Corporate Governance

🧭 Overview

🧠 One-sentence thesis

The U.S. corporate governance system functions as a web of fiduciary and managerial responsibilities that bind management, shareholders, and boards within a broader societal context, shaped by legal frameworks, market forces, and the evolving roles of institutional investors and gatekeepers.

📌 Key points (3–5)

• Core structure: Shareholders own but don't run corporations; they elect directors who appoint managers, creating two layers of principal-agent problems.
• Residual claimant logic: Shareholders get paid last (after creditors, employees, etc.), which theoretically incentivizes them to maximize firm value and societal benefit.
• Institutional vs. small investors: Large institutional investors (pension funds, mutual funds) have different motives and monitoring capacity than passive small shareholders, adding another agency layer.
• Common confusion: Not all shareholders are alike—small investors often sell if unhappy (passive), while large/institutional investors may actively monitor management.
• Gatekeeper conflicts: Auditors, analysts, and rating agencies are paid by the firms they evaluate, not by investors, creating inherent conflicts of interest that contributed to major scandals.

🏛️ The U.S. governance architecture

🏛️ Shareholders and the principal-agent problem

Corporate governance system: the set of fiduciary and managerial responsibilities that binds a company's management, shareholders, and the board within a larger societal context defined by legal, regulatory, competitive, economic, democratic, ethical, and other societal forces.

• Shareholders own corporations but typically do not run them.
• The chain: shareholders elect directors → directors appoint managers → managers run the firm.
• Two agency problems arise:
  1. Managers may act in their own interest rather than shareholders'.
  2. Boards may be beholden to particular interest groups (including management) rather than shareholders broadly.
• Most governance mechanisms aim to align all parties' behavior with shareholder interests.

💰 Why shareholders are residual claimants

• Other stakeholders (creditors, employees) have specific, contractual claims on cash flows.
• Shareholders receive returns only from what remains after all other claims are paid.
• Rationale: This residual position creates the strongest incentive to maximize company value, which theoretically benefits society at large.
• Example: If a company earns $100 and owes $80 to creditors and employees, shareholders get the remaining $20—so they care most about growing that residual.

🔍 Small vs. large shareholders

Type	Ownership stake	Motivation	Behavior
Small (minority) investors	Tiny fraction of outstanding shares	Little power or motivation to monitor	Passive; interested only in returns; often don't vote; sell if dissatisfied
Large shareholders	Controlling block or significant institutional stake	Stake large enough to justify monitoring costs	Active engagement with management; may hold controlling influence

• Don't confuse: Small investors' passivity is rational (monitoring costs exceed their tiny stake), not apathy.
• Large shareholders include institutional investors (mutual funds, pension plans, banks outside the U.S.) and private equity funds.

🏦 Institutional investors: another agency layer

• Who they are: Banks, trust funds, pension funds, mutual funds, and other "delegated investors."
• The paradox: They have purer profit motives than management, but also create another agency problem—why should a pension fund protect minority shareholders better than management does?
• Reality: Many are passive or indifferent monitors due to preference, regulations, or internal investment rules.
• Recent debate focus: Should institutional investors be required or incentivized to monitor more actively?
• Historical failure: Institutions held large positions in Enron, Tyco, Global Crossing, and WorldCom but failed to protect their own investors from managerial misconduct.

🔑 Private equity: a different model

• Key differences from other funds:
  • Larger holdings in individual companies.
  • Longer investment horizons.
  • Fewer companies per portfolio.
• Greater involvement: Private equity managers often sit on boards and continuously engage with management.
• Control vs. influence: In buyouts or majority stakes, private equity exercises substantial control (not just influence) over governance.
• Scholars and regulators are closely watching private equity's impact on corporate performance and governance.

⚖️ Legal and regulatory framework

⚖️ State vs. federal law

• Historically: States (especially Delaware) were the primary legislators for corporations; corporate law was considered private law.
• Four key premises of modern corporations:
  1. Indefinite life: The corporation continues regardless of who owns shares.
  2. Legal personhood: The corporation can contract, sue, be sued, and pay taxes separately from owners.
  3. Limited liability: Shareholders are shielded from the corporation's debts.
  4. Freely transferable shares: Ownership can change hands easily.
• The shift to federal law: The 1929 stock market crash brought the federal government into governance regulation for the first time.
  • 1933: Securities Act.
  • 1934: Securities Exchange Act; creation of the SEC.
  • 2002: Sarbanes-Oxley Act (after Enron/WorldCom scandals).
• Federalization example: Sarbanes-Oxley bans corporate loans to directors and executives—a matter long dominated by state law.

🏛️ Two views on the role of law

View	Perspective	Policy implication
Contract-based (free-market)	Corporation is a voluntary economic relationship between shareholders and management	Little need for government regulation beyond providing courts for breach-of-contract suits
Public interest	Corporations have growing impact on society; markets alone won't protect stakeholders	Government must force firms to behave in ways that advance the public interest (customers, employees, creditors, community, environment)

• Don't confuse: The contract view doesn't oppose all law—it just limits government's role to enforcing private agreements.

🛡️ The Securities and Exchange Commission (SEC)

• Mission: Protect investors; maintain fair, orderly, efficient markets; facilitate capital formation.
• Core concept: All investors (large or small) should have access to basic facts about an investment before buying and while holding it.
• How it works: Requires public companies to disclose meaningful financial and other information, promoting transparency and efficiency.
• Enforcement: Brings hundreds of civil actions yearly for violations (insider trading, accounting fraud, false/misleading information).
• Specific responsibilities:
  • Interpret federal securities laws.
  • Issue and amend rules.
  • Oversee inspection of securities firms, brokers, advisers, ratings agencies.
  • Oversee private regulatory organizations (securities, accounting, auditing).
  • Coordinate with federal, state, and foreign authorities.

📈 The exchanges: NYSE Euronext and NASDAQ

• NYSE Euronext:
  • Traces origins to 1792; highest listing standards globally.
  • Nearly 4,000 listed companies; ~$30 trillion in total global market cap.
  • Auction market: Individuals buy from and sell to one another based on auction prices.
  • Went public in March 2006 after 214 years as not-for-profit.
  • 2007: Merged with Euronext N.V. to form NYSE Euronext holding company.
• NASDAQ:
  • Largest U.S. electronic stock market; ~3,200 companies.
  • Known for high-tech, volatile, growth-oriented stocks (Internet, electronics, biotech).
  • Dealer's market: Participants buy from and sell to a dealer (market maker), not each other.
  • Listed as publicly traded corporation before NYSE.
• Common confusion: NYSE = physical trading floor (auction); NASDAQ = telecommunications network (dealer).
• Both must follow SEC filing requirements and maintain rules to prevent fraud and take disciplinary action against members.

🚪 Gatekeepers and conflicts of interest

🚪 Who are the gatekeepers?

Gatekeepers: External auditors, security analysts, investment bankers, and credit rating agencies whose role is to detect and expose questionable financial and accounting decisions.

• The integrity of financial markets depends heavily on gatekeepers performing their roles diligently.
• The credibility argument: Gatekeepers should be reliable because their business success depends on reputation with investors and creditors; they face private damage suits for fraudulent opinions.

⚠️ The conflict-of-interest problem

• The core issue: Gatekeepers are hired, paid, and fired by the firms they evaluate—not by investors or creditors.
  • Auditors are paid by the firms they audit.
  • Credit rating agencies are retained by the firms they rate.
  • Lawyers are paid by the firms that retain them.
  • Security analysts (working for investment banks) were compensated based on investment banking business their employers did with the firms they evaluated.
• Result: Gatekeepers' interests are often more closely aligned with corporate managers than with investors and shareholders.

🔄 The contrasting view

• Most gatekeepers are inherently conflicted and cannot be expected to act in investors' interests.
• Worsening in the 1990s: Increased cross-selling of consulting services by auditors and rating agencies; cross-selling of investment banking services.
• Regulatory response:
  • Restoration of the "Chinese Wall" between investment banks and security analysts.
  • Separation of audit and consulting services for accounting firms.
• Example: Citigroup paid $400 million to settle charges of fraudulent research reports; Merrill Lynch paid $200 million and agreed analysts would no longer be paid based on related investment-banking work.

🌍 Global governance systems

🌍 German corporate governance

German corporation law goal: Govern the corporation for "the good of the enterprise, its multiple stakeholders, and society at large."

• Two-tier board structure (companies with >500 employees):
  1. Supervisory board (Aufsichtsrat): Strategic oversight; no overlap with management board.
  2. Management board (Vorstand): Operational and day-to-day management.
• Employee representation: In companies with >2,000 employees, half the supervisory board must be employees; the other half are shareholder representatives.
  • Chairperson (typically shareholder rep) has tie-breaking vote.
• Ownership structure:
  • Intercorporate and bank shareholdings common.
  • Ownership more concentrated: ~25% of public firms have a single majority shareholder.
  • Substantial "bearer" stock on deposit with the company's hausbank (house bank).
  • Banks can vote deposited equity by proxy unless instructed otherwise—giving banks substantial control.
• Takeovers: Less common than in the U.S.; usually friendly, arranged deals; hostile takeovers and LBOs virtually nonexistent until recently.

🌍 Japanese corporate governance

Keiretsu: Networks of firms with stable, reciprocal, minority equity interests in each other.

• Types of keiretsus:
  • Vertical: Networks along the supply chain.
  • Horizontal: Networks in similar product markets; typically include a large main bank holding minority equity in each member firm.
• Board structure: Single-tier (like U.S.), but substantial majority are company insiders (current or former senior executives).
  • Outside directorships rare (though increasing).
  • Exception: Main bank representatives usually sit on keiretsu firm boards.
• Ownership: Concentrated and stable; banks limited to 5% of a single firm's stock, but a small group of 4–5 banks typically controls 20–25% of a firm's equity.
• Disclosure: Superior to German companies but poor compared to U.S. firms; insider trading and monopoly laws applied unevenly.

🔗 Similarities between German and Japanese systems

Feature	German & Japanese systems	Anglo-American contrast
Capital markets	Small reliance on external markets	Heavy reliance
Individual ownership	Minor role	Major role
Institutional ownership	Significant, concentrated, stable	More dispersed, active trading
Board composition	Functional specialists, insiders with firm/industry knowledge	More outside directors
Bank role	Important as financiers, advisers, managers, monitors	Less central
Leverage	Emphasis on bank financing	More equity financing
Executive compensation	Salary and bonuses	Equity-based (stock options)
Disclosure	Relatively poor for outside investors	Stronger
Stakeholder emphasis	Employees and creditors as important as shareholders	Shareholder primacy
Takeover market	Largely absent; system itself acts as poison pill	Active market for corporate control

⚠️ Costs of stakeholder orientation

• Inflexibility: Central role of employees (Germany) and suppliers (Japan) can hinder quick responses to competitive challenges.
• Labor costs: Employees' governance role affects labor costs.
• Vertical restraints: Suppliers' role (e.g., Japanese vertical keiretsu) can lead to antitrust problems.
• Takeover difficulty: Ownership structures make takeovers far harder, removing an important source of managerial discipline.
• Don't confuse: Stakeholder systems protect employees and creditors but may sacrifice agility and shareholder value.

📜 Historical evolution in the U.S.

📜 Three models of capitalism

Era	Model	Ownership & control	Key feature
Early 20th century	Entrepreneurial capitalism	Wealthy entrepreneurs (Morgan, Rockefeller, Carnegie, Ford, Du Pont) owned majority stock and ran companies	Ownership and control synonymous
1930s onward	Managerial capitalism	Ownership widespread; hired professional managers run firms	Ownership and control separated; managers have autonomy
1970s onward	Fiduciary capitalism	Institutional investors (pension funds, mutual funds) own major fractions; monitoring becomes important	Ownership concentrated in institutions acting as fiduciaries; monitoring as important as trading

• Why the shift to fiduciary capitalism: Institutional investors' size restricts liquidity, so they rely on active monitoring (often by smaller activist investors) rather than just selling shares.

📜 The 1980s: takeovers and restructuring

• Problems surfaced: Exorbitant executive pay, disappointing earnings, ill-considered acquisitions (empire building) that depressed shareholder value.
• Takeover boom: Wealthy activist shareholders sought to capture underutilized assets.
  • Terms like "leveraged buyout," "dawn raids," "poison pills," "junk bonds" became household words.
  • Corporate raiders: Carl Icahn, Irwin Jacobs, T. Boone Pickens.
• Managerial response: Legal maneuvers, political/popular support against raiders; made hostile takeovers more costly.
• Result: Junk-bond-financed, highly leveraged hostile takeovers faded.
• Lasting impact:
  • Emergence of institutional investors who knew the value of ownership rights and were big enough to make a difference.
  • Boards increased use of stock option plans, allowing managers to share in restructuring value.
  • Shareholder value became an ally rather than a threat.
• Note: Hostile takeovers made a dramatic comeback after the 2001–2002 recession (2001 value: $94 billion, more than double 2000).

💥 The 2001 meltdown

💥 What happened

• 2001: Year of corporate scandals—Enron, WorldCom, Tyco (U.S.); Vivendi (France), Ahold (Netherlands), Parmalat (Italy), ABB (Swiss-Swedish).
• Common patterns:
  • Deliberately inflating financial results (overstating revenues, understating costs).
  • Diverting company funds to managers' private pockets.
• Enron:
  • Named "America's Most Innovative Company" by Fortune for 6 straight years (1996–2001).
  • Created off-balance-sheet partnerships to hide deteriorating finances and enrich executives.
  • Collapsed December 2001; one of the largest U.S. bankruptcies.
  • Executives escaped with millions; employees lost jobs and retirement savings invested in Enron stock.
  • Shook global investor confidence in American governance.
• WorldCom:
  • June 2002: Admitted falsely reporting $3.85 billion in expenses over 5 quarters to appear profitable (actually lost $1.2 billion).
  • March 2004: Full fraud detailed—$11 billion, mainly by artificially reducing expenses.
  • Laid off ~17,000 workers (>20% of workforce); stock fell from $64.50 (1999) to 9 cents (July 2002).
  • Filed for bankruptcy; emerged April 2004 as MCI Inc.; acquired by Verizon in 2005.

💥 Why controls failed

• Internal controls: Boards (especially audit committees) did not understand or detect financial activities.
• External gatekeepers: Auditors, credit rating agencies, stock analysts failed to warn the public until losses were obvious.
• Government role: Politicians received millions in campaign donations from Enron during energy industry deregulation, which enabled Enron's rise.

💥 Fundamental questions raised

1. What motivated executives to engage in fraud and earnings mismanagement?
2. Why did boards condone or fail to recognize and stop managerial misconduct?
3. Why did external gatekeepers (auditors, rating agencies, analysts) fail to uncover fraud and alert investors?
4. Why were shareholders (especially large institutional investors) not more vigilant?
5. What does this say about money managers' motivations and incentives?

💥 Regulatory response

• Stock exchanges: Adopted new standards to strengthen corporate governance for listed companies.
• Sarbanes-Oxley Act of 2002: Imposed significant new disclosure and governance requirements; substantially increased liability for public companies, executives, and directors.
• SEC: Adopted a number of significant reforms.
• Goal: Make boards more responsive, proactive, and accountable; restore public confidence in business institutions.

💥 The 2008 financial crisis

💥 A new crisis emerges

• Just as investor confidence was (somewhat) restored, a new crisis—possibly more damaging and global in scale—emerged.
• Economic indicators: Rising inflation and unemployment, falling house prices, record bank losses, ballooning federal deficit ($10 trillion national debt), millions losing homes, bank and financial institution failures.
• Executive compensation: Freddie Mac chairman earned $14.5 million in 2007; Fannie Mae CEO earned $14.2 million—while taxpayers were asked to pick up the tab.
• Investor impact: 401(k) plans shrank by 40% or more.

💥 Questions being asked

• How did we get into this mess?
• Why should we support Wall Street?
• Where was the government?
• What has happened to accountability?
• Did we rely too much on free markets or not enough?
• Did special interests shape public policy?
• Did greed rule once again?
• Where were the boards of Bear Stearns, Lehman Brothers, and AIG?
• Were regulators asleep at the wheel? Incompetent?

💥 Looking ahead

• Certainty: Another wave of regulatory reform—possibly global in reach—is around the corner.
• Recurring questions: What will be the impact on investor confidence? On corporate behavior? On boards of directors? On society?
• Don't confuse: While not (yet) labeled a "corporate governance" crisis, the 2008 financial crisis once again raises questions about the efficacy of economic and financial systems, board oversight, and executive behavior.

🧭 Overview

🧠 One-sentence thesis

The effectiveness of corporate governance is fundamentally hampered by the lack of consensus—in law, among directors, and in society—about whether corporations exist primarily to maximize shareholder value or to balance the interests of all stakeholders.

📌 Key points (3–5)

• The legal debate is unresolved: U.S. law gives conflicting signals about whether directors owe primary duty to shareholders or must balance all stakeholder interests, leaving boards without clear guidance.
• Historical pendulum swings: Corporate purpose has oscillated between shareholder-focused (profit maximization) and stakeholder-focused (broader social responsibility) views over the past century.
• Directors are divided and confused: Research shows most directors fall into three camps (traditionalists, rationalizers, broad constructionists) with fundamentally different beliefs about accountability, yet many boards avoid discussing these differences openly.
• Common confusion—shareholder value vs. firm value: Shareholder value maximization is not the same as maximizing total firm value (which includes creditors and other claimants); decisions can transfer value from debt holders to shareholders while reducing overall social value.
• Practical consequences: Without a shared understanding of corporate purpose, boards struggle to reach consensus on CEO qualifications, outsourcing, executive compensation, and other strategic decisions.

⚖️ The ownership debate: shareholders vs. stakeholders

⚖️ Do shareholders "own" the corporation?

The excerpt presents two opposing legal views:

Bebchuk's shareholder-primacy view:

• Directors owe their primary fiduciary duty to shareholders.
• Delaware courts have stated "the shareholder franchise is the ideological underpinning upon which the legitimacy of directorial power rests."
• Since directors are expected to serve as shareholders' guardians, shareholders must have the power to replace them.
• In practice, U.S. directors are rarely challenged or removed, making shareholder power "largely a myth."
• Bebchuk proposes secret-ballot director elections open to rival candidates nominated by shareholders, with challengers reimbursed if they receive a threshold number of votes.

Lipton's stakeholder view:

• Shareholders do not "own" corporations; they own securities (shares of stock) that entitle them to limited electoral rights and financial returns.
• Directors are not merely shareholder representatives; their role is to seek what is best for the company itself.
• This means balancing the interests of shareholders and other stakeholders: management, employees, creditors, regulators, suppliers, and consumers.
• The notion that a board's primary fiduciary obligation is to shareholders is "a myth of corporate law."

Don't confuse: Legal ownership of shares with ownership of the corporation as an entity; shareholders own securities with specific rights, not the company itself.

⚖️ U.S. governance law: conduct vs. accountability

Duty of Care: requires directors to be informed, prior to making a business decision, of all material information reasonably available to them in the exercise of their management of the affairs of a corporation.

Duty of Loyalty: protects the corporation and its shareholders; it requires directors to act in good faith and in the best interests of the corporation and its shareholders. The director must be "disinterested" (not appearing on both sides of a transaction, not expecting personal financial benefit) and decisions must be "based on the corporate merits of the subject before the board rather than extraneous considerations or influences."

Business Judgment Rule: protects directors from liability for action taken by them if they act on an informed basis in good faith and in a manner they reasonably believe to be in the best interests of the corporation's shareholders. Does not apply in cases of fraud, bad faith, or self-dealing.

Key limitation: None of these principles provide clear guidance to the central question of who owns the corporation or to whom directors are primarily accountable.

Why this matters: U.S. governance law evolved as a "medley" of federal law, state law, and self-regulating codes (NYSE, accounting industry), creating openings for different interpretations. The law identifies shareholders as "owners" and "investors" but does not meaningfully address how director elections should be implemented or how to resolve conflicts between shareholder and stakeholder interests.

🌍 Two philosophies of corporate purpose

🌍 Shareholder capitalism

Shareholder capitalism: holds that a company is the private property of its owners; the Anglo-American corporation is essentially a capital market institution, primarily accountable to shareholders, charged with creating wealth by exploiting market opportunities.

• Prevalent mainly in the United States and the United Kingdom.
• The corporation's primary goal is to maximize shareholder value.
• Other stakeholder interests are secondary or instrumental to shareholder wealth.

🌍 Stakeholder capitalism

Stakeholder capitalism: embodies a more organic view of the corporation in which companies have broader obligations that balance the interests of shareholders with those of other stakeholders, notably employees but also including suppliers, distributors, customers, and the community at large.

• The corporation is seen as an institution with a continuing purpose and a life of its own.
• Shareholders and wealth creation for owners do not dictate priorities.
• Deep concern for employees, suppliers, and customers defines the corporate mission.

Concrete examples from the excerpt:

Country/Region	Stakeholder mechanism	Details
Germany	Codetermination	Employees and shareholders hold equal seats on supervisory boards in large companies
Denmark	Employee board seats	Firms with >35 workers elect 1/3 of board (minimum 2)
Sweden	Employee board seats	Companies with >25 employees must have 2 labor representatives
France	Employee representatives	Firms with >50 workers have employee reps at board meetings (no vote); privatized firms may have voting reps
EU-wide	Works councils	Corporations with ≥1,000 employees (≥150 in at least 2 EU countries) must have a European Works Council with say in layoffs, plant closures
Japan	Managerial priorities	Only 3% of Japanese managers say companies should maintain dividends in tough times (vs. 89% in U.S./UK); keeping employees on the job is much more important

Don't confuse: Stakeholder capitalism with ignoring shareholders; stakeholder models still consider shareholder interests but do not grant them automatic primacy.

🌍 The Friedman-Mackey debate

The excerpt reprints portions of a debate in Reason magazine between Milton Friedman and John Mackey (Whole Foods CEO):

Friedman's position:

• "There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game."
• Businessmen who claim business has a "social conscience" are "preaching pure and unadulterated socialism" and are "unwitting puppets of the intellectual forces that have been undermining the basis of a free society."
• Maximizing profits is a means from the social point of view; a system based on private property and free markets enables people to cooperate without compulsion and ensures resources are used for their most valued use.

