Glossary of Terms
The following glossary of terms are frequently used in discussions of corporate governance and executive leadership. For an expanded discussion, see Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences by David Larcker and Brian Tayan. Please email us with suggestions for additional terms or to comment on the definitions provided: email@example.com. Words that are asterisked (*) have been provided by guest contributors.
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Abnormal (Excess) Returns (Alpha).
Excess returns are calculated as the difference between observed changes in stock price minus the expected return of the stock, adjusted for risk. Assuming reasonably efficient markets, excess returns provide one measure of the change in economic value for shareholders. Positive alpha is the measure of how much you are beating the market; negative alpha is the reverse.
The difference between accrued income and cash flows (adjusted for typical accruals that occur during the application of accounting standards). Abnormal accruals are sometimes measured as a test of earnings quality.
Accounting (Earnings) Quality
Accounting quality reflects the degree to which accounting figures precisely measure a company’s change in financial position, earnings, and cash flow during a reporting period.
The purposeful misapplication of generally accepted accounting standards in order to inflate reported financial results. Accounting manipulation, when it occurs, is intended to hide financial failures or fraud from auditors and stakeholders.
Investors with at least $1 million in investable assets or $200,000 in annual income. Accredited investors are considered to be "sophisticated" by the SEC, and therefore are given more leeway to invest in funds not covered by the Investment Company Act of 1940 (such as hedge funds).
Investors who are active in the trading of company securities (as opposed to passive investors). Active investors tend to care greatly about individual company outcomes. As a result, they might try to influence corporate activities to improve company performance (such as by meeting with management, lobbying to have board members removed, voicing concern over compensation practices, or advancing policy measures through the annual proxy).
Investors who try to use an ownership position to actively pursue governance changes at a corporation. The objectives of the activist investor might differ from those of other shareholders. Examples of activist investors might include the following:
• Pension funds that manage assets on behalf of union employees
• Institutional funds with a social mission, such as environmental, religious, or humanitarian causes
• Hedge fund managers driven by a desire for short-term gain
• Individual investors with outspoken personal beliefs
Costs resulting from agency problems. See "agency problem."
A situation of misaligned incentives which arises when a third-party agent is hired to act on one's behalf. In a corporate setting, agency problems occur when a manager who is hired to run a company in the interest of shareholders and stakeholders takes actions which benefit himself or herself, with the costs borne by corporation and by extension, shareholders, etc. For example, an executive might manipulate accounting results to increase the size of his or her bonus, or might pursue an expensive acquisition, even though these actions are value destroying. Agency problems can be mitigated through corporate governance features which restrict or discourage these actions or through incentives which align the interest of management and the corporation.
A term used to describe governance models prevalent in the United Kingdom and United States. The Anglo-Saxon model is shareholder-centric (meaning that the primary purpose of the corporation is considered to be the maximization of shareholder value), with a single board of directors, management participation on the board (particularly the CEO), and an emphasis on transparency and disclosure through audited financial reports.
A variable compensation payment, usually in the form of cash, that is awarded to an executive if the yearly performance of the company exceeds specified financial and nonfinancial targets. The size of the bonus is commonly expressed as a percentage of base salary and might include a guaranteed minimum and specified maximum.
A fixed cash compensation payment made evenly during the course of the year. Section 162(m) of the Internal Revenue Code limits the tax deductibility of executive compensation greater than $1 million, unless such compensation is performance driven. The fixed salary is typically set at the beginning of the year.
How an organization provides stakeholders with a degree of confidence or level of comfort that everything is operating in a satisfactory manner. It involves independent conclusions about the impartial assessment or objective examination of a particular subject matter against specific pre-defined criteria. (*Contributed by Sean Lyons, RISC International)
The audit committee is responsible for overseeing the company’s external audit and is the primary contact between the auditor and the company. This reporting relationship is intended to prevent management manipulation of the audit. Under Sarbanes-Oxley, the audit committee must have at least three members, all of whom are financially literate; the chair also must be a financial expert. The obligations of the audit committee include:
1. Overseeing the financial reporting and disclosure process
2. Monitoring the choice of accounting policies and principles
3. Overseeing the hiring, performance, and independence of the external auditor
4. Overseeing regulatory compliance, ethics, and whistleblower hotlines
5. Monitoring internal control processes
6. Overseeing the performance of the internal audit function
7. Discussing risk-management policies and practices with management
A situation in which a corporation becomes insolvent (i.e., the value of its liabilities exceeds the value of its assets). In bankruptcy, the legal obligation of the corporation is to preserve and maximize the financial claims of creditors (rather than shareholders).
Compensation benefits provided with employment, such as health insurance, post-retirement health insurance, defined contribution retirement accounts (401[k]), supplemental executive
retirement plans (SERPs), life insurance, payment for the use of a personal financial planner, and reimbursement of taxes owed on taxable benefits.
Practices, procedures, or routines which are shown to improve financial and nonfinancial outcomes, on average and across a large number of firms.
A period of time during which insiders are restricted from trading in company stock. Blackout periods are designed to protect executives from unintentially violating insider trading laws and are specified on a company-by-company basis in a company's insider trading policy. Blackout periods typically occur between the time when material information is known (such as quarterly earnings, a new product launch, or acquisition) and the time when it is released to the public. Trades within the blackout period are prohibited, and trades outside the blackout period (during the "trading window") commonly require approval in advance by the general counsel’s office.
Blank Check Preferred Stock
A class of unissued preferred stock that is provided for in the articles of incorporation and that the company can issue when threatened by a corporate raider. The purchaser of the preferred stock obtains an economic position senior to that of common shareholders and also typically receives significant voting rights. Combined, these are used to block a corporate raider seeking to take control of the company or its board of directors.
An investor with a significant ownership position in a company’s common stock. No regulatory statute classifies an investor as a blockholder, although researchers generally define a blockholder as any shareholder with at least a 1 to 5 percent stake. A blockholder can be an executive, a director, an individual shareholder, another corporation, or an institutional investor. Blockholders with large ownership positions can exert significant influence (positive or negative) on the governance of a firm.
The degree to which individual directors on a board represent a wide range of personal or professional backgrounds, experiences, or viewpoints.
The process by which the entire board, its committees, or individual directors are evaluated for their effectiveness in carrying out their stated responsibilities. In the United States, annual board evaluations are a listing standard of the New York Stock Exchange (NYSE), which requires that the nominating and governance committee “oversee the evaluation of the board and management.”
Furthermore, each committee (audit, compensation, and nominating and governance) is required to perform its own self-evaluation. The quality of board evaluations varies widely across companies.
Board of Directors
A group of individuals elected to represent the interests of shareholders and monitor the corporation and its management. Generally speaking, a board serves two roles: an advisory role and an oversight role. In its advisory capacity, the board consults with management regarding the strategic and operational direction of the company. Attention is paid to decisions that balance risk and reward. Board members are selected based on the skill and expertise they offer for this purpose, including previous experience in a relevant industry or function. In its oversight capacity, the board is expected to monitor management and ensure that it is acting diligently in the interests of shareholders.
