Chapter 14

Stockholder Rights and

Corporate Governance
 Ch. 14: Key Learning Objectives
 Identifying different kinds of stockholders and
understanding their objectives and legal rights
 Knowing how corporations are governed and
explaining the role of the board of directors in
protecting the interests of owners
 Analyzing the function of executive compensation
and debating if top managers are paid too much
 Evaluating various ways stockholders can promote
their economic and social objectives
 Understanding how the government protects against
stock market abuses, such as fraudulent accounting
and insider trading

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 Stockholders
 Stockholders (also called shareholders)
The legal owners of business corporations

 Types of stockholders
 Individual stockholders are people who
directly own shares of stock issued by
companies
 Institutions, such as pension funds,
mutual funds, insurance companies, and
university endowments
• Called institutional investors
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 Stockholders Trends
 In 2007, institutions accounted for 75% of the value of all
U.S. stocks, worth $16 trillion
 About two-and-a-half times the value of institutional
holdings a decade earlier
 In 2008, nearly one-half of all U.S. households owned
stock, either directly or as institutional investors
 This proportion had dropped somewhat since the
early 2000s  
 Older people are more likely to own stock, slightly over
40% of young households do so.
 At all ages, equity ownership is higher as income and
education rises.
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 Individual household versus institutional
Figure 14.1 ownership of stock in the United States

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 Objectives of Stock Ownership
 To produce a return greater than they could receive
from alternative investments
 Stockholders make money when the price of the stock rises
(capital appreciation) and when they receive their share of the
company’s earnings (called dividends)
 Bull markets (in which share prices rise overall) alternate with
bear market (in which share prices fall overall)
 Although stock prices can be volatile, stocks historically have
produced a higher return over the long run than many other
types of investments
 Some investors use stock ownership to achieve social
or ethical objectives
 Discussed further under “social investment

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Figure 14.2 Major Legal Rights of Stockholders

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 Corporate Governance
 Corporate governance
Refers to the process by which a company is
controlled, or governed

 Board of directors
An elected group of individuals who have a legal duty
to establish corporate objectives, develop broad
policies, and select top-level personnel to carry out
these objectives and policies

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 Boards of Directors
 Vary in size, composition, and structure to best serve the
interests of the corporation and shareholders
 Survey of governance practices in leading firms in the
Americas, Europe, and Asia Pacific:
 Average board size was 10 members
 Typically, 8 of the 10 are outside directors (not managers of the
company)
 Work of the Board is done through committees:
 Typical committees: Compensation, Executive, Nominating, Audit
 Audit has key role to review financial reports, recommend outside
auditors, and oversee integrity of internal financial controls

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 Boards of Directors
 Board members are elected by shareholders at the
annual meeting, where absent owners vote by proxy

 Process is not truly democratic, but tends to be self-

perpetuating
 The board nominating committee, working with the CEO and
chairman, develops a list of candidates. Once approved by
the Board, the names of these individuals are placed on the
proxy ballot. Because alternative candidates are often not
presented, the vote has little significance.

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 Key Features of Effective Boards
 Select outside directors to fill most positions
 Hold open elections for members of the board
 Appoint an independent lead director and hold
regular meetings without the CEO present
 Align director compensation with corporate
performance
 Evaluate the Board’s performance on a regular basis

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 Improving Corporate Governance Worldwide
 OECD, representing 30 nations, issued a revised set of
principles of corporate governance in 2004 to serve as a
benchmark for companies and policy makers worldwide.

 The OECD 2009 report concluded that the financial crisis

affecting may of its member states had been caused, to an
important extent by failures of corporate governance, it called
for re-examination of the adequacy of these principles.

