Do you think Steve Wynns executive compensation was justified, and why or why not? Did the board of directors of Wynn Resorts operate according to the principles of goo

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Shareholders occupy a position of central importance in the corporation because they own shares of the company’s stock. As owners, they pursue both financial and nonfinancial goals. How can share- holders’ rights best be protected? What are the appropriate roles of top managers and boards of directors in the governance of the corporation? How can their incentives be aligned with the pur- poses of the firm, including the interests of the company’s shareholders? And how can government regulators best protect the rights of investors and promote good corporate governance?

This Chapter Focuses on These Key Learning Objectives:

LO 13-1 Identifying different kinds of shareholders and understanding their objectives and legal rights.

LO 13-2 Knowing how corporations are governed and explaining the role of the board of directors in pro- tecting the interests of investors and other stakeholders.

LO 13-3 Analyzing the function of executive compensation and debating if top managers are paid too much.

LO 13-4 Evaluating various ways shareholders can promote their economic and social objectives.

LO 13-5 Understanding how the government protects against stock market abuses, such as fraudulent accounting and insider trading.

Shareholder Rights and Corporate Governance

C H A P T E R T H I R T E E N

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Twenty-first Century Fox, the media company, settled a massive shareholder lawsuit in 2017. Shareholders had sued top executives and the board of directors, saying they had allowed a “toxic culture” of sexual and racial harassment to infect the company, damaging its reputation and stock value. The settlement called for the defendants to pay $90 million to the company, for the benefit of shareholders, and to set up a Workplace Professionalism and Inclusion Council to prevent similar situations from arising in the future. Said the investors who brought the suit, “Corporate boards can no longer pretend that such conduct is isolated, nor can corporate boards pretend that their conduct does not and will not pose a grave risk to companies and their shareholders.”1

In early 2018, two large institutional investors, Jana Partners and the California State Teachers’ Retirement System (CalSTRS), wrote an open letter to the board of directors of Apple Inc. Together, the two organizations—one a hedge fund and the other a public pension fund—owned around $2 billion worth of the tech company’s stock. The letter cited evidence that children who were heavy users of Apple products such as iPhones and iPads were distracted in class, at risk for depression, less empathetic than their peers, and often sleep-deprived. It called on the company to make it easier for parents to control their children’s use of technology. “We believe that addressing this issue now will enhance long- term value for all shareholders,” the letter concluded.2

In 2017, the chairman of the board of SeaWorld Parks, an operator of theme parks and water parks based in Florida, resigned after failing to win the support of the compa- ny’s shareholders. Although he ran uncontested, the chairman did not receive the votes of a majority. Shareholders were apparently angered by high executive compensation, even when attendance and revenues were falling in the wake of the critical documen- tary Blackfish. The day the election results were announced, the company’s stock rose by 7 percent. Said an industry analyst, “The message they’re sending is they’re going to keep management and the board of directors on a relatively short leash to do the right thing for shareholders.”3

As these three examples illustrate, the relationships among shareholders, top execu- tives, and boards of directors in today’s companies are multiple and complex. In these cases, shareholders used a variety of techniques to assert their rights—a lawsuit, public persuasion, and voting for the board of directors. This chapter will address the important legal rights of shareholders and how corporate boards, government regulators, managers, and activist investors can protect them. It will also discuss changes in corporate practice and government oversight designed to better guard shareholder interests, in both the United States and other nations.

Shareholders Around the World

Shareholders (or investors or stockholders, as they also are called) are an important market stakeholder of the firm, as explained in Chapter 1. By purchasing shares of a company’s stock, they become owners. For this reason, they have a stake in how well the company performs.4

1 “Massive Derivative Suit Settlement for Alleged Management Failure to Prevent Sexual Misconduct,” The D&O Diary, November 21, 2017. 2 “Open Letter from Jana Partners and CalSTRS to Apple Inc.,” January 6, 2018. 3 “SeaWorld Stockholders Vote Off Board Chairman, Orlando Sentinel, June 14, 2017, and “SeaWorld Calls Time on Chairman after Shareholder Revolt,” Financial Times, September 13, 2018. 4 The following discussion refers to publicly held corporations; that is, ones whose shares of stock are owned by the public and traded on the various stock exchanges. U.S. laws permit a number of other ownership forms, including sole proprietorships, partnerships, and mutual companies. (A privately held company, by contrast, is one whose shares are not publicly traded.)

