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

This Chapter Focuses on These Key Learning Objectives:

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

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

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

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

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

Shareholder Rights and Corporate Governance

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

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

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

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

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

Shareholders Around the World

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

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

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

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

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

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

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

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

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

0 50 100 150 200 250

Australia

Brazil

India

China

Indonesia

Japan

Korea

Russian Federation

United States

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

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

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

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

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

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

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

Households

Institutions

1975 1985 1995 2000 2005 2010 2016 0

10

20

30

40

50

60

70

80

90

1965 Year

(in billions of dollars) Total

market value

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

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

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

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

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

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

FIGURE 13.3 Major Legal Rights of Shareholders

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

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

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

Corporate Governance

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

∙ Diversify board membership. Many good governance experts have argued that boards should include many different kinds of people. Diversity on the basis of gender, eth- nicity, age, nationality, and other dimensions widens the range of experiences, per- spectives, and values brought to the boardroom. Such “cognitive variety,” in this view, expands options and enriches discussions—potentially improving leadership. A survey of nearly 900 directors conducted by PwC in 2017 found that 73 percent thought that board diversity was beneficial. Of those, 82 percent thought it enhanced board perfor- mance.17 The academic literature on the impacts of board diversity is further discussed in Chapter 16.

The movement to improve corporate governance has been active in other nations and regions, as well as the United States, as some of these examples show. The Organization for Economic Cooperation and Development (OECD), representing 34 nations, has issued a set of principles for corporate governance to serve as a benchmark for companies and policymakers worldwide. For its part, the European Union has worked hard to modernize corporate governance practices and harmonize them across its member states.18 Corporate governance reforms have also taken hold in South Africa, India, and many other nations.

15 “Declassified Boards Are More Likely to Be Diverse,” August 15, 2017, Harvard Law School Forum on Corporate Gover- nance and Financial Regulation. 16 Korn Ferry Institute (in partnership with the National Association of Corporate Directors), Annual Survey of Board Leader- ship, 2017 Edition, www.kornferryinstitute.com. Data based on boards of directors at the 500 U.S.-based firms that made up the S&P Large Cap Index, as of December 31, 2016; and “Results of Public Company Governance Survey,” op. cit. 17 “16 & of Corporate Board Members Say Racial and Gender Diversity Has No Benefit at All,” Fortune, October 17, 2017. 18 The OECD’s corporate governance principles are available at www.oecd.org/corporate. Information about recent changes in corporate governance practices in Europe is available at the website of the European Corporate Governance Institute, www.ecgi.org.

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In short, by the late 2010s the movement to make boards more responsive to sharehold- ers was an international one.

Special Issue: Executive Compensation

Setting executive compensation is one of the most important functions of the board of directors. The emergence of the modern, publicly held corporation in the late 1800s effec- tively separated ownership and control. That is, owners of the firm no longer managed it on a day-to-day basis; this task fell to hired professionals. This development gave rise to what theorists call the agency problem. If managers are merely hired agents, what will guarantee that they act in the interests of shareholders rather than simply helping themselves? The problem is a serious one, because shareholders are often geographically dispersed, and government rules make it difficult for them to contact each other and to organize on behalf of their collective interests. Boards meet just a few times a year. Who, then, is watching the managers?

An important mechanism for aligning the interests of the corporation and its share- holders with those of its top managers is executive compensation. But, as this section will show, the system does not always work the way it is supposed to.

Executive compensation in the United States, by international standards, is very high. In 2017, the median total compensation of the 200 highest paid chief executives in the United States was $17.5 million, including salaries, bonuses, and the present value of retirement benefits, incentive plans, and stock options, according to the compensation firm Equilar. The highest paid executive in 2017 was Hock E. Tan, CEO of Broadcom (a semiconductor company based in San Jose, California), who took home an eye-popping $103 million. A spokesperson for Broadcom said that the CEO’s compensation was justified because the company’s share value had increased more than 680 percent in five years under Tan’s leadership.19 Because the Equilar survey included only public companies, it did not capture the often-outsized pay of hedge fund and private equity firm executives. In many cases, these individuals earned much more than their public company counterparts. Raymond Dalio, founder of Bridgewater, one of the world’s largest hedge funds, for example, earned an astonishing $1.4 billion in 2016.20 (Hedge funds and private equity firms are further discussed later in this chapter.)

Many companies, like Broadcom, compensate their senior executives in part with grants of stock or stock options. The latter represent the right (but not obligation) to buy a company’s stock at a set price (called the strike price) for a certain period. The option becomes valuable when, and if, the stock price rises above this amount. Grants of stock and stock options are often used to align executives’ interests with those of shareholders. The idea behind such pay-for-performance approaches is that executives will work hard to improve the company’s results, because this will increase the stock price and therefore the value of their compensation. In 2017, more than half (54 percent) of executive pay was performance-based.21 But critics have highlighted a danger of equity-based compensation: that unscrupulous executives may become so fixated on their performance pay that they will do anything to increase the stock price, even if this involves unethical accounting prac- tices or actions that would hurt employees, customers, or other stakeholders. The classic

19 Equilar compensation data for 2017 are available at www.equilar.com/reports/56-equilar-new-york-times-highest-paid- ceos-2018. See also “Media CEO Pay for the 100 Largest Companies Reached a Record $15.7 Million in 2017,” The Wash- ington Post, April 11, 2018. 20 “Highest Earning Hedge Fund Managers 2017,” at www.forbes.com. 21 “CEOs Awarded More Cash Pay,” The Wall Street Journal, April 20, 2015.

