Corporate Governance E-Book

Robert A. G. Monks

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 1250

Veröffentlichungsjahr: 2011

Beschreibung

In the wake of the recent global financial collapse the timely new edition of this successful text provides students and business professionals with a welcome update of the key issues facing managers, boards of directors, investors, and shareholders.

In addition to its authoritative overview of the history, the myth and the reality of corporate governance, this new edition has been updated to include:

• analysis of the financial crisis;
• the reasons for the global scale of the recession
• the failure of international risk management
• An overview of corporate governance guidelines and codes of practice;
• new cases.

Once again in the new edition of their textbook, Robert A. G. Monks and Nell Minow show clearly the role of corporate governance in making sure the right questions are asked and the necessary checks and balances in place to protect the long-term, sustainable value of the enterprise.

Features 18 case studies of institutions and corporations in crisis, and analyses the reasons for their fall (Cases include Lehman Brothers, General Motors, American Express, Time Warner, IBM and Premier Oil.)

Leseprobe

Contents

Cover

Title Page

Copyright

Cases in Point

Chapter 1

Chapter 2

Chapter 3

Chapter 4

Chapter 5

Preface

Notes

Acknowledgments

Introduction — How to Use this Book

How to Use This Book

Chapter 1: What is a Corporation?

Defining the Corporate Structure, Purpose, and Powers

Evolution of the Corporate Structure

The Purpose of a Corporation

Metaphor 1: The Corporation as a “person”

Metaphor 2: The Corporation as a Complex Adaptive System

Are Corporate Decisions “Moral”?

Are Corporations Accountable?

Three Key External Mechanisms for Directing Corporate Behavior: Law, The Market, and Performance Measurement

What does “Within the Limits of the Law” Mean?

A Market Test: Measuring Performance

Equilibrium: The Cadbury Paradigm

Esg: Environment, Social Governance – A New Way to Analyze Investment Risk and Value

Quantifying Nontraditional Assets and Liabilities

Future Directions

Summary and Discussion Questions

Notes

Chapter 2: Shareholders: Ownership

Definitions

Early Concepts of Ownership

EARLY CONCEPTS OF THE CORPORATION

A Dual Heritage: Individual and Corporate “RIGHTS”

The Reinvention Of The Corporation: Eastern Europe In The 1990S

The Evolution Of The American Corporation

The Essential Elements Of The Corporate Structure

The Mechanics Of Shareholder Rights

The Separation Of Ownership And Control, Part 1: Berle and Means

Fractionated Ownership

The Separation of Ownership and Control, Part 2: The Takeover ERA

Waking The Sleeping Giant

A Framework For Shareholder Monitoring and Response

Ownership and Responsibility

No Innocent Shareholder

To Sell Or Not To Sell: The Prisoner's Dilemma

Who The Institutional Investors Are

The Biggest Pool Of Money In The World

Public Pension Funds

Private Pension Funds

The Sleeping Giant Awakens: Shareholder Proxy Proposals on Governance Issues

Focus on The Board

Hedge Funds

Synthesis: Hermes

Investing in Activism

New Models and New Paradigms

The “Ideal Owner”

Pension Funds as “Ideal Owners”

Is the “Ideal Owner” Enough?

Summary and Discussion Questions

Notes

Chapter 3: Directors: Monitoring

A Brief History of Anglo-American Boards

Who are They?

Who Leads the Board? Splitting the Chairman and Ceo and the Rise of the Lead Director

Diversity

Meetings

Communicating with Shareholders

Special Obligations of Audit Committees

Ownership/Compensation

Post-Sarbanes–oxley Changes

Board Duties: The Legal Framework

The Board's Agenda

The Evolution of Board Responsibilities: The Takeover Era

The Fiduciary Standard and the Delaware Factor

The Director's Role in Crisis

Limits and Obstacles to Board Oversight of Managers

Information Flow

Practical Limits: Time and Money

The Years of Corporate Scandals – Boards Begin to Ask for More

Director Information Checklist

Who Runs the Board?

Catch 22: The Ex-CEO as Director

Director Resignation

CEO Succession

Director Nomination

Limits and Obstacles to Effective Board Oversight by Shareholders

Carrots: Director Compensation and Incentives

Sticks, Part 1: Can Investors Ensure or Improve Board Independence by Replacing Directors who Perform Badly or Suing Directors who Fail to act as Fiduciaries?

Can Directors be Held Accountable Through the Election Process?

Sticks, Part 2: Suing for Failure to Protect the Interests of Shareholders – are the Duties of Care and Loyalty Enforceable?

Future Directions

Summary and Discussion Questions

Notes

Chapter 4: Management: Performance

Introduction

What Do We Want from the CEO?

The Biggest Challenge

Risk Management

Executive Compensation

Stock Options

Restricted Stock

Yes, We have Good Examples

Shareholder Concerns: Several Ways to Pay Day

Future Directions for Executive Compensation

CEO Employment Contracts

CEO Succession Planning

Sarbanes–oxley

Dodd–frank

Employees: Compensation and Ownership

Employee Stock Ownership Plans

MondragÓn and Symmetry: Integration of Employees, Owners, and Directors

Conclusion

Summary and Discussion Questions

Notes

Chapter 5: International Corporate Governance

The Institutional Investor as Proxy for the Public Interest

The International Corporate Governance Network

The Global Corporate Governance Forum

Governancemetrics International (GMI)

World Bank and G7 Response

The Global Carbon Project (GCP)

A Common Framework for Sustainability Reporting

Towards a Common Language

Vision

Summary and Discussion Questions

NOTES

Chapter 6: Afterword: Final Thoughts and Future Directions

Beyond the Nation State

Government as Shareholder: The Institutional Investor as Proxy for the Public Interest

NOTES

Index

This edition first published in 2011

Copyright © 2011 John Wiley & Sons

Registered office

John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom

For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com

The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher.