The board hires and fires the chief executive officer, measures corporate performance, evaluates management contribution to performance, and awards compensation. It also oversees legal and regulatory compliance, including the audit process, reporting requirements for publicly traded companies, and industry-specific regulations. In fulfilling these responsibilities, the board often relies on the advice of legal counsel and other paid professionals, such as external auditors, executive recruiters, compensation consultants, investment bankers, and tax advisors.
A description of a board based on its prominent structural attributes, such as size, professional and demographic information about the directors serving on it, their independence from management, number of committees, director compensation, etc. Although much attention is paid to board structure, most research evidence finds little relation between board structure and a company's performance or governance quality.
The shares held at a brokerage firm are registered under the name of the brokerage (“street name”), even though they are beneficially owned by the individual. Brokers are required to forward these shares to the beneficial owner and vote according to owner instructions. If the broker does not receive instructions within 10 days of the vote date, a broker nonvote is said to occur. New York Stock Exchange Rule 452 defines the situations in which a broker is allowed to use discretion in voting these shares and when he or she is disallowed. The treatment of broker non votes can be important in determining the outcome of closely contested proxy battles.
The practice of waiting to award stock options to an executive or employee until after the release of unexpected negative news that is likely to drive down the price of a stock.
The ratio of shares granted through a company's equity-based compensation plan and the number of shares outstanding (or authorized). Because equity compensation dilutes the ownership interest of shareholders, much attention is paid to the rate at which new shares are issued. Proxy advisory firms have proprietary models that calculate "appropriate" maximum burn rates, but there is no evidence that these models are correct (i.e., maximize shareholder value).
Business Judgment Rule
Under the business judgment rule, a court will not second guess a board’s decision (even if, in retrospect, it was proved to be seriously deficient) if the board followed a reasonable process by which it informed itself of key, relevant facts and then made a decision in good faith. Good faith requires that the board act without conflicting interests and that it not turn a blind eye to issues within its responsibility. If the board can demonstrate that it satisfied these criteria, the courts will not intervene. For more, see "duty of care."
A model that links specific financial and nonfinancial measures in a logical chain to delineate how a company's strategy translates into the accomplishment of stated financial goals. The board evaluates the business model for logical consistency, realism of targets, and statistical evidence that the relationships between performance metrics and stated goals are valid. See "corporate strategy" and "key performance indicators."
Busy Boards (Busy Directors)
Companies whose directors sit on multiple boards. The numeric threshold that constitutes a “busy” director is subject to discretion, although researchers generally consider a director to be busy if he or she sits on three or more boards. Similarly, a “busy” board is one in which a significant number of directors are busy.
Capital Market Efficiency
The degree to which markets set correct prices for labor, natural resources, and capital, based on the information available to both parties in a transaction. Accurate pricing is necessary for firms and individuals to make rational decisions about allocating capital to its most efficient uses. When capital markets are inefficient, prices are subject to distortion and corporate decision making suffers. Efficient capital markets can act as a disciplining mechanism on corporations. Companies are held to a “market standard” of performance, and those that fail to meet these standards are punished with a decrease in share price or increase in borrowing costs. Companies that do not perform well over time risk going out of business or becoming an acquisition target.
The conglomerate organizations that dominate the Korean economy. Chaebol, which means “financial house,” are not single corporations but groups of affiliated companies that operate under the strategic and financial direction of a central headquarters. A powerful group chairman holds ultimate decision-making authority on all investments and leads headquarters.
Chairman of the Board
The director who presides over meetings of the full board of directors. The chairman is responsible for setting the agenda, scheduling meetings, and coordinating actions of board committees. Because of his or her prominent position, the chairman is considered the most powerful board member and also the public "face" of the board. Traditionally, the CEO has served as the chairman of the board in most U.S. corporations. In recent years, however, it has become more common for a nonexecutive director to serve as chair.
A system of law that relies on comprehensive legal codes or statutes written by legislative bodies. The judiciary bases decisions on strict interpretation of the law instead of legal precedent. Civil law is also known as "code law."
Clause 49 (India)
The standard of corporate governance in India that applies to all listed companies. Important provisions of Clause 49 include the following:
* A majority of nonexecutive directors
* If the chairman is an executive of the company, at least half of the directors must be independent; otherwise, one-third must be independent.
* Board members are limited to serving on no more than ten committees across all boards to which they are elected.
* Audit committee consists of at least three members, two of whom must be independent.
* The CEO and CFO must certify financial statements.
* Extensive disclosure of related-party transactions, board of directors’ compensation and shareholdings in the company, and any financial relationships that might lead to board member conflicts.
Companies are required to include a section in the annual report explaining whether they are in compliance with these standards.
Clawbacks and Deferred Payouts
Provisions in the executive compensation contract that enable a company to reclaim compensation in future years if it becomes clear that bonus compensation should not have been awarded previously. Clawbacks are intended to discourage executives from artificially inflating financial results to increase the value of their bonuses. The Dodd-Frank Wall Street Reform Act requires that companies develop, implement, and disclose clawback policies.
Code of Best Practices*
Benchmark set of recommendations by blue-panel experts and others on corporate governance strategy, structure, model and other related dimensions that companies should incorporate to achieve “good governance” (e.g.; adoption of the chairman/CEO split). Also see: The Cadbury Committee (1992), The Greenbury Report (1995); The Hampel Report (1998), The Higgs Report (2003). Editorial note: These recommendations might reflect a one-size-fits-all approach to governance and the propagation of “best practices” that the research literature has not supported. (Thanks to @CGGovernance for suggesting this term).
A system under which the interests of shareholders and employees are expected to be balanced in corporate decision-making. The philosophy of codetermination underlies German corporate law.
A system of law under which judicial precedent shapes the interpretation and application of laws. Judges consider previous court rulings on similar matters and use this information as the basis for settling current claims.
The committee of the board that is responsible for setting the compensation of the CEO and for advising the CEO on the compensation of other senior executives. The responsibilities of the compensation committee are as follows:
1. Set the compensation of the CEO.
2. Set and review performance-related goals for the CEO
3. Determine appropriate compensation structure for the CEO, given performance expectations
4. Monitor CEO performance relative to targets
5. Set or advise the CEO on other officers’ compensation
6. Advise the CEO and oversee compensation of nonexecutive employees
7. Set board compensation
8. Hire consultants to assist in the compensation process, as appropriate.
How an organization ensures its activities conform with all relevant mandatory and voluntary requirements. Successful compliance management involves clearly defining applicable laws, regulations, codes, best practices, and internal standards, and so on. It must demonstrate how the organization ensures that it is in strict adherence with all relevant requirements. (*Contributed by Sean Lyons, RISC International).
The degree to which a company complies with laws and regulations. Compliance risk is reflected in such factors as labor practices, environmental compliance, and consideration given to the regulatory requirements that govern the company’s products, processes, or publicly listed securities.
Comply or Explain (UK)
A system of governance under which public companies are not legally required to adopt recommended governance standards but instead required to issue an annual statement to shareholders explaining whether they are in compliance with these standards or, if not, stating their reasons for noncompliance. This practice allows companies to deviate from recommended practices if the company believes they are not appropriate for its specific situation. The "comply or explain" system originated in the United Kingdom but has also been adopted in other European countries.