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Stock ownership today is increasingly global. In 2015, the total value of stocks in the world was $62 trillion, slightly down from $64 trillion before the stock market collapse of 2008–09. The market capitalization (total value) of stocks in the United States is by far larger than that of any other country, but stock ownership has grown in many other parts of the world.5 One way to compare the extent of stock ownership among countries is to exam- ine their market capitalization as a percentage of their GDP (gross domestic product, a measure of the size of their economies). By this yardstick, the United States leads, but many other countries are not far behind, as shown in Figure 13.1.

Who Are Shareholders? Whether in the United States or other countries, two main types of investors own shares of stock in corporations: individual and institutional.

∙ Individual shareholders are people who directly own shares of stock issued by compa- nies. These shares are usually purchased through a stockbroker and are held in brokerage accounts. For example, a person might buy 100 shares of Apple or Sony Corporation for his or her portfolio and hold these in an account at a firm such as Edward Jones, Fidelity, or Charles Schwab. Such shareholders are sometimes called “Main Street” investors, because they come from all walks of life.

∙ Institutions, such as pensions, mutual funds, insurance companies, and university endowments, also own stock. For example, mutual funds such as Vanguard Wellington and pensions such as the California Public Employees Retirement System (CalPERS) buy stock on behalf of their investors or members. These institutions are sometimes called “Wall Street” investors. For obvious reasons, institutions usually have more money to invest and buy more shares than individual investors.

5 Comprehensive data on stock market capitalization by countries is available in “Market Capitalization of Listed Companies,” at http://data.worldbank.org.

FIGURE 13.1 Stock Market Capitalization as a Percentage of Gross Domestic Product, for Selected Countries, 2016

Source: “Stocks Traded, Total Value (% of GDP), 2016,” at http://data.worldbank.org.

0 50 100 150 200 250

Australia

Brazil

India

China

Indonesia

Japan

Korea

Russian Federation

United States

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Since the 1960s, growth in the numbers of such institutional investors has been phe- nomenal. In 2016, institutions accounted for about 60 percent of the value of all equities (stocks) owned in the United States, worth a total of about $23 trillion. In 2017, slightly over half of all U.S. households (54 percent) owned stocks, either directly or indirectly through holdings in mutual funds or retirement accounts, according to a Gallup survey. This proportion had fallen significantly since just before the stock market collapse of 2008 (when 65 percent owned stocks), possibly reflecting investors’ lower confidence. Although people of every age, race, and socioeconomic status owned stocks, ownership tended to be higher among some groups than others. For example, whites (60 percent) were more likely to own stocks than African Americans (36 percent), and the college educated (78 percent) were more likely than those with less education (43 percent). The affluent (with household incomes of $100,000 or more) (89 percent) owned stocks as a higher rate than lower income people (with household incomes of less than $30,000) (21 percent). Age also made a difference: 62 percent of people between 50 and 64 years old owned stocks, compared with just 31 percent of young adults under 30.6

Figure 13.2 shows the relative stock holdings of individual and institutional investors from the 1960s through 2016 in the United States. It shows the growing influence of the institutional sector of the market over the past five decades, although the relative share of the institutional sector has leveled off since the financial crisis.

Objectives of Stock Ownership Individuals and institutions own corporate stock for several reasons. Foremost among them is to make money. People buy stocks because they believe stocks will produce a return greater than they could receive from alternative investments. Shareholders make money when the price of the stock rises (this is called capital appreciation) and when they receive

6 “U.S. Stock Ownership Down Among All but Older, Higher-Income,” May 24, 2017, http://news.gallp.com. Data are based on Gallup’s annual economics and personal finance survey.

FIGURE 13.2 Household versus Institutional Ownership in the United States, 1965–2016, by Market Value

Source: Securities Industry and Financial Markets Association, 2017 Fact Book (New York, SIFMA, 2017); U.S. Census Bureau, Statistical Abstract of the United States, 2012, Table 1201; and Securities Industry Association, Securities Industry Fact Book (New York: Securities Industry Association, 2008). Household sector includes nonprofit organizations. Based on Federal Reserve Flow of Funds Accounts (revised).

839 2,270 8,481 17,627 18,512 23,293 38,685735

Households

Institutions

1975 1985 1995 2000 2005 2010 2016 0

10

20

30

40

50

60

70

80

90

1965 Year

(in billions of dollars) Total

market value

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their share of the company’s earnings (called dividends). Most companies pay dividends, but some—particularly new companies with good prospects for rapid growth—do not. In this case, investors buy the stock with the goal of capital appreciation only.