Wiley also publishes its books in a variety of electronic formats and by print-on-demand. Some content that appears in standard print versions of this book may not be available in other formats. For more information about Wiley products, visit us at www.wiley.com.

Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought.

Library of Congress Cataloging-in-Publication Data

Monks, Robert A. G., 1933–

Corporate governance / Robert A.G. Monks and Nell Minow. — 5th ed.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-470-97259-5 (pbk.)

1. Corporate governance—United States. I. Minow, Nell, 1952– II. Title.

HD2745.M66 2011

658.4–dc22

2011013532

ISBN: 978-0-470-97259-5(pbk) ISBN: 978-0-470-97273-1(ebk)

ISBN: 978-0-470-97274-8(ebk) ISBN: 978-1-119-97773-5(ebk)

A catalogue record for this book is available from the British Library.

Cases in Point

Chapter 1

Shlensky v. Wrigley(1968)

Corporate Crime and Punishment

A UK Attempt to Redefine Corporate Manslaughter

What Happens When You Let Corporations Choose their Own Regulators? Just What You Would Expect

Chrysler

The Voluntary Restraint Agreement in the Auto Industry

Corporate Political Donations in the UK and the US

“Delaware Puts Out”

The Years of Accounting Dangerously

Protection, Pennsylvania Style

The “Good,” the “Bad,” and the Real

Green Tree Financial

FASB's Treatment of Stock Options

The Battle of the Theme Parks

Daimler-Benz and the New York Stock Exchange

Johnson & Johnson

Socially Responsible Investing

Price Fixing

Chapter 2

Mis-Trust: The Mysterious Case of the Hearst Will

How Much is a Fiduciary Worth – And Can He Charge More than That?

Of Vouchers and Values – Robert A.G. Monks Visits Vaclav Havel

Standard Oil and the Arrival of Big Business

Partnership versus Corporation

Annual Shareholder Meetings

The Conflicted Owner

When is the Employee Stock Plan Obligated to Step in or Sell?

Who Owns Hershey?

F&C Advises Its Clients to Vote Against Excessive Compensation – At F&C

Junior Invests in Boothbay Harbor

One Share, One Vote

Refco

Hermes

R.P. Scherer and Citicorp

T. Rowe Price and Texaco

Director Resignations

Interlocking Directors

The Alumni Protest Fees Paid to Managers of the Harvard Endowment

The Rose Foundation Takes on Maxxam

Reader's Digest

Eating the Seed Corn: NY's Pension Fund Borrows from Itself

Maine State Retirement System

CalPERS and Enron

Public Fund Activism

CalPERS Invests in Activism

Institutional Investors Address Climate Change

Shareholder Influence on Standardizing and Integrating Corporate Ethics and Sustainability

Myners Shifts the Burden of Proof on Activism

The Institutional Shareholders Committee

AFSCME's Economically Targeted Investment Policy

Can a Fiduciary Invest in Volkswagen?

Socially Responsible Investing

Campbell Soup Company and General Motors

“Universal Widget”

Honeywell and Furr's

Swib and Cellstar

Revolt of the Yahoos: United Companies Financial and Luby's

Deutsche Asset Management Changes Its Vote

From DuPont to Relationship Investing

A&P, Paramount, and K-Mart

Hermes

Chapter 3

Warren Buffet on Boards

The Worldwide Frustration of Audit Committees

The Corporate Library's Interlock Tool

The Walt Disney Company and the Magical Kingdom of Executive Compensation

The Disney Decision

Illicit Backdating: Trends in Illegal Executive Compensation

Upper Deck v. Topps: Getting a Fair Chance

The Duty of Loyalty – A Race to the Bottom?

Further Exploration of the Requirement of Good Faith

Trans Union

Unocal and Revlon

Compaq Computers

RJR Nabisco, Lone Star Industries, Tambrands, and Enron

A Director Quits

A Director Demands More from the Board

Two Directors Depart at Emap

Director Pay at Coca-Cola

Sears

Salomon Inc.

Chapter 4

Merck Creates a Product No One Can Pay For

Tony Hayward and BP's Deepwater Horizon Oil Leak

AT&T and NCR

Beyond the Balance Sheet

More About H-P and Hurd

Exxon, AT&T, and General Electric and Creative Destruction – Internal and External

Warnaco

ICGN on Compensation

The Chairman Speaks

Borden

United Airlines and Employee Ownership

The “Temping” of the Workplace

Mondragon and “Cooperative Enterpreneurship” or “Cooperation Instead of Competition”

Chapter 5

Offshore Outsourcing

Russia's Hostile Takeover

Embraer

Capital Flight, Tax Avoidance, and Tax Competition

Preface

John D. Rockefeller famously sold out of the stock market just before the 1929 crash because of a shoeshine boy. At least according to legend, he knew that when shoeshine boys were giving out stock tips, it was time to sell.

In The Big Short: Inside the Doomsday Machine, by Michael Lewis, there are a couple of shoeshine boy moments. In this case, it was not wealthy industrialists or anyone at the heart of the financial world who figured out that there would be a collapse triggered by billion-dollar bets on the subprime mortgages and their derivative securities.

Lewis writes about four outsiders who saw what was coming and bet it would fail while the entire economy was betting the other way. Steve Eisman had a “light bulb” moment when he found out that his former baby nurse had six investment properties. Michael Burry asked if he could buy a security betting a group of the subprime mortgages would fail. He wanted to bet against a group made up entirely of no-doc loans (those where the applicants for the mortgages did not have to submit any documentation to demonstrate their ability to repay). He wanted it to be a group rated A by one of the ratings agencies, the same rating given to groups of mortgages where the applicants had to demonstrate that they could repay. And he got it.