 EU, South Africa, and India have worked hard to

modernize corporate governance practices, but
progress has been slow in emerging markets
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 Executive Compensation
 Executive compensation is a key Board function
 An important mechanism for aligning the interests of the
corporation and its stockholders with those of its top managers
 Many critics feel that this system is not working and
executive pay has become excessive
 Executive compensation in the U.S., by international
standards, is very high
 In 2008, the U.S. chief executives of the largest corporations
earned, on average, $8.4 million (composed of salaries, bonuses,
benefits and stock options)
• Stock options is controversial subject on its own

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 Ratio of Average CEO Pay to Average
Figure 14.4 Production Worker Pay, 1990-2007

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 Executive Compensation: Is it Justified?
 Arguments of proponents of high executive pay
 Well-paid managers are simply being rewarded for outstanding
performance
 High salaries provide an incentive for innovation and risk-taking
 Not many individuals are capable of running today’s large,
complex organizations

 Arguments of critics of high executive pay

 Inflated executive pay hurts the ability of U.S. firms to compete
with foreign rivals
 Multimillion dollar salaries cause resentment, sap the commitment
of hardworking lower and midlevel employees
 As many extravagantly compensated executives preside over
failure as they do over success

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 Executive Compensation Reform

 Has been the subject of shareholder pressure

 Some companies have changed the way they set executive
pay; have compensation committees of entirely outside
directors and tie pay more directly to company performance
 Small number of companies set multiple of executive pay
versus others workers
 Government regulations
 Under U.S. rules, corporations must disclose top 5
executives’ compensation and the rationale for it
 Allows shareholders to vote on executive and director
compensation
 United Kingdom requires such a vote

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 Shareholder Activism –
Rise of Institutional Investors
 As shown earlier, holdings have increased
significantly; have become more assertive in
promoting interests of their members
 Have large blocks of stock so not easy to sell if become
dissatisfied, therefore strong incentive to work to change
management policy
 Council of Institutional Investors
 Represents institutions and pension funds with investments
collectively exceeding $3 trillion in holdings
 Developed a Shareholder Bill of Rights
 Research shows involvement of institutional investors
can improve company performance

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Shareholder Activism – Social Investment

 Social investment
Refers to the use of stock ownership as a strategy for
promoting social objectives; also called social
responsibility investment
 Social screening of stock
 Some stock purchasers choose stocks based on social or
environmental criteria, called social screens
 In 2007, $2.7 trillion invested in socially responsibility funds;
approximately 1 in 9 investment dollars
 Rapid growth in similar funds in Europe and beyond

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 Shareholder Activism –
Social Responsibility Shareholder Resolutions
 Social responsibility shareholder resolutions
A resolution on an issue of corporate social responsibility
placed before stockholders for a vote at the company’s annual meeting
 Has been a significant rise in social responsibility shareholder
resolutions in recent years – about 650 were sponsored in 2007
 Sponsorship is often from a coalition of groups, like Interfaith Center on
Corporate Responsibility
 Resolutions can be about social issues, not company’s ordinary
business
 Only garner about 15% of votes, yet their influence is stronger
as company managers respond ahead of annual meetings so
they will be withdrawn

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 Shareholder Activism –
Shareholder Lawsuits
 If owners think they or their company have been
damaged by actions of company officers or
director, they have right to bring lawsuits
 Can be initiated to check abuses, for example
insider trading, inadequate stock buyout price, or
lush executive pensions
 Some corporations have claimed were target of
frivolous shareholder lawsuits
 As result Congress passed legislation making it more
difficult for investors to sue corporations for fraud

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Securities and Exchange Commission (SEC)
 Government agency charged with protection of
stockholder interests
 Established in 1934 in the wake of the Great
Depression
 Mission is to protect stockholders’ rights by making
sure that the stock markets are run fairly and that
investment information if fully disclosed
 Unlike more government agencies, generates
revenue to pay for its own operations

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 SEC – Information Transparency and
Disclosure
 Giving stockholders more and better company
information is one of best ways to safeguard investor
interests.
 In recent years, management has tended to disclose
more information than ever before to stockholders and
other interested people.
 Although the overall trend has been to greater
transparency, some observers felt that a lack of
disclosure about complex financial instruments that
became common in the mid-2000s, may have led
investors to underestimate their risk.

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 SEC - Insider Trading
 Insider trading
Occurs when a person gains access to confidential
information about a company’s financial condition and
then uses that information, before it becomes public
knowledge, to buy or sell the company’s stock
 Is illegal under SEC Act of 1934, meaning against the
law to:
 Steal nonpublic information and use it to trade a stock
 Trade a stock based on a tip from someone who had an
obligation to keep quiet
 Pass information to others with an expectation of gain

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