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example of this was Enron, where fraudulent financial reports made the company seem more successful than it really was—temporarily increasing its stock price and benefiting its top executives (whose compensation was mostly performance-based). Enron later col- lapsed, devastating its employees, customers, and shareholders. Evidence on the relation- ship between company performance and equity-based compensation is discussed later in this chapter.

By contrast to the United States, top managers in other countries earn much less. Although the pay of chief executives elsewhere is catching up, it is still generally well below what comparable managers in the United States earn. Figure 13.4 represents graphically the large gap between executive pay in the United States and that of other developed nations.

These disparities have caused friction in some global firms.

A case in point is Carlos Ghosn, the Brazilian-born chief executive of the Renault-Nissan-Mitsubishi Alliance, a strategic partnership of automakers that ranks second after Volkswagen and sells more than one in ten cars worldwide. In 2017, Ghosn received $7.9 million for his services as CEO of the French partner Renault. Although his compensation was above average for CEO pay in France, it did not seem excessive for a leader that Forbes magazine called an “exceptional manager and visionary.” But in Japan, where he earned a separate $9.8 million as CEO of Nissan, his compensation seemed out of line to many. “I understand the sensitivity of the issue,” said Ghosn, who regularly commuted between homes in Paris and Tokyo. “[But] being in Japan should not be a handicap to attract talent.”22

22 “Nissan Says CEO Ghosn’s Salary Rose 2.5 Percent Last Year,” Reuters, June 26, 2017.

FIGURE 13.4 Relative Average Annual CEO Compensation in the United States and Selected Developed Nations, in Millions of Dollars, 2014

Sources: Harvard Business School; Washington Post. Statista 2018.

Poland

0 2 4 6 8 10 12 14

Portugal

Japan

Denmark

Sweden

Czech Republic

Israel

United Kingdom

Australia

Austria

Germany

Norway

France

Spain

Switzerland

United States

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Another way to look at executive compensation is to compare the pay of top managers with that of average employees. In the United States, CEOs in 2016 made 347 times what the average worker did. Figure 13.5 shows that since 1990 the ratio of average executive to average worker pay has increased markedly during periods of economic expansion, such as the “dot com” boom of the late 1990s, but fallen back during periods of economic contrac- tion, such as the Great Recession of 2008–09. The ratio, which has started to rise again, is now more than three times greater than it was in 1990. Research published in the Harvard Business Review found that the U.S. public thought the “ideal” pay ratio would be much, much smaller: 6.7 to one. The average ideal in the 16 countries surveyed was 4.6 to one.23

A provision of the 2010 Dodd-Frank Act (introduced in Chapter 7) required major U.S. firms for the first time to disclose the ratio of their CEO’s compensation to the median compensation of all their employees. This rule went into effect in 2018, revealing informa- tion that some employees might find startling. For example, at Live Nation Entertainment, an employee earning the median wage of $24,406 would have to work for 2,893 years to earn as much as the CEO. Companies that operated their own supplier factories in low- wage countries like China—such as the toy maker Mattel—had unusually high pay ratios. But those that outsourced their production to others had relatively low pay ratios.24

23 “CEOs Get Paid Too Much, According to Pretty Much Everyone in the World,” Harvard Business Review, September 23, 2014. 24 “Want to Make Money Like a CEO? Work for 275 Years,” The New York Times, May 25, 2018, and “SEC Adopts Interpretive Guidance on Pay Ratio Rule,” press release, September 21, 2017, at www.sec.gov.

FIGURE 13.5 Ratio of Average CEO Pay to Average Production Worker Pay, 1990–2016

Sources: Data for 2013, 2014, and 2016 are from the AFL-CIO Corporate Watch website at www.aflcio/corporate watch. Data for earlier years are drawn from the Institute for Policy Studies’ Executive Excess annual surveys conducted by the Institute for Policy Studies and United for a Fair Economy, available at www.ips-dc.org and www.faireconomy.org.

1990 1993 1996 1999 2002 20082005 2010 2013 2014 2016 0:1

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Why are American executives paid so much? Corporate politics play an important role. In their book, Pay without Performance: The Unfulfilled Promise of Executive Com- pensation, Lucian A. Bebchuk and Jesse M. Fried argue that one reason salaries are so high is that top managers have so much influence over the pay-setting process. Compen- sation committees are made up of individuals who are selected for board membership in part by the CEO, and they are often linked by ties of friendship and personal loyalty. Many are CEOs themselves and sensitive to the indirect impact of their decisions on their own salaries. Moreover, compensation committees rely on surveys of similar firms and usually want to pay their own executives above the industry average, over time ratcheting up pay for all.25

Some observers say that the comparatively high compensation of top executives is justified. In this view, well-paid managers are simply being rewarded for outstanding performance. For example, Amazon CEO Jeff Bezos earned just $1.7 million, while his shareholders enjoyed a return of 56 percent; few shareholders would complain that he was overpaid as leader of the astonishingly successful company. Supporters also argue that high salaries provide an incentive for innovation and risk taking. In an era of intense global competition, restructuring, and financial instability, the job of CEO of large corporations has never been more challenging, and the tenure in the top job has become shorter. Another argument for high compensation is a shortage of labor. In this view, not many individuals are capable of running today’s large, complex organizations, so the few that have the nec- essary skills and experience can command a premium. Today’s high salaries are necessary for companies to attract or retain top talent. Why shouldn’t the most successful business executives make as much as top athletes and entertainers?

