Governance and the Role of the Board of Directors
2.5 Governance and the Role of the Board of Directors Privately held and publicly held companies are governed differently. They do share one similarity and that is that all decisions made and actions taken benefit the owner(s) of the company. We now take a closer look at the main differences.
Privately Held Companies Privately held companies are governed or run by either one person, as in the case of a startup entrepreneurial venture, or a group of people in a larger company, like a top-management group. An autocratic CEO will make all decisions of consequence for the company whether the top- management group is consulted or not. A democratic or participative leader will make decisions only with the consensus of the other top managers. Typically, in privately held companies, the CEO and often some key managers are the owners of the company, so decisions that benefit the company also automatically benefit them as owners.
In cases where outsiders have invested capital in the company, the investor receives a negotiated percentage share of the equity in return as well as a seat on the board of directors. This gives the investor a say in making strategic decisions as a way to safeguard the investment. In these cases, such a board shares the governance of the company with the CEO and the top-management team. The CEO makes decisions only after consulting with such a board.
Publicly Held Companies To explain how publicly held companies are governed differently, one has to appreciate what being a public company means. A public company is one whose shares can be publicly traded on a U.S. stock exchange and that is regulated by the United States Securities and Exchange Commission (SEC) to ensure accurate and responsible financial reporting. The SEC was formed to protect inves- tors, maintain fair, orderly, and efficient markets, and facilitate capital formation. An organizing principle is that every investor, ranging from a big corporation to a private individual, deserves to be informed about each investment they purchase or possess. To this end, the SEC mandates that public companies share important financial and business-related information with the public. Only
Discussion Questions 1. Develop an overall purpose for a high school and one for a college/university. What would be
their similarities or differences? 2. Can any organization have a purpose? Can different levels in an organization each have a purpose
(e.g., a department or functional unit within a corporation)? 3. Where do overarching purposes come from? If you had to develop one for an organization, how
would you go about it? How would you know when you had the “right” purpose? 4. Many companies have mission and vision statements and strategies. Does having an overarching
purpose make a difference? In what way?
CHAPTER 2Section 2.5 Governance and the Role of the Board of Directors
when equipped with prompt, thorough, and accurate information can people undertake wise investment decisions (U.S. Securities and Exchange Commission).
The SEC is responsible for monitoring important par- ticipants in the securities arena, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds. The SEC’s foremost pri- orities are to advocate for the transparency of market- related information, promote honest business, and prevent fraud.
Once a company “goes public,” it means that the pub- lic can purchase and trade its shares on one of several stock exchanges such as the NYSE or NASDAQ. In car- rying out its responsibilities, the SEC also oversees the public-accounting profession and the rules it creates, the generally accepted accounting principles (GAAP) to promote honest and uniform reporting by public companies as a basis for investors to buy or sell shares. In fact, the SEC requires that the financial statements and computer systems of public companies be audited by a CPA firm every year to guarantee the information as a basis for decision making (Abraham, 1978).
In addition, the SEC requires all publicly held companies in the United States to have a board of directors to ful- fill a fiduciary duty to the company’s shareholders. That duty is to act solely on behalf of the shareholders and in their best interest. Why was this found to be necessary when a capable CEO and management team exist to make the key strategic and operational decisions for the company?
The truth is that publicly held companies typically have shareholders that number in the hundreds of thousands or millions, and the visceral connection that owners, managers, and investors enjoy in a small company is lost. People buy shares in a public company for monetary gain, nothing else. Their objective is to receive either regular dividends for current income or capital gains when the value of the company rises over time. As a result, top managements of companies have come to make decisions and take actions that benefit themselves more and not the larger group of share- holders. For example, they pay themselves high salaries, high bonuses, and high severance pack- ages, oftentimes without regard to the way the company performs. They have come to behave selfishly in this way not out of any ill will toward shareholders, but rather because they can.
According to a New York Times study of executive pay, the median pay in 2010 for CEOs was $10.8 million, a 23% gain from 2009 (Joshi, 2011), 343 times the median pay of American workers in nonsupervisory positions (AFL/CIO, n.d.). One view for this disparity is that few people have the talent and ability to lead large, often global public companies successfully, which means they are in short supply and so command generous compensation packages.
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When a company “goes public,” it means that the general public can purchase, sell, and trade shares on several stock exchanges, like the New York Stock Exchange and NASDAQ.