See Internal Controls
In its broadest sense represents an organization's collective program (formal or otherwise) for self-defense. It represents the measures taken by an organization to safeguard the interests of its stakeholders from a multitude of potential hazards (risks, threats, and vulnerabilities), the occurrence of which could be detrimental to the achievement of the organization's objectives. (*Contributed by Sean Lyons, RISC International)
Corporate Defense Management (CDM)*
The multi-dimensional framework employed by an organization to manage the critical components which constitute an organization's corporate defense program. This includes the integrated management of its governance, risk, compliance, intelligence, security, resilience, controls, and assurance activities. (*Contributed by Sean Lyons, RISC International).
The need for corporate governance rests on the idea that when separation exists between the ownership of a company and its management, self-interested executives have the opportunity to take actions that benefit themselves, with shareholders and stakeholders bearing the cost of these actions. This scenario is typically referred to as the "agency problem," with the costs resulting from this problem described as "agency costs." Executives make investment, financing, and operating decisions that better themselves at the expense of other parties related to the firm. To lessen agency costs, some type of control or monitoring system is put in place in the organization. That system of checks and balances is called "corporate governance." At a minimum, a governance system consists of a board of directors to oversee management and an external auditor to express an opinion on the reliability of financial statements. In most cases, however, governance systems are influenced by a much broader group of constituents, including owners of the firm, creditors, labor unions, customers, suppliers, investment analysts, the media, and regulators who all influence managerial behavior.
Corporate Governance Ratings
Rating systems which attempt to grade or assess corporate governance quality. Rating systems might take the form of an index, where governance variables are quantified and the scores aggregated to arrive at a numerical value of governance quality. Alternatively, rating systems incorporate qualitative as well as quantitative assessments and assign letter grades to reflect governance quality. To date, no organization or researcher has developed a robust model for ratings that reliably predicts governance failures.
The process by which a company expects to create long-term value for shareholders and stakeholders. The corporate strategy defines the businesses a company will participate in and outlines how the company expects to create value by participating in these businesses. See "business model" and "key performance indicators."
An assessment of the ability and willingness of a borrower to repay debt obligations. Creditworthiness is determined based on a combination of quantitative and qualitative factors, including availability of collateral, leverage ratios, interest coverage, and diversity and stability of revenue streams, among other factors. Institutional investors that invest in corporate debt use credit ratings to determine the likelihood that they will be paid the full principal and interest owed to them over the life of the bond. In some cases, investors such as money market funds are only allowed to invest in debt with a sufficiently high rating. Companies with higher credit ratings are generally rewarded in the market with lower interest rates on their borrowings, while companies with lower credit ratings are generally charged higher rates.
A system for proxy voting that allows a shareholder to concentrate votes on a single board candidate instead of requiring one vote for each candidate. A shareholder is given a number of votes equal to the product of the number of shares owned times the number of seats the company has on its board. For example, a shareholder with 100 shares in a company with a board of nine directors has 900 votes. The shareholder can allocate those votes among board candidates as he or she chooses. To increase the likelihood of electing a specific director, the shareholder might concentrate more votes toward a single candidate or a subset of candidates. Cumulative voting is relatively rare. See "plurality voting" and "majority voting."
An arrangement under which a company pays for or reimburses a director for costs associated with securities class actions and some fiduciary duty cases. Indemnification generally is available to a director for any expense incurred in connection with litigation, including legal fees, settlements, and judgments against the director. Indemnification is only permitted if the director has acted in good faith. Indemnification agreements have been widely adopted by most public companies.
Directors' and Officers' (D&O) Liability Insurance
An insurance contract purchased by a corporation on behalf of directors and officers to protect them from certain costs associated with litigation. These policies cover litigation expenses, settlement payments, and, in rare cases, amounts paid in damages (up to a limit specified in the policy). A D&O insurance policy has three parts, referred to as Side A, Side B, and Side C. Side A protects the director when indemnification is not available, for example, if the company becomes insolvent. Side B reimburses a corporation for its indemnification obligations to directors. Side C insurance reimburses a corporation for its own litigation expenses and amounts it pays in settlement. Most companies purchase D&O insurance on behalf of their board.
Dodd–Frank Wall Street Reform and Consumer Protection Act 2010
A bill to promote the financial stability of the United States by improving accountability and transparency in the financial system. Important governance-related provisions of Dodd-Frank include the following: • Proxy access—Shareholders or groups of shareholders are eligible to nominate directors on the company proxy.
• Say-on-pay—Shareholders are given a nonbinding vote on executive compensation.
• Disclosure—Companies must provide expanded disclosure on executive compensation, hedging of company equity by executives and directors, the independence of compensation
committee members, and the decision of whether to have an independent chairman.
The proxy access guidelines proposed by the SEC pursuant to Dodd-Frank were disallowed by a U.S. Court of Appeals court, and so proxy access rules have not yet been defined.
A company with dual-class shares has more than one class of common stock. In general, each class has equal economic interest in the company but unequal voting rights. For example, Class A shares might be afforded one vote per share, whereas Class B shares might have ten votes per share. Typically, an insider, founding family member, or other shareholder friendly to management holds the class of shares with preferential voting rights, which gives that person significant (if not outright) influence over board elections. Dual-class stock thus tends to weaken the influence of public shareholders and are considered an effective antitakeover defense.
Duty of Candor
A fiduciary duty under state corporate law. The duty of candor requires that management and the board inform shareholders of all information that is important to their evaluation of the company and its management. The company’s management is required in the first instance to provide accurate and timely information to shareholders, and the board is expected to oversee this process. In the absence of direct knowledge of wrongdoing, the board is permitted to rely on management assurances that the information is complete and accurate. See "fiduciary duty."
Duty of Care
A fiduciary duty under state corporate law. The duty of care requires that a director make decisions with due deliberation. In the United States, courts enforce the duty of care through the rubric of the “business judgment rule.” This rule provides that the judgment of a board will not be overridden by a court unless a plaintiff can show that the board failed to inform itself regarding the decision at issue or that the board was infected with a conflict of interest, in which case there may have been a violation of the duty of loyalty. Courts have rarely ruled against a board for a violation of the duty of care. Even if a board decision was clearly wrong, if the board can show that it engaged in some consideration of information related to the decision, the courts will adopt a hands-off posture. The business judgment rule is most protective of outside directors. In the absence of “red flags” regarding what management is telling them, they are permitted to rely on what they hear from management to inform their decision. Moreover, companies are permitted to include exculpatory provisions in the charters that protect an outside director from suits for monetary damages for breach of the duty of care, so long as the director has not acted intentionally or in bad faith. See "fiduciary duty."
Duty of Loyalty
A fiduciary duty under state corporate law. The duty of loyalty addresses conflicts of interest. For example, if management is considering a transaction with a company in which a director has a significant financial interest, the duty of loyalty requires that the terms of the transaction promote the interests of the shareholders over those of the director. As another example, if a director discovers a business opportunity in the course of his or her service to the company, the duty of loyalty requires that the director refrain from taking the opportunity before first determining whether the company will take it. The law lays out procedures for a board to follow in situations when a potential conflict of interest may exist. See "fiduciary duty."