On the other hand, critics argue that inflated executive pay hurts the ability of U.S. firms to compete with foreign rivals. High executive compensation diverts financial resources that could be used to invest in the business, increase shareholder dividends, or pay average workers more. Multimillion-dollar salaries cause resentment and sap the commitment— and sometimes lead to the exodus of—hard-working lower and mid-level employees who feel they are not receiving their fair share. As for the performance issue, most empirical evidence finds little relationship overall between executive pay and company success. A study of 500 large U.S. companies by the nonprofit organization As You Sow, published in 2018, found no statistically significant relationship between total shareholder return (capital gains and dividends) and top executive compensation averaged over the preceding five-year period. In other words, higher paid executives did not necessarily produce higher returns for shareholders. For example, Thomas Rutledge, the CEO of Charter Communi- cations, was paid nearly six times as much as might have been expected, based on share- holder returns.26

Executive compensation has also been the subject of government regulations. Under U.S. government rules, companies must clearly disclose what their five top executives are paid and lay out a rationale for their compensation. Companies must also report the value of various perks, from the personal use of corporate aircraft to free tickets to sporting events, which had previously escaped investor scrutiny. Under the so-called say-on-pay provisions of the Dodd-Frank Act, which went into effect in 2011, public companies must hold shareholder votes on executive compensation at least once every three years.

25 Lucian A. Bebchuk and Jesse M. Fried, Pay without Performance: The Unfulfilled Promise of Executive Compensation (Cambridge, MA: Harvard University Press, 2004). 26 As You Sow, “The 100 Most Overpaid CEOs 2018: Are Fund Managers Asleep at the Wheel?” February 2015, and private correspondence. Calculations were contributed by HIP Investor, a partner of As You Sow. The organization’s work on execu- tive compensation is available at www.asyousow.org/our-work/ceo-pay.

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Many voluntarily now do so annually. For example, in 2018 a majority of shareholders voted against the proposed pay package of CEO Robert Iger, which they apparently thought was excessive.27 Although such say-on-pay referendums are not binding on man- agement, they provide a mechanism for shareholders to voice displeasure over excessive compensation—and boards often take notice. The governments of the United Kingdom, Norway, and Australia require such votes. A study found that in Australia, executive com- pensation had fallen relative to average workers’ pay after these rules went into effect—a “testament to investor vigilance,” the study concluded.28

The SEC has also proposed, but not finalized, a rule that would require companies to take back incentive-based compensation after a restatement of financial disclosures, a pro- cess known as clawback. In other words, if executives lied to pump up their compensation, they would have to pay it back. Even in the absence of SEC requirements, some boards of directors had acted. At Wells Fargo, for example, the board clawed back $75 million in compensation from two senior executives under whose watch the bank fraudulently opened customer accounts without their knowledge.29

Some unusual companies have voluntarily set caps on executive pay or pay differen- tials, and some executives have taken pay cuts. In 2015, the CEO of Gravity Payments, a Seattle credit card processor, slashed his own pay and set the minimum salary of workers at $70,000, saying that he thought that “CEO pay is way out of whack.” (This story is the subject of the discussion case in Chapter 3.) Whole Foods Market set a rule that no execu- tive’s salary could be more than 19 times what the average worker made, but this rule was likely to be revoked after the grocer was acquired by Amazon in 2017.30

Legal scholar Michael Dorff recommended in his book Indispensable and Other Myths that performance pay be eliminated, or at least restructured. Citing evidence that performance pay does not actually improve company performance—and, in fact, may simply “focus executives on their chances of winning the pay lottery rather than on running the company”—Dorff proposed that executives be paid mostly in cash. Base pay could be supplemented by carefully constructed bonuses based on meeting performance targets that are easy to measure, hard to manipulate, and within the executives’ control.31

How to structure executive compensation to best align managers’ interests with those of shareholders and other stakeholders will remain a core challenge of corporate governance.

Shareholder Activism

Shareholders do not have to rely exclusively on the board of directors. Some owners, both individual and institutional, have also acted directly to protect their own interests, as they define them. This section will describe the increased activism of three shareholder groups: large institutions (including hedge funds and private equity firms), social investors, and owners seeking redress through the courts.

27 “Disney Shareholders Reject CEO Iger’s Pay Package,” Market Watch, March 8, 2018. 28 Australian Council of Superannuation Investors, “Boards Respond to Investors on CEO Pay,” press release, September 19, 2013. 29 “Wells Fargo to Claw Back $75 Million from 2 Former Executives,” The New York Times, April 10, 2017. 30 “Whole Foods’ CEO Pay Discount Expires,” June 21, 2017, www.bloomberg.com. 31 Michael B. Dorff, Indispensable and Other Myths: Why the CEO Experiment Failed and How to Fix It (Berkeley: University of California Press, 2014).

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The Rise of Institutional Investors As shown earlier, institutional investors—pensions, mutual funds, endowment funds, and the like—have enlarged their stockholdings significantly over the past two decades and have become more assertive in promoting the interests of their members.