CHAPTER 2Section 2.5 Governance and the Role of the Board of Directors
While it may be true that capable leaders are in high demand, one of the insidious reasons for CEOs’ large compensation packages is the reinforcing cycle that sets and approves such pay. A board’s compensation committee often engages a human-resources-consulting firm to deter- mine whether the salary and compensation proposed is in line with what is paid other CEOs. The response in virtually all cases is that it is. The board is thus supported with evidence when it gives the CEO the salary and compensation package negotiated. The CEO contract often includes a defined employment period like five years, stock, bonuses, severance packages, and other ben- efits. The next time a CEO is hired, the cycle is repeated, the one certainty being that the size of the total compensation package always increases and never decreases.
The SEC must have recognized this tendency to reward insiders a long time ago, and so requires public companies to have a board of directors elected by the shareholders at their annual meet- ing. The role of the board is to represent shareholder interests and oversee the strategic decisions that the CEO and management team take and, when necessary, to reclaim decision-making power and make the crucial decisions itself. This is most evident when the company is trying to acquire another company or fend off an unwanted takeover attempt. In both situations it is the board that takes the lead in deciding what to do.
Boards of directors are comprised of three types of directors (Hitt, Ireland, & Hoskisson, 2007):
• Insiders—the firm’s CEO and other top-level executives • Related outsiders—individuals not involved with the firm’s day-to-day operations but
who have a relationship with the company such as a major stockholder • Outsiders or independents—individuals who have no relationship to the firm at all
Boards of directors are required to have three standing committees to help them to fulfill their obligations: The Audit Committee is responsible for hiring and reviewing the performance of the independent public accountants that audit the company’s financial systems and reports. The committee safeguards the reliability of the accounting operations and monitors and inspects any notable changes in accounting policies. In addition, it helps the company comply with the require- ments of the Sarbanes-Oxley Act of 2002. The Compensation and Benefits Committee is respon- sible for determining compensation packages for the CEO, president, key top managers, and board members. In addition, it oversees pension and other welfare policies for all employees. The Nomi- nating and Corporate Governance Committee is responsible for recommending candidates for the board, overseeing the performance of the board and its committees, and reviewing the orga- nization’s plans for executive succession. These three standing committees are legally required of all public companies.
Corporate boards of directors may choose to establish other committees. A strategic-planning committee is not mandated but may be created by some boards. Its role is to keep the board informed about strategic decisions the company might take and to make sure that the board’s input is taken into account in the company’s strategic-planning process. A public-policy commit- tee is not a legal requirement but many boards choose to have one. These bodies oversee the company’s efforts at protecting the environment, promoting health issues, and other public poli- cies that might affect the company.
The Sarbanes-Oxley Act (SOX) introduced new standards of accountability for the boards of publicly traded companies. Under the Act, directors are directly responsible for internal control, and pen- alties, including large fines and even prison sentences, are enforced for accounting crimes. After the Sarbanes-Oxley Act was passed, the New York Stock Exchange and the American Exchange
CHAPTER 2Section 2.5 Governance and the Role of the Board of Directors
required independent directors to head the major standing commit- tees (Petra, 2005). Today, boards of directors of companies trading on those exchanges are required to have a majority of the board be independent and the audit com- mittee to be composed entirely of independent directors (Hitt, Ire- land, & Hoskisson, 2007). Even so, in some cases, the CEO is powerful enough to offset the independence of the board. Some companies have countered this with efforts to prevent the same person being chairman of the board and CEO concurrently (Lorsch & Zelleke, 2005).
The downside to having more inde- pendent directors is that they have,
by definition, less information about the day-to-day operations of the company. But the issue is a red herring; they can get all the information they need from interactions with and requests of the insider directors, who are on the board because they can share with the board all the strategic, financial, and operational information the board needs.
With all of these committees and regulatory bodies in place, it’s easy to see how governing a publicly held company is more complicated than, and substantially different from, governing a privately held company. In later chapters, the strategic-management process will be described in more detail in a way that applies equally well to both kinds of company. The emphasis will be placed on what the management team must do to make and act on its strategic decisions. Bear in
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Boards of Directors are required to have three standing com- mittees: an Audit Committee, a Compensation and Benefits Committee, and a Nominating and Corporate Governance Com- mittee. These committees will report directly to the board.