Mackey's position:

• The enlightened corporation should try to create value for all of its constituencies.
• Each stakeholder group (investors, customers, employees, suppliers, community) will define the purpose of the business in terms of its own needs, and each perspective is valid and legitimate.
• "We have not achieved our tremendous increase in shareholder value by making shareholder value the primary purpose of our business."
• The most successful businesses put the customer first; in a customer-centered business, customer happiness is an end in itself, pursued with greater interest, passion, and empathy.
• "Making high profits is the means to the end of fulfilling Whole Foods' core business mission" (improving health and well-being through higher-quality foods); high profits are necessary to fuel growth, but "most people don't live to eat, and neither must a business live just to make profits."

Peter Drucker's synthesis (quoted in the excerpt):

• "The purpose of a business is not to make a profit. Profit is a necessity and a social responsibility" (to cover risks, produce capital for future jobs, pay for society's non-economic needs).
• "But profit is not the purpose of business. Rather a business exists and gets paid for its economic contribution. Its purpose is to create a customer."

📜 Historical swings in U.S. corporate law

📜 Early 19th century: corporation as social instrument

• Each incorporation required a special act of the state legislature.
• The corporation was viewed as a social instrument for the state to carry out public policy goals.
• Law protected stakeholders by ensuring corporations would not pursue activities beyond their original charter.

📜 Late 19th century: shift to shareholder primacy

• States began to allow general incorporation, fueling explosive growth in companies for private business purposes.
• Concern for stakeholder welfare gave way to managing the corporation for shareholders' profits.

📜 1919: Dodge vs. Ford Motor Company

• Henry Ford wanted to invest retained earnings in the company rather than distribute to shareholders, intending to benefit employees and consumers.
• The Dodge brothers (minority shareholders) sued, alleging Ford's intention was at the expense of shareholders.
• Michigan Supreme Court ruling affirmed shareholder value maximization:

  "A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the non-distribution of profits among stockholders in order to devote them to other purposes."

📜 1932: Berle and Means warn of separation of ownership and control

• The Modern Corporation and Private Property called attention to a new phenomenon: ownership of capital had become widely dispersed among many small shareholders, yet control was concentrated in the hands of just a few managers.
• They warned this separation would destroy the foundation of the existing economic order.
• They argued managing on behalf of shareholders was the sine qua non of managerial decision making because shareholders were property owners.

📜 Post-1929 crash: stakeholder concerns resurface

• Following the stock market crash and Great Depression, stakeholder concerns were voiced again.
• If the corporation is an entity separate from its shareholders, it has citizenship responsibilities.
• Management's role is that of a trustee with citizenship responsibilities on behalf of all constituencies, even if it means a reduction in shareholder value.
• States adopted stakeholder statutes reflecting corporate responsibility toward labor, consumers, and the natural environment.

📜 Late 20th century: return to shareholder primacy

• American-style market-driven capitalism prevailed; the pendulum swung back to the shareholder.
• Friedman's view that "the sole social responsibility of business is to increase profits" energized pushback on corporate social responsibility.
• Agency theory and the concept of the corporation as a nexus of contracts became influential in finance and economics.
• 30 states enacted stakeholder statutes allowing directors to consider interests of nonshareholder constituencies, giving boards latitude in determining what is in the best long-term interests of the corporation.
• Nevertheless, the mainstream of U.S. corporate law remains committed to shareholder wealth maximization.

Don't confuse: The existence of state stakeholder statutes with a clear legal mandate; these statutes allow directors to consider other stakeholders but do not require it, leaving the primary question unresolved.

🧩 Directors' confusion: three groups

Lorsch (1989) identified confusion among directors about their accountabilities and categorized them into three groups:

🧩 Traditionalists

• See themselves as accountable to shareholders only.
• No need to debate the fundamental purpose of the corporation—it is and always has been maximization of shareholder value.
• Do not believe there is a conflict between putting shareholders first and responding to other constituencies' needs.
• Experience little role ambiguity or conflict.
• Find support in a narrow interpretation of current state and federal law.
• View abuses at Enron, WorldCom, Vivendi as anomalies made possible by imperfections in the system, not systemic problems.

🧩 Rationalizers (the largest group)

• Experience more anxiety about their role.
• Recognize that real tensions can occur between the interests of different constituencies in today's complex, global economy.
• Not all decisions can be reduced to "What is good for the shareholder is good for everyone else."
• Examples of tension: whether to close a domestic plant in favor of foreign manufacturing; whether to outsource production; how to respond to pressures for "greener" operations.
• Nevertheless, feel constrained by the law (primarily Delaware law) and behave accordingly.

🧩 Broad constructionists

• Recognize specific responsibilities to constituencies other than shareholders and are willing to act on their convictions.
• Constantly struggle to balance their views with the traditional view of director accountabilities.
• To stay within the boundaries of the law, frame their decisions in terms of what is in the best long-term interest of the corporation as a whole.

Lorsch's summary:

"Thus we found the majority of directors felt trapped in a dilemma between their traditional legal responsibility to shareholders, whom they consider too interested in short-term payout, and their beliefs about what is best, in the long run, for the health of the company."

Critical observation: In many boards, a group norm has evolved prohibiting open discussion of a board's true purpose. Many directors are unaware of recent legal rulings that grant them latitude to consider constituencies other than shareholders.

Why this matters: Real (economic and psychological) ownership of the corporation is moving from shareholders to employees, customers, and other stakeholders that make up the human capital of the firm. Boards must think about and discuss among themselves the constituencies and time horizons they have in mind as they think about the board's responsibilities. Many boards have skirted discussion of these complex issues because they seem too abstract and reaching consensus takes too much time.

🔍 Three challenges to shareholder value maximization

The excerpt presents three important assumptions underlying shareholder value maximization, all of which can be challenged:

🔍 Challenge 1: Is shareholder value the best measure of wealth creation?

The assumption: Shareholder value is the best measure of wealth creation for the firm.

The challenge: "Firm value" (which includes the values to all other financial claimants—creditors, debt holders, preferred shareholders) is a better indicator of wealth.

Why it matters: Managers and boards can make decisions that transfer value from debt holders to shareholders and decrease total firm and social value while increasing shareholder value.

Example: A decision that benefits shareholders at the expense of creditors might increase shareholder value but reduce the total value of the firm.

🔍 Challenge 2: Does shareholder value maximization produce the greatest competitiveness?

The assumption: Shareholder value maximization produces the greatest long-term competitiveness.

The challenge: An increasingly influential group of critics (including many CEOs) thinks product-market rather than capital-market objectives should guide corporate decision making.

Their concerns:

• Companies that adopt shareholder value maximization as their primary purpose lose sight of producing or delivering a product or service as their central mission.
• Shareholder value maximization creates a gap between the mission of the corporation and the motivations, desires, and capabilities of employees who only have direct control over real, current, corporate performance.
• Shareholder value maximization is simply not inspiring for employees, even though they often share in gains through benefit, bonus, or option plans.
• To many employees, shareholders are nameless and faceless, under no obligation to hold their shares for any length of time, never satisfied, always asking "What will you do for me next?"
• It may encourage employees to view maximizing one's financial well-being as a legitimate or even the only goal.

What critics want instead: Companies should create a moral purpose that provides a clear focus on creating competitive advantage and unites purpose, strategy, goals, and shared values into one coherent management framework that has the power to motivate constituents and legitimize the corporation's actions in society.

🔍 Challenge 3: Does shareholder value maximization fairly serve other stakeholders?

The assumption: Shareholder value maximization is congruent with fairly serving the interests of the firm's other stakeholders.

Proponents' view (Jensen, McTaggart et al.):

• If the objective is to maximize the efficiency with which society utilizes its resources, then the proper and unique objective for each company is to maximize the long-run total value of the firm.
• Firm value will not be maximized with unhappy customers and employees or poor products; therefore, value-maximizing firms will be concerned about relations with all their constituencies.
• "A firm cannot maximize value if it ignores the interest of its stakeholders."
• As long as management invests in higher levels of customer satisfaction that enable shareholders to earn an adequate return, there is no conflict; if there is insufficient financial benefit to shareholders, the conflict should be resolved for the benefit of shareholders.

Stakeholder theorists' view:

• Shareholders are but one of a number of important stakeholder groups.
• Like customers, suppliers, employees, and local communities, shareholders have a stake in and are affected by the firm's success or failure.
• An exclusive focus on maximizing stockholder wealth is both unwise and ethically wrong.
• The firm and its managers have special obligations to ensure shareholders receive a "fair" return, but the firm also has special obligations to other stakeholders that go above and beyond those required by law.

Ian Davis (McKinsey) critique:

• In today's global business environment, shareholder value is rapidly losing relevance.
• In much of the world, government, labor, and other social forces have a greater impact on business than in the U.S. or other free-market Western societies.
• In China, for example, government is often an owner; "If you're talking in China about shareholder value, you will get blank looks. Maximization of shareholder value is in danger of becoming irrelevant."

CEO concerns about implementation:

• A growing number (including CEOs) worry that the stock market has a bias toward short-term results.
• Stock price, the most common gauge of shareholder wealth, does not reflect the true long-term value of a company.
• Example: Lucent Technologies CEO Henry Schacht stated, "What has happened to us is that our execution and processes have broken down under the white hot heat of driving for quarterly revenue growth."

❌ Why stakeholder theory faces practical problems

❌ The "no single criterion" problem

Freeman and McVea on stakeholder management: "The stakeholder framework does not rely on a single overriding management objective for all decisions. As such it provides no rival to the traditional aim of 'maximizing shareholder wealth.' To the contrary, a stakeholder approach rejects the very idea of maximizing a single-objective function as a useful way of thinking about management strategy. Rather, stakeholder management is a never ending task of balancing and integrating multiple relationships and multiple objectives."

The pragmatist's objection: Directors occasionally face situations in which it is impossible to advance the interests of one set of stakeholders and simultaneously protect those of others. Whose interests should they pursue when there is an irreconcilable conflict?

Example from the excerpt: The decision whether to close down an obsolete plant.

• Who is harmed: The plant's workers and the local community.
• Who benefits: Shareholders, creditors, employees working at a more modern plant (to which the work is transferred), and communities around the modern plant.
• The problem: Without a single guiding decision criterion, how should the board decide?

❌ The "managerial sin" problem

Bainbridge (1994) argues the stakeholder model is flawed because of its failure to account adequately for "managerial sin."

The mechanism: The absence of a single decision-making criterion allows management to freely pursue its own self-interest by playing shareholders off against nonshareholders.

• When management's interests coincide with those of shareholders, management can justify its decision by saying shareholder interests prevailed.
• When management's interests coincide with those of nonshareholders, management can justify its decision by saying other stakeholder interests prevailed.

Example from the excerpt: The plant closing decision.

• If management's compensation is tied to firm size, we can expect it to resist any downsizing. The plant will likely stay open, with the decision justified by the impact on the plant's workers and the local community.
• If management's compensation is linked to firm profitability, the plant will likely close, with the decision justified by management's concern for shareholders, creditors, and other constituencies that benefit from the closure.

❌ Are shareholders actually more vulnerable?

The excerpt argues shareholders may be more vulnerable to management misconduct than nonshareholder constituencies:

Shareholders' limited power:

• Legally, shareholders have essentially no power to initiate corporate action.
• Shareholders are entitled to vote on only very few corporate actions.
• Formal decision-making power resides mainly with the board of directors.
• Shareholders, like nonshareholder constituencies, have but a single mechanism to "negotiate" with management: withholding their inputs (capital).

Why withholding inputs may be less effective for shareholders:

• Some firms go for years without seeking equity investments; if management disregards shareholder interests, shareholders have no option other than to sell out at prices that reflect management's lack of concern for shareholder wealth.
• In contrast, few firms can survive for long without regular infusions of new employees and new debt financing; few management groups can prosper while ignoring nonshareholder interests.

Nonshareholders' political advantages:

• Nonshareholder constituencies often are more effective in protecting themselves through the political process.
• Shareholders (especially individuals) typically have no meaningful political voice.
• Many nonshareholder constituencies are represented by cohesive, politically powerful interest groups (e.g., unions played a major role in passing state antitakeover laws; environmental concerns are increasingly a factor in regulatory actions).

The conclusion: An explicit focus on balancing stakeholder interests is not only impractical but also unnecessary because nonshareholder constituencies already have adequate mechanisms to protect themselves from management misconduct.

🔄 Jensen's proposed synthesis: enlightened value maximization

🔄 The core idea

Enlightened value maximization: recognizes that communication with and motivation of an organization's managers, employees, and partners is extremely difficult. If we simply tell all participants that the organization's sole purpose is to maximize value, we will not get maximum value. Value maximization is not a vision or a strategy or even a purpose; it is the scorecard for the organization.

What this means in practice:

• People must be given enough structure to understand what maximizing value means so they can be guided by it and have a chance to achieve it.
• They must be turned on by the vision or strategy in the sense that it taps into some human desire or passion (e.g., a desire to build the world's best automobile or create a film that will move people for centuries).
• All this can be not only consistent with value seeking but a major contributor to it.

🔄 The principle of enlightened value maximization

"It is a basic principle of enlightened value maximization that we cannot maximize the long-term market value of an organization if we ignore or mistreat any important constituency. We cannot create value without good relations with customers, employees, financial backers, suppliers, regulators, and communities."

But: Having said that, we can use the value criterion for choosing among those competing interests. The word "competing" is key because no constituency can be given full satisfaction if the firm is to flourish and survive.

The claim: Using this value criterion will result in making society as well off as it can be (apart from the possibility of externalities and monopoly power).

🔄 Enlightened stakeholder theory

Jensen defines this as stakeholder theory with the specification that maximizing the firm's total long-term market value is the right objective function.

The importance of "long-term":

• Enlightened stakeholder theorists can see that although stockholders are not some special constituency that ranks above all others, long-term stock value is an important determinant (along with the value of debt and other instruments) of total long-term firm value.
• Value creation gives management a way to assess the tradeoffs that must be made among competing constituencies.
• It allows for principled decision making independent of the personal preferences of managers and directors.

🔄 The practical reality

Even though shareholder value maximization is increasingly challenged on pragmatic and moral grounds, its roots in private property law—a profound element in the American ethos—guarantee it will continue to dominate the U.S. approach to corporate law for the foreseeable future.

What the courts have done: Given boards increasing latitude in determining what is in the best long-term interests of the corporation and how to take the interests of other stakeholders into account.

What this latitude requires: Directors must openly and fully discuss these issues and agree on a clear, unambiguous statement of purpose for the corporation.

🧭 Overview

🧠 One-sentence thesis

The board of directors must balance three core functions—making decisions, monitoring corporate activity, and advising management—while maintaining governance independence from management and adapting its role to the company's specific circumstances and ownership structure.

📌 Key points (3–5)

• Three core board functions: decision-making (e.g., appointing CEO, approving financials), monitoring corporate activity, and advising management.
• Legal duties framework: directors owe a Duty of Care (diligent performance with reasonable inquiry), are protected by the Business Judgment Rule (no liability for good-faith mistakes), and must uphold a Duty of Loyalty (fiduciary duty to act in the corporation's best interests).
• Governance vs. management distinction: boards govern on behalf of shareholders/stakeholders; they must not intrude into day-to-day management territory despite pressure to become "more involved."
• Common confusion—board involvement: "more involved" does not mean micromanagement; effective governance requires arms-length oversight, not running the company.
• Context-dependent role: the board's precise role varies by company size, ownership structure (no controlling shareholder vs. owner-manager vs. controlling owner not in management), industry, and special circumstances (crises, takeovers).

⚖️ Legal framework and fiduciary duties

⚖️ What the law requires of directors

From a legal perspective, the board of a public corporation is charged with setting a corporation's policy and direction, electing and appointing officers and agents to act on behalf of the corporation, and acting on other major matters affecting the corporation.

• Directors must act in good faith: honestly and fairly, for the corporation's welfare, not personal benefit.
• They must form beliefs that are reasonably believed: subjective honesty plus objective rationality (understandable to others).
• They must focus on the best interests of the corporation: primary allegiance to the corporate entity.
• They must exercise care: pay attention, ask questions, read materials in advance, request expert advice when needed.
• Standards are calibrated to a person in a like position under similar circumstances: no special qualifications assumed; common sense and informed judgment expected; preparation and oversight vary by company and decision type.

🛡️ Duty of Care

The Duty of Care requires that a director's duties must be performed "with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances."

• This is the most important duty owed by a director.
• It is very broad and requires diligent performance of all obligations.
• Example: A director must read board materials before meetings, ask management questions until satisfied all significant information is available, and request legal or expert advice when a decision warrants it.

🧑‍⚖️ Business Judgment Rule

"A director who exercises reasonable diligence and who, in good faith, makes an honest, unbiased decision will not be held liable for mere mistakes and errors in business judgment."

• Works in conjunction with the Duty of Care.
• Protects directors from liability for decisions that turn out badly, as long as they acted diligently and in good faith.
• Don't confuse: this rule does not excuse negligence; it only shields directors who meet the care standard but whose decisions produce poor outcomes.

🤝 Duty of Loyalty

The Duty of Loyalty exists as a result of the fiduciary relationship between directors and the corporation—a relationship of trust and confidence.

• Directors must not take selfish advantage of the corporation's trust.
• They must give the corporation the first opportunity to take advantage of any business opportunities within the corporation's scope that they become aware of.
• Only if the board declines the opportunity may the director pursue it personally without violating this duty.
• Liability can arise when directors cause financial harm, act solely for their own benefit to the corporation's detriment, or commit crimes/wrongful acts.
• Indemnification and insurance: corporations can reimburse directors for defense expenses and purchase insurance to cover matters that cannot be indemnified or when the corporation lacks resources.

🎯 Board responsibilities from a governance perspective

🎯 The Business Roundtable's eight responsibilities

The excerpt cites the Business Roundtable's description of board duties:

1. Select and oversee the CEO: paramount duty to choose the CEO and oversee the CEO and senior management in competent, ethical operation.
2. Management's duty to produce value ethically: management must operate effectively and ethically; CEO and board set a "tone at the top" culture of legal compliance and integrity; no personal interests ahead of the corporation's.
3. Financial statements and disclosure: management, under audit committee and board oversight, must produce fairly presented financial statements and timely disclosures for investors.
4. Engage independent auditor: the board, through its audit committee, engages an independent accounting firm to audit financials and oversee the relationship with the auditor.
5. Shape corporate governance: the board, through its governance committee, leads in shaping governance policies and recommends qualified director candidates for shareholder election.
6. Compensation oversight: the board, through its compensation committee, adopts compensation policies, sets performance goals, and determines CEO and senior management pay.
7. Respond to shareholders: the board must respond appropriately to shareholder concerns.
8. Fair treatment of stakeholders: the corporation must deal fairly and equitably with employees, customers, suppliers, and other constituencies.

🎯 Milstein, Gregory, and Grapsas's six duties

The excerpt also cites a broader perspective:

1. Take charge of focus, agenda, and information flow: enables the board to provide meaningful guidance, determine its own agenda, and obtain information for objective judgments.
2. Ensure management performs with integrity: selecting, monitoring, compensating, and (when necessary) replacing management remain at the heart of board activity.
3. Set tone and culture: standards of ethics and business conduct impact the bottom line; "tone at the top" should be a priority, not just a compliance matter.
4. Formulate strategy with management: agree on strategic course through iterative process, determine success benchmarks, and regularly monitor performance against objectives.
5. Ensure alignment: corporate culture, strategy, management incentives, audit/accounting, internal controls, and disclosure must be consistent and aligned.
6. Help management understand expectations: boards help management recognize shareholder and regulator expectations (e.g., meaningful input into board selection, concerns about excessive compensation).

🧩 Three broad categories of board work

• Make decisions: e.g., appointing CEO, approving financials (often framed by law and bylaws).
• Monitor corporate activity: oversight of management and operations.
• Advise management: provide counsel and guidance.

The key challenge: deciding when board oversight must become active intervention (e.g., when to remove a CEO, when to veto a major capital decision). Lists cannot capture this complexity because the answer depends on specific governance scenarios.

🏢 How company context shapes the board's role

🏢 Company size and type

• Small, private, or closely held companies: directors often serve as key advisers in strategic planning, raising and allocating capital, human resources planning, and sometimes performance appraisal.
• Large public corporations: directors focus more on oversight than planning, on capital allocation and control rather than raising capital, and on management development and succession rather than broader HR responsibilities.

🏢 Ownership structure: three scenarios

The excerpt (citing Buffett) describes three public corporation governance situations:

Ownership structure	Board role	Director action if dissatisfied
No controlling shareholder (most common)	Directors act as if serving a single absentee owner's long-term interests; primary responsibility is to appoint and, if necessary, change management.	Attempt to persuade other directors; if unsuccessful, make views known to absentee owners (shareholders); if still no change on serious issues, consider resigning.
Controlling owner is also the manager (e.g., Google with dual-class stock)	Board does not act as agent between owners and management; directors cannot effect change except through persuasion.	Object; if no change and the matter is sufficiently serious, outside directors should resign (signals doubts about management).
Controlling owner not involved in management (e.g., Hershey Foods, Dow Jones)	Outside directors can go directly to the owner (who may be on the board) with concerns; potentially value-creating position.	Make the case to the single, presumably interested owner who can immediately make a change; if still unsatisfied on a critical matter, resign.

🏢 Industry, competitive situation, and special circumstances

• Global vs. domestic: global corporations face different challenges.
• Regulated vs. technology/service industries: issues differ by sector.
• High growth vs. mature: different demands on boards.
• Turbulence or rapid change: boards often play a more active, strategic role.
• Special events: takeovers, mergers, acquisitions, crises (defective products, hostile takeovers, executive misconduct, natural disasters) threaten stock price and sometimes the company's existence; directors' fiduciary duties are clearly on view in crises.