One reason institutions have become more active is that it is more difficult for them to sell their holdings if they become dissatisfied with management performance. Large insti- tutions have less flexibility than individual shareholders, because selling a large block of stock could seriously depress its price, and therefore the value of the institution’s holdings. Accordingly, institutional investors have a strong incentive to hold their shares and orga- nize to change management policy.

The Council of Institutional Investors (CII) is an organization that represents pension funds, endowments, and foundations with combined assets of $3.5 trillion. The council has devel- oped a Shareholder Bill of Rights and has urged its members to view their proxies as assets, voting them on behalf of shareholders rather than automatically with management. Two orga- nizations, ISS (formerly Institutional Shareholder Services) and Glass Lewis, analyze share- holder resolutions and advise institutions how to vote. The activism of institutional shareholders has often improved company performance. One study showed that in the five years before and after a major pension fund became actively involved in the governance of companies whose shares it owned, stock performance improved dramatically, relative to the overall market.32

The activism of institutional investors has begun to spread to other countries. In many cases, U.S.–based pension and mutual funds that have acquired large stakes in foreign companies have spearheaded these efforts. As of 2017, U.S. investors had allocated about a fifth of their portfolios to foreign securities. To protect their globalized investments, fund managers have become active in proxy battles in Japan, Britain, Hong Kong, and many other countries. In addition, sovereign wealth funds operated by the governments of Singapore, Abu Dhabi, and China have recently become more active as institutional investors.

Another important group of activist investors is made up of private equity and hedge funds. Private equity firms are managed pools of money invested by very wealthy individ- uals and institutions (they are not usually open to ordinary individuals). Hedge funds are also pools of private capital; they are so-called because of the aggressive strategies they use to earn high returns for their investors. Their net asset values in 2017 were $2.9 trillion and $3.7 trillion, respectively.33 Both types of funds often invest in public companies with the intention of intervening to dramatically improve their shareholder returns.

For example, in 2017 an activist hedge fund called Trian Partners, headed by Nelson Peltz, waged an aggressive campaign for a seat on the board of Procter & Gamble, the giant consumer staples conglomerate. Trian, which owned a 1.5 percent stake, argued that P&G had not delivered for shareholders and called for the company to be split into three independent global business units. During the three-month campaign, P&G’s stock rose 8 percent, as shareholders anticipated that Peltz would improve the company’s value. After the shareholder vote yielded a virtual tie, the board offered a seat to the activist investor. “Peltz’s experience in the consumer product space will add value to P&G’s board,” said the director of corporate governance at the California teachers’ retirement system.34

32 “The ‘CalPERS Effect’ on Targeted Company Share Price,” July 31, 2009, at www.calpers-governance.org. 33 “Private Fund Statistics,” January 17, 2018, Securities and Exchange Commission Division of Investment Management Analytics Office.   34 “Procter & Gamble Bets on Electoral Math to Keep Nelson Peltz Away,” The New York Times, October 6, 2017, and “P&G Concedes Proxy Fight, Adds Nelson Peltz to Board,” The Wall Street Journal, December 15, 2017.

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Although some individual investors no doubt welcomed the intervention of activist shareholders like Trian, others sounded an alarm. Commented Jeffrey Sonnenfeld, a pro- fessor at the Yale School of Management, “Too often activists pressure companies to cut costs, add debt, sell divisions and increase share repurchases, rather than invest in jobs, R&D, and growth. They do all this in the name of creating shareholder value. But that value is often short-lived.”35

Social Investment Another movement of growing importance among a very different kind of activist share- holder is social investment, sometimes also called socially responsible investment or sus- tainable, responsible, and impact investment (all these terms use the acronym SRI). Social investment refers to the use of stock ownership as a strategy for promoting social, environ- mental, and governance (ESG) objectives. This can be done in two ways: through selecting stocks according to various social criteria, and by using the corporate governance process to raise issues of concern.

Stock Screening

Shareholders wishing to choose stocks based on social, environmental, or governance cri- teria often turn to screened funds. A growing number of mutual funds and pension funds use social screens to select companies in which to invest, weeding out ones that pollute the environment, overpay their executives, discriminate against employees, make dangerous products like tobacco or weapons, or do business in countries with poor human rights records. In 2016, according to the Global Sustainable Investment Alliance, $23 trillion of assets were managed using responsible investment strategies, making up more than a quar- ter of all managed assets globally. $8.7 trillion in the United States was invested in mutual funds or pensions using social responsibility as an investment criterion, accounting for more than one in every five investment dollars. In recent years, socially responsible invest- ing has also grown rapidly in Europe, Latin America, and Asia.36 Growth has been driven, in part, by government rules requiring pension funds to disclose the extent to which they use social, environmental, or governance criteria in selecting investments. It has also been influenced by growing demand by investors who want to align their investment choices with their values. Most evidence shows that ESG–screened portfolios provide returns that are competitive with or superior to the broad market. For example, a study by Morgan Stanley found that sustainable investment (investment in companies focused on creat- ing social and environmental as well as economic benefits) “had usually met, and often exceeded, the performance of comparable traditional investments” on both an absolute and risk-adjusted basis.37

Social criteria may also be used when selling stocks. For example, some have at various times called for divestment (sale of stock) from companies that had operations in China, where some products were made by forced labor, and in Nigeria, Myanmar (Burma), and Sudan, where repressive regimes had been accused of human rights abuses. More recently, activists have called for divestment from companies that mine, extract, and market fossil fuels, because of their impact on climate change.