Why were they the only ones who saw that as a problem? And how did that problem get created in the first place?

What went wrong?

In late 2007, the United States economy suffered its worst economic catastrophe since the Great Depression of the 1930s. The American taxpayers found themselves guarantors of the entire financial services industry when almost overnight assets that had been valued at hundreds of billions of dollars turned out to be worth some undetermined amount but much, much less. The entire economy seemed to collapse like a house of cards.

This was not supposed to happen. Just five years before, the most sweeping reform legislation in decades was passed to deal with the then-record-setting scandals of the time. From late 2001 through 2002 spectacular corporate failures at Enron, Global Crossing, Adelphia, WorldCom, and more resulted in the loss of hundreds of billions of dollars and hundreds of thousands of jobs. Front-page news stories were illustrated with photographs of men in suits doing perp walks. CEOs went to prison.

The passage of the Sarbanes–Oxley legislation in 2002 helped to restore confidence in the markets. Perhaps it restored too much confidence because people like Federal Reserve Chairman Alan Greenspan kept insisting that the mushrooming category of derivative securities did not need to be regulated, because he said the efficiency of the market was all that was needed.

He does not think that any more. “Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief,” he told the House Committee on Oversight and Government Reform in 2008.

So, what happened? The failures that led to this collapse were widespread and the fault extends to every element of the system: corporations, regulators, accountants, ratings agencies, securities analysts, politicians, shareholders, journalists, and more. A lot of blame has been assigned, mostly from those trying to deflect it from themselves. The alleged culprits have included “monetary policy,” the government-sponsored entities (Fannie Mae and Freddie Mac), and lax oversight by regulators. Those all played a role, but unquestionably, the primary culprit was a failure of corporate governance.

The proof of that statement will be one of the key themes of this book. The first element of that proof is a sentence that occurs near the end of The Big Short. “What's strange and complicated about [the subprime mortgage market], however, is that pretty much all the important people on both sides of the gamble left the table rich.”1

That tells you everything you need to know – except for how that anomalous situation came about, which is what the rest of this book will cover. The point to keep in mind here is that it is not the market that malfunctioned. On the contrary, the market did exactly what it was supposed to do. It responded to risks and incentives in a rational manner. It was the risks and incentives that were distorted. That is what made it possible – in fact, what made it inevitable – that the people on both sides of the table got rich.

However, if both sides made money, someone had to lose it. The problem is that it was not the buyer or seller or counter-party or insurer who was on the other side of the transaction, it was the rest of us. What happened was a massive shift of costs as Wall Street externalized the risk on to just about everyone else. For example, a hedge fund called Magnetar helped create arcane mortgage-based instruments, made them even riskier, and then bet against them, putting their customers on the other side.

We have seen a fairly consistent cycle of boom and scandal in the financial markets since the savings and loan failures of the 1980s, and the one common theme is the ability of one segment of the economy to externalize its risks. In every case, the system was gamed so that the upside gain was diverted in one direction and the downside losses were diverted in another. The market cannot operate efficiently under those circumstances.

Corporate governance is about how public companies are structured and directed. Every strategy, every innovation in product, operations, and marketing, every acquisition and divestiture, every decision about asset allocation, finance, joint ventures, financial reports, systems, compensation, and community relations – every decision and every one of the thousands of decisions within each one – is determined by some part of the system of corporate governance. Every one of those decisions can be made consistent with long-term, sustainable value creation for investors, employees, and the community or for the short-term benefit of one group regardless of the consequences for the others. When corporate governance operates optimally, the three key players – the executives, the board of directors, and the shareholders – provide through a system of checks and balances a system for a transparent and accountable system for promoting objectively determined goals and benchmarks. When it does not, well, take a look at these examples:

A very successful CEO had something he wanted to ask his board of directors. He wanted an employment contract. This was not the norm but it was hardly unusual. One-third of Fortune 500 CEOs had written contracts, mostly reflecting the negotiations leading to their employment and spelling out the terms of their compensation packages and how they would be affected by a merger or termination of employment. What was a little bit unusual was that he was asking after three years on the job without a contract. What was very unusual – what was, in fact, unprecedented – was a particular provision of the contract, which stated that conviction of a felony was not grounds for termination for cause, that is, unless the felony was directly and materially injurious to the corporation.

Huh?

You might think that the board of directors, presented with such a proposal, would ask a few questions. One might be, “Why now – why do you need a written contract now when you did not need one before?” Another one might be, “What exactly prompted this language about the felony – is there something you want to tell us?”

But the board did not ask any questions. The CEO was, as noted above, very successful. Everyone was making a lot of money. Some directors were getting substantial side payments from deals with the company. The board of Tyco signed the contract.

The board of another very successful company listened to a presentation about a new “special purpose entity” that would allow the company to burnish its financial reports by moving some of its debt off the balance sheet. There was one small problem, however. The deal was a violation of the company's conflict of interest rules because it permitted an insider, the company's general counsel, to essentially be on both sides of the transactions. The board was asked to waive the company's conflict of interest rules to permit the transaction.

Huh?

You might think that the board of directors, presented with such a proposal, would ask a few questions. “Why can't someone who is not an insider run this thing?” “Is this something that is going to look good on paper or is there some actual benefit?”

But the board did not ask any questions. The company was, as noted above, very successful. Everyone was making a lot of money. Some directors were getting substantial side payments from deals with the company. The board of Enron agreed to the waiver – three separate times.