Example: In 2008, JP Morgan acquired Bear Stearns for $240 million (a steep discount from ~$3.5 billion the week before) to prevent collapse during the mortgage crisis; in 2002, Martha Stewart Omnimedia's stock fell 40% in 3 weeks after insider trading allegations; in 1993, Jack in the Box's share price plummeted from $14 to ~$3 in hours after E. coli contamination allegations.

🚧 Governance vs. management: the critical distinction

🚧 The danger of micromanagement

• Recent reforms and shareholder activism push boards toward "more involvement," but this risks intrusion into management's territory.
• The differences that separate governance from management are still not sufficiently well understood by directors, executives, regulators, and the press.
• The most obvious (and dangerous) opportunity for boards to expand involvement is to intrude into management's domain.

🚧 How boards add value—and to whom

Governance is an extension of ownership, not of operations. Directors must be more allied with shareholders than with managers.

• The potential of directors to add value is often framed in terms of advising management (strategy, markets, etc.), but this obscures the primary role: to govern, which means adding value to shareholders and other stakeholders.
• Directors' mentality, language, concerns, skills, and interactions should be subsets of ownership, not management.
• Don't confuse: governance is not "übermanagement"—not focusing on management methods, strategies, and planning.

🚧 Arms-length relationship and the trust-verification balance

• Recent reforms (e.g., Sarbanes-Oxley) create greater independence and minimize managerial excess while enhancing accountability, leading to greater tension between management and the board.
• Sarbanes-Oxley Section 404 requires management at all levels to "sign off" on key financial statements, effectively asking boards to substitute verification for trust.
• Trust and verification are not incompatible; we need both. Effective governance is about striking a reasonable accommodation between them, not elevating one over the other.
• Adversarial relationships can create pathologies of miscommunication and mismanaged expectations regarding risk and reward.

🚧 The trade-offs in effective governance

• Is better governance defined primarily by active prevention of abuse? Or by active promotion of risk taking and profitability?
• The quick answer is "all of those things," but history shows it is hard to do even one consistently well.
• A board trying to do all of these things well is not merely active; it is actively running the company—that is management, not overseeing or holding management accountable.
• The reform agenda risks dissolving most critical distinctions between the CEO and the board.

📋 Governance guidelines and best practices

📋 NYSE requirements for governance policies

The NYSE requires companies to adopt and publicly disclose corporate governance policies addressing:

1. Director qualification standards: independence requirements, substantive qualifications, policies on number of boards a director may serve, director tenure, retirement, and succession.
2. Director responsibilities: clearly articulate basic duties, attendance expectations, and advance review of meeting materials.
3. Director access to management and independent advisors: define protocols for director access to corporate managers and identify situations when the board should retain external advisors.
4. Director compensation: general principles for determining form and amount of compensation and for reviewing those principles.
5. Director orientation and continuing education: responsibility of the governance committee (or full board/nominating committee if no separate governance committee).
6. Management succession: policies and principles for CEO selection, performance review, and succession in emergencies or retirement.
7. Annual performance evaluation of the board: self-evaluation at least annually to determine whether the board, its committees, and individual directors are functioning effectively.

📋 Purpose of governance guidelines

• By elaborating on the board's and directors' basic duties, carefully constructed guidelines help both the board and individual directors understand their obligations and the general boundaries within which they operate.
• Best practice: the board should review the guidelines at least annually.

📊 Recent board trends

📊 Board size

• Smaller boards have advantages: easier to convene, require less effort to lead, often have a more relaxed, informal culture; research supports that smaller groups are typically more effective.
• But size should be governed by skills needed: larger corporations with complex structures, global interests, or multibusiness operations require larger boards than smaller, domestic, single-business firms.
• Current average: Standard & Poor's 500 boards average 11 directors (down from ~18 about 25 years ago).
• Unlikely to shrink further: new rules require audit, nominating/governance, and compensation committees to be composed of independent directors only, some with specialized expertise (audit committee).

📊 Board membership shifts

• Fewer CEOs accepting directorships for two reasons:
  1. Many boards now insist CEOs concentrate fully on their job and restrict or prohibit outside board service.
  2. Boards look for directors with specialized functional expertise (sales/marketing, global operations, manufacturing) rather than just CEO experience.
• Growing demand for CFOs and finance experts in the aftermath of Sarbanes-Oxley.
• Talent pool has become larger: boards are changing the definition of "qualified candidate" and widening their search—tapping division presidents and other executives with large-operation experience or specialist expertise, not just CEOs.
• Expanded diversity candidate pool: redefinition includes those who may not have risen to CEO but excel in critical functional areas.
• Candidates are more reluctant: perform extensive due diligence, look to mitigate personal liability risk, are critical about their ability to add value in complex organizations.
• Overwhelming reason for declining: lack of time; many feel unable to devote adequate attention given their existing responsibilities.

📊 Director independence

Director independence: the absence of any conflicts of interest through personal or professional ties with the corporation or its management.

• Regulatory consensus: Sarbanes-Oxley, NYSE, NASDAQ listing rules (affirmed by SEC) are premised on the belief that director independence is essential to effective corporate governance.
• Current practice: about 10 out of 12 directors of a major U.S. public company board are nonexecutives; in the UK, a little less than half.
• Intuitive appeal: independence suggests objectivity, impartiality, decisiveness, and therefore a stronger fiduciary.
• Practical benefits: easier to discuss issues involving senior executives without them present; stops destructive practices like "rewarding" former CEOs with board seats (which limits the new CEO's ability to develop their own board relationship).
• Limited evidence: outsider-dominated boards are more proactive in firing underperforming CEOs, less willing to approve outsized compensation or poison pills.

📊 Limitations of independence as a proxy for good governance

• Independent directors are less knowledgeable about the company's business than executive directors or senior managers.
• CEOs value directors with industry experience, counter to current independence tests.
• Higher proportion of outside directors makes it harder to foster high-quality, deep board deliberations.
• Less likely a CEO can mislead the board when some directors are insiders with intimate knowledge of the company.
• Boards with mostly independent directors must create regular opportunities to interact with senior executives other than the CEO; the more complex the business, the more important such communications are.
• Bottom line: Effective governance does not depend on independence of some particular subset of directors but on the independent behavior of the board as a whole. Focus should be on fostering board independence as a behavioral norm, a psychological quality, not quasi-legal definitions. Director independence can contribute to but is no guarantee for better governance.

👔 Board leadership: Chairman and CEO roles

👔 The debate: separate or combined?

• UK practice: ~95% of FTSE 350 companies have different people in each role.
• US practice: most companies still combine them, but momentum is growing for separation; roughly one third of U.S. companies have adopted split-leadership (up from historical ~one fifth).
• Recent examples of U.S. companies splitting roles: Boeing, Dell, Walt Disney, MCI, Oracle, Tenet Healthcare.

👔 Four arguments for splitting the roles

(Emanating chiefly from UK, Germany, Netherlands, South Africa, Australia, Canada)

1. Key component of board independence: The CEO runs the company; the chairman runs the board, one of whose responsibilities is to monitor the CEO. If they are the same person, it is hard for the board to criticize the CEO or express independent opinions. A separate chairman, responsible for setting the board's agenda, is more likely to probe and encourage debate. Separation is essentially a check on the CEO's power.

2. Nonexecutive chairman as sounding board, mentor, advocate: CEOs face enough challenges without having to run the board. A relationship with the chairman based on mutual trust and regular contact is good for the CEO, shareholders, and the company. Essential: clearly define the two roles from the outset to avoid territorial disputes or misunderstandings.

3. Ideally placed to assess CEO performance: A nonexecutive chairman can take into account fellow directors' views, help maintain a longer term perspective, reduce risk of CEO focusing too much on shorter term goals (especially when powerful incentives exist), play a helpful role in succession planning, and reduce trauma when a CEO departs (voluntary or otherwise) by providing continuity.

4. Time needed to do both jobs well: As companies grow more complex, a strong board requires a skilled chairman not distracted by daily business, able to devote required time and energy (one or more days per week) to tasks like maintaining contact with directors between meetings, organizing board evaluations, listening to shareholder concerns, acting as ambassador, liaising with regulators—allowing the CEO to concentrate on running the business.

👔 Arguments against splitting the roles

• Why change a system that has worked well? Moral and ethical failures are part of the human condition; no rules can guarantee honesty. Wrongdoing at a small number of S&P 500 companies is not a compelling reason for sweeping change.
• Temporary split may be desirable in specific situations (company crisis, new CEO lacking governance/boardroom experience), but such instances are infrequent and temporary, not justifying sweeping change.
• Combined model has served the U.S. economy well; splitting roles might set up two power centers, impairing decision making.
• Finding the right chairman is difficult; what works in the UK does not necessarily work in the US (UK executives retire earlier and view nonexecutive chairman role as pinnacle of career; US normal retirement age is higher).

👔 The "lead director" alternative

• Proposed to allay concerns that combined leadership compromises board independence.
• A lead director is a nonexecutive who acts as a link between the chairman–CEO and outside directors, consults on board meeting agendas, and performs other independence-enhancing functions.
• About 30% of largest U.S. companies have taken this approach.
• Defenders claim that—combined with other measures (majority of independent directors, board meetings without management)—this obviates the need for a separate chairman.

👔 The case for separation

• On balance, arguments for separation are persuasive: separation gives boards a structural basis for acting independently.
• Reducing CEO power may not be bad: compared with other leading Western economies, the U.S. concentrates corporate authority in a single person to an unusual extent.
• Clarifies accountability: separation makes clear that the board's principal function is to govern (oversee management, protect shareholders' interests), while the CEO's function is to manage the company well.
• Not a guarantee: separation is no guarantee for board effectiveness. Some companies with separate chairman and CEO have failed miserably in oversight. A structurally independent board will not necessarily exercise that independence.
• Must be complemented by: the right boardroom culture and a sound process for selecting the chairman.
• Challenge of finding the right chairman: must have experience, personality, leadership skills to mesh with board and management, show the board is not a rubber stamp, have enough time, strong interpersonal skills, working knowledge of the industry, willingness to play a behind-the-scenes role. Best candidate is often an independent director who has served on the board for several years.

🗂️ Board committees and director compensation

🗂️ Value of committees

• Key change in board functioning over the last 50 years: greater and more effective use of committees.
• Advantages: permit the board to divide work among directors; allow board members to develop specialized knowledge about specific issues.
• Required by NYSE, NASDAQ, SEC: public company boards must have independent audit, nominating (and governance), and compensation committees.
• Growing trend: creating committees to communicate with and stay abreast of external stakeholder concerns (names include public responsibility, corporate social responsibility, stakeholder relations, or external affairs committees).

🗂️ The Audit Committee

Charged with assisting the board in its oversight of (a) the integrity of the company's financial statements and internal controls; (b) compliance with legal and regulatory requirements, as well as the company's ethical standards and policies; (c) the qualifications and independence of the company's independent auditor and the performance of the company's internal audit function and its independent auditors; and (d) preparing the audit committee report for inclusion in the company's annual proxy statement.

• Composition: no fewer than three members, all meeting NYSE and SEC rule 10A-3 independence and experience requirements.
• Qualifications: each member must be financially "literate"; at least one member must have accounting or related financial management expertise (the "audit committee financial expert").
• Appointment: members, including chair, usually appointed by the board on recommendation of the nominating and governance committee.

🗂️ The Nominating (and Governance) Committee

• Multifaceted responsibilities: recommending new board candidates; determining eligibility of proposed candidates; reviewing the company's governance principles and practices; establishing and overseeing board self-assessment; recommending director compensation; implementing CEO succession planning.
• Composition: normally three or more independent directors.
• Appointment: members and chair usually appointed by the board on recommendation of the chairman of the board.

🗂️ The Compensation Committee

• Duties: related to human resources policies and procedures, employee benefit plans, and compensation; preparing a report on executive compensation for inclusion in the annual proxy statement.
• Composition: typically three or more independent members.
• Appointment: members normally appointed by the board on recommendation of the chairman of the board with concurrence of the nominating (and governance) committee.

🗂️ Other board committees

• Ad hoc committees: address specific issues (e.g., strategy committee for growth options, finance committee for recapitalization recommendations). Should have clear sunset clauses to prevent institutionalization or balkanization of the board on important issues.
• Stakeholder-focused committees: growing number of boards create committees to communicate with and stay abreast of external stakeholder concerns (corporate social responsibility, stakeholder relations, external affairs, public responsibilities). Example: GE's public responsibilities committee reviews and oversees the company's positions on corporate social responsibilities and public issues affecting investors and other key stakeholders.
• Executive committee: usually consisting of chair, CEO, other designated officers, and key directors (e.g., chairs of standing committees). In theory, has power to act for the full board in emergencies or when no time for full board to meet, but this is fraught with danger. Advances in communication technology have made executive committees increasingly redundant; their use has all but disappeared.

🗂️ Director compensation

• Who sets it: typically the nominating committee, not the compensation committee.
• Justification: (1) provides separation of director and executive compensation decisions; (2) allows nominating committee to integrate compensation with board-building strategies.
• Context: the director job has become significantly more challenging (stronger qualifications, more time, personal financial risk); the pool of available independent directors has shrunk, pushing up director pay.
• Structure: directors typically paid with a mix of cash and equity, with equity representing about half of total direct compensation.
• Nonemployee chair and lead-director pay: generally structured like other directors (retainer, meeting fees, equity).
• Employee, non-CEO chairs: typically paid like an employee (salary, incentives, benefits).
• Committee chair premiums: a majority of companies pay a premium to committee chairs—especially audit and compensation committee chairs—reflecting increased time commitment and additional responsibility.
• Equity component trend: companies have reduced reliance on stock options and increased use of full-value awards.

🧭 Overview

🧠 One-sentence thesis

The wave of U.S. corporate governance reforms following early-2000s scandals—centered on director independence, audit oversight, and executive compensation—addressed structural weaknesses but left unresolved whether ethical behavior and long-term value creation can truly be legislated into being.

📌 Key points (3–5)

• What triggered the reforms: governance scandals around the turn of the century prompted Congress (Sarbanes-Oxley Act of 2002), stock exchanges (NYSE, NASDAQ, AMEX), and the SEC to impose sweeping disclosure, independence, and accountability requirements.
• Core structural changes: mandatory director independence, reformed audit/compensation/nominating committees composed of independent directors, and new rules on equity compensation, ethics codes, and financial statement certification.
• Rationale behind independence: shareholders cannot directly monitor management, so boards must act as monitors—but management-controlled or affiliated boards lose monitoring potential, creating conflicts of interest.
• Common confusion—structure vs. culture: Enron already met many "independence" requirements on paper yet still failed; structural reforms alone cannot guarantee ethical behavior or change boardroom culture.
• Ongoing debate: critics argue reforms are too narrow (focused only on shareholders), too burdensome (especially for smaller firms), and insufficient to address root causes like runaway executive pay and misaligned incentives.

📜 The reform landscape

📜 What was enacted

After the governance scandals, a cascade of reforms reshaped U.S. corporate governance:

• Sarbanes-Oxley Act of 2002 (SOX): imposed significant new disclosure and governance requirements; increased liability for public companies, executives, and directors under federal securities laws.
• Stock exchange rules: NYSE, NASDAQ, and AMEX adopted more comprehensive reporting requirements for listed companies.
• SEC regulations: issued new rules to strengthen transparency and accountability through timelier, more accurate disclosure of corporate performance.

🎯 Key areas of reform

The most important changes targeted:

Area	What changed
Director independence	Boards must have a majority of independent directors
Audit committee	Must be composed entirely of outside independent directors; oversees financial reporting and internal controls
Compensation committee	Must be composed entirely of outside independent directors; evaluates and recommends executive pay
Nominating committee	Must be independent; nominates individuals to serve on the board
Other reforms	Shareholder approval of equity plans, codes of ethics, executive certification of financials, independent accounting oversight board, disclosure of internal controls

These reforms are described in detail in Chapter 12 "Appendix A: Sarbanes-Oxley and Other Recent Reforms."

🔍 Why independence matters

🔍 The monitoring problem

• Shareholders cannot directly monitor management because of their distance from day-to-day operations and their dispersed ownership.
• They rely on the board of directors to perform critical monitoring activities.
• When management effectively controls the board's actions, the board's monitoring potential is "reduced or perhaps eliminated."

⚠️ Conflicts that undermine independence

• Outside directors may lack true independence through various affiliations with the company (consulting fees, donations to affiliated groups, business transactions).
• They may support management's decisions in hopes of retaining their relationship with the firm.
• Requiring a majority of independent directors increases the quality of board oversight and lessens damaging conflicts of interest.

Example: A director who receives consulting fees in addition to board fees may hesitate to challenge management for fear of losing that income stream.

🧾 Committee reforms explained

🧾 Audit committee

The audit committee is in the best position within the company to identify and act when top management may seek to misrepresent reported financial results.

Why reform was needed:

• An audit committee composed entirely of outside independent directors can provide independent recommendations to the board.
• The committee's responsibilities include:
  • Review of the internal audit department
  • Review of the annual audit plan and results
  • Selection and appointment of external auditors
  • Review of internal accounting controls and safeguarding of corporate assets

Don't confuse: having an audit committee vs. having an independent audit committee—Enron had an audit committee with a state-of-the-art charter, but it still failed to prevent fraud.

💰 Compensation committee

Why reform was needed:

• Responds to unprecedented growth in executive compensation over the last two decades.
• A dramatic increase in the ratio between executive and employee compensation.
• A reasonable and fair compensation system is fundamental to long-term corporate value creation.

How it works:

• The compensation committee evaluates and recommends compensation for the firm's top executive officers, including the CEO.
• To fulfill this responsibility objectively, the committee must be composed entirely of outside independent directors.

🗳️ Nominating committee

Nominating new board members is one of the board's most important functions.

Why independence matters here:

• The nominating committee nominates individuals to serve on the board.
• Placing this responsibility in the hands of an independent committee increases the likelihood that chosen individuals will:
  • Be more willing to act as advocates for shareholders and other stakeholders
  • Be less beholden to management

🔬 Four critical questions about the scandals

🔬 Edwards's framework for analysis

To assess whether the reforms would have prevented the 2001 scandals, the excerpt poses four key questions:

1. What motivated executives to engage in fraud and earnings mismanagement? Is there a fundamental misalignment between management's and shareholder interests, and what causes this misalignment?

2. Why did boards either condone or fail to recognize and stop managerial misconduct? Are board members' incentives properly aligned with those of shareholders?

3. Why did external gatekeepers fail? (Auditors, credit rating agencies, securities analysts) What are their incentives, and are these consistent with those of shareholders and investors?

4. Why were shareholders themselves not more vigilant? Especially large institutional investors—what does this say about money managers' motivations and incentives?

💸 The compensation-misconduct link

💸 How equity-based pay changed

The dramatic shift:

• 1989: less than 5% of median CEO pay in S&P 500 industrial companies was equity-based; 95%+ was salary and cash bonuses.
• By 2001: equity-based components had grown to two-thirds of median CEO compensation.
• Stock options accounted for most of this increase.

⚡ Why this created problems

• Executive pay became far more sensitive to short-term corporate swings in performance.
• As long as stock prices climbed, executives could exercise options profitably.
• The incentive to report (or misreport) continued favorable performance was substantial.

Example: Enron's executive compensation was closely linked to shareholder value, giving senior managers a strong incentive to increase earnings and the company's short-term stock price.

🔄 The need for reevaluation

• The basic rationale behind equity-based compensation is sound: to motivate managers and align manager and stockholder interests.
• But such pay structures must promote long-term value creation rather than reward short-term fluctuations in share prices.

Don't confuse: aligning interests (good goal) vs. creating perverse short-term incentives (unintended consequence).

🛌 Were boards asleep?

🛌 The Enron paradox

On paper, Enron's governance looked strong:

• 14-member board with only 2 internal executives (Kenneth Lay and Jeffrey Skilling).
• The remainder: 5 CEOs, 4 academics, a professional investor, a former subsidiary president, and a former U.K. politician.
• The vast majority met the "independence" requirement.
• All had significant ownership stakes in Enron, so their interests should have been aligned with shareholders.
• Board structure was strong: audit, compensation, and nominating committees all made up of outside independent directors.
• The audit committee's charter made it the "overseer of Enron's financial reporting process and internal controls," with direct access to staff and power to retain outside consultants.

Yet what actually happened:

• The Congressional Subcommittee concluded the board failed in its fiduciary duties (duties of care, loyalty, and candor).
• It permitted high-risk accounting, inappropriate conflicts of interest, extensive undisclosed off-the-books activities, inappropriate public disclosure, and excessive compensation.

🤔 Would reforms have prevented Enron?

Hard to say:

• Enron already met some new requirements (independence for board members and key committees).
• Other new rules—eliminating conflicts of interest, greater disclosure of off-balance-sheet arrangements—might have made a difference.
• But: it is highly questionable whether ethical behavior can be legislated into being.
• Changing the ethics of business behavior and the "sociology" of the boardroom cannot be accomplished through structural changes alone; they require fundamental cultural change.

Warren Buffett's observation (2003 letter to shareholders):

• He had often been silent on management proposals contrary to shareholder interests while serving on 19 boards since the 1960s.
• Most boards had an atmosphere where "collegiality trumped independence."

🚪 Did the gatekeepers fail?

🚪 Who are the gatekeepers?

External auditors, investment bankers, analysts, and credit rating agencies.

🔀 Two competing views

View 1—Gatekeepers are motivated to monitor:

• Their business success ultimately depends on their credibility and reputation with investors and creditors.
• Lacking credibility, why would firms even employ them?

View 2—Gatekeepers are inherently conflicted:

• Gatekeepers are typically hired, paid, and fired by the very firms they evaluate or rate, not by creditors or investors.
• This holds for auditors, credit rating agencies, lawyers, and security analysts.
• Security analysts' compensation (until recently) was directly tied to the amount of related investment banking business their employers did with the firms they evaluated.
• Most gatekeepers are inherently conflicted and cannot be expected to act in the interests of investors and shareholders.

