors in the annual
accounts.
 Prior approval by the shareholder meeting of share and share option schemes in which
directors will be awarded.
 Proper recognition in the annual accounts of the costs of such schemes for the
company.

Rules to be implemented by 2006 in each country. The idea is to comply or explain (?)