A graduate of the United States Military Academy at West Point, which teaches the ideals of “duty, honor, country,” retired from the Army as a general and went to work for a major and very successful corporation. He participated in a tour of the company's operations for securities analysts that included a fake trading floor where secretaries pretended to be negotiating transactions, peering into computer screens that were not connected to anything, and talking on their telephones to each other. He later admitted that he knew the trading floor was a fake. Yet he did not say anything.

Huh?

Tom White, the former general, was paid more than $31 million by Enron in that year.

Angelo Mozillo, founder and CEO of Countrywide, ground zero for subprime mortgages, made $550 million as his company's stock went down 78 percent, taking the entire US economy down with it. When the compensation consultant advising the board suggested that the pay plan he wanted might be too high, he hired another consultant – at company expense. They unsurprisingly agreed with his proposal and the board agreed.The Lehmann board's finance and risk management committee, chaired by an 80-year-old director, met only twice in 2007 and twice in 2006. Nine of the company's directors were retired and one had been on the board for 23 years. Four of the directors were over 75 years old. One was an actress, one was a theatrical producer, another a former Navy admiral. Only two board members had direct experience in the financial-services industry. Until 2008 it had no one on the board who was familiar with the kinds of derivatives that caused the collapse of the 158-year-old firm that year.At Indymac, the CEO's pay was as large as CEO salaries at firms exponentially larger and included $260,000 one-time initiation fee to a country club, reimbursement for payment of taxes ($12,650), financial planning ($15,000), and other perks. It became the then-second-largest bank failure in history.The compensation committee at Chesapeake Energy not only paid CEO Aubrey McClendon $100 million, a 500 percent increase as the stock dropped 60 percent and the profits went down 50 percent, but spent $4.6 million of the shareholders' money to sponsor a basketball team in which McClendon owned a 19 percent stake, they purchased catering services from a restaurant where he was just under a half-owner, and they took his collection of antique maps off his hands for $12.1 million of the shareholders' money, based on a valuation from the consultant who advised McClendon on assembling the collection. The board justified this by referring to McClendon's having to sell more than $1 billion worth of stock due to margin calls, his having concluded four important deals, and the benefit to employee morale from having the maps on display in the office.RBS CEO Fred “the Shred” Goodwin said he would consider reducing his £17 million pension (but as of this writing has not done so). His leadership, which included the disastrous acquisition of the Dutch firm Amro, ended with the company laying off 2,700 people and writing down £240 billion worth of assets, resulting in a £20 billion bailout. The board allowed him to characterize his departure as a resignation rather than termination for cause, doubling the size of his severance and retirement package.The WorldCom CEO asked his board for a loan of over $400 million. According to public filings, the loans were to repay debts that were secured by his shares of company stock and the proceeds of these secured loans were to be used for “private business purposes.” The board agreed.Hollinger CEO Lord Black informed his board that a particular acquisition had been a mistake and offered to take it off the books by buying it for one dollar. The board agreed.Linda Wachner told her board she wanted to take a portion of the company private, with herself continuing as CEO of both organizations, being paid separately by each. They agreed. She subsequently offered to sell the private entity back to the public company, taking not only a profit but an investment banking fee. The Warnaco board agreed.A CEO made a phone call to a large institutional investor that had voted against her proposed merger, reminding them that her company did significant business with the institutional investor's parent company. Deutsche Asset Management changed their vote.

This is the description of the bailout and the banking industry's response from President Reagan's budget director turned private equity mogul David Stockman:

The banking system has become an agent of destruction for the gross domestic product and of impoverishment for the middle class. To be sure, it was lured into these unsavory missions by a truly insane monetary policy under which, most recently, the Federal Reserve purchased $1.5 trillion of longer-dated Treasury bonds and housing agency securities in less than a year. It was an unprecedented exercise in market-rigging with printing-press money, and it gave a sharp boost to the price of bonds and other securities held by banks, permitting them to book huge revenues from trading and bookkeeping gains. Meanwhile, by fixing short-term interest rates at near zero, the Fed planted its heavy boot squarely in the face of depositors, as it shrank the banks' cost of production – their interest expense on depositor funds – to the vanishing point.

The resulting ultrasteep yield curve for banks is heralded, by a certain breed of Wall Street tout, as a financial miracle cure. Soon, it is claimed, a prodigious upwelling of profitability will repair bank balance sheets and bury toxic waste from the last bubble's collapse. But will it?

In supplying the banks with free deposit money (effectively, zero-interest loans), the savers of America are taking a $250 billion annual haircut in lost interest income. And the banks, after reaping this ill-deserved windfall, are pleased to pronounce themselves solvent, ignoring the bad loans still on their books. This kind of Robin Hood redistribution in reverse is not sustainable. It requires permanently flooding world markets with cheap dollars – a recipe for the next bubble and financial crisis.2

What is wrong here? How did so many different people in so many different roles make so many bad decisions? How did corporate governance go from being an arcane, almost vestigial topic in scholarly circles to being the source of scandals, headlines, lawsuits, and business school course materials?

The importance of corporate governance became dramatically clear in 2002 as a series of corporate meltdowns, frauds, and other catastrophes led to the destruction of billions of dollars of shareholder wealth, the loss of thousands of jobs, criminal investigation of dozens of executives, and record-breaking bankruptcy filings.