🛠️ What reforms addressed this

• Separating consulting from auditing services.
• Restoring the "Chinese Wall" between analysts and investment banks.
• Mandating term limits for auditors.

But: it is unlikely these reforms would have prevented or minimized scandals like Enron and WorldCom.

Example: Citigroup paid $400 million to settle charges of fraudulent research reports; Merrill Lynch paid $200 million and agreed analysts would no longer be paid based on related investment-banking work.

🏦 Could institutional shareholders have made a difference?

🏦 The ownership problem

It is a basic tenet of free-market capitalism that the system rests on the effective ownership of private property—that owners choose how their assets are used to their best advantage.

Yet:

• The largest single category of personal property—stocks and shares—lack effective ownership.
• Those who hold shares directly (50% of all shares in the U.S.) are individually so small as to be virtually powerless.
• Only if shareholders can unite effectively—in practice, only institutional shareholders—will corporate managements be held accountable.
• This seldom happens except in a rare corporate crisis, by which time the damage often has been done.

🏛️ Who are institutional investors?

In the United States, more than half of all shares are owned by:

• Life insurance companies
• Mutual funds
• Pension funds

401(k) plans (retirement savings plans funded by employee contributions and matching employer contributions) have become a major factor; mutual funds compete heavily for this business.

😴 Why they have not been active

In theory, institutional investors' corporate governance activities could make a crucial difference.

In practice (with the exception of a few public pension funds):

• Institutional investors have not played an active role in monitoring corporations.
• They have been content to do nothing or simply sell the stock of companies where they disagree with management's strategy.

Why this behavior may be rational:

• Any other course of action is likely more costly and less rewarding for their shareholders and beneficiaries.
• Institutional fund managers have serious conflicts of interest that incentivize them against direct intervention.

💼 Fund manager conflicts

• Compensation structure: typically a flat percentage of assets under management, which depends largely on the amount of assets under management.
• Source of new funds: retirement funds originating with corporations have been the most important source.
• Result: mutual fund managers are unlikely to engage in corporate governance actions that antagonize corporate managers for fear of losing these pension funds.

⚖️ Legal barriers to activism

The law also discourages institutional investors from acquiring large positions and taking a direct interest in corporate affairs:

• "Five and ten" rule (Investment Company Act of 1940): a clear attempt to limit mutual fund ownership—at least 50% of a fund's total assets must satisfy two criteria:
  • An equity position cannot exceed 5% of the fund's assets
  • The fund cannot hold more than 10% of the outstanding securities of any company
• Section 16(b) (Securities and Exchange Act of 1934, the "short-swing profits" rule): discourages mutual funds from taking large equity positions and from placing a director on a portfolio company's board.

🤷 Complex questions

Making institutional investors more active involves complex legal, structural, and philosophic issues:

• Should we encourage larger ownership in firms and more activism by institutional investors?
• What are the motives and incentives of fund managers, and are they likely to be consistent with those of shareholders?
• If we want to encourage more institutional activism, do we want to encourage active ownership by all institutions—in particular, by public pension funds, which may be conflicted by public or political interests?
• What structural and legal changes must be made to change the culture of institutional passiveness and bring about more activism?

📊 What is the state of U.S. corporate governance?

📊 The skeptics' view

The excerpt quotes several critics who have long argued that U.S. corporate governance is fundamentally broken:

Critic	Quote/Observation
Berle and Means (1932)	Warned that changes in ownership patterns would foreshadow "governance co-opted by management"
Mace	Likened boards to "ornaments on a Christmas tree"
Drucker	Said boards "do not function"
Gillies	Proclaimed that "boards have been largely irrelevant throughout most of the twentieth century"
Lorsch and MacIver	Titled their book Pawns or Potentates
Anonymous executive	"Our board is like a bunch of ants on top of a big log carried by a turbulent current swiftly down a river. The ants think they are steering the log."

🗣️ Robert Monks's critique

Monks (pioneer shareholder activist, founder of Institutional Shareholder Services, well-known author):

On the state of reform:

"There is almost universal agreement that corporate governance in America is failing. There was a large window of opportunity following public revulsion with the scandals of the 1990s. That energy has dissipated and virtually no 'real' reform has occurred."

On appearance vs. reality:

"Appearance and reality are conspicuously at variance with respect to recent governance 'reforms.' So much attention has been paid to such widely discussed 'apparent' reforms as the NYSE listing requirements and Sarbanes Oxley ('SOX') that observers fail to note the fundamental difference between process and substance."

On the root problem:

"Most of the observed problems of governance failure arise out of the excessive power lodged in the Chief Executive Officers. Persons having power are reluctant to give it up. This is the problem, and this is the challenge."

On what real change requires:

"The informing energy of business is greed; solutions that are not based in economic incentives will certainly fail. Reform proposals will be credible only to the extent they make desired action profitable."

💡 Monks's proposals for real change

Focus on making shareholder responsibility a reality by removing "many biases in the current legal/regulatory/institutional structure of governance":

• Tax incentive on term ownership: to encourage long-term holding of securities and discourage "churning."
• Increase shareholder role in nominating directors: to achieve true director independence.
• Split common equity into two classes: "ownership" and "trading" shares—to more meaningfully engage institutional owners in the governance process.
• Restore CEO pay to credible levels: calling CEO compensation the "smoking gun" of governance failure; even if this means changing existing agreements.

✅ The counterargument—the system is not broken

A reasonable argument can be made that the broad evidence is not consistent with a failed U.S. system:

• On the whole, the U.S. economy and stock market have performed well, both on an absolute basis and relative to other countries over the past two decades, even after the scandals broke.
• While parts of the U.S. corporate governance system clearly failed under the exceptional strain of the 1990s, the overall system (which includes oversight by the public and the government) reacted quickly to address the problems.
• On balance, most of the reforms that have been enacted are welcomed.
• Along with other increasingly common board features (periodic self-evaluation, requiring directors to own significant company stock), they have, by and large, had a positive effect on governance and, indirectly, on company performance.

⚠️ Persistent problems and unintended consequences

⚠️ Runaway executive compensation

• Perhaps the most visible and contentious unsolved problem.
• A growing number of investors and directors, upset with absolute levels of pay and with forms of compensation not aligned with long-term corporate performance, want concrete change.

🗳️ Shareholder activists push for more

• Right to directly nominate and elect directors: rather than work with the slate recommended by the board's nominating committee.
• Binding shareholder resolutions: resolutions receiving majority support should become binding upon boards.
• Mandatory shareholder votes on merger proposals.

But: support for these proposals has been lukewarm because they tend to undermine rather than strengthen the role of the board.

🌍 Narrow focus complaint

• The recent wave of reforms has been too narrow in focus—exclusively aimed at the immediate interests of shareholders.
• It has not addressed or even seriously contemplated the broader set of stakeholder concerns and societal pressures emerging on issues such as:
  • Companies' growing political influence
  • Sustainable business practices
  • Various dimensions of corporate social responsibility

In academic terms: reforms enacted to date can be characterized as being primarily focused on addressing the so-called agency problem—the innate conflict that exists between owners (investors) and management, even though managers ostensibly act in the shareholders' interests.

🔨 Unintended negative consequences

There is growing concern that the recent wholesale adoption of new rules and processes may have had unintended, negative consequences:

• Regulation is an extremely blunt instrument for solving complex problems and impacts different companies in different ways.
• Many smaller companies are struggling to cope with the additional regulatory burden and comply with the new law.
• Proposals under active consideration: allowing smaller companies to scale back or postpone compliance with some Sarbanes-Oxley provisions.

Example: A small public company may spend a disproportionate share of its resources on compliance, diverting attention and funds from growth and innovation.

🛡️ Boards becoming more defensive

Evidence is emerging that some boards have become even more "defensive" than before in the face of increased exposure to shareholder and legal action.

Questions to ask:

• Although there is no critical shortage of qualified directors at this time, has the new regulatory environment made it harder to attract the right talent to serve on boards?
• Has the regulatory pendulum swung too far?
• Do more regulated boards produce greater value—for shareholders, for other stakeholders, for society?
• Could the additional regulatory burdens reduce business productivity and creativity, or even board assertiveness, especially in smaller firms?

⚖️ The challenge—striking a balance

⚖️ Beyond compliance

While no one disputes the need for transparency, honesty, and accuracy, corporate governance is about much more than the accuracy of the income statement and balance sheet.

• Compliance is a means to an end.
• The numbers merely summarize and reflect the full array of decisions—from strategy to structure to process—that guide a corporation.
• Encouraging responsible, responsive governance rather than mere compliance should be the overriding goal and the principal focus of reform.

🎯 What truly effective boards understand

• Their obligations to shareholders, other stakeholders, and society at large.
• The strategic challenges faced by their companies and the role they play in assisting management in seizing competitive opportunity.
• The dynamics of the interplay between management and directors.
• They value partnership over adversarial relationships without sacrificing independence.
• Especially in smaller companies, they alert management to opportunities for growth, assist in raising capital, and provide a sounding board on issues of strategy, asset redeployment, and fiscal and legal affairs.

🚫 No unique model

• There is no unique model for developing a highly effective and responsive board.
• There is no unique model for what such a board looks like, how it organizes itself, or how it operates.
• It is unlikely that it can be legislated and regulated into being.

🌱 Internal process required

Changing the ethics of business behavior and the "sociology" of the boardroom cannot be accomplished through structural changes alone.

• Instilling ethical behavior and creating a value-creating orientation is fundamentally an internal process.
• It can only be successfully concluded with the complete support of both management and directors.
• It requires:
  • Openness to self-examination
  • A willingness to question individual and collective roles
  • A resolve to address [the excerpt ends here]

Don't confuse: structural reforms (necessary but insufficient) vs. cultural and ethical transformation (the deeper challenge).

🧭 Overview

🧠 One-sentence thesis

Effective CEO succession planning is a continuous, board-led strategic process that requires deep understanding of the company's value-creation activities and future needs, yet most boards fail at this critical responsibility due to lack of preparedness, over-reliance on flawed selection strategies, and insufficient time spent developing internal candidates.

📌 Key points (3–5)

• Why succession matters: Selecting the right CEO is arguably the board's most important responsibility, yet record CEO turnover reveals widespread board failures in this area.
• The preparedness gap: Most boards lack formal succession processes—a quarter have no emergency plan, and almost half of directors are dissatisfied with their involvement in succession planning.
• Common confusion—insider vs. outsider: Three popular but often ineffective strategies dominate: hiring prior CEOs, poaching active CEOs from other firms, and the "apprentice model" (former CEO becomes chairman); insider candidates are frequently overlooked despite their advantages.
• What effective planning requires: Succession must be an ongoing activity integrated with strategic thinking, starting 5–10 years ahead, with the full board involved and regular interaction with internal candidates.
• The development challenge: Preparing future CEOs requires identifying talent early (around age 30), providing 15+ years of progressively larger P&L responsibilities, and creating "stretch jobs"—not just functional rotations.

📊 The current state of CEO succession

📊 Sobering statistics

The 2007 Spencer Stuart survey of S&P 500 companies revealed significant gaps:

Area	Finding	Implication
Discussion frequency	62% discuss annually; 34% more than once/year	Still leaves 4% not discussing at all
Emergency plans	25% have no emergency succession plan	One in four boards unprepared for sudden departure
CEO involvement	50% say current CEO leads the process	Potential conflict of interest
Time allocation	Directors spend less time on succession than any other activity	Immediate concerns (Sarbanes-Oxley, accounting) crowd out long-term planning

📉 The failure rate

• Global CEO turnover set a record in 2005: more than 1 in 7 of the world's largest companies changed leadership.
• Fewer than half of outgoing CEOs left willingly; the vast majority were forced out due to poor performance.
• High-profile failures include talented individuals with strong track records (Gil Amelio at Apple, Durk Jager at P&G, Doug Ivester at Coca-Cola, Jill Barad at Mattel, Robert Nardelli at Home Depot).

Key insight: These were not untalented people—they were intelligent individuals with strong management track records who nevertheless failed as CEOs.

🔍 Why boards struggle

Most board members have little or no experience with CEO selection, leading to:

• Approaching the task with only the broadest requirements rather than well-thought-out lists of real needs.
• Being seduced by reputation (Wall Street favorites, media darlings) or blinded by charisma.
• Focusing on what candidates are like rather than what they can and cannot do.

Don't confuse: A candidate's reputation or charisma with their actual ability to execute the specific value-creating activities your company needs.

🎯 Four departure scenarios and their challenges

🎯 Reactive vs. proactive changes

The excerpt identifies four broad categories of CEO departure, each requiring different board responses:

Reactive scenarios (board must respond to someone else's initiative):

1. Voluntary departure: CEO leaves to lead another company
2. Retirement/leave: CEO retires or takes extended absence

Proactive scenarios (board initiates the change): 3. Strategic replacement: Board replaces a currently successful CEO who may not be best suited for future challenges

• Examples: Replacing a founder whose decisions have become emotionally biased; replacing a private-company CEO with someone experienced in taking companies public; replacing a growth-company CEO with someone familiar with rapid multinational expansion

4. Performance-based dismissal: Firing an underperforming CEO or dismissal for cause

⏱️ Why preparedness matters

• Reactive scenarios: Unless comprehensive succession plans have been in place for a while, boards may have little choice but to recruit an outsider.
• Proactive scenarios: A well-thought-out succession process enhances the board's ability to make informed choices and broadens its portfolio of alternatives.
• Special case—transitional leadership: Boards may appoint interim CEOs during turnarounds, mergers, acquisitions, IPOs, or restructurings; the right interim leader can steer through volatility while the permanent search continues.

🔄 The opportunity in crisis

As painful and disruptive as it can be, the dismissal of a CEO often provides companies a much-needed opportunity to reexamine goals, strategies, and values.

❌ Three flawed selection strategies

❌ Strategy 1: Hiring prior CEOs

The appeal: Prior CEOs appear to bring important advantages—track record of creating shareholder value, experience working with boards, communicating with investors, developing and implementing strategy.

The reality: Compelling evidence shows prior CEOs perform no better and sometimes worse than new, previously untested CEOs.

Why it fails:

• Prior CEO experience may not be as valuable as experience in the company, in the industry, or with the specific types of challenges the company faces.
• May lack the high energy level needed to take on a major new challenge.

❌ Strategy 2: Poaching active CEOs

The appeal: Reflects the belief that executive leadership is a generic skill set, not specific to industry or company; targets currently successful leaders.

The reality: Evidence is thin (few have completed their careers), but if prior-CEO results hold true, poaching may also be a losing proposition.

The underlying problem: Both strategies assume bringing in an outsider is automatically better than choosing from inside, which is not always true.

❌ Strategy 3: The apprentice model (former CEO as chairman)

The setup: Former CEO becomes chairman of the board while a second individual (insider or outsider) is promoted to CEO—covers more than one-third of all CEO departures in 2005.

The appeal:

• Consistent with best practice (separates chairman and CEO roles)
• Keeps former CEO's skills and experience available
• Allows mentoring of new CEO

The reality: 2005 Booz Allen Hamilton study found the worst performance came from this model; best-performing companies had split roles with a true outsider as chairman, not the former CEO.

Why it fails:

• Ineffective division of authority: Former CEO set direction for years, controlled promotions/compensation, defined culture—likely to be approached by anyone unsettled by successor's strategy.
• Undermines new CEO's authority: Creates impression the new CEO needs more training and isn't yet qualified.
• Board relationship problems: Former CEO manages a board whose members were appointed by or know the former CEO, hampering new CEO's ability to gain support.
• Extreme risk: If former CEO is unhappy with direction or performance, can get the apprentice fired and take back the CEO title.

Additional context: The apprentice model is inconsistent with Sarbanes-Oxley (majority of board must be independent; nominating committees entirely outsiders) and shareholder activism (which favors independent outsider chairmen).

Don't confuse: Mentoring and continuity (which sound beneficial) with the practical reality of divided authority and undermined leadership.

🔄 The insider vs. outsider decision

🔄 When to go outside

More than one-third of Fortune 1,000 companies are run by external appointees.

Valid reasons to recruit externally:

• Company lacks the culture or processes to internally develop the next CEO
• Organization needs to be "shaken up"
• Outstanding fit exists between an outsider and the job at hand (example: Lou Gerstner at IBM)
• Credibility of outgoing CEO or management team is so damaged that only a "new broom" can sweep clean
• Shift in industry or market landscape renders carefully nurtured internal skills irrelevant

⚠️ Risks of going outside

Recruiting from outside is almost always more risky than promoting from within because directors and top management cannot know outside candidates as well as their own people.

Specific dangers:

• Outsiders are often chosen because they can do a job (e.g., turn around the company, restructure the portfolio), but the job is to provide purposeful leadership to a complex organization over a sustained period.
• Board requirements for the larger job are often not well defined.
• Wrong outside appointments have devastating effects: morale drops, energy to execute dissipates, employees worry about job security, companies look inward rather than at competition.
• Bad external appointments are expensive (even poor performance often rewarded with rich severance packages).

Example: Some outsiders rally the troops and create a following; others are immediately overwhelmed, lock themselves in offices with data, don't spend time with key stakeholders, and risk being viewed as perpetual outsiders.

✅ Advantages of insiders

• Familiar with the culture and the business—gives them a leg up on outside candidates
• When inside candidates are automatically ignored, outstanding executives one or two layers down may leave, imperiling future succession

⚠️ Risks of insiders

Selecting an insider can also be a big mistake in certain situations:

Risk factor	Why it's a problem
Lax due diligence	As "known quantities," may sail through without proper scrutiny
Social/psychological ties	May complicate efforts to change culture
Wrong experience	Individuals from functional areas may not be ready to lead entire business
Lack of testing	May not have been tested in the right ways
Market shifts	Industry or market landscape changes may render nurtured skills irrelevant

Don't confuse: Being a "known quantity" (which sounds safe) with being properly vetted and tested for the CEO role specifically.

🌱 Developing the next generation of CEOs

🌱 The scale of the challenge

"In CEO succession, it takes a ton of ore to produce an ounce of gold." — Ram Charan

The timeline problem:

• To prepare candidates for a 10-year run in the top job, companies must identify them around age 30.
• Must expose them to the right challenges and mentors for 15+ years.
• Few companies have the skill, resources, or commitment to spot and evaluate potential talent this early and purposefully.

Example: General Electric had ~225,000 employees in 1993 when Jack Welch identified 20 potential successors; over 7 years, he narrowed this to 3.

🎓 What real development requires

The development of the next generation of leaders requires creating challenging assignments and "stretch jobs" supported by coaching, mentoring, and action learning.

Action learning: Brings high-potential individuals together to work on pressing issues (e.g., whether to enter a new geography or launch a new product); forces emerging leaders to look beyond functional silos to solve strategic problems and learn what it takes to be a general manager.

The critical path—P&L progression:

• The very best preparation is progression through positions with responsibility for steadily larger and more complex profit-and-loss centers.
• Example progression: manage a single product → customer segment → country → several product lines → business unit → division.
• Key requirement: Overall P&L responsibility at every level is critical.

❌ What doesn't work

Rotation-based programs: Many companies equate leadership development with rotating candidates through multiple functions or cultural assignments.

Why this fails:

• Functional leaders learn to lead functions, not whole companies.
• Major drawback: Potential candidates often don't stay long enough in one position to live with the consequences of their decisions.

The HR trap: Many companies view succession planning as primarily a human resources function—this is insufficient for developing CEOs.

Don't confuse: Valuable functional or cultural rotations with the specific preparation needed for the unique challenges of being a CEO.

🤝 Board involvement in development

Boards can greatly improve the chances of finding a strong successor:

1. Charter responsibility: Senior executive development should be an explicit element in the compensation committee's charter.
2. Regular reporting: Committee should receive and create regular reports on the pool of potential CEOs.
3. Get to know candidates:
   • Invite promising internal candidates to give presentations at board meetings
   • Meet informally with directors whenever possible
   • Directors should meet with and observe candidates in their own business operations
4. Dedicated time: Full board should devote more time to succession; at minimum, review and update the list of top five contenders (internal and external) twice a year.

🎯 What effective succession planning looks like

🎯 The right starting point

The right process starts with the board's commitment to:

1. Make succession a permanent agenda item
2. Meaningfully link succession with strategic oversight

What directors must thoroughly understand:

• How the CEO adds value
• What the key strategy levers are that the chief executive has or must create
• What skill sets and leadership attributes are needed to be successful

The knowledge requirement: Directors must have deep knowledge of:

• The firm's competitive position and challenges
• Its unique competences
• Its cultural and administrative heritage

Only this depth of knowledge allows a board to focus its search on the key executive skills and past experiences needed to effectively move the company forward.

🔍 The role of executive search firms

What they can do:

• Open doors
• Identify and screen candidates
• Conduct thorough, fact-based due diligence
• Create a bridge between the board and candidates

What they cannot do:

• Tell the board what leadership qualities and experiences to look for

Board responsibility: Provide the search firm with a detailed profile of the skills, experiences, and character traits the next CEO needs.

The danger: In the absence of an effective succession-planning process and carefully articulated qualifications, recruiters may be forced to substitute their own, more generic list of desirable CEO attributes; they also tend to gravitate to the prior-CEO and poaching strategies.

Don't confuse: What executive recruiters can contribute (access, screening, due diligence) with the board's irreplaceable role in defining what the company actually needs.

👤 The outgoing CEO's role

What it should be: Mainly consultative

Appropriate activities:

• Active in spotting and grooming talent
• Help define the job's requirements
• Provide accurate information about both internal and external candidates
• Facilitate discussions between candidates and directors

What it should not be: The outgoing CEO has no vote when it comes to choosing the successor—that decision belongs to the board.

✅ Ten best practices for succession planning

✅ The comprehensive framework

Succession planning is a dynamic process too often given short shrift when regarded as an HR-led exercise rather than a high-priority, comprehensive board-led process.

Definition: High-impact succession planning is a continuous leadership "optimization" process with the goal of identifying and developing a pool of talent armed with the skills, attributes, and experiences to fill key leadership positions, including that of CEO, as well as the cultivation of a talent pipeline to meet emerging leadership needs.