The total value of compensation that an executive "earns the right to keep" as cash is delivered and vesting restrictions removed from equity grants. Salary and annual bonuses are earned over one-year periods. Long-term cash awards are typically earned at the end of multiple-year periods. Equity awards are earned as they vest. The earned value of compensation often differs significantly from the originally expected value. Earned pay can be compared to corporate performance during the measurement period and used to assess "pay for performance." See "expected pay" and "realized pay."
Altering or manipulating financial results to meet or exceed quarterly forecasts. Earnings management may or may not be fraudulent, depending on the tactic employed. Still, manipulated earnings tend to be a signal of governance problems.
A situation in which management seeks to acquire another company primarily for the sake of managing a larger enterprise. Empire building is a type of agency problem that effective corporate governance systems are expected to prevent.
The process of testing a hypothesis through real-world observation. Large sample statistical testing, field studies, and individual case studies are examples of empirical testing. The opposite of empirical testing is deductive reasoning based on theoretical principles.
Event studies measure the stock market’s reaction to news or events, and are used by researchers to measure whether corporate actions or governance changes are value increasing or value decreasing to shareholders. These studies have validity only to the extent that the reader believes that markets are at least partly efficient. Even if so, event studies cannot easily control for confounding events (such as other news released by the company during the measurement period). Moreover, event studies require the researcher to make important risk adjustments when computing excess stock returns. Although several risk adjustments have become “accepted,” their computation is complex, and it is difficult to know whether the researcher made them properly.
The total set of cash and noncash incentives offered to attract, retain, and motivate an executive to achieve corporate objectives.
A meeting of the board of directors in which only independent (nonexecutive) directors are present. Under Sarbanes Oxley, a company's board is expected to hold at least one executive session per year. While no formal actions are taken at these meetings, executive sessions give outside directors an opportunity to discuss candidly the performance of management, operating results, internal controls, and succession planning. The lead independent director or nonexecutive chairman presides over these meetings.
The total expected value of compensation promised to an executive in a given year. Expected compensation is composed of the annual salary, expected value of the annual bonus, plus the expected fair market value of equity grants and long-term incentive cash plans. The future (earned and realized) values of compensation might differ significantly from the expected value. Expected pay represents the incentive value of compensation. See "earned pay" and "realized pay."
Under state corporate law, the board of directors has a legal obligation to act in the “interest of the corporation.” In legal terminology, this is referred to as a fiduciary duty to the corporation. Although somewhat ambiguous—since a corporation is simply a legal construct that cannot have its own interests—the courts have interpreted this phrase to mean that a director is expected to act in the interest of shareholders. Court decisions often refer to a fiduciary duty to “the corporation and the shareholders” or even just to the shareholders. The fiduciary duty of the board includes three components: a duty of care, a duty of loyalty, and a duty of candor.
Financial Accounting Standards Board (FASB)
A nonprofit organization that determines accounting standards in the United States. Members include accounting experts from academia, industry, audit firms, and the investing public.
Sarbanes Oxley requires that at least one member of the audit committee be a "financial expert." A financial expert is defined as: someone who has past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual’s financial sophistication, including being or having been chief executive officer, chief financial officer, or other senior officer with financial oversight responsibilities. To qualify as a financial expert, the director must have experience as a public accountant, auditor, principal financial officer, comptroller, or principal accounting officer at an issuer. The director also is required to have an understanding of accounting principles, the preparation of financial statements, internal controls, and audit committee functions. The financial expert serves as chair of the audit committee.
A financial restatement occurs when a material error is discovered in a company’s previously published financials. When such an error is discovered, the company is required to file a Form 8-K, alerting investors that previously published financials can no longer be relied upon and are under review for restatement. If the error is not material, the financial statements are not restated but are simply amended.
The degree to which a company relies on external financing (including capital markets and private lenders) to support its ongoing operations. Financial risk is reflected in such factors as balance sheet leverage, off-balance sheet vehicles, contractual obligations, maturity, schedule of debt obligations, liquidity, and other restrictions that reduce financial flexibility. Companies that rely on external parties for financing are at greater risk than those that finance operations using internally generated funds.
Foreign Corrupt Practices Act (FCPA)
The Foreign Corrupt Practices Act (FCPA) of 1977 makes it illegal for a company to offer payments to foreign officials for the purpose of obtaining or retaining business, to fail to keep accurate records of transactions, or to fail to maintain effective controls to detect potential violations of the FCPA. In recent years, the number of prosecutions of the FCPA by the Department of Justice and SEC has increased significantly.
A situation in which a target company is open to receiving a takeover offer from an acquiring firm. The opposite of a friendly acquisition is a "hostile takeover."
See “Corporate Governance.”
An economic contract used to protect or preserve the value of a common stock position. An individual might hedge a stock portfolio that is significantly concentrated in a single company. Similarly, an executive who has received considerable equity in a company through the compensation program might hedge the value of his or her holdings. While attractive from a diversification standpoint, hedges change the incentive value of an executive compensation program. They might also be used to trade on the basis of inside information without attracting as much attention as an outright sale. As a result, many companies restrict the timing and ability of executives to hedge their stock positions through guidelines laid out in the insider trading policy. See "prepaid-variable forward" and "zero-cost collar."
A tendency among certain executives to copy the actions or decisions of other firms, without regard to economics. For example, a company might pursue a diversification strategy because a competitor recently pursued a similar strategy. Or, a company might spin off certain subsidiaries because a competitor has sold off a similar subsidiary. Herd behavior can be value destroying for shareholders.
A clause that disallows a hedge fund from assessing a performance fee (known as "the carry") unless the investor's account value is at its highest level. High-water marks prevent hedge funds from double-charging if the fund's value rises, falls, and then rises again.
A model for CEO succession planning in which two or more internal candidates are promoted to high-level positions where they compete to become CEO. See "Succession Planning."
A situation in which a target company resists attempts to be acquired by an unsolicited bidder or corporate raider. To protect against a hostile takeover, management might adopt defense mechanisms which discourage or prevent a change in control. Examples include a poison pill, staggered board structure, dual-class shares, or blank check preferred stock.
Overconfidence on the part of management. Management might exhibit hubris in pursuing corporate acquisitions if it (wrongly) believes it can more efficiently utilize the assets of a target to achieve greater profits than current owners can. Hubris can be value destroying for shareholders.
Free from conflicts of interest that impair objectivity. Companies that trade publicly in the United States are required to have a majority of independent directors. The New York Stock Exchange defines independence as having “no material relationship with the listed company (either directly or as a partner, shareholder, or officer of an organization that has a relationship with the company).” A director is not considered independent if the director or a family member
• Has been employed as an executive officer at the company within the last three years.
• Has earned direct compensation in excess of $120,000 from the company in the last three years.
• Has been employed as an internal or external auditor of the company in the last three years.
• Is an executive officer at another company where the listed company’s present executives have served on the compensation committee in the last three years.
• Is an executive officer at a company whose business with the listed company has been the greater of 2 percent of gross revenues or $1 million within the last three years.
A chairman of the board who is not an executive (such as a current or former CEO) and also who meets the independence standards of the New York Stock Exchange.