Seven of the twelve largest bankruptcies in American history were filed in 2002 alone. The names Enron, Tyco, Adelphia, WorldCom, and Global Crossing have eclipsed past great scandals like National Student Marketing, Equity Funding, and ZZZZ Best. Part of what made them so arresting was how much money was involved. The six-figure fraud at National Student Marketing seems almost endearingly modest by today's standards. Part was the colorful characters, from those who were already well known like Martha Stewart and Jack Welch, to those who became well known when their businesses collapsed, like Ken Lay at Enron and the Rigas family at Adelphia. Part was the breathtaking hubris – as John Plender says in his 2003 book, Going off the Rails, “Bubbles and hubris go hand in hand.” Then there were the unforgettable details, from the $6,000 shower curtain the shareholders unknowingly bought for Tyco CEO Dennis Kozlowski to the swap of admission to a tony pre-school in exchange for a favorable analyst recommendation on ATT at Citigroup.

Another reason for the impact of these stories was that they occurred in the context of a falling market, a drop-off from the longest, strongest bull market in US history. In the 1990s, we saw billions of dollars of fraudulently overstated books at Cendant, Livent, Rite Aid, and Waste Management, but those were trivial distractions in a bull market fueled by dot-com companies. Those days were so heady and optimistic that you didn't need to lie. Why create fake earnings when an honest disclosure that you had no idea when you were going to make a profit wouldn't stop the avalanche of investors ready to give Palm a bigger market cap than Apple on the day of its IPO?

However, the most important reason these scandals became the most widely reported domestic story of the year was the sense that every one of the mechanisms set up to provide checks and balances failed at the same time. All of a sudden, everyone was interested in corporate governance. The term was even mentioned for the first time in the President's annual State of the Union address. Massive new legislation, the Sarbanes–Oxley Act, was quickly passed by Congress and the SEC had its busiest rule-making season in 70 years as it developed the regulations to implement it. The New York Stock Exchange and NASDAQ proposed new listing standards that would require companies to improve their corporate governance or no longer be able to trade their securities. The rating agencies S&P and Moody's, who had failed to issue early warnings on the bankrupt companies, announced that they would factor in governance in their future analyses. Then six years later, things were even worse. Even bigger legislation has been passed and more rule-making is underway – and the ratings agencies are still promising to do better.

Corporate governance is now and forever will be properly understood as an element of risk – risk for investors, whose interests may not be protected by ineffectual or corrupt managers and directors, and risk for employees, communities, lenders, suppliers, taxpayers, and customers as well.

Just as people will always be imaginative and aggressive in creating new ways to make money legally, there will be some who will devote that same talent to doing it illegally, and there will always be people who are naive or avaricious enough to fall for it. Scam artists used to use faxes to entice suckers into Ponzi schemes and Nigerian fortunes. Now, they use email – or, sometimes, they use audited financial reports.

The businesses that grabbed headlines with spectacular failures that led to Sarbanes–Oxley were fewer than a dozen of the thousands of publicly traded companies, and the overwhelming majority of executives, directors, and auditors are honorable and diligent. Yet, even in the post-Sarbanes–Oxley world, the scandals continued. Refco had a highly successful initial public offering in 2005, despite unusual disclosures in its IPO documents about “significant deficiencies” in its financial reporting, pending investigations, and potential conflicts of interest. Just a few months later, in the space of a week, the stock dropped from $29 a share to 69 cents and the company declared bankruptcy. In 2006, widespread undisclosed backdating of stock options at public companies was uncovered not by regulators or prosecutors but through a statistical analysis conducted by an academic. Then came the subprime/too-big-to-fail mess, with an emergency $700 billion infusion of cash from the government. In the midst of that, the government's taking over of most of the automotive industry, once the flagship of American commerce, hardly seemed worth noting.

If the rising tide of a bull market lifts all the boats, then when the tide goes out some of those boats are going to founder on the rocks. That's just the market doing its inexorable job of sorting. Some companies (and their managers and shareholders) get a free ride due to overall market buoyancy in bull markets. If the directors and executives were smart, they recognize what is going on and use the access to capital to fund their next steps. If they were not as smart, they thought they deserved their success. If they were really dumb, they thought it would go on forever – and kept creating more derivative securities based on increasingly fragile subprime mortgages.

One factor that can make the difference between smart and dumb choices is corporate governance. It is not about structure or checklists or best practices. It is about substance and outcomes. Think of it as the defining element in risk management. In essence, corporate governance is the structure that is intended (1) to make sure that the right questions get asked and (2) that checks and balances are in place to make sure that the answers reflect what is best for the creation of long-term, sustainable, renewable value. When that structure gets subverted, it becomes too easy to succumb to the temptation to engage in self-dealing.

This book is about managing the risk of that temptation. Corporate governance is our mechanism for addressing the core conundrum of capitalism, the problem of agency costs. This is the problem that persuaded that great advocate of the free market that the corporate structure could not work. Adam Smith wrote, “People of the same trade seldom meet together but the conversation ends in a conspiracy against the public, or in some diversion to raise prices.”

Corporate governance is our way of answering these questions:

How do we make a manager as committed to the creation of long-term shareholder value as he would be if it was his own money?How do we manage corporate value creation in a manner that minimizes the externalization of its costs on to society at large?

Good corporate governance requires a complex system of checks and balances. One might say that it takes a village to make it work. In the last decade, we have seen a perfect storm of failures, negligence, and corruption in every single category of principal and gatekeeper: managers, directors, shareholders, securities analysts, lawyers, accountants, compensation consultants, investment bankers, journalists, and politicians. In this book, we will discuss the theory and practice of corporate governance with examples from the good, the bad, and the very, very ugly, with reference to theoretical underpinnings and real-life cases in point, and with some thoughts on options for reform, future directions, and the prospects for some kind of global convergence on governance standards.