35 “Activist Shareholders, Sluggish Performance,” The Wall Street Journal [commentary], April 1, 2015. 36 Global Sustainable Investment Alliance, “2016 Global Sustainable Investment Review,” at www.gsi-alliance.org. Data are as of early 2016. 37 Morgan Stanley Institute for Sustainable Investing, “Sustainable Reality: Understanding the Performance of Sustainable Investment Strategies,” March 2015.

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Social Responsibility Shareholder Resolutions

Another important way in which shareholders have been active is by sponsoring social responsibility shareholder resolutions. This is a resolution on an issue of corporate social responsibility placed before shareholders for a vote at the company’s annual meeting.

The Securities and Exchange Commission (SEC), a government regulatory agency that is further described later in this chapter, allows shareholders to place resolutions concern- ing appropriate social issues, such as environmental responsibility or alcohol and tobacco advertising, in proxy statements sent out by companies. The SEC has tried to minimize harassment by requiring a resolution to receive minimum support to be resubmitted— 3 percent of votes cast the first time, 6 percent the second time, and 10 percent the third time it is submitted within a five-year period. Resolutions cannot deal with a company’s ordinary business, such as employee wages or the content of advertising, since that would constitute unjustified interference with management’s decisions.38

In 2018, shareholder activists sponsored more than 400 resolutions dealing with major social issues. Backers included faith-based institutions, individual shareholders, unions, environmental groups, socially responsible asset managers, universities, and public pen- sion funds. In the 2018 proxy season, some of the issues most commonly raised in these resolutions included corporate political activity, sustainability and climate change, work- place diversity, and governance practices such as board composition.39

When a social responsibility shareholder resolution is filed, several outcomes are possi- ble. In some cases, managers enter into a dialogue with shareholder activists and resolve an issue before the election. For example, activists withdrew a shareholder proposal at Exxon- Mobil after the company met their key request to issue a report on its forecasts of energy demand and how it was positioning itself for a “lower-carbon future.”40 Many companies now engage with shareholder activists, and in 2017 about a quarter of shareholder propos- als resulted in some company action, as it did at ExxonMobil. If no resolution is reached, the proposal will generally be submitted for a vote by shareholders. In 2017, proposals on climate-related risks and proxy access were supported by more than a third of voters, a threshold at which many boards pay serious attention.41

Shareholder Lawsuits Another way in which shareholders can seek to advance their interests is by suing the company. If owners think that they or their company have been damaged by actions of company officers or directors, they have the right to bring lawsuits in the courts, either on behalf of themselves or on behalf of the company (the latter is called a derivative lawsuit). Shareholder lawsuits may be initiated to check many abuses, including insider trading, an inadequate price obtained for the company’s stock in a buyout (or a good price rejected), or failure to disclose material information in a timely manner. The outcome can be very expensive for companies, as illustrated by the following example.

Multiple groups of shareholders sued LendingClub, a company that runs a digital platform connecting consumers who need loans with lenders, banks, and credit partners. After revelations that some loan information had been falsified—and the

38 Current SEC rules on shareholder proposals may be found at www.sec.gov/rules/final. 39 As You Sow, “Proxy Preview 2018: Helping Shareholders Vote Their Values,” Oakland, Calif.: 2018. 40 “ExxonMobil Gives in to Shareholders on Climate Risk Disclosure,” Fortune, December 17, 2017. 41 EY Center for Board Matters, “2017 Proxy Season Review,” Ernst & Young, June 2017. This and additional information about shareholder resolutions are available at www.ey.com/gl/en/issues/governance-and-reporting/center-for-board-matters.

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company’s internal controls had failed to flag these irregularities—the stock fell by 35 percent, destroying $950 million in market value. In 2018, LendingClub settled its shareholder lawsuits for $125 million.42

Lawsuits brought by shareholders against the board of Wynn Resorts after a sexual harassment scandal hurt the firm’s share price are described in the discussion case at the end of this chapter.

In many ways—whether through their collective organization, the selection of stocks, the shareholder resolution process, or the courts—shareholder activists can and do protect their economic and social rights.

Government Protection of Shareholder Interests

The government also plays an important role in protecting shareholder interests. This role expanded as legislators responded to the corporate scandals of the early 2000s and the financial crisis later in the decade.

Securities and Exchange Commission The major government agency protecting shareholders’ interests is the Securities and Exchange Commission (SEC). Established in 1934 in the wake of the stock market crash and the Great Depression, its mission is to protect shareholders’ rights by making sure that stock markets are run fairly, and that investment information is fully disclosed. The agency, unlike most in government, generates revenue to pay for its own operations. (The revenue comes from fees paid by companies listed on the major stock exchanges.)

Government regulation is needed because shareholders can be damaged by abusive practices. Two areas calling for regulatory attention are protecting shareholders from fraudulent financial accounting and from unfair trading by insiders.

Information Transparency and Disclosure Giving shareholders more and better company information is one of the best ways to safe- guard their interests, and this is a primary mission of the SEC. By law, shareholders have a right to know about the affairs of the corporations in which they hold ownership shares. Those who attend annual meetings learn about past performance and future goals through speeches made by corporate officers and documents such as the company’s annual report. Those who do not attend meetings must depend primarily on annual reports issued by the company and the opinions of independent financial analysts.