The SEC uses the term "insider" to identify individuals—corporate officers, directors, employees, and certain professional advisors—who have access to material financial and operational information about a company that has not yet been made public. Insiders are restricted in their ability to engage in transactions involving company securities (both purchases and sales) and may trade only when they are not in possession of material nonpublic information. Trades made on the basis of such information are considered "illegal insider trading" and, under various acts passed by Congress, are punishable with jail time and financial penalties (up to three times the profit gained or loss avoided from such activity).
How an organization ensures that it provides the right information, in the right format, to the right person, in the right place, at the right time, in order to help arrive at the right decision. It relates to the mechanisms, processes, and systems in operation as an organization identifies, gathers, interprets, and communicates the information and knowledge available within (and outside) the organization. (*Contributed by Sean Lyons, RISC International).
Interlocked (Connected or Networked) Boards
Companies whose senior executives sit reciprocally on each other’s boards: an executive of one firm sits on the board of another and an executive of the second firm sits on the board of the first.
The processes and procedures that a company puts in place to ensure that account balances are accurately recorded, financial statements reliably produced, and assets adequately protected from loss or theft. Effectively, internal controls act as the “cash register” of the corporation, a system that confirms that the level of assets inside the company is consistent with the level that should be there, given revenue and disbursement data recorded through the accounting system.
A system of interrelation between companies that is prevalent in Japan. Under the keiretsu, companies maintain small but not insignificant ownership positions among suppliers, customers, and other business affiliates. These ownership positions cement business relations along the supply chain and encourage firms to work together toward an objective of shared financial success. Bank financiers own minority stakes in industrial firms and are key partners in the keiretsu. Their investments indicate that capital for financing is available as needed.
Key Performance Indicators (KPIs). Also, Key Performance Measures.
Key performance indicators (KPIs), or key performance measures, include both financial and nonfinancial metrics that validly reflect the current and future performance of a company. The board uses key performance measures to evaluate management performance and award compensation. Financial KPIs include measures such as total return; revenue growth; earnings per share; earnings before interest, taxes, depreciation, and amortization (EBITDA); return on capital; economic value added (EVA); and free cash flow. Nonfinancial KPIs include measures such as customer satisfaction, employee satisfaction, defects and rework, on-time delivery, worker safety, environmental safety, and research and development (R&D) pipeline productivity. Although each company should develop a set of KPIs that is relevant for its own business, in practice certain KPIs are broadly used by many companies. See "corporate strategy" and "business model."
Labor Market Efficiency
The labor market refers to the process by which the available supply of talent is matched with demand. For the labor market to function properly, information must be available on the needs of the corporation and the skills of the individuals applying to serve in executive roles. The efficiency of this market has important implications on governance quality. When it is efficient, the board of directors will have the information it needs to evaluate and price executive talent. This leads to improved hiring decisions and reasonable compensation packages. It also tends to increase discipline on managerial behavior—that is, when managers know they can lose their jobs for poor performance, they have greater incentive to perform.
Lead Independent (Presiding) Director
Sarbanes Oxley requires that companies designate one independent director as “lead director” for each board meeting. The lead director may be named to serve on a meeting-by-meeting basis or may be appointed to serve continuously until replaced. The role of the lead director is to represent the independent directors in conversations with the CEO. This structure is intended to fortify an independent review of management among companies with a dual chairman/CEO . The lead director at most companies serves as liaison between the chairman/CEO and independent directors. This person also plays a prominent role in the evaluation of corporate performance, CEO succession planning, director recruitment, and board and director evaluations. Sometimes the lead director serves as the main contact to receive and address shareholder communications. He or she can particularly be important during times of crisis, including periods of increased government or regulatory scrutiny, hostile takeover attempts, and contentious proxy battles.
Cash or noncash compensation (such as stock options, restricted stock, or performance units) that vests over multiple years and therefore rewards an executive for long-term performance. Long-term incentives extend the time horizon of the executive and are intended to counteract the natural tendency of a risk-averse executive to focus on short-term rewards at the expense of long-term investment.
A system for proxy voting under which a director is required to receive a majority of votes to be elected. The specific procedures of majority voting systems vary. In some companies, candidates who receive more withhold votes than votes in favor are strictly refused a seat on the board. More commonly, the director is required to submit a letter of resignation, and the rest of the board has discretion over whether to accept it. Other companies require resignation, but only after a replacement director is appointed. Majority voting gives shareholders more power to control the composition of the board, even in the absence of an alternative slate. See "plurality voting."
Management and Supervisory Boards (Germany)
A two-tiered board structure required under German corporate law. The management board (Vorstand) is responsible for making decisions on such matters as strategy, product development, manufacturing, finance, marketing, distribution, and supply chain. The supervisory board (Aufischtsrat) oversees the management board.
The degree to which management is shielded from the market forces and performance standards to which management teams are typically held accountable. An entrenched management is able to retain employment, despite poor performance or opposition from the board, shareholders, and/or stakeholders.
Market for Corporate Control
A term used to describe the market for mergers and acquisitions. Rather than replace an underperforming executive, the board of directors (or in some cases shareholders directly) can decide to transfer ownership of the firm to new owners who will manage its assets more profitably. A change in control involves not only a change in ownership, but also possibly substantial changes to firm strategy, cost structure, and capital structure. A change of control makes economic sense only when the value of a firm to new owners, minus transaction costs associated with the deal, is greater than the value of the firm to current owners.
The ratio of the stock market value of a company's equity to the accounting value of its equity. A market-to-book ratio that is high relative to peers' suggests that a company can more efficiently employ assets to create value.
Information that an investor would consider important to an investment decision.
The degree to which individuals refrain from self-interested behavior on moral grounds, without regard to economic rewards. The knowledge that certain actions are inherently wrong even if they are undetected and left unpunished.
Nominating and Governance Committee
The governance committee is responsible for evaluating the company’s governance structure and processes and recommending improvements, when appropriate. The nominating committee is responsible for identifying, evaluating, and nominating new directors when board seats need to be filled. The nominating committee is also typically in charge of leading the CEO succession-planning process. In most companies, the nominating and governance committees are combined into a single committee with these responsibilities:
1. Identifying qualified individuals to serve on the board
2. Selecting nominees to be put before a shareholder vote at the annual meeting
3. Hiring consultants to assist in the director recruitment process, as appropriate
4. Determining governance standards for the corporation
5. Managing the board evaluation process
6. Managing the CEO evaluation process
In the 1990s, the legislatures of many states enacted statutes that allow the board to consider nonshareholder interests. (Delaware, where the majority of public companies are incorporated, did not adopt such a statute.) These statutes are referred to as “nonshareholder constituency” or “expanded constituency” provisions. They allow the board to consider the impact of their actions on stakeholders such as workers, customers, suppliers, and the surrounding community. The primary application of these statutes is in the evaluation of a takeover bid. These statutes purportedly allow management and the board to reject a takeover offer that is in the interest of shareholders if the takeover would harm other constituents. Still, courts generally have not allowed these statutes to be used to the disadvantage of shareholders.