Our primary focus will be on the three key actors in the checks and balances of corporate governance: management, directors, and shareholders. We begin with some thoughts about the role of the board from a speech given by one of America's most successful CEOs at a 1999 conference on ethics and corporate boards:

[A] strong, independent, and knowledgeable board can make a significant difference in the performance of any company . . . . [O]ur corporate governance guidelines emphasize “the qualities of strength of character, an inquiring and independent mind, practical wisdom and mature judgment . . . .” It is no accident that we put “strength of character” first. Like any successful company, we must have directors who start with what is right, who do not have hidden agendas, and who strive to make judgments about what is best for the company, and not about what is best for themselves or some other constituency . . . .

[W]e look first and foremost for principle-centered leaders. That includes principle-centered directors. The second thing we look for are independent and inquiring minds. We are always thinking about the company's business and what we are trying to do . . . . We want board members whose active participation improves the quality of our decisions.

Finally, we look for individuals who have mature judgment – individuals who are thoughtful and rigorous in what they say and decide. They should be people whom other directors and management will respect and listen to very carefully, and who can mentor CEOs and other senior managers . . . . The responsibility of our board – a responsibility which I expect them to fulfill – is to ensure legal and ethical conduct by the company and by everyone in the company. That requirement does not exist by happenstance. It is the most important thing we expect from board members . . . .

What a CEO really expects from a board is good advice and counsel, both of which will make the company stronger and more successful; support for those investments and decisions that serve the interests of the company and its stakeholders; and warnings in those cases in which investments and decisions are not beneficial to the company and its stakeholders.

That speech, “What a CEO Expects From a Board,” was delivered by then-Enron CEO, the late Kenneth Lay. The company's code of ethics is similarly impressive. The company got high marks from just about everyone for best corporate governance practices.

The board looked good on paper: the former dean of the Stanford Business School was chairman of the audit committee. Another director was formerly a member of the British House of Lords and House of Commons, as well as Energy Minister. In addition, the board included one of the most prominent business leaders in Hong Kong, the co-founder and former president of Gulf and Western, two sitting CEOs of large US corporations, and the former head of the Commodities Future Corporation who was an Asian woman, with an economics PhD, and married to a prominent Republican Congressman. There was also a former professor of economics and a former head of General Electric's Power Division worldwide, a senior executive of an investment fund with a PhD in mathematics, the former president of Houston Natural Gas, the former head of M.D. Anderson, the former head of a major energy and petroleum company, and a former Deputy Secretary of the Treasury and PhD economist.

That shows the most important point to keep in mind as you consider the challenges of corporate governance: it is easy to achieve the letter of good corporate governance without achieving the spirit or the reality. While it is tempting to engage in checklists of structural indicators, there is no evidence that intuitively appealing provisions like independent outside directors (rather than people whose commercial or social ties might create conflicts of interest) or annual election of directors (rather than staggered terms) have any correlation to the creation of shareholder value or the prevention of self-dealing.

Therefore, keep in mind throughout this book that corporate governance is about making sure that the right questions get asked and the right checks and balances are in place, and not about some superficial or theoretical construct. Every other topic in business school – analysis, strategy, finance, marketing – is developed and executed under a structure that either does or does not address the issues of agency costs and risk management. Strategic planning is overseen by the board who either does or does not have the expertise, information, and authority to make the right decisions. Every incentive program either does or does not link pay to performance. The difference between the does and does not is corporate governance.

William Donaldson, then Chairman of the Securities and Exchange Commission, made this point in a 2003 speech at the Washington Economic Policy Conference:

[A] “check the box” approach to good corporate governance will not inspire a true sense of ethical obligation. It could merely lead to an array of inhibiting, “politically correct” dictates. If this was the case, ultimately corporations would not strive to meet higher standards, they would only strain under new costs associated with fulfilling a mandated process that could produce little of the desired effect. They would lose the freedom to make innovative decisions that an ethically sound entrepreneurial culture requires.

As the board properly exercises its power, representing all stakeholders, I would suggest that the board members define the culture of ethics that they expect all aspects of the company to embrace. The philosophy that they articulate must pertain not only to the board's selection of a chief executive officer, but also the spirit and very DNA of the corporate body itself – from top to bottom and from bottom to top. Only after the board meets this fundamental obligation to define the culture and ethics of the corporation – and, for that matter, of the board itself – can it go on and make its own decisions about the implementation of this culture.

Notes

1. W.W. Norton & Co., 2010, pp. 256 (emphasis added).

2. David Stockman, “Taxing Wall Street Down to Size,” New York Times, January 19, 2010.

Acknowledgments

First and foremost, we want to thank Kit Bingham, former editor of the indispensable magazine Corporate Governance, without whom this book would still be just a dream. His tireless, thorough, creative, and even cheerful diligence provided most of the case studies and supporting material in the first three editions, and he made even the more tedious aspects of research and writing a genuine pleasure. Professor emerita D. Jeanne Patterson did a masterful job of reading through hundreds of academic papers, assembling the material for the NYSE (Grasso) case study, and providing assistance throughout the process of writing and editing. David Smith was very helpful with the fourth edition and Zachary Cloyd's superb research skills and good spirits were an essential contribution for the fifth.

We are honored to be able to include case studies from three top scholars and extend our deepest thanks to Beth Young, Jennifer Taub of the Vermont Law School, and John Coleman of NCI Consulting. Dave Wakelin was most generous with his time in bringing us up to date on the Maine State Retirement System. Paul Lee of Hermes allowed us to use his superb case studies of Premier Oil and Trinity Mirror. Paola Perotti and Rolf H. Carlsson gave us outstanding case studies with an insider's perspective. Teresa Barger and Michael Lubrano of Cartica Capital and formerly of the Corporate Governance and Capital Markets Advisory Department International Finance Corporation/World Bank were kind enough to allow us to use their superb Embraer case study. Lynn Turner provided daily email updates on the latest developments in corporate governance. Jackie Cook's pioneering work in applying social networking theory to corporate boards has been of inestimable value.

