Ch 4, Instructor’s Manual, Business & Society, Carroll 10e
Chapter 4
Corporate Governance: Foundational Issues
LEARNING OUTCOMES
After studying this chapter, you should be able to:
1. Link the issue of legitimacy to corporate governance.
2. Discuss the problems that have led to the recent spate of corporate scandals and problems
5. Discuss the role of the SEC in protecting investors.
6. Discuss the principal ways in which shareholder activists exert pressure on corporate
management to improve governance.
7. Discuss investor relations and the concept of shareholder engagement.
TEACHING SUGGESTIONS
INTRODUCTION – In this chapter, the authors explore corporate governance and the ways in
which it has evolved, and propose an alternative model of corporate governance. They first
examine the concept of legitimacy and the part that corporate governance plays in establishing
the legitimacy of business. They then explore how good corporate governance can mitigate the
problems created by the separation of ownership and control and examine some of the specific
challenges facing board members today.
KEY TALKING POINTS – In some sense, discussing corporate governance may seem a bit
premature for business students, especially at the undergraduate level. Most of the students will
not have direct contact with board members of publicly-traded companies and their issues for
Further, as citizens, they should be concerned with the legitimacy of corporations and understand
the power that they hold. The 2008 financial crisis illustrates how breakdowns in corporate
governance can create legitimacy problems for business. As investors, they should realize the
impact that boards and CEOs have on the firm and be aware of the relationship between the
board and senior management. They will, in all likelihood, understand the theoretical
relationship—the board oversees management activity and has authority over managers. The
Ch 4, Instructor’s Manual, Business & Society, Carroll 10e
reality, that the power structure is inverse to the theory, may come as quite a surprise. It is at this
juncture that the alternative model of corporate governance may be suggested – the director-
As workers, they should be aware of the issues surrounding executive compensation. Executives
are often in the enviable position of setting their own compensation plans, with the board
providing only rubber stamp approval in some cases (although compensation committees of
publicly-traded companies now are required to explain and justify executive compensation). An
As the authors point out, boards are making an effort to wrest control back from management. In
addition to the steps pointed out in the textbook, there are many efforts to “create” better board
members, through education and research. The National Associate of Corporate Directors works
to improve corporate governance in companies ranging from Fortune 100 companies to small,
over-the-counter, closely held, and private firms (http://www.nacdonline.org/). Jeffrey
Sonnenfeld, a professor at Yale University, is well known for his “CEO College.” He has
written several articles about the CEO position and board of directors. Two of his articles are:
Students also may be interested in finding out more about the issue of executive compensation.
Two excellent websites provide a wealth (no pun intended) of information about the topic. The
AFL-CIO (an umbrella labor organization) provides Executive Pay Watch information at http://
www.aflcio.org/corporateamerica/paywatch/. The Institute for Policy Studies and United for a
Fair Economy jointly produce an annual report on CEO pay entitled Executive Excess. The most
recent report, for 2008, is available at
http://www.faireconomy.org/files/executive_excess_2008.pdf.
Students also may want to explore the stock option backdating scandals from a few years ago.
Various federal agencies, including the Department of Justice, the IRS and the SEC, became
involved in the investigation of over 200 companies implicated in the controversy. This is an
PEDAGOGICAL DEVICES – In this chapter, instructors may utilize a combination of:
Cases:
3-The Body Shop (B) – Reputation is Tarnished
4-The Body Shop (C) – Into the New Millennium
6-The Waiter Rule: What Makes for a Good CEO?
17-Chiquita – An Excruciating Dilemma
20-DTCA – The Pill Pushing Debate
21-Big Pharma’s Marketing Tactics
23-McDonald’s Coffee Spill
24-The Betaseron Decision (A)
Ethics in Practice Cases:
Excessive Director Compensation at Facebook?