Observer (Advisory) Directors
Individuals not formally elected to the board who instead participate in board meetings as observers or advisory directors. These directors do not vote on corporate matters, so they are shielded from the potential liability that comes with being an elected director. However, they are available to advise the corporation on important matters, such as strategy, finance, and investment. For example, a venture capital firm might nominate a partner of the firm to sit on the board and an associate to attend board meetings as a nonvoting observer.
The degree to which a company is exposed to disruptions in its operations. Operational risk is reflected in such factors as concentration of suppliers, concentration of buyers, redundancy in the supply chain, and the extent to which the company monitors its supply chain.
Outside (Nonexecutive) Directors
Directors who are not executives of the firm. Outside directors are expected to be more independent than executive directors because they have no reporting lines to the CEO and do not rely on the company for their livelihood. They are expected to draw on their professional backgrounds and lend functional expertise to advise on the company strategy and business model. However, outside directors are also likely to be less informed about the company than inside directors (creating an "information gap"). When an information gap occurs, decision making can suffer.
Investors that attempt to generate returns that mirror the returns of a predetermined market index. Passive investors tend to be less attentive to firm-specific performance and governance issues.
Pay for Performance
A term used to describe the relationship between executive compensation and corporate performance over a specified measurement period. "High" pay for performance indicates that compensation is both correlated with and appropriate in size given company performance. There is no commonly accepted methodology for measuring pay for performance. A term used to describe the relationship between executive compensation and corporate performance over a specified measurement period.
A group of companies that are similar in industry, size, complexity, and/or geography. Peer groups are used to evaluate the relative financial and operating performance of a given company. They are also used for benchmarking the size and structure of executive compensation programs. Because the choice of participants in a peer group can influence relative comparisons, peer groups can be subject to manipulation (e.g., a company that is not relevant might be included in the peer group to create a favorable comparison, or a company that is relevant might be excluded to obscure an unfavorable comparison).
Performance Units (Shares)
Cash (or stock) awards granted only after specified financial and nonfinancial targets are met during a three- to five-year time period. Performance units and performance shares work the same way, the difference being whether the final award is paid in cash or in stock. The size of the award is generally based on a percentage of base salary, similar to the method used to calculate the annual cash bonus. The maximum award is usually 200 percent of the target. In many ways, performance plans are simply a longer-term version of the annual bonus plan. The performance criteria generally include a profit measure (such as earnings-per-share growth or return on assets) or total shareholder return.
Stock options that vest based on the achievement to a predetermined target, rather than the simple passage of time. Three example of performance-vested options include:
1. Accounting-based triggers: options are subject to accelerated vesting contingent upon achieving accounting-based performance results (such as earnings-per-share or EBITDA targets).
2. Nonfinancial performance triggers: options have accelerated vesting contingent upon achieving major strategic goals (such as the launch of a new product or FDA approval of an experimental drug).
3. Stock-based triggers: options have accelerated vesting contingent upon achieving a total stock price return threshold.
Amenities purchased or provided by the company, such as personal use of the company car or airplane, club memberships, or the purchase of a home or apartment.
The use of directly owned shares in a company as collateral for a loan, the proceeds of which are used for investment or spending purposes (such as the purchase of a diversified portfolio of assets, starting a new business, or personal spending). As with hedging transactions, pledging might be more tax efficient than an outright sale. Furthermore, an individual does not necessarily have to sell shares to settle the loan and thus might be able to achieve financial objectives without reducing his or her ownership position in the company. See "hedge."
A system for proxy voting under which the director who receives the most votes wins. In an uncontested election, a director is elected as long as he or she receives at least one vote. See "majority voting."
Poison Pill (Shareholder's Rights Plan)
A common antitakeover defense in which a company threatens to flood the market with new shares to prevent a hostile takeover. The "poison pill" is triggered if a shareholder or shareholder group accumulates an ownership position above a threshold level (typically 15 to 20 percent of shares outstanding). Once this threshold is exceeded, existing shareholders are offered the right to buy new shares at a steep discount to the current price (e.g., for $0.01 each).
The flood of new shares associated with the rights plan dilute the would-be acquirer’s holdings and make it prohibitively expensive for the acquirer to take control of the firm through open market purchases or a tender offer. The effect is so severe that no rational acquirer triggers the pill; instead, a corporate raider will pressure the target board to disable the pill and allow the acquisition to go forward.
At the same time, the acquirer will launch a proxy contest to replace the incumbent board with a board that is friendly to the deal and will disable the pill. The poison pill defense was first used in 1982 by General American Oil to prevent a hostile takeover by T. Boone Pickens. The defense was ruled legal in 1985 by the Delaware Supreme Court and subsequently has been imitated by numerous other firms.
Preferred stock is a class of stock that is senior to common stock in terms of credit and capital.
Stock options with an exercise price higher than the market price on the date of the grant.
Prepaid-variable forward (PVF)
An economic contract used to hedge the value of a common stock position. Under a PVF, the holder of stock enters into a contract that promises future delivery of shares that he or she owns, in return for an upfront payment of cash. Delivery occurs at the end of the contract (generally two to five years). Because delivery is deferred, the cash payment is discounted from the current fair value of the stock (say, a 15 percent discount). The individual can take the cash payment and invest it in a diversified portfolio. The individual does not owe capital gains tax on the underlying shares until the end of the contract. The forward contract is variable in that the number of shares that the individual owes upon delivery is based on a sliding scale. If the price of the stock has fallen below some threshold, the individual is required to deliver all the shares. If the share price has risen, the individual is required to deliver only a fraction of the shares (subject to a minimum percentage defined up front). In some cases, the individual agrees to a cash payment at settlement rather than the delivery of shares. The PVF structure gives an individual full downside protection and allows for partial participation in the upside.
Principles-Based Accounting Standards
A system of accounting under which general accounting concepts are outlined but the specific application of those concepts to various business activities is not defined. International Financial Reporting Standards (IFRS) used in Europe and many Asian countries is considered a principles-based system. A principles-based system allows for more discretion than a rules-based system. See "rules-based accounting standards."
An individual whose full-time career is to serve on boards of directors. Professional directors include retired executives, consultants, lawyers, financiers, politicians, or other professionals. They tend to bring expertise based on their professional background, diversity of board experience (both current and former), as well as their extensive personal and professional networks.
The practice of allowing shareholders or groups of shareholders to directly nominate board candidates through the company proxy.
Proxy Advisory Firms
Third-party firms that evaluate management- and shareholder-sponsored proposals on the annual proxy and provide recommendations on how investors should vote. The largest proxy advisory firms are Institutional Shareholder Services (ISS) and Glass-Lewis.
A situation in which a corporate raider or other activist nominates a slate of directors (known as the "dissident slate") to run in opposition to the directors that the company has nominated. The proxy nominating the dissident slate must be mailed separately from the official company proxy and therefore proxy contests are very expensive to wage. Proxy contests tend to occur in hostile takeovers or when an activist shareholder with a significant minority position wishes to impose greater change on a company or force a sale.
Public Pension Funds
Pension funds that manage retirement assets on behalf of state, county, and municipal governments. Beneficiaries primarily include public employees who are covered by a collective bargaining agreement.