We are also very grateful to the heroic scholars whose work instructed and inspired us, especially Warren Buffett (special thanks for suggesting a case study on fiduciary obligation and the lack thereof), Sir Adrian Cadbury, David Walker, Robert Clark, Simon Wong, Alfred Conard, Peter Drucker, Melvin Eisenberg, Shann Turnbull, Betty Krikorian, Lucian Bebchuk, Simon Deakin, Margaret Blair, Joe Grundfest, Charles Elson, Bernie Black, Mark Roe, Marcy Murninghan, Bob Massie, Jack Coffee, Jeffrey Sonnenfeld, the late Jonathan Charkham, Adolf Berle and Gardiner Means, and James Willard Hurst.

We have also learned a great deal from our colleagues, clients, and friends, including the widely disparate group of institutional investors all joined together by their commitment to the beneficial owners they serve as fiduciaries and the corporate managers they monitor as shareholders. It also includes the corporate managers, lawyers, regulators, commentators, and individual shareholders who care enough about making things work better to make a difference. These are also our heroes. They include Alan Hevesi, Allen Sykes, Tim Bush, Ann Yerger, Kayla Gillan, Anne Simpson, Alyssa Machold, Roger Raber, Peter Gleason, Deborah Davidson, Alan Kahn, Sarah Ball Teslik, Carol Bowie, Peter Clapman, Brock Romanek, Stephen Davis, William McDonough, Charles D. Niemeier, Rich Koppes, Ned Regan, Olena Berg, Dale Hanson, Tom Pandick, Harrison J. Goldin, Carol O’Cleireacain, Patricia Lipton, Ned Johnson, Dean LeBaron, Dick Schleffer, Keith Johnson, Elizabeth Smith, Ken Bertsch, Janice Hester-Amey, Doug Chia, Adam Turteltaub, Phil Lochner, the late Al Sommer, Cathy Dixon, Martin Lipton, Ira Millstein and Holly Gregory, Vineeta Anand, Luther Jones, Roland Machold, Michael Jacobs, the late John and Lewis Gilbert, Peg O’Hara, Mort Kleven, Alan Lebowitz, Karla Scherer, Bill McGrew, Kurt Schacht, Beth Young, Kimberly Gladman, Abbot Leban, Bill Steiner, Bob Massie, Tom Flanagan, Bill McEwen, David Greene, Alan Towers, and Gary Lutin. We are also grateful for the journalists who have produced exceptionally thoughtful and illuminating stories, especially Mark Gunther, Mathew Bishop, Gretchen Morgenson, Ralph Ward, Mary Williams Walsh, Jim Kristie, Leslie Wayne, John Plender, and Joann Lublin.

We are also especially grateful to our dear friends Ann Yerger, Executive Director of the Council of Institutional Investors, and Ralph Whitworth, of Relational Investors, who provided the leadership, support, and intellectual foundation for most of the developments in this area over the past few years. John M. Nash and the late Jean Head Sisco, former Director and Chair of the National Association of Corporate Directors, and current Chair Barbara Franklin and director Ken Daly deserve special thanks for their labors in the field of governance.

We are grateful to those who permitted us to use their material in this book, which added greatly to its value. Thanks to Chancellor William Allen, Ira Millstein, Shann Turnbull, Marcy Murninghan, Martin Lipton, Jay Lorsch, Cyrus F. Freidheim, Hugh Parker, Oxford Analytica, Jeanne Patterson, Aaron Brown, Joe Grundfest, Jamie Heard, Sophie L’Helias, Howard Sherman, Bruce Babcock, and Geoff Mazullo. Cathy Dixon guided us through the thorny securities law issues with patience, good humor, and unbounded expertise. We are deeply grateful.

Our dear friends Beth Young, Kimberly Gladman, Jackie Cook, Annalisa Barrett, Paul Hodgson, Howard Sherman, Gavin Anderson, Jack Zwigli, Jim Kaplan, Rick Bennett and all of the staff of The Corporate Library/Governance Metrics/Audit Integrity were generous, knowledgeable, and completely indispensable in giving us the latest data and analyses. Ric Marshall, our trusted colleague, developed the website that has made it possible for us to include and update the book's supporting materials. Manpower CEO Mitchell Fromstein was most generous not only with useful material but also his own time. Newton Minow and the late Stanley Frankel sent us constant clippings and gave us thoughtful advice.

There is a special section of heaven for those who were willing to trudge through early drafts and provide comments. Thanks very much to Margaret Blair, Alfred Conard, Wayne Marr, Jane Zanglein, and Stu Gillan.

We want to thank our colleagues, including everyone at the three companies we have worked at together: Institutional Shareholder Services, Lens, and The Corporate Library (now GovernanceMetrics International). Barbara Sleasman is the finest professional with whom we have ever worked. Sylvia Aron and Stephanie Philbrick provided crucial support. We would also like to thank the people at Wiley, including Rosemary Nixon, Michaela Fay, Tessa Allen, and Pat Bateson. Alexandra Lajoux was a brilliant (and tactful) editor of the original edition.

Note from Bob Monks: I am long accustomed to being told that “I married above myself.” In my work with corporate governance, happily the pattern has been repeated in a different form – “I have partnered above myself” – and am in particular grateful to John Higgins, Ric Marshall, Rick Bennett, Peter Butler, Steve Brown, Simon Thomas, Barbara Sleasman, and, above all, Nell Minow for their willingness to help me along this delightful passage of life.