Stock prices rise and fall over time, affected by both the performance of the company and by the overall movement of the stock market. For example, in 2008 and early 2009 share values declined sharply—for example, the Dow Jones Industrial Average, a widely tracked index, lost almost half its value in just a year and a half—as the global economy fell into a severe recession. This is called a bear market. This was followed by a period in which markets rose again in a bull market, which produced gains for many investors. Typically, bull and bear markets alternate, driven by the health of the economy, interest rates, world events, and other factors that are often difficult to predict. Although stock prices are sometimes volatile, stocks historically have produced a higher return over the long run than investments in bonds, bank certificates of deposit, or money markets.

Shareholders are not a uniform group. Some seek long-term appreciation, while others seek short-term returns. Some are looking for capital gains, while others are looking for dividend income. Although the primary motivation of most shareholders is to make money from their investments, some have other motivations as well. Some investors use stock ownership to achieve social or ethical objectives, a trend that is discussed later in this chapter. Investors may also buy stock to take control of a company in a hostile takeover bid. Some investors have mixed objectives; for example, they wish to make a reasonable return on their investment but also to advance social or ethical goals.

Shareholders’ Legal Rights and Safeguards As explained in Chapter 1, managers have a duty to all stakeholders, not just to those who own shares in their company. Nevertheless, in the United States and most other countries, shareholders have extensive legal rights, as shown in Figure 13.3. They have the right to share in the profits of the enterprise if directors declare dividends. They have the right to receive annual reports of company earnings and company activities and to inspect the corporate books, provided they have a legitimate business purpose for doing so and that it will not be disruptive of business operations. They have the right to elect members of the board of directors, usually on a “one share equals one vote” basis. They have the right to hold the directors and officers of the corporation responsible for their actions, by lawsuit if they want to go that far. For example, in 2017 the home health care giant Amedisys paid $44 million to settle a lawsuit brought by its shareholders, whose share values had dropped by half after the company was found to have committed Medicare fraud.7 Furthermore,

7 “Amedisys Will Pay $43.8 Million to Settle Class-Action Lawsuit,” Modern Healthcare, June 16, 2017.

• To receive dividends, if declared • To vote on Members of board of directors Major mergers and acquisitions Charter and bylaw changes Proposals by stockholders • To receive annual reports on the company’s financial condition • To bring shareholder suits against the company and officers • To sell their own shares of stock to others

FIGURE 13.3 Major Legal Rights of Shareholders

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shareholders usually have the right to vote on mergers, some acquisitions, and changes in the charter and bylaws, and to bring other business-related proposals. And finally, they have the right to sell their stock.

Many of these rights are exercised at the annual shareholders’ meeting, where directors and managers present an annual report and shareholders have an opportunity to approve or disapprove management’s plans. Typically, however, only a small portion of shareholders vote in person. Those not attending are given an opportunity to vote by absentee ballot, called a proxy. Evidence shows that institutional investors are more likely to vote their proxies; 91 percent of institutions vote, compared with only 29 percent of individual share- holders.8 The use of proxy elections by activists to influence corporate policy is discussed later in this chapter.

Who protects these rights? Within a publicly held company, the board of directors bears a major share of the responsibility for making sure that the firm is run with the interests of shareholders, as well as those of other stakeholders, in mind. We turn next, therefore, to a consideration of the role of the board in the system of corporate governance.

Corporate Governance

The term corporate governance refers to the process by which a company is controlled or governed. Just as nations have governments that respond to the needs of citizens and estab- lish policy, so do corporations have systems of internal governance that determine overall strategic direction and balance sometimes divergent interests.