In recent years, management has tended to disclose more information than ever before to shareholders and other interested people. Prompted by the SEC, professional accounting groups, and individual investors, companies now disclose a great deal about their financial affairs, with much information readily available on investor relations sections of company web pages. Shareholders can learn about sales and earnings, assets, capital expenditures and depreciation by line of business, details of foreign operations, and many other financial matters. Corporations also are required to disclose detailed information about directors and top executives and their compensation. In addition, many companies have begun reporting detailed information about social and environmental, as well as financial, performance, as discussed in Chapters 3, 10, and 17.

42 “LendingClub Agrees to Settle Shareholder Litigation for $125 Million,” American Banker, February 20, 2018, and “Lend- ingClub CEO Fired Over Faulty Loans,” The Wall Street Journal, May 9, 2016.

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Insider Trading Another area the SEC regulates is stock trading by insiders. Insider trading occurs when a person gains access to confidential information about a company’s financial condition and then uses that information, before it becomes public knowledge, to buy or sell the company’s stock. Since others do not know what an inside trader does, the insider has an unfair advantage.

In 2011, Raj Rajaratnam, founder and former manager of the prominent hedge fund Galleon Group, was sentenced to 11 years in prison for 14 counts of illegal insider trading, the longest-ever sentence for this crime at that time. He was also ordered to pay $157 million in fines and forfeitures. Federal prosecutors built their case from wiretap evidence. Over several months, they listened as Rajaratnam—as The New York Times put it—“brazenly and matter-of-factly swapped inside stock tips with corporate insiders and fellow traders.” In one particularly shocking example, a member of the board of directors of Goldman Sachs called Rajaratnam seconds after a board meeting to share earnings information. The government said that Gal- leon Group had made $63 million in all from illegal trades. “The defendant knew the rules, but he did not care,” said one of the government prosecutors. “Cheating became part of his business model.”43

Insider trading is illegal under the Securities and Exchange Act of 1934, which outlaws “any manipulative or deceptive device.” The courts have generally interpreted this to mean that it is against the law to trade stock (or stock options) based on material, nonpublic information. This includes company officials, of course, who may have inside information based on their work. But it also includes also other individuals who obtain such informa- tion through a “breach of trust,” that is, a tip from someone who has an obligation to keep the information confidential. The tipper can also be guilty, if he or she benefits from the exchange. It is not, however, illegal to trade based on information developed from publicly available sources. Unfortunately, drawing these distinctions in practice has been challeng- ing, and the courts and Congress and the courts have gone back and forth trying to pin down exactly what constitutes a consequential benefit to the tipper, and what information can be said to come from inside versus public sources. Insider trading is also illegal in most other countries.

Insider traders are not necessarily high-placed executives, wealthy individuals, or household names. In 2017, the SEC brought insider trading charges against Daniel Rivas, who worked for the Bank of America, saying he had passed nonpublic infor- mation about upcoming mergers and acquisitions to his girlfriend’s father, James Moodhe. Moodhe generated $2 million in profits by trading on the tips. Several of the two men’s friends and associates were also charged. Rivas and Moodhe both pleaded guilty.44

The best-known kind of insider trading—as in this case—occurs when people improp- erly acquire confidential information about forthcoming mergers and acquisitions before these are announced to the public. A startling study conducted by professors at New York University and McGill University, which examined stock trades between 1996 and 2012,

43 “Hedge Fund Billionaire is Guilty of Insider Trading” and “A Circle of Tipsters Who Shared Illegal Secrets,” The New York Times, May 11, 2011; and “Rajaratnam Ordered to Pay $92.8 Million Penalty,” The New York Times, November 8, 2011. 44 “Seven Charged in Insider Trading Ring Linked to Bank of America Leaks,” Fortune, August 17, 2017, and “Insider Trading Case to Be a Test of the Role of Friendship,” The New York Times, August 21, 2017.

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found that insider trading had probably occurred in no less than a quarter of all such deals.45 In another kind of insider trading, called front-running, traders place buy and sell orders for stock in advance of the moves of big institutional investors. They also track big trades in real time and act on them quickly; with today’s high-speed trading, even a few millisec- onds of advance notice of news about to hit the market can be enough to execute valuable insider trades.

Insider trading is contrary to the logic underlying the stock markets: All stock buyers and sellers ought to have access to the same information. In the Galleon Group case described above, Rajaratnam had insider information that ordinary investors did not—information that he used to give his fund and its investors an unfair advantage over others. If ordinary investors think that insiders can use what they know for personal gain, the system of stock trading could break down from lack of trust. Insider trading laws are important for inves- tors to have full confidence in the fundamental fairness of the markets.

Another responsibility of the SEC is to protect investors against fraud. One situation where they apparently failed to guard against a massive scheme to cheat investors was the fraud perpetrated by Bernard Madoff.

The victims of Madoff’s fraud—including prominent universities, charities, and cultural institutions, as well as individual investors—lost as much as $65 billion. Where were the government regulators in all of this? In congressional hearings, SEC chairman Christopher Cox admitted that his agency had missed repeated warnings, dating back to 1999, that things might be amiss at Madoff’s firm. “I am gravely concerned by the apparent multiple failures over at least a decade to thoroughly investigate these allegations or at any point to seek formal authority to pursue them,” said Cox. The New York Times wrote in a harsh editorial that the agency’s failure to uncover the Madoff fraud “exemplifies its lackadaisical approach to enforcing the law on Wall Street.”46

Some evidence suggested that the SEC had become less aggressive in pursuing finan- cial crimes since President Trump’s appointee as SEC chair, a Wall Street attorney, took over in 2017.47

Shareholders and the Corporation

Shareholders have become an increasingly powerful and vocal stakeholder group in cor- porations. Boards of directors, under intense scrutiny after the recent wave of corporate scandals and business failures, are giving close attention to their duty to protect owners’ interests. Reforms in the corporate governance process are under way that will make it easier for them to do so. Owners themselves, especially institutional investors, are pressing directors and management more forcefully to serve shareholder interests. The government, through the Securities and Exchange Commission, has taken important new steps to pro- tect investors and promote fairness and transparency in the financial marketplace.

