Chapter 05 – Corporate Governance
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CHAPTER 5
Corporate Governance
Table of Contents
Chapter Summary 5-2
Learning Outcomes 5-2
Frontline Focus: “Incriminating Evidence” Questions 5-2
Learning Outcome 1 5-3
Learning Outcome 2 5-3
Learning Outcome 3 5-4
Learning Outcome 4 5-5
Learning Outcome 5 5-6
Life Skills 5-7
Progress ✓Questions 5-7
Ethical Dilemma 5-11
Frontline Focus: “Incriminating Evidence”—Marco Makes a Decision Questions 5-14
Key Terms 5-14
Review Questions 5-15
Review Exercises 5-16
Internet Exercises 5-17
Team Exercises 5-18
Thinking Critically 5-21
Chapter 05 – Corporate Governance
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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 for more information on this.
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?
Chapter 05 – Corporate Governance
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Education.
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
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
• 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
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.
Chapter 05 – Corporate Governance
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o They are typically a fragmented group, including individual public shareholders,
• 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
• 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:
• 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
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
several high-profile companies in Great Britain.
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• 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
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
profitability.
o The triple bottom line recognizes the economic, environmental, and social aspects of
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 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.
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• “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
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.
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.
Chapter 05 – Corporate Governance
quality of a board of directors.
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.
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.
2. Explain the roles of a corporate governance committee.
The corporate governance committee is staffed by board members and specialists. It
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3. Explain the role of the board of directors.
The board of directors is a group of individuals who oversee governance of an organization.
4. What is an outside director?
5. Which two scandals greatly increased the attention paid to the 1992 Cadbury Report?
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
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
Chapter 05 – Corporate Governance
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Education.
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
9. What is the argument in favor of merging the roles of chairman and CEO?
10. What is the argument against merging the roles of chairman and CEO?
11. Explain the difference between a short-term and long-term view in the governance of a
corporation.
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12. Is it unethical to populate your board of directors with friends and business acquaintances?
Why or why not?
13. What are INSEAD’s “CRAFTED” principles of governance?
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
• Does your audit committee, not management, have the authority to approve the partner
in charge of auditing the company?
eliminates the situation of conflict of interest.
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
outsiders can intervene.
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• Do the outside directors meet without management on a regular basis?
• Is the performance of each of your directors periodically reviewed?
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.
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
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
• 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
Chapter 05 – Corporate Governance
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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
2. Why would investors be willing to sacrifice immediate access to the funds they deposited
with SIB?
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
Chapter 05 – Corporate Governance
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Education.
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
5.2 – A Spectacular Downfall
1. Which stakeholders were impacted by Blatter’s leadership at FIFA?
2. Where were the failures in corporate governance in this case?
3. Is there any evidence of good corporate governance in this case?