The Board of Directors The board of directors plays a central role in corporate governance. The board of direc- tors is an elected group of individuals who have a legal duty to establish corporate objec- tives, develop broad policies, and select top-level personnel to carry out these objectives and policies. The board also reviews management’s performance to be sure the company is well run, and all stakeholders’ interests are protected, including those of shareholders. In recent years, the role of the board has expanded, with greater emphasis given to strat- egy development, talent management, and investor relations. Like any group, it also has its own interests, which it seeks to protect. Boards typically meet in full session around six times a year, with about a third of boards now also scheduling strategy retreats and other off-site work.9

Corporate boards vary in size, composition, and structure to best serve the interests of the corporation and its shareholders. Some patterns are evident, however. According to a survey of its members by the Society for Corporate Governance, corporate boards typi- cally have between 9 and 11 members. Most of them are outside directors (not managers of the company, who are known as inside directors when they serve on the board). (The New York Stock Exchange requires the boards of listed companies to have a majority of outsiders.) Board members may include chief executives of other companies, major share- holders, bankers, former government officials, academics, representatives of the commu- nity, or retired executives from other firms. Women now make up 20 percent of the boards of Fortune 500 companies; African Americans, 8 percent; Latinos, 3 percent; and Asian Americans, 2 percent. (The representation of women on boards of directors and laws

8 “Small Investors Support the Boards. But Few of Them Vote,” The New York Times, October 6, 2017. 9 “How Boards of Directors Are Reshaping to Meet New Challenges,” Forbes, May 26, 2017.

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mandating quotas for women on boards in some European countries are further discussed in Chapter 16.) The average tenure of a director is eight to ten years.10

Board structure in Europe is quite different from its counterpart in the United States. Many European boards use what is called a two-tier system. This means that instead of one board, as is common in the United States, these companies have two boards. One, which is called the executive board, is made up of the CEO and other insiders. The other, which is called the supervisory board, is made up of outsiders—sometimes including labor representatives—and has an independent chairperson. These boards operate autonomously, but of course also coordinate their work. This system is used in all firms in Germany and Austria and in many firms in Denmark, Finland, the Netherlands, Norway, Poland, and Switzerland. Other European nations often use a hybrid system, which has elements of both the unitary and two-tiered systems.11

Corporate directors are typically well paid. Compensation for board members is com- posed of a complex mix of retainer fees, meeting fees, grants of stock and stock options, pensions, and various perks. In 2017, median compensation for non-management directors at the largest U.S. corporations was $300,000. This amount had risen steadily over time (it had been $225,000 a decade earlier). Of this compensation, 40 percent was paid in cash and 60 percent in stock or stock options.12 Some critics believe that board compensation is excessive, and that high pay contributes to complacency by some directors who do not want to jeopardize their positions by challenging the policies of management. (Compensa- tion of executives is discussed later in this chapter.)

Most corporate boards perform their work through committees as well as in general ses- sions. The compensation committee (required by U.S. law and staffed exclusively by out- side directors) administers and approves salaries and other benefits of high-level managers in the company. The nominating committee is responsible for finding and recommending candidates for officers and directors. The executive committee works closely with top man- agers on important business matters. A significant minority of corporations now has a spe- cial committee devoted to issues of corporate responsibility. Often, this committee works closely with the firm’s department of corporate citizenship, as discussed in Chapter 3.

One of the most important committees of the board is the audit committee. Present in virtually all boards, the audit committee is required by U.S. law to be composed entirely of outside directors and to be “financially literate.” It reviews the company’s financial reports, recommends the appointment of outside auditors (accountants), and oversees the integ- rity of internal financial controls. Their role is often critical; at Enron, for example, lax oversight by the audit committee was a major contributor to the firm’s collapse in 2001. Directors who fail to detect and stop accounting fraud, as occurred at Enron, may be liable for damages.

How are directors selected? Board members are elected by shareholders at the annual meeting, where absent owners may vote by proxy, as explained earlier. Thus, the system is formally democratic. However, as a practical matter, shareholders often have little choice. Typically, the nominating committee, working with the CEO and chairman, develops a list of possible candidates and presents these to the board for consideration. When a final

10 Deloitte and Society for Corporate Governance, 2016 Board Practices Report, 10th ed. (2017), and Deloitte and Alliance for Board Diversity, Missing Pieces Report: The 2016 Board Diversity Census of Women and Minorities on Fortune 500 Boards (2017). 11 Information about corporate governance in Europe is available in Heidrick & Struggles, “Towards Dynamic Governance 2014: European Corporate Governance Report,” at www.heidrick.com. 12 “Pay for Big Company Directors Tops $300,000,” The Wall Street Journal, June 28, 2018.