The ten components:

1. ⏰ Plan 5 to 10 years ahead: Multiyear process is essential to develop and prepare internal candidates versus recruiting from outside.

2. 👥 Involve the full board: Full board is required in critical parts (establishing criteria, evaluating candidates, making the decision)—should not be relegated to a committee.

3. 🔄 Establish open, ongoing dialogue and annual review: Board and CEO maintain open dialogue; review plan and candidate assessments at least once a year.

4. 📋 Develop comprehensive selection criteria: Criteria should be developed with the company's future strategic needs in mind and include:

   • Bottom-line impact
   • Operational impact
   • Leadership effectiveness dimensions

5. 📊 Use formal assessment: Formal assessment processes from multiple sources provide information that helps boards objectively assess candidates and identify development needs.

6. 🤝 Interact with internal candidates: Board members should be given ongoing opportunities to interact with internal candidates in various settings.

7. 🎯 Stage the succession but avoid horse races:

   • Place candidates in a series of expanding roles that give them opportunity to learn and grow
   • Allow directors to assess their abilities
   • Critical: Potential successors should never be publicly announced, so candidates don't feel they are competing for the role

8. 🔍 Develop good working relationship with executive search firm: To identify, screen, and attract external candidates; while many boards prefer internal candidates (familiar with "territory"), the pool should be enriched with talented outsiders.

9. 🚪 Have outgoing CEO leave or stay as chair for limited time: Outgoing CEO should either leave the board immediately or stay on as chairman for a transitional period of 6 to 12 months maximum—to avoid potential leadership conflicts.

10. 🚨 Prepare comprehensive emergency succession plan: Emergency succession planning should be dealt with as soon as a new CEO takes the helm; board should review the plan every year thereafter.

📖 Warren Buffett's example

The excerpt concludes with Warren Buffett's 2005 letter to Berkshire Hathaway shareholders as a model of transparent, thoughtful succession planning:

What Buffett has in place:

• Three managers at Berkshire who are reasonably young and fully capable of being CEO
• Board has fully discussed all three candidates and unanimously agreed on who should succeed if replacement needed today
• Directors stay updated and could alter their view as circumstances change
• Plan to have another person handle marketable securities (the new CEO won't have Buffett's crossover experience in both business and investments)

On the "decay" problem:

• Acknowledges humans age at varying rates; some managers remain effective into their 80s, others fade in their 60s
• When abilities ebb, powers of self-assessment usually do too—someone else needs to "blow the whistle"
• Board members' financial interests are completely aligned with shareholders (unusual among boards)
• Buffett explicitly asks the board to tell him when the time comes, viewing it as a favor

The key principle: Every share Buffett owns goes to philanthropies; he wants society to reap maximum good, so it would be a tragedy if philanthropic potential was diminished because associates shirked their responsibility to (tenderly) show him the door.

Don't confuse: Buffett's confidence in his board and successors with complacency—he has built specific, detailed plans and explicitly addressed the hardest scenario (his own decline).

🧭 Overview

🧠 One-sentence thesis

The Sarbanes-Oxley Act fundamentally transformed the role of audit committees and boards from passive monitors to active overseers who must proactively investigate risks, certify controls, and ensure ethical compliance or face legal liability.

📌 Key points (3–5)

• Sarbanes-Oxley expanded responsibilities: Audit committees now directly oversee external auditors, certify internal controls, and must include independent, financially literate members with at least one financial expert.
• Duty of Oversight vs. Business Judgment Rule: Boards are protected when they investigate and decide, but face liability when they ignore or fail to consider problems—even if unaware.
• Common confusion: Deciding there is no problem (protected) vs. ignoring a problem (not protected)—the key difference is whether the board engaged in a process.
• Red flags and proactive monitoring: Boards must watch for warning signs in management culture, aggressive practices, and weak oversight that predict ethical and financial problems.
• Enterprise Risk Management (ERM): A strategic, enterprise-wide approach to balancing risk and opportunity, overseen by the board through committees.

📜 The New Regulatory Climate

📜 What Sarbanes-Oxley changed

The Sarbanes-Oxley Act dramatically increased the workload and fundamentally changed the role of CFOs, finance teams, and directors:

• Section 302: Corporate responsibility for financial reports—senior executives must certify accuracy.
• Section 404: Management assessment of internal controls—executives certify the strength of controls and the information they generate.
• Section 409: Rapid public disclosure of material events in company performance.

The relationship shifted from management-auditor to audit committee-auditor, with the committee now directly responsible for appointment, compensation, retention, and oversight of external auditors.

🏛️ Audit committee transformation

Audit committee: A board committee that oversees, monitors, and advises company management and outside auditors in conducting audits and preparing financial statements.

Before 2002: Recommended by SEC (1972) and stock exchanges; primarily advisory role.

After Sarbanes-Oxley: Expanded responsibilities and authority; stricter membership requirements.

👥 Composition requirements

Public companies must have an audit committee with:

• At least three independent members of the board
• Each member must be "financially literate"
• At least one member designated as the "financial expert"

📋 Audit committee charter

Audit committee charter: A document that clearly delineates audit committee processes, procedures, and responsibilities sanctioned by the entire board.

A charter should include:

Element	Purpose
Membership requirements	Define qualifications including financial expert provision
Meeting frequency	Designate minimum number of meetings
Executive sessions	Allow for engaging outside counsel as needed
Risk management responsibilities	Outline compliance issues and review of effectiveness
Auditor relationships	Appoint, evaluate, set time limits for, and discharge external auditors
Annual reviews	Allow for yearly reviews and changes

🔍 Expanded duties

The audit committee must now:

• Ensure accountability of management and internal/external auditors
• Establish procedures for handling complaints about accounting, internal controls, or auditing matters
• Provide confidential submission channels for employee concerns
• Pre-approve all audit services and permitted non-audit services
• Disclose all approvals of non-audit services in periodic reports
• Safeguard objectivity of the financial reporting process

Don't confuse: The audit committee doesn't replace the full board—it has specific delegated authority that appears to alter traditional state law delegation of board power to committees.

💡 Warren Buffett's Perspective on Audit Committees

💡 The core problem

Buffett argues that structural reforms miss the point:

"Audit committees can't audit. Only a company's outside auditor can determine whether the earnings that a management purports to have made are suspect."

The real issue: Auditors have historically viewed the CEO/CFO as their client (who pays fees and determines retention) rather than shareholders or directors, creating a "cozy relationship."

🎯 Buffett's four questions

To break this relationship, audit committees should ask auditors these questions (with answers recorded and reported to shareholders):

1. Preparation differences: If the auditor were solely responsible for financial statements, would they have been prepared differently in any way (material or nonmaterial)?
2. Investor perspective: If the auditor were an investor, would he have received—in plain English—the information essential to understanding the company's financial performance?
3. Internal audit procedures: Is the company following the same internal audit procedures the auditor would follow if he were CEO? If not, what are the differences and why?
4. Revenue/expense timing: Is the auditor aware of any actions—accounting or operational—that moved revenues or expenses from one reporting period to another?

Key insight: When auditors are "put on the spot" with these questions, committee composition becomes less important—they will do their duty. Without being put on the spot, problems emerge.

⚖️ Legal Framework: Duty of Oversight

⚖️ Two duties distinguished

Duty of Care: Requires directors to perform duties in good faith and with the degree of care an ordinary person would use under similar circumstances.

Business Judgment Rule: Courts will not second-guess directors' business decisions if directors act on an informed basis and in good faith.

The oversight role is less well-defined and stricter than the decision-making role.

🔀 Two scenarios with different outcomes

Scenario	Process	Protection	Result
Deciding no problem exists	Board investigates, considers situation, consciously decides action not necessary	Business Judgment Rule applies	Protected even if decision is wrong
Ignoring a problem	Board fails to consider the situation; no process, no decision	Business Judgment Rule does NOT apply	May face liability for breach of Duty of Oversight

⚠️ When liability arises

Duty of Oversight: Directors may face liability when they know or should know of wrongdoing and fail to act.

Boards can be held liable for:

• Failing to act when aware of material improper conduct
• Failing to investigate violations of law
• Ignoring actions that could result in material harm

Critical distinction: The board may not take action in either scenario, but the legal outcomes are dramatically different based on whether they engaged in a process.

🛡️ How boards can protect themselves

• Investigate when there are red flags: If a director has actual knowledge of a material problem, don't wait for management to bring it to the board.
• Take proper board action: Always the best defense to a Duty of Oversight claim.
• Note: Delaware law allows corporations to eliminate or reduce personal liability for breaches of fiduciary duty in their certificate of incorporation, but courts have not specifically held this would bar a Duty of Oversight claim.

Don't confuse: Having a charter provision limiting liability vs. actually fulfilling the duty—the provision's protection for oversight claims is uncertain.

🚩 Red Flags and Risk Indicators

🚩 Warning signs in corporate culture

Analysis of corporations with major ethical and financial difficulties reveals common patterns. Red flags include combinations of:

• Aggressive management practices creating rapid short-term revenue and stock-price growth
• Weak board oversight allowing CEO to rapidly accumulate personal wealth through stock-based incentive compensation
• Aggressive financial practices and high leverage

Key insight: Individual factors may not be predictive, but in groups they define a heightened risk profile requiring additional scrutiny.

Example: A company with aggressive revenue growth + weak oversight + high CEO stock compensation + high leverage = significantly elevated risk of rapid financial deterioration and potential fraud.

📊 Questions about ethics and compliance

Building a culture of ethics and compliance requires asking the right questions:

Tone and culture:

• Does senior management demonstrate that ethics and compliance are vital to business success?
• Does the organizational culture support ethical choices?

Program structure:

• How is the ethics and compliance program structured?
• Does it cover global operations?
• Has it been updated to comply with Sarbanes-Oxley?
• Is there an ethics and compliance officer with adequate resources and board access?

Reporting mechanisms:

• Is there an effective reporting mechanism for employees to raise issues without fear of retribution?
• Is there an anonymous helpline?
• Are audit committee members named as an outlet for employee concerns?

Monitoring and enforcement:

• What ongoing monitoring and auditing processes assess program effectiveness?
• Does management take action on reports?
• Are employees appropriately and consistently disciplined?

💱 Questions about hedging and derivatives

For companies engaging in hedging, derivative, and trading activities, boards should ask:

1. Where are the risks embedded, and who is responsible?
2. Does the board understand the nature and purposes of the risk positions?
3. Are there risk limitations in place, and how effectively are they implemented?
4. What is the risk-to-reward ratio that fits the strategic plan?
5. Does the board have a glossary to translate technical explanations?

Don't confuse: Hedging activities may mitigate risky positions, but hedges are rarely perfect, and the sophisticated nature complicates oversight.

🎯 Enterprise Risk Management (ERM)

🎯 What ERM is

Enterprise Risk Management (ERM): A strategic approach to addressing organizational and financial risk on an enterprise-wide basis, aimed at enhancing and protecting tangible and intangible assets.

Traditional risk management: Focuses on protecting tangible assets and related contractual rights and obligations.

ERM scope: Much broader—more than crisis management or regulatory compliance; it's a tangible, structured approach to strategic risk.

🎲 Core premise

Uncertainty presents both risk and opportunity, with potential to erode or enhance value. Value is maximized when management:

• Sets strategy and objectives to strike an optimal balance between growth/return goals and related risks
• Efficiently and effectively deploys resources in pursuit of objectives

👔 Board oversight of ERM

Although management is ultimately responsible for risk management, the board must understand risks and oversee the process.

Best practice approaches:

Approach	How it works
Governance/nominating committee	Ensures preparedness by evaluating director capabilities, nominating directors with crisis-management experience, establishing orientation programs and succession plans
Audit committee	Most common—corporate governance guidelines often delegate risk management responsibility here
Risk-management officer	Dedicated position for risk oversight
Risk-management committee	Separate board committee focused on risk
Finance/compliance committee	Alternative assignment of responsibility

The responsible committee should meet regularly with the internal auditor, CFO, general counsel, head of compliance, and business unit leaders to discuss specific risks and assess system effectiveness.

📖 Codes of Ethics and Conduct

📖 SEC requirements

To implement Sarbanes-Oxley sections 406 and 407, the SEC requires companies to:

• Disclose whether they have adopted a code of ethics applying to principal executive officer, principal financial officer, principal accounting officer/controller, or similar functions
• If no code exists, disclose this fact and explain why
• Promptly disclose amendments to and waivers from the code for these officers

📖 What a good code includes

Code of ethics (also called code of conduct, statement of business practice, or set of business principles): Establishes and articulates corporate values, responsibilities, obligations, and ethical ambitions and how the organization functions.

A good code should:

• Be signed by the CEO and endorsed by the board
• Focus on values important to top management: integrity, responsibility, reputation
• Demonstrate commitment to high standards internally and externally
• Provide guidance for handling dilemmas between right courses of action or when facing pressure to consider right vs. wrong

💬 Buffett's simple test

Warren Buffett's advice for Berkshire Hathaway directors, executives, and employees:

"I want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper—to be read by their spouses, children and friends—with the reporting done by an informed and critical reporter."

Key insight: This simple, memorable standard makes ethics concrete and personal rather than abstract.

🧭 Overview

🧠 One-sentence thesis

Boards are increasingly urged to engage more actively in strategy formulation, yet creating a meaningful strategic role remains extremely difficult due to tensions between oversight and management, knowledge gaps, time constraints, and the complex, nonlinear nature of strategy development itself.

📌 Key points (3–5)

• The central tension: Strategy formulation is traditionally a management responsibility, but boards must evaluate strategic plans—raising the question of how deeply boards should participate without crossing into management.
• Why boards struggle with strategy: Most directors have limited understanding of their company's current strategy and long-term prospects; boards are better at monitoring short-term financials than engaging with future-oriented issues like customer trends or core competencies.
• When boards engage more: Crisis situations (performance decline, new CEO, major organizational change) typically trigger deeper board involvement in strategy.
• Common confusion: "Active" vs. "passive" board roles oversimplify reality—boards can shape strategy through influence and guidance without directly formulating it; strategic decisions evolve through complex, fragmented processes, not neat sequences.
• Special situations requiring board involvement: Capital structure decisions and M&A transactions demand substantial board participation and scrutiny because they carry high risk and often destroy shareholder value if mishandled.

🤔 The Fundamental Dilemma: Where to Draw the Line

🤔 Management responsibility vs. board oversight

The widely shared belief: strategy formulation is fundamentally a management responsibility; the board's role should be confined to ensuring an appropriate strategic planning process is in place, with actual development and approval left to the CEO.

• The core question: If boards must evaluate the quality of management's strategic plans and assess whether the company can deliver, should they independently audit strategic assumptions or does that signal lost confidence in the CEO?
• Two opposing views:
  • Hiring outside experts to review strategy means the board has lost confidence and should fire the CEO.
  • Hiring consultants is the most cost-effective way for the board to prove independence and challenge management.
• The practical reality: Even "codes of best practice" urge boards to set direction, review initiatives, and assess risks—but reality is far more complex than these guidelines suggest.

🚧 Why boards limit their involvement

Traditional triggers for board engagement (historically boards became involved only when specific reasons arose):

• Retirement of an incumbent CEO
• Major investment decision or acquisition proposal
• Sudden decline in sales or profits
• Unsolicited takeover bid

Barriers to ongoing strategic engagement:

1. Fear of overstepping: Both executives and directors worry about crossing the line from contributing ideas to trying to manage the company.
2. Compliance overload: Post-Enron and Sarbanes-Oxley, many boards turned inward, focusing so heavily on accounting compliance that strategic considerations took a backseat.
3. CEO resistance: Some CEOs view board engagement in strategy as interference and a threat to personal power; the downside is boards may not understand or buy into the strategy, and board talent is underutilized (this can backfire when disengaged boards become overengaged and make CEOs "walk through fire" on tactics).
4. Knowledge gaps: Most directors are effective with short-term financial data but lack detailed understanding of future-oriented issues (changing customer preferences, competitive trends, technological developments, core competencies).

📊 Directors' limited strategic understanding (McKinsey survey findings)

Understanding level	Current strategy	Long-term prospects (5–10 years)	Key initiatives for the future
Complete/full	11%	4%	(not specified)
Limited or none	More than 25%	More than 50%	More than 50%

• A typical board is poorly designed and ill-equipped for strategy tasks requiring long-term, future-oriented analysis.
• Example: Directors may know this quarter's financials but have little sense of the company's position a decade out or the 5–10 key initiatives needed to secure the long-term future.

⏰ Time and forum constraints

• Board meetings are not conducive to creative strategy work: They suit questioning specific assumptions and monitoring progress, but not the elaborate, nonlinear process of crafting strategy.
• Revealing serious reservations about underlying strategic assumptions can be seen as distracting, inappropriate, or even a vote of no confidence in management.
• Time commitment has doubled: The average U.S. director's commitment increased from 13 hours/month (2001) to more than 26 hours/month today (Korn/Ferry), yet boards typically perform strategic governance in a couple of hours every third meeting, plus an annual 2-day retreat.

🔄 The Complexity of Strategic Processes

🔄 Why "passive vs. active" is an oversimplification

The passive conception (dangerous oversimplification):

• Strategic decisions are separate and sequential
• Managers generate options → boards choose → managers implement → boards evaluate

The active conception (also oversimplified):

• Boards and management formulate strategy in partnership → management implements → both evaluate

The reality:

• Strategic decisions evolve through complex, nonlinear, and fragmented processes
• A board can be actively involved in strategy without being involved in its formulation
• Example: A board can "shape" strategy through influence over management, guiding strategic thinking without ever participating in developing the strategies themselves

🎯 Situational factors that determine board engagement level

Organizational factors:

• Firm size
• Nature of the core business
• Directors' skills and experience
• Board size, occupational diversity, tenure, and member age
• Board attention to strategic issues
• Board processes (e.g., use of strategy retreats)
• Prior firm performance
• Relative power between board and CEO (especially in monitoring and evaluating the CEO position)

External factors:

• Concentration and level of engagement of the firm's ownership
• Degree of environmental uncertainty

Don't confuse: The appropriate level of board engagement is not fixed—it depends on context and changes over time.

🧩 The independence-expertise trade-off

• Recent governance reforms focused on making boards more independent
• Unintended consequence: Many boards now lack directors with relevant industry expertise to participate effectively in shaping strategy
• In the post-scandal climate, boards prioritize compliance-oriented appointments over visionary ones, even as the business landscape becomes more complex
• This creates a paradox: boards are more independent but less equipped to engage meaningfully with strategy

🎯 Nadler's Framework: Making Board Engagement Workable

🎯 The key principle

Create a process in which directors participate in strategic thinking and strategic decision making but do not infringe on the CEO's and senior executive team's fundamental responsibilities.

• Division of labor: CEO and management lead and develop strategic plans with directors' input; the board approves the strategy and the metrics to assess progress.

📋 Four sequential types of strategic activity

Phase	Focus	Board's appropriate role
1. Strategic thinking	Collection, analysis, discussion of information about the environment, competition, business models	Provide advice and counsel on process, perspectives, inside-outside balance, presentation formats
2. Strategic decision making	Core directional decisions defining fundamental choices about business portfolio and dominant business model	Evaluative and decision-focused; make key directional choices
3. Strategic planning	Identifying priorities, setting objectives, securing and allocating resources to execute directional decisions	Review and approve plans
4. Strategy execution	Implementing, monitoring results, corrective action; may involve fund allocation, acquisitions, divestitures	Primary focus on reviewing and monitoring progress

Key insight: The board's role should differ dramatically across these phases—advisory early, evaluative in the middle, monitoring later.

🗺️ The five-step strategic choice process

🗺️ Step 1: Agreeing on the company vision

Vision: a description of the company's aspirations in relation to multiple stakeholders (investors, customers, suppliers, employees, legislative/regulatory institutions, communities).

• Should be aspirational and paint a picture in tangible, measurable terms
• Good vision statements discuss measures of growth, relative positions in markets/industries, or returns to shareholders
• Provides a benchmark against which to assess strategic alternatives
• Example: Buffett's advice for Berkshire Hathaway—"ask whether they are willing to have any contemplated act appear the next day on the front page of their local paper—to be read by their spouses, children and friends—with the reporting done by an informed and critical reporter"

🗺️ Step 2: Viewing the opportunity space

• Analyze the full array of strategic options from different perspectives
• Different "lenses" to examine the environment:
  • Different emerging markets
  • Range of available technologies to meet a customer need
  • Potential set of customers
  • Constellation of competitors
• Each lens presents a different view of the strategic landscape

🗺️ Step 3: Assessing the company's business design and internal capabilities

• Look inward: analyze relative strengths and weaknesses
• Cover human capital, technologies, financial situation, work processes, among others
• Objective: understand what the firm can realistically execute

🗺️ Step 4: Determining the company's future strategic intent

• Bring together vision, opportunity space view, and current capabilities assessment
• Identify the most attractive opportunities given the company's vision and capabilities
• This step bridges analysis and choice

🗺️ Step 5: Developing business design prototypes

• Develop prototypes for each business design option
• Consider multiple distinct, viable options to enable real comparison and true choice
• Test leading choices against current organizational capabilities to understand execution challenges
• Make final decision against criteria developed in the strategic intent stage
• Complete initial planning of execution

Process characteristics:

• Unfolds over months with numerous meetings, work sessions, rounds of data collection and feedback
• Builds board engagement gradually
• Management benefits from the board's informed point of view

⚖️ Benefits and costs of deeper board engagement

Direct benefits:

• Deeper understanding by directors of the company and its strategic environment
• Sense of ownership of the process and resulting strategy
• Better decisions reflecting a broader array of perspectives
• Greater collaboration between board and management on other initiatives
• Increased board satisfaction
• More effective external advocacy

Costs:

• Time and commitment: Directors must thoroughly understand capital allocation, debt levels, risks, business unit strategies, growth opportunities, and many other issues; they must engage on major challenges and grasp trade-offs
• Less management control: Real participation means influence, and influence means the ability to change outcomes
• The trade-off: A well-designed process yields the benefits while limiting time requirements and potential loss of control

💰 Special Situation: Capital Structure Decisions

💰 What capital structure means

Capital structure: how a business constructs its balance sheet from three sources of capital.

