Corporate Governance Matters

David Larcker is James Irvin Miller Professor of Accounting (Emeritus) at Stanford Graduate School of Business; Director of the Corporate Governance Research Initiative; and Senior Faculty, Arthur and Toni Rembe Rock Center for Corporate Governance. David's research focuses on executive compensation, corporate governance, and managerial accounting. He has published many research papers and is frequently quoted in both the popular and business press. He received his BS and MS in engineering from the University of Missouri–Rolla and his PhD in business from the University of Kansas. He previously was on the faculty of the Kellogg Graduate School of Management at Northwestern University and The Wharton School at the University of Pennsylvania. Professor Larcker presently serves on the Board of Trustees for the Wells Fargo Funds. Brian Tayan is a member of the Corporate Governance Research Initiative at Stanford Graduate School of Business. He has written broadly on the subject of corporate governance, including studies and other materials on boards of directors, succession planning, executive compensation, financial accounting, and shareholder relations. Previously, Brian worked as a financial analyst at Stanford University's Office of the CEO and as an investment associate at UBS Private Wealth Management. He received his MBA from the Stanford Graduate School of Business and his BA from Princeton University.

Preface     xviii

Chapter 1  Introduction to Corporate Governance     1

Self-Interested Executives    4

Defining Corporate Governance     8

Corporate Governance Standards     9

Best Practice or Best Practices? Does “One Size Fit All”?     12

Relationship between Corporate Governance and Firm Performance     13

Endnotes     15

Chapter 2  International Corporate Governance     19

Capital Market Efficiency     19

Legal Tradition     22

Accounting Standards     23

Enforcement of Regulations     25

Societal and Cultural Values     26

Individual National Governance Structures     28

    United States     29

    United Kingdom     31

    Germany     35

    Japan     37

    South Korea    40

    China    41

    India    43

    Brazil    44

    Russia    46

Endnotes    47

Interlude     53

Chapter 3  Board of Directors: Duties and Liability     55

Board Responsibilities     55

Board Independence     56

The Operations of the Board     57

    Board Committees     60

Duration of Director Terms     64

Director Elections     64

Removal of Directors     66

Legal Obligations of Directors     66

    Fiduciary Duty     67

    Environmental, Social, and Governance (ESG)     70

    Disclosure Obligations under Securities Laws     71

    Legal Enforcement of State Corporate Law (Fiduciary Duties)     72

    Legal Enforcement of Federal Securities Laws     73

    Director Indemnification and D&O Insurance     73

Endnotes     75

Chapter 4  Board of Directors: Selection, Compensation, and Removal     79

Market for Directors     79

    Criteria for Director Recruitment     80

    Active CEOs     81

    International Experience     82

    Special Expertise     82

    Diverse Directors     84

    Professional Directors     85

    Disclosure Requirements for Director Qualifications     86

Director Recruitment Process     87

Director Compensation     90

    Ownership Guidelines     95

    Board Evaluation     96

Removal of Directors     98

Endnotes     102

Chapter 5  Board of Directors: Structure and Consequences     109

Board Structure     110

    Chairman of the Board     113

    Lead Independent Director     116

    Outside Directors     119

    Board Independence     122

    Independent Committees     125

    Bankers on the Board     126

    Financial Experts on Board     127

    Politically Connected Boards     127

    Employee Representation     129

    Boards with “Busy” Directors     131

    Interlocked (or Connected) Boards     134

    Committee Overlap     135

    Board Size     136

    Board Diversity     136

    Female Directors     138

Summary     139

Endnotes     141

Interlude     150

Chapter 6  Strategy, Performance Measurement, and Risk Management     151

Organizational Strategy     151

Strategy Implementation Process     154

Business Model Development and Testing     156

    Example 1: Fast-Food Chain and Employee Turnover     156

    Example 2: Financial Services Firm and Investment Advisor Retention     158

Key Performance Measures     159

How Well Are Boards Doing with Performance Measures and Business Models?     162

Risk and Risk Management     164

Risk and Risk Tolerance     165

Risk to the Business Model     166

Risk Management     169

Oversight of Risk Management     172

Assessing Board Performance on Risk Management     174