Note from Nell Minow: The single best thing about writing a book is the opportunity to give a shout-out to my dear friends and family. Thanks and love to my wonderful parents and sisters and all of the Minows and Apatoffs; my friends Kristie Miller, Patty Marx, Jeff Sonnenfeld, David and Marcie Drew, Jesse Norman, Lilah Lohr, Daniel and Matthew Ornstein, Michael O'sullivan, the Anthes-Mayer family, Alexandra Burguieres, Adam Frankel, A. T. Palmer, Steve Lawrence, Tom Dunkel, Robert Elisberg, Judy Viorst, Jim Cheng, Judy Pomeranz, Cynthea Riesenberg, Kathy and Andrew Stephen, Mary, Richard, Jack, and Neal Kelly, Elizabeth, David, and Riley Alberding, the Klein and Marlette families, Nadine Prosperi, Deborah Baughman, Jon Friedman, Brett, Tracy, and Kathy in Wichita and the Froggy gang in Fargo, Liza Mundy, Paul Zelinsky and Deborah Hallen, Desson Thomson, Deborah Davidson, Kayla Gillan, Alyssa Machold Ellsworth, John Adams, Hannah and Jonathan Beker, Shannon Hackett, Beth Young, Ann Yerger, Terry Savage, Bill Pedersen, Gary Waxman, Toby, Bhupinder, and Kabir Kent, Victor, Alex, and Nico Mandel, Adam Bernstein, the Bingham-Kavenaugh family, Jane Leavy, Eleonor Peralta, Steve Wallman, Sam Natapoff, Steve Waldman and Amy Cunningham, Michael Kinsley, Dante Cesa, Parvané Hashemi, Ken Suslick, Ellen, Sandy, and Elyse Twaddell, Steve Friess, Duncan Clark, Ellen Burka, Michael Deal, and Stuart Brotman. Thanks to my pals Tim Gordon, Ivan Walks, Mark Jenkins, Brandon Fibbs, Kevin McCarthy, Josh Hylton, Dustin Putman, Patrick Jennings, Eli and Andrea Savada, Jay Carr, Willie Waffle, Cindy Fuchs, and Jim Judy. Very special thanks to Lauren Webster. Thanks, as ever, to Bob Monks, the perfect partner for almost a quarter century. Here's to whatever comes next.

Most of all, I want to thank my family – my children, Benjamin and Rachel, and my husband David, still the best person I know.

Introduction

How to Use This Book

Corporate governance is sometimes marginalized by those who claim it is about “best practices” and checklists. However, the corporate failures of the first decade of the twenty-first century have shown us that corporate governance is best understood as a critical element of risk management. Corporate failure, whether caused by accounting fraud or misaligned incentive compensation, is a failure of corporate governance, the essential system of checks and balances that keeps corporations vital, focused, and supple enough to respond to change and come out stronger than before.

In theory, we minimize the agency costs of outside capital through a system of accountability to boards of directors and shareholders. As the examples and case studies in this book show, however, that system has too often been subverted. We begin with an overview about the history of the corporate structure from a governance perspective. We look at the days of a direct connection between the investor and the portfolio company and how companies have become exponentially larger, more complex, and more far-reaching, with global operations. Shareholders have also changed, with well over half of equity securities in the hands of intermediaries like pension funds, some with many layers between the beneficial holder and the person who makes the buy–sell–hold–vote decisions.

We then go into more depth with chapters on each of the three major players in corporate governance, the shareholders, board of directors, and managers. In each of these chapters, the focus is on one key question: What role does this group play in determining corporate direction and what obstacles interfere with their ability to do so? Our overall guideline is that each decision should be made by those with the best access to information and the fewest conflicts of interest. How can those criteria be applied?

Chapter 5 takes these questions to the global level as we make comparisons between established and emerging economies and put corporate governance in the context of a worldwide competition for capital. Chapter 6 is a brief discussion of some conclusions and thoughts about the future, and Chapter 7 (online only) includes our in-depth case studies, referred to throughout the text but also suitable for stand-alone discussion as illustrations of the successes and failures of corporate governance.

Throughout the rest of the business curricula, you will discuss the ways to evaluate every possible strategic option and risk assessment presented to corporations. Corporate governance is about making sure that the people who will make those decisions have the ability and the incentives to get them right as often as possible.

Chapter 1

What is a Corporation?

Henry Ford once said, “A great business is really too big to be human.” Indeed, that is the purpose of the corporate structure, to transcend the ability and lifespan of any individual. It is also the challenge of the corporation. The efforts by humans in directing and controlling other humans, whether through democracy or fascism, whether by carrots or sticks, have been notoriously unsuccessful. Efforts by humans to control institutions are an even greater challenge.

The very elements of the corporate structure that have made it so robust – the limitation on liability, the “personhood” that can continue indefinitely – make it very difficult to impose limits to ensure that the corporation acts in a manner consistent with the overall public interest. The corporate structure creates both the motive and the opportunity for externalizing costs to benefit the insiders. As we will see, most of the problems and failures and obstacles we find in looking at corporate functioning from both a micro and macro perspective come from this seemingly intractable element of their existence. In other words, we must make sure that we have created a structure that is not just perpetual, but sustainable.

In this book, we will devote chapters to the three most significant forces governing the direction of corporations and trying to reduce agency costs and maximize sustainable value creation. They are management, shareholders, and boards of directors, all internal and structural. Throughout our examples we will also look at other significant forces like government/law, employees, competitors, suppliers, service providers, and other partners, as well as communities and customers. Key issues include how we establish goals, align incentives for corporate managers to reach those goals, measure performance to see how well they have done, and make whatever adjustments to the goals, the measurement, and the management itself to make sure that the aspirations and operations of the corporation result in sustainable, long-term value creation.