The three sources:

1. Long-term debt: Bonds or similar obligations (notes, capital lease obligations, mortgage issues) with repayment horizon > 1 year
2. Preferred stock: Equity interest with claims ahead of common stock, normally no rights to share in increased company worth if it grows
3. Common stockholders' equity: Principal ownership, made up of:
   • Nominal par or stated value of outstanding stock
   • Capital surplus (amount above par value paid when issuing stock)
   • Earned surplus/retained earnings (portion of earnings retained after dividends)
   • = Net worth after all liabilities (including long-term debt) and preferred stock are deducted from total assets

💰 The debt vs. equity trade-off

Leverage mechanism:

• Creating a high percentage of debt relative to common equity
• Tax advantage: Corporate interest payments are tax-deductible expenses; dividends to preferred and common stockholders must be paid with after-tax dollars
• Lower net cost of bond interest helps accrue more value for common stockholders
• This can minimize cost of capital while enhancing return on common equity

The inescapable trade-off—higher debt increases risk:

Risk dimension	How higher debt hurts
Bankruptcy risk	Grows as leverage increases
Capital access	May diminish, especially during tight credit
Management focus	Must spend more time on finances and raising capital at expense of operations
Future capital cost	Cost of any additional debt or preferred stock increases

Fixed cost burden: Higher debt increases fixed costs that must be paid in good times and bad, severely limiting flexibility.

💰 When companies use debt

• Decision often related to nature and risks of cash flows associated with capital investment
• Diversification pattern:
  • Moving into related fields → tend to use equity capital
  • Entering unrelated fields → tend to use debt
• Ownership structure matters:
  • High management ownership → less likely to carry high debt
  • Significant institutional ownership → less likely to carry high debt

💰 Historical shift: from "clean" balance sheets to leveraged buyouts

Earlier era:

• Debt-free structure considered a sign of strength
• Companies prided themselves on "clean" all-common capitalization balance sheets

The 1980s LBO twist:

• Large corporations with conservative, low-debt capitalizations became vulnerable to capture
• The mechanism: Corporate raiders with limited resources raised huge amounts of non-investment grade ("junk") debt to finance deals
• Captured companies would be dismembered and stripped of cash holdings so raiders could pay down borrowings
• Irony: The prey's own assets were used to pay for its capture

Defensive response:

• Potential targets began to assume heavy debt themselves, often to finance internal management buyouts
• Raiders forced cuts in low-return growth avenues and sale of divisions more valuable outside the firm
• Significant intrinsic firm value was distributed to stockholders (especially those who bought in for that purpose) at the expense of other stakeholders and the company's long-term needs
• Justification: Managers operating with low leverage were either inept or feathering their own nest, or both

🤝 Special Situation: Takeovers, Mergers, and Acquisitions

🤝 Definitions and differences

Term	What it means	Management control implication
Merger	Two companies join to form one company	(varies)
Acquisition	One firm buys another	Management team of the buyer tends to dominate decision making

• To outsiders, the difference might seem small and related to financing
• Critical difference: often in management control

🤝 Why acquisitions are attractive—and risky

Advantages:

• Quickly position a firm in a new business or market
• Eliminate a potential competitor
• Do not contribute to development of excess capacity

Disadvantages:

• Generally expensive (premiums of 30% or more than current stock value are common)
• Acquiring companies frequently lose shareholder value, even though sellers pocket handsome profits

🤝 Theory vs. practice in M&A decision-making

In theory (how it should work):

• Acquisitions are part of a corporate growth strategy
• Explicit identification of most suitable players in most attractive industries as targets
• Comprehensive framework for due diligence assessments
• Plans for integrating acquired companies
• Careful determination of "how much is too much" to pay

In practice (how it actually works):

• Once board approves expansion plans or a target is identified, time to act is typically short
• Intense pressures to "do a deal" from:
  • Senior executives
  • Directors
  • Investment bankers (who stand to gain from any deals)
  • Shareholder groups
  • Competitors bidding against the firm
• The environment becomes frenzied:
  • Valuations rise as corporations become overconfident in their ability to add value
  • Expectations regarding synergies reach new heights
  • Due diligence conducted more quickly than desirable, confined to financial considerations
  • Integration planning takes a backseat
  • Differences in corporate cultures are discounted

Don't confuse: Even the best designed strategies can fail in this climate—the process matters as much as the plan.

🤝 Empirical evidence on M&A success rates

Most studies show:

• Probability of major acquisition/merger failing (measured by financial return) is greater than probability of success
• Probability of failure increases with:
  • Size and complexity of the merger
  • Degree of unfamiliarity with the target business

Why buyers often pay too much (overoptimism about):

1. Ability to do better than existing management
2. Ability to implement identified synergies
3. Ability to integrate the target in a timely manner

New accountability mechanism:

• International Accounting Standard (IAS) 36 on impairment of assets forces companies to examine asset value (especially intangible assets) on a recurring basis
• Each overpaid acquisition will inevitably result in impairment of goodwill
• Sooner or later, board and management must publicly admit their decision destroyed shareholder value
• This regulation alone is a powerful reason for boards to become much more actively involved in M&A activity

🤝 Why board involvement in M&A is particularly sensitive

Factors that limit board engagement:

• Acquisition results from long, confidential negotiation process
• Often involves extremely technical issues
• Outcome is largely uncertain
• These factors lead management to present only summary, high-level information to the board
• Management waits for process outcome before organizing in-depth discussions

Why this is unfortunate:

• M&A represents a unique opportunity for a board to add value
• Outside directors may have unique experience with M&A process, particular intermediaries, or merger integration challenges
• The outside view at an early stage may counterbalance:
  • Optimism of executives driving the deal
  • Partiality of numerous experts pushing for completion
• Result: more "realistic" attitude to the opportunity

🤝 Five best practices for boards in M&A

🤝 1. Validate the strategic benefits

Key questions the board should ask:

• How did the opportunity come about—has management been working on it for some time?
• Does it concern a business activity or market the company is familiar with?
• Does it represent geographical or other diversification?

Important principle:

• Rarely can an acquisition be justified solely on grounds of savings (often illusionary)
• Must either meet a clearly defined need the company cannot meet with own resources, or enhance competitive position
• To create value: acquisition must build a genuine competitive advantage or decisively prolong an existing one
• Directors' role: test the solidity of this premise

Don't confuse: A "strategic fit" justified only after the fact is a red flag—many mistakes are attributable to such post-hoc rationalizations.

🤝 2. Verify that the price paid is reasonable

Valuation should reflect realistic assessment of:

• (a) Intrinsic value of target under different scenarios
• (b) Value of expected synergies (and cost of implementing them)
• (c) Positive and negative impacts on purchaser's value (e.g., management time devoted to integration may adversely impact purchaser's business)
• (d) Price management offers to pay and terms/conditions of payment

When to get a fairness opinion:

• Acquisition is particularly significant relative to company size
• Possibility of conflict of interest
• Possibility of challenge by minority shareholders concerning price paid
• Should be drawn up by an independent expert

Ensuring true independence:

• Usually opinions are prepared by company's financial advisers or consultants hired by management (who hope for repeat business)
• Board must verify independence and skills of expert(s)
• When report is submitted, ensure work was done properly per professional standards
• Requires at least one board member with adequate relevant experience, or board assistance from another expert

🤝 3. Ensure comprehensive due diligence

Due diligence: enables purchaser to verify integrity of seller's financial statements, representations, and warranties, and to identify potential problems.

The problem with typical due diligence:

• Too often mainly based on legal and accounting criteria
• Company needs to identify all areas of major risk, particularly current and future operating risks or obstacles to effective integration

What comprehensive due diligence covers:

• Analysis of target's competitive advantages and their durability
• Identification of key people (especially those to rely on for integration)
• Measurement of stability of most significant customer relations
• Long-term prospects of formal or informal alliances

Must be based on: Broad (but relevant) objectives concerning integration of the target.

🤝 4. Approve a specific integration plan

Why this matters:

• Integrating the target is the most complex part of the M&A process
• Experience shows this difficulty remains largely underestimated despite broad consensus

Board's role: Ask management to provide an integration plan prior to concluding the transaction.

Plan must include:

• (a) Timetable for the integration program
• (b) Identification of main initiatives to recover a significant portion of the control premium paid
• (c) Assessment of human resources and expertise earmarked for integration process
• (d) Detailed business plan showing all costs and benefits associated with integration

Often neglected—talent due diligence:

• Boards focus on strategic, financial, and governance aspects
• Often neglect one of the greatest sources of value: talent of the management team in the target company
• Exercising due diligence about talent is as important as attention to balance sheet, cash flow, and expected synergies
• By asking about human capital, boards contribute to:
  • Smoother transition to single company
  • Better merging of cultures
  • Loss of fewer "A" players
  • Stronger talent bench for merged company
  • Ultimately, more value from the deal

🤝 5. Organize the board's work to assist management upstream

• Board's contribution is more useful if it contributes to management's thought process as early as possible in the analytical and decision-making process
• If M&A is a cornerstone of strategy: Creating a special committee may be useful to deal with:
  • Efficiency
  • Confidentiality
  • Constraints inherent in a long and uncertain negotiating process

📊 Monitoring Strategy: Choosing the Right Metrics

📊 What makes a good set of metrics

The goal: Identify a manageable number of metrics that:

• Strike a balance among different areas of the business
• Are directly linked to value-creating activities

Beyond standard financial metrics, key indicators should cover:

• Operations: Quality and consistency of key value-creating processes
• Organizational issues: Company's depth of talent, ability to motivate and retain employees
• Product markets: State of markets and company's position within them (including quality of customer relationships)
• External relationships: Nature of relationships with suppliers, regulators, NGOs

📊 Three time horizons for metrics

📊 Short-term health metrics (1–3 years)

Purpose: Show how a company achieved recent results; indicate likely performance over next 1–3 years.

Examples:

• Consumer products company: Did it increase profits by raising prices or by launching a new marketing campaign that increased market share?
• Auto manufacturer: Did it meet profit targets only by encouraging dealers to increase inventories?
• Retailer: Revenue growth per store and in new stores; revenue per square foot compared with competitors

📊 Medium-term metrics (1–5 years, longer for some industries)

Purpose: Highlight prospects for maintaining and improving rate of growth and returns on capital.

Time frame adjustments:

• Should be longer for industries with long product cycles (e.g., pharmaceuticals must focus on number of profitable new products in pipeline)

Examples:

• Metrics comparing company's product launches with competitors (e.g., time needed to reach peak sales)
• Online retailer: Customer satisfaction and brand strength might be most important drivers

📊 Long-term metrics (5+ years)

Purpose: Assess company's ability to sustain earnings from current activities and identify/exploit new growth areas.

What to monitor:

• Threats to current businesses:
  • New technologies
  • New customer preferences
  • New ways of serving customers
• Growth opportunities:
  • Number of new initiatives under way
  • Size of relevant product markets
  • Metrics tracking initiatives' progress

📊 People metrics

Ultimately, it is people who make strategies work.

What a good set of metrics should show:

• How well business retains key employees
• True depth of management talent

What's important varies by industry:

• Pharmaceutical companies: Need scientific innovators but relatively few managers
• Companies expanding overseas: Need people who can work in new countries and negotiate with governments

Don't confuse: Financial metrics are probably the least valuable component of a board member's strategic information requirements, yet they still dominate board discussions.

🎯 Creating a Strategy-Focused Board

🎯 What it takes

• Fostering a strategic mind-set is difficult and takes time
• Requires rethinking:
  • Board composition
  • How board approaches its responsibilities
  • How board interacts with management
• Must help develop strategic vision (though vision must originate with CEO)

Progressive CEOs must:

• Articulate a clear strategy
• Have personal confidence to build board teams including experts who may be far more skilled in certain industry and operational areas than the CEOs themselves

🎯 A practical first step: balance short- and long-term oversight

Rather than immediately seeking deeper involvement in strategy development:

1. First seek more effective balance between short- and long-term considerations in oversight
2. Identify and agree on core set of metrics reflecting balance tailored to:
   • Company's industry
   • Maturity
   • Culture
   • Current situation

Then: 3. Management draws up set of long-term strategy options that board can test and challenge 4. Management develops detailed plan for board's final approval

🎯 How the process should unfold

• Over several board meetings
• Allows board members to probe specific strategic issues:
  • Does the company really have ability to execute in a particular area?
  • Has it analyzed different options to enter the markets it wants to compete in?
• Board plays important role in monitoring progress of plan and any changes in risk

Division of focus:

• Board can be selective in its focus on details
• Management must deal with all aspects of strategic plan

Ongoing nature:

• Once accepted, strategy can be expected to evolve over time
• Requires ongoing dialogue between board and management

Don't confuse: This is not about boards taking over strategy formulation—it's about creating a structured process for meaningful engagement that respects the CEO's and management's fundamental responsibilities while leveraging the board's perspective and experience.

🧭 Overview

🧠 One-sentence thesis

Effective CEO performance evaluation and executive compensation require structured board processes that balance accountability for past results with forward-looking strategic goals, while avoiding common pitfalls like excessive pay disconnected from performance and misaligned incentives.

📌 Key points (3–5)

• CEO evaluation is foundational: 91% of surveyed directors conduct annual CEO evaluations, but implementation varies widely across committees and processes.
• Dual objectives create tension: Evaluations must look backward (accountability and rewards) and forward (future objectives and development), but time constraints often force both into one meeting, weakening both.
• Three dimensions of CEO performance: bottom-line impact (financial results), operational impact (strategy execution and customer satisfaction), and leadership effectiveness (how well the CEO fulfills role responsibilities).
• Stock options drove pay explosion: Options were treated as "cost-free" by many boards despite their high economic cost, transferring wealth from shareholders to executives and fueling compensation growth over three decades.
• Common confusion: Benchmarking vs. performance—many boards set CEO pay above median levels ("Lake Wobegon effect") based on market comparisons rather than actual value creation.

📋 CEO Performance Evaluation Process

🎯 Why evaluation matters

• Regular, purposeful CEO evaluation is described as "a cornerstone of effective governance."
• A well-designed process serves multiple purposes:
  • Assists the compensation committee in making pay and employment decisions
  • Establishes focus on the company's future direction through strategic objectives
  • Provides ongoing leadership development for the CEO
  • Identifies areas needing improvement or new skills

⚠️ Common pitfalls to avoid

Pitfall	What it means	How to address
Uncertainty over roles	Confusion about who does what in the evaluation	Clear charter, role descriptions, timelines; lead director clarifies expectations
Lack of time and energy	Elaborate process meets resistance	Well-designed evaluation actually saves time by structuring other board responsibilities
Disagreement over criteria	Debate about what to measure	Resolve by appealing to strategy and business needs
Lack of direct information	Financial metrics available, but "softer" dimensions (leadership effectiveness) harder to measure	Design specific measures for qualitative performance

🔄 The tension between backward and forward focus

An effective CEO evaluation process looks backward, focusing on accountability and rewards for past performance, as well as forward, focusing on future objectives and whether the CEO has the vision, strategy, and personal capabilities to achieve those objectives.

• The problem: Time constraints often force boards to evaluate past performance, make compensation decisions, set next year's targets, and discuss improvement areas in a single meeting.
• The consequence: When objectives are not clearly separated, neither gets served well; the developmental part is often skipped entirely.
• What gets lost: The board uses compensation review to set future objectives, emphasizing what the CEO should achieve (short-term financial targets) over how the CEO should behave (e.g., developing future leaders); the CEO is unlikely to receive candid, detailed feedback about behavior and personal impact.

Don't confuse: Accountability (past) with development (future)—both are essential but require separate attention and different types of feedback.

📊 Three Dimensions of CEO Performance

💰 Bottom-line impact

Most CEO evaluation and "pay-for-performance" plans are based on the assumption that the top executive has a direct and significant impact on corporate performance, and therefore hold CEOs accountable for the company's overall financial health.

• What it measures: Shareholder-oriented, accounting-based financial measures; overall financial health.
• The limitation: Most CEOs know their ability to affect the bottom line is indirect and often limited; relying solely on these measures has "severe deficiencies."
• Example: A CEO may face market-wide downturns or inherit structural problems beyond immediate control, yet be judged purely on stock price or earnings.

🔧 Operational impact

Operational impact refers to the CEO's influence on the company's effectiveness in operational areas, such as customer satisfaction, new product introduction, or productivity enhancement, and how well the firm implements its strategy.

• Why it's better: Gives a better indication of underlying potential to create value because measures are more directly related to CEO actions.
• Still imperfect: Subject to external and internal forces outside the CEO's immediate control, but more closely related to the CEO's actions than bottom-line measures.
• Less volatile: Not as subject to market-wide volatility as immediate stock price.

👔 Leadership effectiveness

Leadership effectiveness addresses how well the CEO carries out his or her responsibilities, both in terms of executing specific role responsibilities—identifying a successor, meeting with key customers and investors, developing a long-term strategy—and the quality of those actions—communicating with external stakeholders, energizing the organization, and gaining the confidence of investors.

• What it captures: How the CEO behaves as a leader; the quality of execution, not just outcomes.
• Measurement challenge: "Softer" dimensions require rating methods (e.g., how often the CEO demonstrates desired behaviors and their impact).

🧭 General principles for selecting objectives

1. Reach beyond bottom-line performance: Financial measures are critical but capture only one aspect.
2. Focus on a manageable number: Best practice is 5–10 dimensions (too few = dominated by short-term financial goals; too many = unworkable).
3. Use separate objectives for chairman and CEO roles: Even if the same person holds both, evaluate each role distinctly.
4. Define measures for each objective: Explicit measures assist in tracking; even "softer" dimensions can be measured through rating methods.
5. Specify performance levels for each rating measure: Specificity creates shared understanding of performance standards between CEO and board.

🗓️ Integrated Evaluation Process

📅 Step 1: Defining the CEO's objectives (before fiscal year)

• CEO works with compensation committee to establish key business objectives for the coming year.
• Use the strategic plan as starting point.
• Produce initial set of personal performance targets and associated measurements.
• Full board reviews, amends if needed, and approves final set.
• These targets can then align objectives at each leadership level in the company.

📅 Step 2: Mid-year review (six months in)

• Compensation committee and CEO review targets and progress.
• Value 1: Helps board see how CEO is meeting or exceeding targets; identifies areas requiring closer attention.
• Value 2: Provides opportunity to amend targets in light of changed circumstances (e.g., rapidly changing business conditions).

📅 Step 3: Year-end assessment (end of fiscal year)

• Measure CEO's performance against previously established objectives.
• CEO provides self-evaluation and addresses areas where targets were not met.
• Self-assessment shared with compensation committee, then full board for input.
• Evaluations by all board members go to compensation committee.
• Committee uses results to determine performance-linked portion of CEO's pay.
• Critical step: Board discusses evaluation in executive session (without CEO or other inside directors) before providing feedback.

Don't confuse: Mid-year review (adjustment and monitoring) with year-end assessment (final evaluation and compensation decision).

💸 Executive Compensation Challenges

📈 The scale of the problem

• 2007 data: Average S&P 500 CEO received $14.2 million total compensation; median was $8.8 million—more than 350 times the pay of the average U.S. worker.
• Growth rate mismatch: Executive compensation increased 20.5% in 2007 while revenues grew just 2.8% (Economic Research Institute study of 45 random public companies).
• Discretionary bonuses: When performance-based bonuses dropped 18.6% in 2007, companies compensated with bigger discretionary bonuses and other payments not tied to specific financial targets; overall CEO bonuses still increased 1.4%.

🎯 Why excessive pay matters

• Takes dollars out of shareholders' pockets, including retirement savings of working families.
• Poorly designed packages can reward decisions not in the long-term interests of company, shareholders, and employees.
• Creates perception that directors remain beholden to management despite rules mandating greater board autonomy.

📜 Historical context and unintended consequences

• Early 1990s: CEO pay became major political issue; Graef Crystal's In Search of Excess demonstrated prevalence of excessive compensation.
• 1992 SEC action: Required companies to include nonbinding shareholder resolutions about CEO pay in proxy statements; announced new disclosure rules.
• 1994 tax act: Defined nonperformance-related compensation over $1 million as "unreasonable" and not tax-deductible.
• Ironic outcome: Although objective was to reduce excessive pay, the ultimate outcome was significant increase in executive compensation; escalation in option grants satisfied IRS regulations and allowed pay significantly over $1 million to be tax deductible; once the act defined $1 million as reasonable, many companies increased cash compensation to $1 million then added performance-based components.

Don't confuse: Intended policy goals with actual outcomes—regulations designed to limit pay can inadvertently create new mechanisms for increasing it.

📉 Stock Options: The Main Driver

🔑 What stock options are

A stock option is a right to buy shares at a particular price—the so-called strike price—at some future date.

• How they work: If an employee receives an option to buy 100 shares at a $5 strike price and the stock rises to $10 by vesting, the employee can buy at the lower price and reap a quick profit.
• The idea: Align employees' interests with shareholders' to encourage productivity and profits.
• The reality: Excessive use created a mechanism for companies to transfer profits directly to employees—mostly top executives—at the expense of shareholders.

💰 The economic cost vs. perceived cost problem

• Economic cost: The opportunity cost the firm gives up by not selling the option in the market; should be recognized as an expense in accounting statements.
• Employee valuation: Employees are more risk-averse and undiversified than shareholders; prohibited from trading options or hedging risk; therefore employees value options less than they cost the company to grant.
• The paradox: Company's cost can exceed perceived value to employee, making options an expensive compensation mechanism, not a low-cost one.
• Justification: Use can only be justified when productivity benefits exceed the pay premium offered to employees receiving options.