Pyramidal Business Groups
Two or more listed firms under a common controlling shareholder that holds a significant minority position in each (at least 10 percent).
A trend characterized by steady increases without periodic decreases. In governance, the term "ratcheting" is used to describe executive compensation trends as companies increase pay to match amounts offered by peers. When multiple companies within a group try to meet or exceed the median, the median itself tends to increase, creating a ratcheting effect.
In The Economic Approach to Human Behavior, economist Gary Becker applied a theory of “rational self-interest” to economics to explain human tendencies, including one to commit crime or fraud. He demonstrated that, in a wide variety of settings, individuals can take actions to benefit themselves without detection and, therefore, avoid the cost of punishment. Control mechanisms are put in place in society to deter such behavior by increasing the probability of detection and shifting the risk–reward balance so that the expected payoff from crime is decreased.
The total value of compensation that an executive converts to cash in a given year. Salary and bonuses are realized over one-year periods. Long-term cash awards are realized at the end of multiple-year periods when they are delivered (typically in a lump sum). Equity awards are realized when they are exercised and sold for cash. Compensation that has been earned (vested) but not realized (converted to cash) remains "at risk" and therefore provides incentive for continued performance. Once compensation is converted to riskless cash, it loses its future incentive value. See "expected pay" and "earned pay."
Repricing (Exchange Offer)
A transaction in which employees holding stock options are allowed to exchange those options for either new options, restricted stock, or (less frequently) cash. Exchange offers generally occur when stock options are trading out-of-the-money to such an extent that they will not likely become profitable or offer value to employees in the foreseeable future.
The degree to which a company protects the value of its intangible assets, including corporate reputation. Reputational risk is mitigated by investing in product
brand development, investing in corporate brand development, monitoring the use of brands, monitoring supplier and customer business practices, performing community outreach,
and handling stakeholder relations.
How an organization ensures that it can withstand, rebound, or recover from the direct and indirect consequences of a shock, disturbance, or disruption. Organizational resilience relates to sustainability and involves adapting to the constantly changing business environment. (*Contributed by Sean Lyons, RISC International).
An outright grant of shares that are restricted in terms of transferability and are subject to a time-based vesting schedule. (Outside of the U.S., performance-accelerated vesting is common.) Once vested, the shares are economically equivalent to a direct investment in company stock.
A provision within a compensation contract that requires an executive to take a percentage of proceeds that he or she realizes through option exercises and keep the money invested in company stock.
The likelihood and severity of loss from unexpected or uncontrollable outcomes. This includes both the typical losses that occur during the course of business and losses from extremely unlikely and unpredictable events (so-called black swans, or outliers). Risk arises naturally, both from the nature of the activities that a corporation participates in and from the manner in which it pursues its objectives. Risk cannot be separated from the strategy and operations of the firm but instead is an integral feature of organizational decision making.
An organizational practice where risk is discussed and considered as a part of routine decision making. The term "risk culture" does not necessarily imply either a high or low level of risk tolerance but instead suggests that risk will be considered within the parameters of the company's accepted risk tolerance.
The process by which a company evaluates and reduces its risk exposure. This includes actions, policies, and procedures that management implements to reduce the likelihood and severity of adverse outcomes and to increase the likelihood and benefits of positive outcomes.
The degree to which a company is comfortable pursuing a strategy with highly uncertain outcomes.
Rules-Based Accounting Standards
A system of accounting under which detailed rules specify how accounting standards should be applied to various business activities. U.S. Generally Accepted Accounting Principles (GAAP) is considered a rules-based system. A rules-based system allows for less discretion than a principles-based system. See "principles-based accounting standards."
Sarbanes-Oxley Act of 2002
One of the most important pieces of formal legislation relating to governance in the United States, which was enacted following the failures of Enron and other companies. Sarbanes-Oxley mandates a series of requirements to improve corporate controls and reduce conflicts of interest. Important governance-related provisions include the following:
• The requirement that the CEO and chief financial officer (CFO) certify financial results (with misrepresentations subject to criminal penalties)
• An attestation by executives and auditors to the sufficiency of internal controls
• Independence of the audit committee of the board of directors (as incorporated in the listing standards of the NYSE)
• A limitation of the types of nonaudit work an auditor can perform for a company
• A ban on most personal loans to executives or directors
The practice of giving shareholders a vote to approve executive and/or director compensation programs. In most countries (such as the U.S. and U.K.), say-on-pay votes are advisory (nonbinding), which means that companies are not required to adhere to the outcome. In other countries, such as the Netherlands, the results are binding.
SEC Rule 10b5-1 Plan
Under Rule 10b5-1, insiders are allowed to enter into a binding contract that instructs a third-party broker to execute purchase or sales transactions on behalf of the insider. These contracts are referred to as "10b5-1 plans." The contract can only be initiated during a period in which the insider does not have knowledge of material nonpublic information (i.e., outside the blackout window). The insider is required to specify a program or algorithm that dictates the conditions under which sales are to be made. Such factors might include the number of shares, the interval between transactions, or a share price limit. Once a 10b5-1 plan is initiated, the insider may not contact the third-party broker to influence in its execution. However, the insider can terminate the 10b5-1 plan any time (except during a blackout window).
Securities and Exchange Commission (SEC)
Congress created the SEC through the Securities and Exchange Act of 1934 to oversee the proper functioning of primary and secondary financial markets, with an emphasis on the protection of security holder rights and the prevention of corporate fraud. Among its various powers, the SEC has the authority to regulate securities exchanges (such as the New York Stock Exchange, the NASDAQ, and the Chicago Mercantile Exchange), bring civil enforcement actions against companies or executives who violate securities laws (through false disclosures, insider trading, or fraud), ensure the quality of accounting standards and financial reporting, and oversee the proxy solicitation and annual voting process.
How an organization ensures that it protects its assets (i.e. people, information, technology, and facilities) from threats and danger. This involves the ongoing management of both physical and logical security issues in order to secure the assets of the organization by mitigating threats and minimizing possible vulnerabilities. (*Contributed by Sean Lyons, RISC International).
Severance Agreement (Golden Parachute)
A provision in an employment contract which entitles an executive to additional compensation upon resignation or dismissal. The terms of the agreement are typically included in the broader employment agreement and must be disclosed to shareholders through SEC filings. A typical severance agreement offers a lump-sum cash payment equal to three times the current annual salary, plus immediate vesting of all unvested equity grants.
A movement that advocates greater shareholder influence over corporate governance systems. Advocates of shareholder democracy believe that expanded voting rights on corporate matters make board members more accountable to shareholders (and possibly stakeholders). Elements of shareholder democracy include majority voting in uncontested director elections, restricted discretion over broker nonvotes, say on pay, proxy access, and a reduction of antitakeover protections.
The viewpoint that the primary obligation of the organization is to maximize shareholder value. Actions such as improving labor conditions, reducing environmental impact, and treating suppliers fairly are seen as desirable only to the extent that they are consistent with improving the long-term financial performance of the firm.
A proposal put before shareholders for a vote on the annual proxy that is sponsored by one or more shareholder groups. SEC Rule 14a-8 dictates the conditions under which a company is allowed to exclude shareholder proposals.