Monitoring the Monitors
Spotlight on Sustainability:
Shareholder Impact on Sustainability
LECTURE OUTLINE
I. LEGITIMACY AND CORPORATE GOVERNANCE
A. The Purpose of Corporate Governance
B. Components of Corporate Governance
1. Roles of Four Major Groups
2. Separation of Ownership from Control
1. The CEO Pay-Firm Performance Relationship
2. Excessive CEO Pay
3. Executive Retirement Plans and Exit Packages
4. Outside Director Compensation
5. Transparency
III. IMPROVING CORPORATE GOVERNANCE
A. Legislative Efforts
B. Changes in Boards of Directors
C. Board Diversity
IV. THE ROLE OF SHAREHOLDERS
A. Shareholder Democracy
V. THE ROLE OF THE SEC
VI. SHAREHOLDER ACTIVISM
A. The History of Shareholder Activism
VII. INVESTOR RELATIONS AND SHAREHOLDER ENGAGEMENT
VIII. AN ALTERNATIVE MODEL OF CORPORATE GOVERNANCE
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
Students should recognize that their answers to these discussion questions should be well
reasoned and supported with evidence. Although some answers will be more correct than others,
students should be aware that simplistic answers to complex questions, problems, or issues such
as these will never be “good” answers.
1. Question: Explain the evolution of corporate governance. What problems developed?
What are the current trends?
Answer: Corporations at their inception were run by owner-managers who retained full
responsibility for all functions of the enterprise. As corporations grew (the availability of
the functions of managing the business were divorced from the ownership function,
leaving managers effectively in charge of the organization. As “ownership” became more
diluted among many investors, shareholders soon lost any pretense of control over the
firm. Even the board of directors, designed to oversee the company’s operations for the
investors, became subservient to management, as many directors have financial,
Congress, various regulatory agencies and shareholders of public companies took a critical
look at the inherent agency problems present in the corporate form as a result of the
scandals that erupted in the early 2000s. As Sarbanes-Oxley, the New York Stock
Exchange and the NASDAQ ramped up independence requirements for publicly-held
companies, a new trend emerged for publicly-held boards. Many board members became
more active, taking some control back from management. More independent board
members began serving on the boards of public companies, as well as the audit and
nominating committees. Private companies began to follow suit, as creditors, lenders and
2. Question: What are the major criticisms of boards of directors? Which single criticism do
you find to be the most important? Why?
Answer: The major criticisms of boards of directors center on their effectiveness. Boards
are less effective than they should be because too many members are inside directors, they
often do not put enough time into their positions, they may be paid too much money for the
work they do, and they may become “yes men” to the CEO.
3. Question: Explain how governance failures such as Enron and the global financial crisis
could happen. How might they be avoided?
Answer: Governance failures like Enron happen primarily because the power relationship
between the board and top management is inverse. Although the board should have
Ch 4, Instructor’s Manual, Business & Society, Carroll 10e
authority over top management, the reverse is generally true. Members of top management
select who will be on the board and continuing to hold a seat is dependent upon rubber
stamping top management’s decisions. For example, members of the board of directors of
Enron waived provisions of the company’s code of conduct so that Andy Fastow could
Failures like Enron also happen when the lines between the external auditor, management
and the audit committee are blurred. Sarbanes-Oxley attempts to address this corporate
governance failure by implementing independence requirements for the audit committee
and forcing the audit committee to take ownership over the oversight of the external
auditor.
4. Question: Outline the major suggestions that have been set forth for improving corporate
governance. In your opinion, which suggestions are the most important? Why?
Answer: Several suggestions for improving corporate governance have been made. Most
center on board composition and performance. Recommended changes in who sits on
boards include more outside directors, more women, and more people of color.
5. Question: Discuss the pros and cons of the shareholder-primacy and director-primacy
models of corporate governance. Which do you prefer and why?
Answer: Companies can become more responsive to shareholders by fully disclosing their
activities and by placing the owners’ interests above the managers’ (although this is
probably unreasonable to expect from anyone on a consistent basis). There is a significant
While boards are becoming more responsive to shareholders in general, many boards are
still criticized for their executive compensation practices. Many shareholders believe that
boards approve compensation packages for executives due to board member/management
relationships rather than as a result of management performance. A few years ago, the
SEC implemented new rules regarding executive compensation disclosure. While the SEC
stressed that its objective was not wage controls, it did indicate that it wanted to focus on
wage clarity. Specifically, the SEC had concerns that companies were using existing
proxy statement disclosure rules to avoid disclosure of certain compensation elements.
The rules require companies to disclose a total compensation figure for its top executives.
The director-primacy model of corporate governance asks whether the balance of power in
corporate governance should favor shareholders or board members. While in the
shareholder-primacy model, the corporation is owned by shareholders, in the director-
primacy model, the corporation is not owned, but is instead an independent legal entity that
owns itself. In that model, boards are “mediating hierarchs” who are responsible for
balancing the competing interests of a variety of stakeholders, but their primary duty is to
GROUP ACTIVITY
Group Activity 1 – Public Disclosure of Corporate Governance Issues
governance structure. The instructor may want to have the students answer specific questions
related to the company’s corporate governance structure, using the company’s annual report and
proxy statement. The following are sample questions:
How many shareholders hold common stock according to the company’s annual report?