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selection is made, the names of these individuals are placed on the proxy ballot. Share- holders may vote to approve or disapprove the nominees, but because alternative candi- dates are rarely presented, the vote has little significance. The selection process therefore tends to produce a kind of self-perpetuating system. This has begun to change, however, as shareholders have increasingly demanded the right to nominate their own candidates, in a move for greater proxy access. Sixty percent of U.S. companies now have rules permitting shareholders to nominate directors under some circumstances.13 And, as shown in one of the opening examples, board members will sometimes step down when they fail to win the support of a majority of shareholder votes, even if they are running unopposed. Because boards typically meet behind closed doors, scholars know less about the kinds of processes that lead to effective decision making by directors than they do about board composition and structure.

In their book Back to the Drawing Board, Colin Carter and Jay Lorsch observe, based on their extensive consulting experience, that boards develop their own norms that define what is—and is not—appropriate behavior. For example, pilot boards see their role as actively guiding the company’s strategic direction. Watchdog boards, by contrast, see their role as assuring compliance with the law—and intervening in management decisions only if something is clearly wrong. These norms are often powerfully influenced by the chairman. Boards that share a consensus on behavioral norms tend to function more effectively as a group than those that do not.14

Principles of Good Governance In the wake of the corporate scandals of the early 2000s and the financial crisis later in the decade, many sought to define the core principles of good corporate governance. What kinds of boards were most effective? By the late 2010s, a broad consensus had emerged among public agencies, investor groups, and stock exchanges about some key features of effective boards. These included the following:

∙ Select outside directors to fill most positions. (Outside directors are also called indepen- dent directors.) Normally no more than two or three members of the board should be current managers. Moreover, the outside members should be truly independent; that is, should have no current connection to the corporation other than serving as a director. This would exclude, for example, directors who had served as employees of the com- pany within the past three years, who provided consulting services for the company, who were officers of other firms that had a business relationship with the company, or who had a close personal relationship with the CEO. The audit, compensation, and nominating committees should be comprised solely of outsiders. By the late 2010s, vir- tually all major companies were following these practices.

∙ Hold open elections for members of the board. In recent years, dissident shareholders have organized to put their own candidates for the board on the proxy ballot, creating elections with genuine choice. For example, in 2017 investor Nelson Peltz ran for a seat on the board of Procter & Gamble, in a move opposed by management—an example further discussed later in this chapter. Contested board elections are rare, however; more often, dissidents simply vote against candidates nominated by management. Some have argued that candidates should have to get at least 50 percent of votes to be elected (most

13 EY Center for Board Matters, “2017 Proxy Season Review,” Ernst & Young, June 2017. 14 Colin B. Carter and Jay W. Lorsch, Back to the Drawing Boards: Designing Corporate Boards for a Complex World (Boston: Harvard Business School Press, 2003).

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companies required only a plurality; that is, more votes than other candidates, but not necessarily a majority of votes cast).

∙ Hold elections for all directors annually. Some boards are classified; this means that board elections are staggered; only some directors (“a class”) stand for election each year, and then serve for a multi-year term. Proponents of declassification believe that all directors should stand for election every year, allowing more opportunities to unseat underperforming directors. This can increase accountability and responsiveness to shareholders. In the past five years, many boards have switched to annual elections; in fact, in 2017, 90 percent of large U.S. companies had declassified boards, up from two- thirds in 2011. Declassified boards are also more likely to be diverse.15

∙ Appoint an independent lead director (also called a nonexecutive chairman of the board.) Many experts in corporate governance believed that boards should separate the duties of the chief executive and the board chairman, rather than combining the two in one person as done in some corporations, especially in the United States. The inde- pendent lead director can hold meetings without management present, improving the board’s chances of having completely candid discussions about a company’s affairs. For example, after John Stumpf resigned as Wells Fargo’s CEO and chairman, the board decided to split the roles of CEO and chairperson. (The unauthorized customer accounts scandal that led to Stumpf’s departure is further described in a case at the end of this book.) One study found that separating the positions of CEO and chairman was most likely in companies that had experienced shareholder activism and had recently appointed a new chief executive. In 2016, 50 percent of S&P 500 companies separated the roles of CEO and chairperson.16

∙ Diversify board membership. Many good governance experts have argued that boards should include many different kinds of people. Diversity on the basis of gender, eth- nicity, age, nationality, and other dimensions widens the range of experiences, per- spectives, and values brought to the boardroom. Such “cognitive variety,” in this view, expands options and enriches discussions—potentially improving leadership. A survey of nearly 900 directors conducted by PwC in 2017 found that 73 percent thought that board diversity was beneficial. Of those, 82 percent thought it enhanced board perfor- ma

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