Clearly, shareholders are a critically important stakeholder group. By providing capital, monitoring corporate performance, assuring the effective operation of stock markets, and

45 “Study Asserts Startling Numbers of Insider Trading Rogues,” The Wall Street Journal, June 16, 2014. 46 “Standing Accused: A Pillar of Finance and Charity,” The New York Times, December 13, 2008; “SEC Issues Mea Culpa on Madoff,” The New York Times, December 17, 2008; “SEC Knew Him as a Friend and Foe,” The New York Times, December 18, 2008; and “You Mean That Bernie Madoff?” The New York Times [editorial], December 19, 2008. 47 “Wall Street Penalties Have Fallen in Trump’s First Year, Study Says,” November 14, 2017, www.bloomberg.com.

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Key Terms social investment, 297 social responsibility shareholder resolutions, 298 stock option, 291

board of directors, 287 corporate governance, 287 executive compensation, 291 hedge fund, 296 insider trading, 300 institutional investors, 285

private equity firm, 296 proxy, 287 proxy access, 289 say-on-pay, 294 Securities and Exchange Commission (SEC), 299 shareholders, 283 shareholder lawsuits, 298

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bringing new issues to the attention of management, shareholders play a very important role in making the business system work. A major theme of this book is that the relation- ship between the modern corporation and all stakeholders is changing. Corporate leaders have an obligation to manage their companies in ways that attempt to align investors’ inter- ests with those of employees, customers, communities, and others. Balancing these various interests is a prime requirement of modern management. While shareholders are no longer considered the only important stakeholder group, their interests and needs remain central to the successful operation of corporate business.

∙ Individuals and institutions own shares of corporations primarily to earn dividends and receive capital gains, although some have social objectives as well. Shareholders are entitled to vote, receive information, select directors, and attempt to shape corporate policies and action.

∙ In the modern system of corporate governance, boards of directors are responsible for setting overall objectives, selecting and supervising top management, and assuring the integrity of financial accounting. The job of corporate boards has become increasingly difficult and challenging, as directors seek to balance the interests of shareholders, managers, and other stakeholders. Reforms have been proposed to make boards more responsive to shareholders and more independent of management.

∙ Some observers argue that the compensation of top U.S. executives is justified by per- formance, and that high salaries provide a necessary incentive for innovation and risk taking in a demanding position. Critics, however, believe that it is too high. In this view, high pay hurts firm competitiveness and undermines employee commitment.

∙ Shareholders have influenced corporate actions by forming organizations to promote their interests, intervening in board elections, and by filing lawsuits when they feel they have been wronged. They have also organized under the banner of social investment. These efforts have included screening stocks according to social and ethical criteria, and using the voting process to promote shareholder proposals focused on issues of social responsibility.

∙ Recent enforcement efforts by the Securities and Exchange Commission have focused on improving the accuracy and transparency of financial information provided to inves- tors. They have also focused on curbing insider trading, which undermines fairness in the marketplace by benefiting those with illicitly acquired information at the expense of those who do not have it.

Summary

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Discussion Case: Corporate Governance and Executive Misconduct at Wynn Resorts

On January 26, 2018, The Wall Street Journal published an explosive story about Steve Wynn, the chief executive and chairman of the board of Wynn Resorts, a leading operator of luxury hotels and casinos. The Journal reported that dozens of people had recounted “a decades-long pattern of sexual misconduct” involving Wynn’s unwanted advances on mas- sage therapists, cocktail waitresses, and other women who worked at his properties. One of the most serious allegations was that in 2005 the CEO had forced a manicurist to remove her clothes and have sex with him. After the woman filed a detailed complaint about the episode, Wynn had settled privately with her for $7.5 million. The executive immediately challenged the Journal story, saying, “The idea that I ever assaulted any woman is preposterous.”

The day the article came out, the share price of Wynn Resorts dropped by 10 percent, wiping out $2 billion in shareholder value.

Steve Wynn, 76, had begun his career as a young man by taking over his father’s bingo parlors in Maryland. He moved on to Las Vegas, Nevada, where he renovated the Golden Nugget, and later developed (and sold) the Mirage, Bellagio, and Treasure Island proper- ties. Over his long career, Wynn was widely credited with driving the transformation of Las Vegas from a seedy strip into a world-class destination for entertainment and gaming. A larger-than-life character, Wynn was said to be inspiration for the casino owner played by Andy Garcia in the “Ocean’s” films.

In 2018, Wynn Resorts owned the Wynn Las Vegas and two hotel casinos in Macau, an autonomous zone in southeast China that permitted gambling, and was in the process of building a new property in Massachusetts, expected to open in 2019. The firm had more than 24,000 employees and earned revenues in 2016 of $4.5 billion, about three-quarters of which came from its Macau operations. Wynn’s signature was the company’s logo.