What is the date of record for determining shareholders entitled to receive notice and to vote at
the annual meeting?
How are directors elected? What are the voting requirements for the election of directors? How
would a shareholder propose a candidate for nomination to the board of directors?
What board committees does the company have? Describe the function(s) of each committee as
described in the company’s proxy statement.
Who is the audit committee financial expert? What are his or her qualifications?
What internal controls framework does the company use?
Did management determine that the internal control over financial reporting was effective?
Did the auditor find that management’s assessment of the effectiveness of the company’s internal
controls was fairly stated?
Group Activity 2 – Executive Compensation
Divide the students into groups of four to five students. Have the students select a publicly-
understanding of the company’s compensation structure, philosophy and objectives. The
instructor may want to have the students answer specific questions related to executive
compensation, using the company’s annual report and proxy statement. The following are
sample questions:
What is the total compensation for the three highest paid officers (including the value of stock
options and other benefits)?
What are the company’s compensation philosophy and objectives? How does the company set
executive compensation?
What are the components of the company’s compensation program (i.e., what “mix” of salary,
benefits, stock, etc. does the company use to compensate its executives)? Do you think that the
company is using the appropriate compensation incentives? According to the compensation
committee, is the current compensation of the top executive(s) justified based on the company’s past
and/or current performance?
Based on the information in the proxy statement and the annual report, would any of the other
executive officers be an appropriate replacement for the CEO? If not, who would you recommend as
an outside candidate (hint: you might review the profiles of top management in competitors’ annual
reports)?
INDIVIDUAL ASSIGNMENT
Distribute the following instructions to each student:
how it will affect the corporate governance of companies. You also should explain why ISS has
adopted the proposal and whether or not you agree with the proposal. Finally, you should
provide a recommendation as to how shareholders should proceed regarding the proposal.
BOARD SELECTION AND FIDUCIARY DUTY SIMULATION
Students should be assigned the following roles: The CEO, Director 1, Director 2, Director 3,
Director 4, Director Candidate A, Director Candidate B, Director Candidate C, Director
Candidate D, Director Candidate E, and Director Candidate G. Name tags should be distributed
so that each student can print his/her role on the name tag and other students can identify who is
playing which role.
PART 1
Each student should read the background information for his/her role. After reading the
PART 2
Once the nominating committee decides who they would like to nominate for the board, they
PART 3
Part 3 concludes with a simulated board meeting.
Distribute the Following for Parts 1 & 2 to the CEO and Nominating Committee
The Nominating Committee – The CEO and Directors 1, 2, 3 & 4
Murray Rentals, Inc. is a new, privately-held company that owns and operates buildings for
commercial lease and apartments and homes for residential lease in western Kentucky. The
residential leases range from executive home rentals on two major lakes to college apartments,
including one of the largest collegiate rentals, Racer Place. The CEO of Murray Rentals, Inc. has
The following director nominees have been proposed to you. Each of these directors is presently
available in the room. Consider the following questions: Who do you choose and why? What
do you need to do to fill the board? Once you decide who should be nominated, you should
“recruit” these members for board membership.
Director Candidate A
Candidate A has been the president of a local bank since 1999. Candidate A has been in the
Director Candidate B
Candidate B owns his/her own real estate agency and has been a local real estate agent for over
30 years. Candidate B’s company closed over $8 million dollars in sales last year. Candidate B
supervises a staff of 15 people. His/Her company rarely brokers real estate leases but
Director Candidate C
Candidate C has been the senior Vice President of a large local manufacturer for 8 years. Prior
Director Candidate D
Candidate D is the Chief Financial Officer of Murray Rentals, Inc. Prior to joining Murray
Rentals, Candidate D served as the controller of Paducah Realty, Inc. for 10 years. Candidate D
Director Candidate E
Candidate E is the CEO’s spouse. Candidate E has an accounting degree and has worked as a
CPA for over 15 years. In the course of his/her work as a CPA, she/he has primarily focused on
personal and corporate taxes.
Director Candidate F
Candidate F is a senior at Murray State University. Candidate F has lived in Racer Place for the