🚫 Why boards treated options as "cost-free"

Until recently, many U.S. companies were not diligent in assessing cost and value:

• Option grants do not incur cash outlay.
• Until recent accounting rule changes, did not bear an accounting charge.
• When exercised, company incurs no cash outlay and receives tax deduction for the spread.
• These factors made "perceived cost" much lower than economic cost, often even lower than value to employee.
• Result: Many options granted to many people; options with favorable accounting treatment preferred over better incentive plans with less favorable treatment.

Don't confuse: Accounting treatment (no immediate expense) with economic reality (significant opportunity cost).

⚖️ Illegal practices: Backdating and spring loading

• Backdating: Picking a date when stock was trading at lower price than actual grant date, resulting in instant profit; violates accounting rules, state corporate law, federal securities laws, and tax laws.
• Spring loading: Granting options right before company announces news guaranteed to drive up share price.
• Impact: Forced numerous CEOs and officials to resign or be fired; SEC investigated over 100 companies; money belongs to shareholders; restatements and additional taxes cause further shareholder losses.
• Sarbanes-Oxley protection: Since 2002, companies must report stock option grants to executives within 2 business days, making backdating much harder (but spring loading still possible).

🔄 Recent reforms

• Investors submitted dozens of shareholder proposals seeking to limit executive severance and realign pay with performance.
• Boards have started changing practices despite initial resistance:
  • Example: PepsiCo replaced traditional stock options with performance-based restricted shares worthless unless earnings targets met.
  • Example: Merrill Lynch made all but 2% of CEO's pay package restricted shares untouchable until 2009 (vs. almost 50% cash in 2003).

🪂 Golden Parachutes

🎁 What they are

A "golden parachute," or change-of-control agreement, is an agreement that provides key executives with generous severance pay and other benefits in the event that their employment is terminated as a result of a change of ownership of the company.

• Voted on by board; may require shareholder approval depending on state law.
• Some trigger even without complete control change—after a certain percentage of stock is acquired.

✅ Three justifications

1. Recruitment and retention: Enable corporations that are prime takeover targets to hire and retain high-quality executives who would otherwise be reluctant to work for them.
2. Takeover deterrent: Add to cost of acquiring a corporation, may discourage takeover bids.
3. Shareholder-aligned decisions: Executives with golden parachutes more likely to respond to takeover bids in manner benefiting shareholders; without parachute, executives might resist a beneficial takeover to save their own job.

❌ Growing criticism

• Have become more prevalent and lucrative; many promise benefits well into the millions.
• Example: Gillette CEO collected $185 million when Procter & Gamble acquired the company.
• Many agreements do not specify that executive must perform successfully to be eligible.
• High-profile cases: Executives cashed in while companies lost millions and thousands of employees were laid off.
• Particularly suspect: Large parachutes awarded once takeover bid announced—little more than going-away presents; may encourage executives to work for takeover at shareholders' expense.

📋 New disclosure requirements

• New SEC rules require companies to disclose terms of arrangements providing payments for resignation, retirement, or termination of five highest-paid executives.
• Must detail specific circumstances triggering payment and estimated amounts for each situation.
• Limitation: Shows whether package is excessive but does not provide investors way to limit them.
• Pending legislation: Congress considering requiring nonbinding vote on executive pay plans, including advisory vote if company awards new golden parachute during merger, acquisition, or proposed sale.

🔄 Factors Driving Compensation Higher

📊 Record CEO turnover

• More than one in seven of world's 2,500 leading companies made CEO change in 2005.
• Almost half involved involuntary dismissals—four times the number a decade ago.
• Interpretation 1: Recent reforms working; boards under shareholder pressure more proactive in firing underperforming CEOs.
• Interpretation 2: CEOs just as likely to leave prematurely as retire normally (for top job elsewhere or to become "consultant")—evidence that board-CEO relationship still more adversarial than constructive in many companies.

🔀 External hires vs. internal promotions

• Increasing prevalence of filling CEO openings through external hires rather than internal promotions.
• CEOs hired from outside typically paid more than those promoted from within.
• CEOs in industries with higher prevalence of outside hiring paid more than those in industries with internal promotions.
• Competitive job market makes retention more critical, further driving up pay.
• Boards err on side of paying more because of difficulty, disruptiveness, time, and cost of finding replacement.

🎯 The "Lake Wobegon" effect

Many boards, acting on advice of compensation consultants, have adopted a policy of setting their CEO's pay above median levels, a practice known among pay critics as the "Lake Wobegon" effect where most every CEO is considered above average.

• Competition for talent not limited to CEOs; extends to second-tier managers, especially CFOs.
• Base salaries and target bonus levels getting higher because of "benchmarking."
• Even if senior executives not threatening to leave, pay rises due to market comparisons.

Don't confuse: Market benchmarking (what others pay) with performance-based pay (what value the executive creates).

🏛️ The Role of the Compensation Committee

📋 Core responsibilities

• Board of directors responsible for setting CEO pay, but determining appropriate compensation policies for CEO and most senior executives normally task of board's compensation committee.
• Well-designed packages:
  • Tied to effective performance evaluation process
  • Reward strong current performance
  • Provide incentives for creating long-term value
  • Attract, retain, and motivate right talent
  • Avoid paying premiums for mediocre, poor performance, or value destruction
  • Align management interests with shareholders and stakeholders in short and long term

🔄 Expanded mission

The compensation committee's mission has grown to include two distinct elements:

Element	Responsibilities
Strategic	Determine how achievement of overall goals and objectives is best supported by specific performance-oriented compensation policies and plans; design and implement policies aimed at attracting, retaining, and motivating top-flight executives
Administrative	Ascertain that executive compensation programs (base salary, short- and long-term incentives, supplemental benefits, perquisites) remain competitive within the market

✅ Specific duties

Within the expanded mission, compensation committees must:

• Provide necessary transparency through proper disclosures in SEC filings.
• Recommend for board approval specific performance criteria and annual/long-term performance targets.
• Review performance of top five officers relative to achievement of objectives for calculating award levels.
• Provide periodic oversight of all incentive plans, perquisites, and benefits to ensure programs meet stated performance goals.
• Ensure all committee business conducted in moral and ethical fashion; maintain highest levels of personal conduct and professional standards.
• Notify board of any issues and necessary corrective action that may affect committee's ability to objectively fulfill duties.

🔄 Recent changes

• In wake of Sarbanes-Oxley, new SEC rules, and other regulations, many boards reevaluating composition, charter, and responsibilities of compensation committee.
• Focus shifting beyond transparency and compliance to creating value by adopting policies and structures that assist in attracting, developing, and managing executive talent and driving performance.

🎯 Best Practices for Compensation Committees

🧠 Think strategically about executive compensation

• Proactive committees integrate compensation policies with company's overall strategy.
• Example: A move to a new business model may require different incentives from other growth strategies.

🔄 Integrate compensation decisions with succession planning

• Very few events have more dramatic impact than unexpected loss of successful CEO.
• Winning companies have succession plan addressing not only "who takes over and when" but also "why" and "how."
• Requires board agreement on set of skills and competencies needed to execute long-term vision.
• Adopt objective framework for identifying right talent to implement chosen strategy.

📊 Understand the limitations of benchmarking

• External benchmarking widely blamed for escalating executive pay levels.
• The problem: Not the analysis methods themselves, but their application.
• Benchmarks can be useful for assessing competitiveness of compensation packages.
• Critical caveat: Should only be considered within the context of performance.

Don't confuse: Using benchmarks to assess market rates (appropriate) with setting pay above median regardless of performance (the "Lake Wobegon" problem).

👥 Understand how executives view compensation issues

Executives often take different perspective from directors:

Directors focus on	Executives focus on
Accounting expense	Personal, risk-based perspective
Tax consequences
Potential share dilution
Alignment with business strategy
Administrative complexity

💬 Communicate with major shareholders

• Investors increasingly value open dialogue about matters such as potential board nominees or equity grant reserves.
• Their input can give compensation committees sense of broader shareholder views.

🔍 Carefully select, monitor, and evaluate advisers and advisory processes

• NYSE listing standards require boards to evaluate themselves at least annually.
• Board self-evaluations quickly becoming governance best practice.
• Evaluation process should include performance of consultants and other outside advisers.

🧭 Overview

🧠 One-sentence thesis

Boards today must actively manage shareholder activism, corporate social responsibility demands, hostile takeovers, and crises—each requiring distinct strategies and a shift from passive oversight to proactive engagement with stakeholders beyond traditional shareholders.

📌 Key points (3–5)

• Shareholder activism has evolved: from 1920s transparency concerns to today's multi-issue campaigns (governance, social, environmental), driven by institutional investors and hedge funds seeking both influence and short-term stock gains.
• CSR pressure is reshaping governance: demands from NGOs, socially responsible investors, and civil society are forcing boards to consider stakeholder interests and nonfinancial performance, not just shareholder value.
• Hostile takeovers require built-in defenses: boards can use "shark repellent" (golden parachutes, poison pills, staggered boards) but face growing shareholder opposition to such measures as entrenching management.
• Crisis management demands board leadership: when the CEO is the crisis source (death, fraud, conflict of interest), the board must step in as chief crisis manager; otherwise, it supports the CEO with oversight, independent investigation, and communication.
• Common confusion: shareholder activism vs. stakeholder accountability—activism focuses on shareholder rights and governance structure, while CSR/stakeholder pressure broadens the board's agenda to include social, environmental, and ethical impacts beyond financial returns.

📢 The rise and mechanics of shareholder activism

📜 Historical evolution of shareholder voice

• 1920s–1930s origins: the stock market crash led to the creation of the SEC to protect investors through transparency and disclosure.
• 1970s socially oriented activism: religious investors formed the Interfaith Center for Corporate Responsibility (ICCR) and filed resolutions on apartheid, peace, environment, and equality.
• 1980s corporate governance activism: the Council for Institutional Investors (CII) was formed in 1985 to protect pension funds and promote good governance; focus shifted to board structure, executive pay, and director election processes.
• 1989 environmental alliance: after the Exxon Valdez disaster, the Coalition for Environmentally Responsible Economies (CERES) combined investors and environmentalists to push for environmental disclosure and principles.

🔧 Tools and tactics of activists

• Shareholder resolutions: typically nonbinding but draw public attention and force companies to reconsider policies; many companies now meet with institutional shareholders during planning stages.
• Popular proposals today:
  • Direct shareholder nomination and election of directors (bypassing the board's nominating committee).
  • Making majority-supported resolutions binding on boards.
  • Mandatory shareholder votes on mergers.
• Voting "no": institutions increasingly vote against key items (compensation plans, board nominees) as their most powerful form of activism.
• Short-term stock impact: a Thomson Financial study (2001–2006) found that companies targeted by activists saw shares rise nearly 12% within 3 months (vs. <1.5% for control group) and 17% after one year (vs. 7.2%).

⚖️ The controversy: fire alarm vs. disruptive meddling

Proponents' view	Opponents' view
Active shareholders act as "fire alarms" and reduce managerial complacency	Activism is uninformed, populist meddling that encourages short-term behavior
Engaged shareholders improve long-term company success	Diverts boards from value creation
Vigilance is a check on poor governance	Hedge-fund activism may serve hedge-fund interests, not all shareholders

• Don't confuse: all shareholder activism with hedge-fund activism—hedge funds may have divergent interests from other shareholders despite their governance involvement.

🌍 Corporate social responsibility (CSR) as a governance issue

🌐 Why CSR is now on the board agenda

Corporate social responsibility (CSR): pressure on boards to make social, environmental, and economic responsibility an integral part of corporate strategy and to be accountable to stakeholders beyond shareholders.

• Shift in popular opinion: the role of business in society is being redefined; CSR is no longer voluntary but a core governance question.
• Four converging forces:
  1. Globalization: over 60,000 multinational corporations exist; their reach and influence draw scrutiny of their social, environmental, and economic impacts.
  2. Loss of trust: high-profile scandals (Enron, WorldCom) and irresponsibility cases (Shell in Nigeria, Exxon Valdez, Nike sweatshops, Nestlé baby formula) eroded public trust and increased readiness to assume immoral corporate intent.
  3. Civil society activism: ~48,000 international NGOs (Oxfam, Amnesty International, Greenpeace) monitor corporate behavior and mobilize public opinion via the Internet.
  4. Socially responsible investing (SRI): growth in SRI assets outpaces all professionally managed investment in the U.S.; institutional demand for CSR-committed companies is rising.

🔮 Future implications for boards

• Growing pressure to give stakeholders a governance role: not just shareholders but employees, communities, NGOs.
• More disclosure: better information about social, environmental, and economic management.
• Regulatory compulsion: elements currently voluntary may become mandatory.
• Mainstream finance interest: the link between shareholder value and nonfinancial performance is gaining attention.
• Cooperation over competition: companies are forming coalitions with competitors, activists, SRI firms, and academics (e.g., 2007 World Economic Forum coalitions on online free speech in China with Google, Microsoft, Yahoo, BSR, Amnesty International).

⚠️ Don't confuse CSR with traditional shareholder activism

• Shareholder activism = shareholders (owners) demanding better governance, transparency, and financial performance.
• CSR pressure = stakeholders (employees, communities, NGOs, society) demanding accountability for social, environmental, and ethical impacts.
• Both are reshaping governance, but CSR broadens the board's accountability beyond financial returns.

🛡️ Defending against hostile takeovers

🎯 What is a hostile takeover

• Definition: acquisition of a poorly performing firm in a mature industry when the target board opposes the sale.
• Two main methods:
  1. Tender offer: bidder offers to buy stock directly from shareholders or on the secondary market at a premium price; must disclose plans and file with the SEC; allows bidder to go "over the heads" of management.
     • Creeping tender offer: gradually buying stock to gain controlling interest without a public offer (risky if discovered).
  2. Proxy fight: when board and shareholders disagree on strategy, compensation, or M&A, the board seeks shareholder approval via proxy statement; contests usually aim to replace directors.
• Leveraged buyout (LBO): buyer borrows heavily (bank loans or junk bonds) to pay for acquisition; risky because debt can harm the acquiring company's value.

🦈 Built-in defenses ("shark repellent")

Defense	How it works
Golden parachute	Generous severance for executives if employment ends due to ownership change; requires board vote (and sometimes shareholder approval); can trigger at a certain stock-acquisition percentage
Supermajority	Requires 70–80% shareholder approval for any acquisition (vs. simple majority)
Staggered board	Directors elected in different years (e.g., some every 2 years, others every 4); prevents entire board replacement at once
Dual-class stock	Owners hold voting stock; public gets little/no voting rights; investors can buy shares but not control
Lobster Trap	Prevents anyone with >10% ownership from converting convertible securities (bonds, preferred stock, warrants) into voting stock

💊 Active defenses ("poison pills")

• Legal challenge: sue the bidder for antitrust or securities violations.
• People pill: managers/employees threaten mass departure if acquired (only works if employees are highly valuable).
• Asset restructuring:
  • Crown Jewel defense: sell or spin off the most valuable division (e.g., a pharma company's R&D unit).
  • Buy assets the bidder doesn't want or that create antitrust problems.
• Liability restructuring:
  • Macaroni defense: issue bonds that must be redeemed at high price if takeover occurs (redemption price "expands like macaroni").
  • White Knight defense: issue shares to a friendly third party to dilute the bidder's ownership.
  • Jonestown defense: accumulate debt to force bankruptcy rather than be acquired.
• Flip-in: current shareholders can buy more stock at steep discount if any shareholder reaches 20–40% ownership; dilutes stock value and voting power.
• Greenmail: target repurchases the hostile suitor's shares at a premium over market price.
• Pac-Man defense: target buys stock in the acquiring company and launches a counter-takeover.

📉 Shareholder backlash against poison pills

• Complaints: poison pills entrench management/board and discourage legitimate tender offers.
• Institutional Shareholder Services (ISS): recommends voting for shareholder proposals to submit pills to shareholder vote or redeem existing pills; companies with unapproved pills get downgraded ratings.
• Current status: about one-third of S&P 500 companies still have poison pills.
• Nonbinding proposals: even if shareholders overwhelmingly approve a proposal to terminate a pill, the board is not legally bound—but failure to implement leads to negative consequences (perception of unresponsiveness, vote withholding in director elections, downgraded governance ratings).

🚨 The board's role in crisis management

🔍 Types and origins of crises

Crisis: any sudden event that threatens a company's financial performance, reputation, or relations with key stakeholders.

• Frequency: large corporations face a crisis every 4–5 years on average; every CEO will manage at least one; directors may face two or three during a normal board tenure.
• Four categories (Nadler, 2004):

Origin	Gradual emergence	Abrupt emergence
External	Economic downturns, competitive threats (new tech, alliances), regulatory changes	Natural disasters, terrorist attacks, product tampering
Internal	Strategic mistakes (bad merger), failed product launches, loss of key talent, discrimination suits	Sudden CEO death/resignation, critical system failure, discovery of fraud

• Preventable vs. not: many crises result from "sins of commission or omission" and develop gradually with opportunities for board intervention; abrupt crises are unpredictable but consequences can be mitigated with planning.

🎯 When the CEO is the crisis

• Board must lead: when the CEO is the source (death, sudden departure, fraud, conflict of interest), the board has no choice but to assume full crisis-management responsibility.
• Conflict of interest: hostile takeover bids may threaten executives' jobs but benefit shareholders—only the board can provide leadership and maintain stability.
• Emergency succession plan: every board must have a detailed plan for sudden CEO loss; review and update at least annually.
• Board crisis-management plan essentials:
  • Identify different roles depending on management's role in the crisis.
  • Specify which board leaders/directors play what role.
  • Identify independent advisers (legal, financial, PR).
  • Clarify board organization during crisis and which members have relevant expertise.

🤝 Supporting the CEO in other crises

• CEO as chief crisis officer: in most crises not involving the CEO, the CEO leads and the board supports.
• Board's supporting role:
  • Approve key decisions.
  • Provide confidential sounding board.
  • Give informed advice based on directors' crisis experience or expertise.
  • Demonstrate confidence in CEO and support for management.
• What boards need:
  1. Information: constant communication between CEO and board as events unfold.
  2. Credible communications policy: keep shareholders, media, and others informed.
  3. Independent investigation: if necessary, launch investigation and retain outside counsel.
• Engage the board: CEO should involve board in evaluating alternative courses of action to benefit from collective experience.

🔄 Recovery and learning

• Brief window for introspection: after a crisis, there's a push to regain normalcy; the board must insist management stop and learn lessons.
• Board's leadership opportunity: demonstrate independence and value by reviewing and updating risk assessment, crisis planning, and organizational recovery capabilities.
• New environment: boards can no longer operate in privacy and anonymity; they must function in openness and transparency and respond effectively to public scrutiny, government, regulators, shareholders, NGOs, press, consumers, and citizens.

🧭 Overview

🧠 One-sentence thesis

A high-performance board must manage itself effectively by balancing motivation and capability, understanding both formal rules and informal group dynamics, and continuously challenging the company's operations while maintaining clear boundaries between governance and management.

📌 Key points (3–5)

• Board's first priority: A board must manage its own agenda and processes independently from management, understanding the difference between governing (board's role) and managing (management's role).
• Seven habits of effective boards: Best-in-class boards own strategy, build top teams, link reward to performance, focus on financial viability, match risk with return, manage reputation, and manage themselves.
• Sociology matters: Board behavior is governed by both formal rules (explicit policies) and powerful informal norms (unstated expectations) that can significantly influence individual director behavior and decision-making.
• Common confusion: Director independence is often misunderstood—legal independence does not address the deeper sociological issues of group dynamics, peer pressure, and informal norms that shape actual board behavior.
• Information and time barriers: Directors face significant constraints in available time and often receive inadequate information (mostly historical data) to answer forward-looking strategic questions effectively.

🎯 Board fundamentals and effectiveness drivers

🎯 Managing itself as first priority

A board's principal duty is to provide oversight; management's duty is to run the company.

• The board, not management, has ultimate legal responsibility for directing company affairs.
• A board must control its own agenda to maintain independence—management should have only a consultative role in decisions like choosing new directors.
• Boards can no longer be passive "advisers" waiting for management; as fiduciaries, they must actively monitor management.
• Don't confuse: Advising versus governing—boards that wait for management to come to them are not fulfilling their fiduciary duty.

📊 Two critical determinants

The excerpt identifies motivation and capabilities as the two dimensions that determine board effectiveness:

Board Type	Motivation	Capabilities	Result
Most effective	High	High	Know difference between governance and management; add value appropriately
Statutory only	Low	Low	Ineffective; function mainly as required by law
Missed opportunity	Low	High	Capable but underutilized
Problematic	High	Low	Tend to meddle or micromanage

🏆 Seven habits of best-in-class boards

🏆 Own the strategy

• Strong boards contribute to strategic thinking and feel ownership of the resulting strategy.
• Example: An organization holds multi-day strategy retreats where each director contributes to the list of key strategic decisions, beginning with analytic overviews of markets and competitors.
• When boards understand issues at this depth and ask critical questions early (Is the strategy bold enough? Is it achievable?), they can respond more quickly to opportunities like major acquisitions.

👥 Build the top team

• Selecting, developing, and evaluating the top executive team are major board responsibilities.
• Effective boards understand that developing leaders creates market value.
• However, analysis of 23 high-growth companies revealed only a minority systematically develop new leadership through internal advancement.

💰 Link reward to performance

• Determining the right reward structure starts with how the company measures success and how closely these measures tie to long-term value drivers.
• Effective compensation schemes:
  • Measure what matters and pay for performance
  • Include real downside for mediocre results
  • Are simple and transparent
  • Focus on sustained value creation, balancing short-term and long-term focus

💵 Focus on financial viability

• Extends beyond Sarbanes-Oxley compliance to include choosing appropriate debt levels and scrutinizing major investments and acquisitions.
• Negative example: An investigation into an organization's accounting irregularities concluded that directors were kept in the dark about acquisitions and made little effort to monitor debt levels, yet rubber-stamped proposals to increase borrowings.