In 2016, Steve Wynn’s total compensation was $28.2 million, placing him tenth on the list of top-paid U.S. CEOs. The research organization As You Sow ranked Wynn sixth on its list of “most overpaid” CEOs, based on a comparison of his compensation with total return to shareholders over the prior five years. But the company defended Wynn’s com- pensation package, pointing out in its proxy statement that between the initial public offer- ing in 2002 and 2017, shareholders had averaged a total return of 19 percent per year, well above the 9 percent return of the S&P 500 during that period. “Mr. Wynn is the founder, creator and name behind our brand,” the company said. “We believe he brings extraordi- nary talent . . . that is unrivaled in our industry.”

Wynn Resorts’ board of directors was comprised of ten people. Wynn served as chair- man, a role he had held continuously since the company went public. The other nine

Internet Resources

www.nyse.com New York Stock Exchange www.cii.org Council of Institutional Investors www.ussif.org Forum for Sustainable and Responsible Investment www.socialfunds.com Site for socially responsible individual investors www.ecgi.org European Corporate Governance Institute www.issgovernance.com ISS (formerly Institutional Shareholder Services) www.calpers.ca.gov California Public Employees Retirement System www.sec.gov U.S. Securities and Exchange Commission

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directors, although nominally independent, had close personal ties with the chief execu- tive. They included D. Boone Wayson, whose father had been Steve Wynn’s father’s part- ner in the bingo business; Edward Virtue, who had managed the Wynn family money; and Robert Miller, a former Nevada governor, who had known the CEO for more than 40 years. Patricia Mulroy, the sole woman on the board, was a former member of the Nevada gaming commission. The nine outside directors served staggered terms, with three standing for election or re-election to three-year terms each year. Their annual compensation ranged from $362,406 to $517,973.

Wynn Resorts’ board was widely viewed as compliant with the CEO’s wishes. The board had voted against Wynn only three times since 2002. The sole board member who was ever opposed for re-election was Elaine Wynn, Steve’s ex-wife, who lost the support of the other directors after the couple’s divorce. Glass Lewis, a proxy advisory firm, had given the company’s corporate governance practices an “F” grade in both 2016 and 2017. In the latter year, 41 percent of shareholders—including the big institutional investors Van- guard Group and BlackRock Inc.—had opposed the company’s compensation policies in a “say-on-pay” vote.

On the day the Journal article broke, the board issued a statement affirming the compa- ny’s commitment to maintaining a respectful culture and announced it had formed a com- mittee, headed by Mulroy, to investigate the allegations. But these actions failed to stem a tide of negative press. On February 6, Wynn resigned as CEO and chairman, saying he could no longer be effective. The board accepted his resignation “with a collective heavy heart,” calling Wynn a “beloved leader and visionary.” A week later, it hired Gibson Dunn, a law firm that had represented the board in earlier litigation, to conduct an inquiry.

Less than four weeks after the publication of the allegations against Steve Wynn, New York state’s public pension fund filed a lawsuit against the Wynn Resorts board of direc- tors, saying the board had done nothing to prevent the CEO’s sexual abuse and harassment and had allowed him to resign without being held accountable. The pension fund called for the defendants to “disgorge” (give back) all compensation obtained from wrongful con- duct. Other states, union pensions, and individual shareholders also filed suit, and gam- bling regulators in Massachusetts, Nevada, and Macau opened investigations.

“The story of Steve Wynn is a cliché: a powerful man preying on the powerless,” said the state of Oregon in its shareholder lawsuit. “But the directors of Wynn Resorts were not powerless. They were the only people with the knowledge and ability—and duty to the company—to investigate and stop Steve Wynn’s conduct.”

Sources: “Dozens of People Recount Pattern of Sexual Misconduct by Las Vegas Mogul Steve Wynn,” The Wall Street Journal, January 26, 2018; “Wynn Board Faces Scrutiny Following Allegations Against Steve Wynn,” The Wall Street Journal, January 30, 2018; “Wynn Steps Down as Wynn Resorts CEO,” and “The Board of Wynn Resorts Needs to Go, Too,” The Wall Street Journal, February 7, 2018; “Who’s Going to Fix Wynn Resorts? Not Its Board,” February 14, 2018, www.bloomberg. com; “Stockholders File Class Action Lawsuit Against Wynn Resorts,” The Real Deal, February 23, 2018; “Oregon Sues Steve Wynn, Board of Directors for Failing to Stop Sexual Misconduct,” March 7, 2018; www.hollywoodreporter.com; “Steve Wynn Remade Vegas, But China is Where He Makes Real Money,” January 29, 2018, http://money.cnn.com; “Steve Wynn’s Tarnished Name and Now a Tainted Brand,” The New York Times, February 11, 2018; and John L. Smith, Running Scared: The Life and Treacherous Times of Las Vegas Casino King Steve Wynn (Cambridge, MA: Da Capo Books, 2001).

Discussion Questions

1. Do you think Steve Wynn’s executive compensation was justified, and why or why not? 2. Did the board of directors of Wynn Resorts operate according to the principles of good

corporate governance, as described in this chapter? Why or why not? 3. Do you think Wynn Resorts’ institutional and individual shareholders used the rights

described in this chapter effectively to protect their interests? Why or why not? 4. What do you recommend senior executives and the board of Wynn Resorts do now?

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