Social Responsibility Investment Funds
Mutual funds that cater to investors who value specific social objectives and want to invest only in companies whose practices are consistent with those objectives. Examples include funds that advocate fair labor practices, humanitarianism, environmental sustainability, or the promotion of religious or moral values.
The practice of awarding stock options immediately before the release of positive news that is likely to drive up the price of a stock.
Staggered Board (Classified Board)
A board structure in which directors are elected to multiple-year terms, with a only subset of directors standing for reelection each year. Under a typical staggered board, directors are elected to three-year terms, with one-third of the board standing for reelection every three years. As a result, it is not possible for the board to be ousted in a single year. Two election cycles are needed for a majority of the board to turn over. Staggered boards are an effective antitakeover defense.
The viewpoint that the organization has a societal obligation beyond increasing shareholder value and that obligations to constituents such as employees, suppliers, customers, and local communities should be held in equal importance to shareholder returns.
A contract that grants the recipient the right to buy shares in the future at a fixed exercise price, generally equal to the stock price on the grant date. Stock options typically have vesting requirements (i.e., they are “earned” in even batches over time or in blocks, such as 25 percent at the end of each of the following four years) and expire after ten years (with seven years being the next-most-popular term).
Stock Ownership Guidelines
Guidelines that specify the minimum amount of stock that an executive is required to hold during employment, generally expressed as a multiple of base salary.
Stock options whose grant dates have been retroactively changed to coincide with a relative low in the company’s share price. This practice reduces the strike price of the option and increases the potential payoff to its recipient. Existing shareholders bear the cost of backdating, because the company receives lower proceeds when the stock option is exercised.
The process by which a board of directors plans for and selects a new CEO. In general, there are four models of succession planning.
1. The board selects an external candidate from outside the company. External candidates are generally preferred when the company lacks internal talent, faces current operating or financial challenges that require significant turnaround, or does not have a succession plan in place.
2. The board promotes an executive to the role of president or chief operating officer (COO) where he or she is groomed to take the place of the existing CEO.
3. The board establishes a “horse race” in which two or more internal candidates are promoted to high-level positions where they compete to become CEO.
4. The company adopts an “inside-outside model” which combines an internal horse race with an evaluation of the external job market to select the most qualified candidate from the total labor market.
Rights that grant minority shareholders the ability to dispose of shares on the same terms as majority shareholders.
Tender Offer A public offer to acquire the shares of a target company at a stated price. Tender offers are common practice in unsolicited, hostile takeover battles. In the absence of antitakeover defenses such as a poison pill, a tender offer allows a hostile bidder to bypass the target’s board of directors and seek approval directly from shareholders. When antitakeover defenses are in place, a tender offer must be combined with a proxy contest. The acquirer asks the target shareholders to elect a board proposed by the acquirer to replace the incumbent board. If elected, the new board will disable the antitakeover defenses and allow the acquisition to go forward. See "proxy contest."
The Cadbury Committee (1992)
The Cadbury committee was the result of an initiative by the accountancy profession and its sponsors (the Financial Reporting Council, the London Stock Exchange and the Bank of England) “to help raise the standards of corporate governance and the level of confidence in financial reporting and auditing." The committee's final report, published in 1992, provided a benchmark set of recommendations on governance widely considered to be best practices. These included:
1. Separation of the chairman and chief executive officer titles.
2. The appointment of independent directors to the board.
3. Reduced conflicts of interest at the board level because of business or other relationships.
4. The creation of an independent audit committee.
5. A review of the effectiveness of the company's internal controls.
The recommendations of the Cadbury Committee formed the basis of London Stock Exchange listing requirements and have influenced governance standards in the U.S. and several other countries. They have subsequently been revised by later committees.
The Greenbury Report (1995)
The Greenbury Committee was commissioned to review executive compensation in the U.K. The committee recommended establishing an independent remuneration committee entirely comprised of nonexecutive directors.
The Hampel Report (1998)
The Hampel Committee was established to review the effectiveness of the Cadbury and Greenbury reports. The committee recommended no substantive changes and consolidated the Cadbury and Greenbury 40 Corporate Governance Matters reports into the "Combined Code of Best Practices," which the London Stock Exchange subsequently adopted.
The Higgs Report (2003)
A report produced by Sir Derek Higgs who was asked to evaluate the role, quality, and effectiveness of nonexecutive directors among British companies. The Higgs report recommended the following:
1. At least half of the board should be nonexecutive directors.
2. The board appoint a lead independent director to serve as a liaison with shareholders.
3. The nomination committee should be headed by a nonexecutive director.
4. Executive directors should not serve more than six years on the board.
5. Boards should “undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors.”
The recommendations of the Higgs Report were combined with those of the Turnbull Report and the Combined Code to create the Revised Combined Code of Best Practices. Higgs believed that the elevated status of nonexecutive directors on the board would be “pivotal in creating conditions for board effectiveness."
A severance agreement that allows every employee in a company who is terminated without cause following a change in control to receive both a cash payment and immediate vesting of all unvested stock options and restricted shares.
A theory proposed in 1981 by Professors Edward Lazear and Sherwin Rosen to explain internal pay differentials between the compensation of the CEO and the executives immediately below the CEO. They hypothesize that pay differentials not only reflect the economic value of their labor but also serve as incentive for promotion (i.e., executives are competing in an internal "tournament," whose prize is a promotion). The winner of the tournament will receive a large payoff in terms of compensation increase. As a result, the executive’s current salary is not his or her only financial incentive. The potential for promotion is itself an incentive, and the value of this incentive is reinforced by a large pay differential between the current and potential positions.
The degree to which a company provides details that supplement and explain accounts, items, and events reported in its financial statements and other public filings. Transparency is important for shareholders to properly understand a company’s strategy, operations, risk, and performance of management. It is also necessary when shareholders make decisions about the value of company securities. As such, transparent disclosure plays a key role in the efficient functioning of capital markets.
Beyond the powers in Latin. This doctrine which is found in the law of corporations states that if a corporation enters into a contract that is beyond the scope of its corporate powers, the contract is illegal. (Thanks to @CGGovernance for suggesting this term).
An election in which only one slate of directors is nominated. The vast majority of corporate elections are uncontested. The opposite of an uncontested election is a "contested election." See "proxy contest".
A strategy where multiple hedge funds, each with minority positions in a company, work together to force change on a target company.
At a board meeting, resolutions are presented to the board and voted upon. An action is complete when it receives a majority of votes in support. When the board acts by written consent, a written resolution is circulated among board members for their signatures. The action is complete when a majority of the directors have signed the document. Because board actions by written consent do not require advance notice, they can occur more quickly than actions taken at board meetings
An economic contract used to hedge the value of a common stock position. The holder of stock purchases a put option with an exercise price at or slightly below the current market price of the stock. The individual offsets the cost of the put option by selling a call option, with an exercise price generally 10 to 20 percent above the current market price. The individual has effectively reduced the downside risk and has given up much of the upside gains. In economic substance, the collar is similar to a sale, although taxes are not owed until option expiration and the eventual stock sale. The individual can also take out a loan against the value of the collar (not the underlying stock) and invest the proceeds in a diversified portfolio.