⚖️ Match risk with return

• Most boards assess operational risk, but few understand the true risks inherent in their strategies.
• Key statistics from the excerpt:
  • Almost three-quarters of major acquisitions destroy rather than create value
  • 70% of diversification efforts away from core business into new markets fail
  • More than 40% of recent CEO departures (not retirement-related) can be attributed to controversial or failed "adjacency" moves
• Boards need to understand and accept strategic risks and recognize implications for required risk-weighted returns.

🎭 Manage corporate reputation

• Strong boards avoid "check-the-box" compliance and short-term horizons.
• They target long-term value creation and ignore guidance by "analysts," courting investors who seek long-term value.
• Once a course is set, they focus on transparency and effective communication to enhance reputation.

🔧 Manage themselves

• An effective board chair sets the tone from the top and implements an effective governance model.
• Such a model:
  • Focuses the agenda on performance issues and regularly reviews board effectiveness
  • Builds a team of directors with the right mix of skills and experience
  • Is clear about the value a board can contribute
  • Ensures directors have ample opportunities to fulfill their roles

👔 Leadership structure and the chair role

👔 Why independent leadership matters

• Independent board leadership capable of shepherding priorities and providing a voice for outside directors is critical to effectiveness.
• A nonexecutive chair can strengthen board independence and create healthy checks-and-balances between management and board.
• Alternative: Some boards adopt the "lead director" model.

📋 Four main responsibilities of the chair

According to the excerpt, the chair's responsibilities cover:

1. Managing the board: Chairing board meetings and leading executive sessions of independent directors
2. Communication: Maintaining regular communications with senior management and other directors to set agendas and discuss information flow and emerging issues
3. Succession planning: Well positioned to play a leading role in CEO succession planning
4. Board evaluations: Significant role in conflict resolution (though the governance committee should manage the evaluation process)

🎯 Required qualities

• Must understand the function of each board committee and role of individual directors
• Must not undermine the CEO's authority, especially in front of senior management
• Needs good "people" and "communication" skills
• Must know how to create focus and build consensus
• Must facilitate effective communication between board and management without becoming a barrier
• Requires diplomacy, ability to be direct and concise without offending, passion for the job, and minimal ego
• Key statistic: 73% of nonexecutive chairs on S&P 500 boards are retired corporate executives; about half formerly served as CEO of another company.

🧠 Understanding board sociology

🧠 Formal versus informal rules

All group behavior, including that of boards, is governed by formal and informal rules.

Formal rules include:

• Explicit policies about meeting frequency
• Meeting structure
• Committee participation
• Decision-making processes (discussion and vote)

Informal rules (norms) are unstated but powerful:

• Example: Asking "tough, penetrating" questions is formally encouraged as part of a director's duty, but pursuing an issue too long or vigorously may violate unstated rules about what others consider "effective" board membership.
• This explains why many boardroom votes are unanimous—repeatedly voting "against" peers may lead to questions about whether a director is "for" or "against" management or has a hidden agenda.
• Many boards operate under an unstated rule that directors should not criticize or reexamine past decisions.

⚠️ Consequences of violating norms

• Punishment for violating informal rules is less well-defined than for formal rules.
• Corrective action primarily takes the form of peer pressure.
• Since directors don't interact much outside the boardroom, peer pressure is mainly confined to the boardroom itself.
• Directors don't have power to directly remove ineffective or confrontational peers.
• The chair (especially if also CEO) will likely hesitate before confronting an offending director unless the breach is highly disruptive.

👥 Group influences on individual behavior

The excerpt identifies several key phenomena:

Social inhibition: The presence of more experienced and powerful group members can discourage individuals from participating to their full potential, expressed as:

• Loafing: Minimizing effort while hiding behind others' work
• Self-handicapping: Knowingly accepting a very difficult challenge to avoid risk of failing at a simple task
• Conforming: Simply going along to get along

Common dilemmas directors face:

• Should I go along with a compensation committee's recommendation for a substantial CEO increase when I believe he is already paid too much?
• Do I vote "no" on an aggressive debt restructuring when other board members clearly favor it?
• How do I act when a senior board member who mentored me urges me to go along with the majority for "unity"?

Why current independence focus may be misplaced: Legal director independence has little or no relation to the underlying sociological issues that shape board behavior—group norms strongly influence and may even dictate what perceptions, beliefs, and judgments are deemed appropriate.

🔄 Why boards seek similar directors

Boards have tended to search "among their own" (other CEOs with board experience) for new directors because:

• It avoids potentially embarrassing problems
• New candidates likely already understand the "rules," especially informal norms, that govern board conduct
• Reduces uncertainty about whether candidates will fit the existing culture

📊 Overcoming information and time barriers

⏰ Time constraints

• Outside, independent board members usually hold significant leadership positions in their own organizations.
• This makes it difficult to spend large amounts of time on board matters.
• The only effective approach is for the board to focus on lead indicators.
• The challenge: knowing which lead indicators are unique to the company and its business model.

📉 Information inadequacy

Directors typically receive:

• Operating statements, balance sheets, and cash flow statements comparing current results to plan and prior year
• Management comments explaining variations from plan and revised forecasts
• Market share information
• Minutes of prior board and some management committee meetings
• Selected documents on the company, products, services, and competition
• Financial analyst reports for the company and sometimes major competitors
• Ad hoc special information (consultant reports, customer preference data, employee attitude surveys)

The problem: This is mostly historical information or summaries of proposed actions—insufficient for answering forward-looking questions like:

• Are we going in the right direction?
• Are management's assumptions about major trends correct?
• Is the company doing the critical things to get the job done?
• Should our strategy be changed?

📱 Dashboards and scorecards as solutions

Originally created for CEOs, CFOs, and business unit heads, these tools are increasingly introduced to boardrooms.

Advantages:

• Display critical information in easy-to-understand charts and graphics on a timely basis
• Most sophisticated versions allow users to drill down for additional details
• Example: To diagnose negative cash-flow trend, a director can probe whether the shortfall is due to receivables problems or excessive spending
• Can be tailored to specific needs (e.g., audit committee member might want special fraud prevention/detection information)

Common information: Financial, sales, and compliance-related data should be on every dashboard.

🔗 Direct communication channels

• Directors should have access to top management beyond the CEO.
• Effective boards have protocols allowing a director (with permission of board chair and CEO) to speak directly with employees.
• Directors need to be accessible to management and employees.
• Historical problem: Many CEOs have followed a practice that all communication from senior managers to the board flows first through the CEO—this has potential to obstruct information flow.

🔍 Access to external advisers

• The board and committees should retain external experts (counsel, consultants, other professionals) as needed.
• These experts should have a direct line of communication and reporting responsibility to the board, not management.
• This allows the board to investigate any issues to fulfill its duty of care.

🧩 Building the right team

🧩 Tailoring composition to company needs

• An acquisitive company should have deal-making expertise and judgment.
• A fast-moving technology company needs directors with sound views of the industry's future direction.
• Every board needs essential ingredients: directors with knowledge in accounting and finance, technology, management, marketing, international operations, and industry knowledge.
• Best directors bring perspective from someone who has faced similar problems the company may face in the future.

✅ Behavioral characteristics of effective directors

Effective directors:

• Do not hesitate to ask hard questions
• Work well with others
• Understand the industry
• Provide valuable input
• Are available when needed
• Are alert and inquisitive
• Have relevant business knowledge
• Contribute to committee work
• Attend meetings regularly
• Speak out appropriately at board meetings
• Prepare for meetings
• Make meaningful contributions

📋 Qualification standards and training

The NYSE recommends:

• Director qualification standards should be included in corporate governance guidelines
• Companies sometimes include substantive qualifications: policies limiting number of other boards a director may serve on, director tenure, retirement, and succession
• The nominating committee chairman should certify in the proxy that the committee has reviewed qualifications of each director

Training requirements:

• Every director should receive appropriate training on their duties when first appointed
• Should include orientation-training program to ensure incoming directors are familiar with the company's business and governance practices
• Directors should receive ongoing training on relevant new laws, regulations, and changing commercial risks as needed

🔄 Board self-evaluation process

🔄 Post-Sarbanes-Oxley requirements

• Stock exchanges mandated that boards of public companies and key committees (e.g., audit committee) evaluate their own performance annually.
• No mandated or standard approach exists—boards should select a process that best fits their needs.
• At minimum, the process should ensure each director meets the board's qualifications for membership when nominated or renominated.
• Evaluation should determine whether the board and committees have fulfilled their basic, required functions.

❓ Key design questions

Before designing a process, boards must answer:

• Why are we doing this?
• What areas do we need to focus on?
• How can we receive valid feedback?
• How can we act on that feedback to make a difference?
• Where can we find required expertise, internally and externally?
• Who do we want to handle, analyze, and provide feedback to the board? To the chairman or lead director? To the CEO? To committees? To individual directors?

🔧 Sources of expertise

Internal or external counsel:

• Many law firms are broadening scope to include board evaluation
• Makes sense in a litigious environment where directors worry about shareholder lawsuits
• Retaining legal counsel may reduce fear by having counsel assert privilege over evaluation matters
• Even without legal privilege, courts likely view favorably a board that takes a tough look at how it can improve, documents the process intelligently, and acts on findings

Industrial and organizational psychology professionals:

• Often have relevant training
• May bring more important skills than legal counsel
• Depending on litigation likelihood, may be advisable to have external counsel work collaboratively with external experts specializing in board and director performance effectiveness

✨ Best practice characteristics

An effective board and director evaluation process is:

1. Controlled by the board itself—not by management or outside consultants
2. Confidential and collegial—fosters an atmosphere of candor and trust
3. Led by a champion—alternatives include the non-CEO chairman, lead independent director, or chair of the nominating and governance committee
4. Focused on identifying areas of improvement—such as:
   • Creating balance of power between board and management
   • Focusing the board more on long-term strategy
   • More effectively fulfilling oversight responsibilities
   • Adequacy of committee structures
   • Updating the evaluation process itself

Individual director performance evaluation:

• Should include self-assessment and peer review
• Should consider independence, level of contribution, and attendance
• Should take specific board roles into account
• Should provide a basis for determining suitability of a director's reelection

🧭 Overview

🧠 One-sentence thesis

Corporate governance is converging globally and evolving domestically through three major forces: globalization pressures, domestic reform demands (especially around shareholder democracy and accountability), and the expanding influence of stakeholders demanding corporate social responsibility.

📌 Key points (3–5)

• Three forces shaping the future: globalization (market laws and emerging international frameworks), domestic reforms (Sarbanes-Oxley compliance, shareholder resolutions, private equity), and the Corporate Social Responsibility movement widening the governance landscape.
• Global convergence is happening in three areas: regulations/listing requirements/codes, board independence/structure/shareholder representation, and accounting/disclosure/audit standards.
• U.S. reform focuses on director independence and accountability: majority voting, proxy access, elimination of entrenchment devices (staggered boards, poison pills), and "Say on Pay" proposals.
• Common confusion—convergence vs. uniformity: global convergence does not mean identical systems everywhere; it means transparent principles and practices that build investor trust across borders, respecting national differences.
• Why it matters: institutional investors increasingly view corporate governance as a business imperative tied to portfolio performance, and companies that embrace stakeholder engagement and social responsibility gain strategic value.

🌍 Globalization and the convergence of governance practices

🌍 Two sets of laws shaping corporations

• Rule of law: local/national legislatures, multilateral agreements, emerging international law.
  • These vary greatly worldwide, have deep societal roots, and exhibit high inertia.
  • Proactive convergence is unlikely, but a new global regulatory framework may be needed.
• Market laws: affect or determine a company's fate regardless of location or product.
  • Becoming the dominant force in governance evolution worldwide, within legal boundaries.
  • Example: investor demands for transparency and accountability drive governance changes across borders, even where legal systems differ.

🔄 How governance standards spread globally

• Regulatory spillover: one country's reform influences others.
  • Example: U.K. required nonbinding shareholder votes on executive compensation in 2002; Netherlands made it binding in 2003; Sweden and Australia adopted nonbinding votes in 2005.
  • U.S. Sarbanes-Oxley and SEC rules on disclosure have shaped standards worldwide.
• Investor activism: institutional investors use proxy voting power outside their home markets.
  • 73% of U.S., 67% of Canadian, and 60% of U.K. investors vote at least 50% of shares held abroad.
• Market competition: developing markets adopt high governance standards to attract global capital.
  • High standards are viewed as a way to make markets more attractive to international investors.

📊 Top global investor concerns (2006 ISS study)

Concern	Description	Markets affected
Better boards	Independence of board and committees; nominating/electing process; accountability and responsiveness to shareholders	Number one issue in all markets except Japan
Executive pay	Linking pay to performance; disclosing metrics; justifying compensation	Critical in all markets but Japan; strongest concerns in U.S. and Canada
Financial reporting	Improved disclosure; reliable numbers; making sense of complex reports	Key issue in every market but Australia–New Zealand; over 70% cited improved disclosure as most needed

• Don't confuse: developed vs. developing market concerns—developed markets struggle to "see the forest for the trees" in complex reports; developing markets (e.g., China) worry about obtaining reliable numbers in the first place.

🤝 The OECD principles and global alignment

🤝 What the OECD principles are

OECD principles: the first multilateral set of guidelines (adopted 1999) providing a conceptual framework for policymakers, companies, investors, and others to address corporate governance issues in commonly understood terms worldwide.

• Purpose: define basic requirements for an adequate governance environment; do not target harmonization but insist all differences be transparent.
• Negotiated by lawmakers from 30 major developed economies with widely differing standards.
• Used as a benchmark by investor initiatives: ICGN guidelines, CALPERS, TIAA-CREF (U.S.), Hermes Asset Management (U.K.).
• 2001: International Institute of Finance (IIF) issued a set of global guidelines.

🎯 Three areas of convergence

1. Regulations, listing requirements, codes, and best practices:

   • U.S. legislative changes brought American rules closer to European norms (e.g., senior officers certifying accounts, criminal sanctions for fraud, prohibition on lending to executives).
   • NYSE requires listed non-U.S. companies to "comply or explain" why they don't follow U.S. governance codes.
   • "Comply or explain" approach pioneered by London Stock Exchange (LSE) is spreading globally—middle ground between hard mandatory rules and purely voluntary best practice.

2. Board independence, structure, and shareholder representation:

   • Almost all codes require a "significant" number of independent, nonexecutive directors.
   • U.S. rules set high bar: majority of directors must be independent; audit, nominating, and compensation committees must be exclusively independent.
   • European codes often don't specify numbers; Asian codes vary (Korea: one fourth; Malaysia/Singapore: one third; IIF best practice: at least half).
   • Convergence in reverse: Japan amended commercial code (2002) to allow choice between old audit board structure and new U.S.-like audit committee with independent directors; Deutsche Bank moved toward individual officer responsibility (U.S. model); Siemens established audit committee on supervisory board.

3. Accounting, disclosure standards, and audit regulation:

   • Goal: improved reporting model built on principle-based standards.
   • Phase I (2001–2005): European Commission required adoption of International Financial Reporting Standards (IFRS) by 8,000+ companies worldwide.
   • Phase II (2006–2009): rigorous testing of IFRS; addressing differences between IFRS and U.S. GAAP; objective is substantial equivalence and elimination of SEC reconciliation requirement for foreign issuers.
   • Phase III and beyond: coordinate actions, issue substantially identical standards; longer term, merge FASB into IASB to create single global standard setter and framework.

🔑 Key insight on convergence

• Convergence does not mean globally uniform norms and behaviors.
• It signals adoption of principles and practices that allow investors and corporations to operate on a basis of trust across national borders.
• Primary force: investors' demands for better governance and their willingness to value it.

🇺🇸 Prospects for further U.S. governance reform

🗳️ Majority voting for directors

• Current (plurality voting): directors with greatest number of favorable votes are elected; shareholders can only withhold votes, not vote against; most nominees elected even with very few favorable votes.
• Proposed (majority voting): nominee must get a majority of votes cast to be elected.
• Why it matters: investor and regulatory sentiment favors majority voting; fighting the proposal harms corporate governance ratings and may trigger withhold-vote campaigns.
• Advice to boards: seize the "high ground" by adopting modified plurality or full majority voting rather than fighting the proposal.

🚪 Proxy access proposals

• What it is: allowing certain shareholders to place director nominees in the company's proxy materials and proxy card.
• SEC decision: proposed rules a few years ago but decided against enactment.
• Arguments against: shareholders can already solicit votes for their own nominees; special interest groups might unduly influence elections; not all shareholders have same interests.
• Arguments for: would diversify boards; give shareholders more prominent voice in decision making.

🛡️ Elimination of "entrenchment" devices

• Staggered (classified) boards: electing directors a few at a time with overlapping multiyear terms instead of all at once with one-year terms.
  • Makes hostile takeovers more difficult (bidders must win multiple proxy fights).
  • Combined with poison pill, one of the most potent U.S. takeover defenses.
• Trend: 2006 marked key switch—more than half (55%) of S&P 500 companies have declassified boards, up from 47% in 2005.
• Shareholders also fight for elimination of poison pills and related entrenchment devices.

💰 "Say on Pay" proposals

• What it is: annual advisory shareholder vote on executive pay.
• International roots: originated in U.K. (mandatory for LSE-listed companies since 2002); adopted in Australia, Sweden (advisory); Netherlands, Norway (binding).
• U.S. momentum: 2008 proxy season "hot-button" issue; strongly supported by ISS (RiskMetrics Group) and proxy advisory firms.
• Practical impact: executive pay policies must meet ISS guidelines or risk ISS recommending shareholders vote "No on Pay," which can lead to withhold-vote recommendations against compensation committee or entire board.
• Alternative: negotiate exceptions with ISS based on particular facts, or secure enough shareholder votes to overcome ISS recommendation.

🔄 Shift to bylaw amendments

• Shareholder activists moving from nonbinding proposals (recommending board action) to bylaw amendments (implementing reform directly).
• Reasons: frustration with boards that fail to act or "water down" implementation; concern that boards can too easily amend or rescind board-adopted policies under fiduciary duty umbrella.

🤔 Broader issues warranting attention

• Separating CEO and chairman positions: in most U.S. boardrooms, CEO serves as board chair—a conflict of interest (number one manager responsible for oversight of management).
  • Solution: separate the two positions; fill chair with nonexecutive leader chosen by outside directors.
  • Evidence from Great Britain shows this works well.
  • Currently subject of only a handful of shareholder proposals.
• Board-shareholder communication: most U.S. companies meet only infrequently with largest shareowners, and only when threatened.
  • Resistance attributed to SEC rules, but it's time to test whether these regulations enhance or inhibit stronger governance.

⚠️ Limitations of current focus

• Increased director independence is not a panacea; does not prevent future misconduct or managerial inefficiency.
• Evidence of positive relationship between independence and performance is weak.
• Activists should adopt broader, bolder agenda beyond independence.

🌱 A new compact between business and society

🌱 The push for social responsiveness and stakeholder relations

• Strategic imperative: dealing effectively with full range of stakeholders is emerging as essential to core strategy and business model design.
• Historical approach: issues like communities, environment, employee well-being, human rights in supply chains, and NGO activism were handled by PR or legal departments.
• New reality: "business as usual" is no longer an option; traditional strategies (grow, cut costs, innovate, differentiate, globalize) now subject to increased scrutiny by all stakeholders.

🌍 Climate change as example of stakeholder pressure

• 2007 proxy season: record 43 climate-related resolutions filed with U.S. companies by investors (Ceres coalition).
  • Filed by state/city pension funds, labor, foundation, religious, and institutional shareholders managing $200+ billion in assets.
  • Sought greater disclosure about responses to climate change or called for greenhouse gas (GHG) reduction targets.
• Positive outcomes: 15 resolutions led to business actions, shareholders withdrew resolutions.
  • Example: ConocoPhillips announced support for aggressive mandatory federal GHG policy, committed $300 million to low-carbon research, agreed to set GHG reduction target.
  • Example: Wells Fargo committed to GHG assessments of key lending portfolios (agriculture, energy production, power generation).
  • Example: Hartford Insurance and Prudential Financial agreed to improve public reporting on climate risks and mitigation strategies.
• Investor support: resolutions requesting GHG reduction targets received strong support (over 30% at ExxonMobil), showing investors want transparency about climate risks and information on how companies prepare for challenges and opportunities.

💼 "Good citizenship" as strategic value

• Companies that accept, understand, and embrace the new reality find that being a "good citizen" has significant strategic value.
• Does not detract but enhances business success.
• "Good citizenship" has become "the business of business"—even if Milton Friedman might have had trouble accepting this.

🔗 The new governance environment

• Corporate Social Responsibility (CSR) movement has widened the range of players deemed to have a legitimate role in shaping corporate decision making and controlling corporate power.
• Appropriate board response: develop fuller appreciation of the emerging governance environment.
• Key feature: increasing pressure on corporations to involve stakeholders in governance and hold the corporation answerable to social claims and demands for nonfinancial information (just as it is answerable to financial claims and information demands from shareholders).

📜 Sarbanes-Oxley and recent reforms (Appendix overview)

📜 What Sarbanes-Oxley introduced

• Significant new disclosure and corporate governance requirements for public companies.
• Substantially increased liability under federal securities laws for public companies, executives, and directors.
• After adoption, NYSE, NASDAQ, AMEX adopted more comprehensive reporting requirements; SEC issued new regulations for timely, accurate disclosure.

🔑 Most important changes

• Director independence: majority of directors must be independent; board must affirmatively determine no material relationship with company; disclose determinations in annual proxy or Form 10-K.
• Committee composition and responsibilities: audit, nominating, and compensation committees.
• Shareholder approval: equity compensation plans.
• Codes of ethics or conduct.
• Certification of financial statements by executives.
• Payments to directors and officers.
• Independent accounting oversight board.
• Disclosure of internal controls.

🎯 Rationale for independence

• Shareholders cannot directly monitor management behavior, so independent directors serve as a check on management power.

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Note: This epilogue frames the future of corporate governance around three forces (globalization, domestic reform, stakeholder engagement) and emphasizes that convergence means building trust through transparent principles, not imposing uniform systems. The excerpt shows governance evolving from a narrow shareholder focus toward a broader stakeholder model where "good citizenship" is strategic, not optional.