Cybersecurity     175

Endnotes     177

Chapter 7  CEO Selection, Turnover, and Succession Planning     181

Labor Market for Chief Executive Officers     181

Labor Pool of CEO Talent     184

CEO Turnover     186

Newly Appointed CEOs     191

Models of CEO Succession     193

    External Candidate     193

    President and/or Chief Operating Officer     195

    Horse Race     196

    Inside–Outside Model     197

The Succession Process     197

How Well Are Boards Doing with Succession Planning?     201

Executive Search Firms     203

Endnotes     205

Chapter 8  Executive Compensation and Incentives     211

The Controversy over Executive Compensation     212

Competing Theories of CEO Pay     213

Components of Compensation     214

Determining Compensation     218

Compensation Consultants     221

Compensation Levels     221

Ratio of CEO Pay to Other Top Executive Pay     226

Ratio of CEO Pay to Average Employee Pay     229

Compensation Mix     230

Short-Term Incentives     233

Long-Term Incentives     235

Benefits and Perquisites     237

Compensation Disclosure     238

Say-on-Pay     239

Competing Theories of CEO Pay     242

Endnotes     243

Chapter 9  Executive Equity Ownership     251

Equity Ownership and Firm Performance     251

Equity Ownership and Risk     254

Equity Ownership and Agency Costs     259

Accounting Manipulation     260

Manipulation of Equity Grants     261

    Other Examples of Value Extraction through Timing     263

Equity Sales and Insider Trading     264

Rule 10b5-1     267

Hedging     269

Pledging     273

Repricing and Exchange Offers     274

Endnotes     277

Chapter 10  Financial Reporting and External Audit     285

The Audit Committee     285

Accounting Quality, Transparency, and Controls     286

Financial Reporting Quality     288

    Non-GAAP Reporting     290

Financial Restatements     291

Models to Detect Accounting Manipulations     297

The External Audit     299

Audit Quality     302

Structure of Audit Industry     302

Impact of Sarbanes–Oxley     305

External Auditor as CFO     307

Auditor Rotation     308

Endnotes     310

Chapter 11  The Market for Corporate Control     319

The Market for Corporate Control     320

Stock Market Assessment of Acquiring and Target Firms     324

    Who Gets Acquired?     324

    Who Gets the Value in a Takeover?     327

Antitakeover Protections     330

Antitakeover Actions     331

    Poison Pills     333

    Staggered Board     335

    State of Incorporation     337

    Dual-Class Shares     339

Warding Off Unwanted Acquirers     341

Endnotes     344

Chapter 12  Shareholders and Shareholder Activism     351

The Role of Shareholders     351

Blockholders and Institutional Investors     354

Institutional Investors and Proxy Voting     357

Activist Investors     359

    Pension Funds     361

    ESG and Socially Responsible Investing     363

    Individual Activist Investors     364

    Activist Hedge Funds     366

The Rise of Index Investing     370

Shareholder Democracy and Corporate Engagement     371

    Majority Voting in Uncontested Director Elections     371

    Proxy Access     372

    Proxy Voting     372

    Corporate Engagement     374

Proxy Advisory Firms     375

Endnotes     381

Chapter 13  Stakeholders and Stakeholder Activism     391

Pressure to Incorporate Stakeholder Interests     392

Legal and Economic Implications     397

Director and CEO Views on Stakeholders    401

ESG Metrics and Disclosure    402

External Assessment of ESG    407

Endnotes    417

Chapter 14  Corporate Governance and ESG Ratings    425

Third-Party Ratings    425

Credit Ratings    426

Commercial Corporate Governance Ratings    428

    ISS: Corporate Governance Quotient    428

    ISS: Governance Risk Indicators    430

    ISS: QualityScore    430

    MSCI ESG Governance Metrics    431

    Testing the Predictability of Corporate Governance Ratings    432

Governance Rating Systems by Academic Researchers    433

The Viability of Governance Ratings    438

ESG Ratings    439

    MSCI ESG    440

    Sustainalytics    441

    Vigeo Eiris    442

    HIP (Human Impact + Profit)    442

    ISS E&S Disclosure QualityScore    442

    TruValue Labs    443

    Evaluation of ESG Ratings    443

Endnotes    444

Chapter 15  Alternative Models of Governance    449

Family-Controlled Corporations    449

Venture-Backed Companies    452

Private Equity-Owned Companies    458

Nonprofit Organizations    462

Endnotes    466

Chapter 16  Summary and Conclusions    473

Testing Remains Insufficient    474

The Current Focus Is Misdirected    475

Important Variables Are Clearly Missing    476

Context Is Important    477

Rights of Shareholders and Stakeholders    478

Endnotes    478

Index    481