July 01, 2008
Corporations 101: The Role of Corporations and Corporate Governance
Related Studies & Resources
In an era of increasing global competition and economic uncertainty, understanding the role that corporations play is more important than ever. Therefore, Business Roundtable has prepared this paper to provide a brief introduction to corporations, the economic benefits they provide, their governance structure and their record of reforms.
Business Roundtable is an association of chief executive officers (CEOs) from more than 160 leading U.S. corporations. Combined, Business Roundtable member corporations:
- Employ nearly 10 million people.
- Are technology innovation leaders, with $90 billion in annual research and development (R&D) spending — more than 40 percent of the total private R&D spending in the United States.
- Contribute $7 billion to charity each year, representing nearly 60 percent of total corporate giving.
- Generated $114 billion in dividends to shareholders in 2006.
- Paid $179 billion in corporate income taxes in 2006 — nearly 40 percent of corporate income tax paid that year.
- Provide health care for 35 million people.
II. The Role of Corporations
Corporations — legal entities created under state law that are designed to generate a profit — are the engines that drive the growth of the U.S. economy and create wealth worldwide. Together, U.S. corporations:
- Create millions of jobs.
- Produce innovative products and services that affect every aspect of daily life.
- Generate economic prosperity for employees and shareholders.
Many individuals invest in corporations directly by purchasing shares or indirectly by purchasing mutual funds or contributing to pension and retirement plans. More than 6,800 companies are publicly traded in U.S. stock markets, including on the New York Stock Exchange, the Nasdaq and the American Stock Exchange. When individuals buy shares in a corporation, they provide the corporation with the necessary capital to grow. But investment in public corporations also provides individuals with the opportunity to profit — through increases in stock prices and dividends — from the wealth generated by companies. Investing in a corporation is voluntary, and shareholders can change their investments at any time.
III. Corporate Governance
Corporations are governed by three principal groups:
- The board of directors,
- Management and
The relationship and the allocation of powers among these groups are defined primarily by state corporate law and a corporation’s charter and bylaws. Historically, the federal government’s role in corporate governance has been limited. The U.S. Securities and Exchange Commission (SEC) plays a role by promoting full disclosure of information to protect investors and establishes procedures for companies to solicit proxies from shareholders. In 2002, the Sarbanes-Oxley Act increased the federal regulation of the accounting profession and the composition and responsibilities of the board’s audit committees, and it provided for executive certification of financial statements.
Board of Directors
The board of directors is responsible for oversight of management’s strategy and performance. Its role is to make decisions in the best interests of the corporation’s shareholders, taking into account the interests of other stakeholders. The board considers the advice, reports and opinions of management, counsel and auditors and also seeks independent advice when appropriate.
“Some 10 percent of CEOs currently heading the top S&P 500 companies received undergraduate degrees from Ivy League colleges, according to a survey by executive recruiter Spencer Stuart. But more received their undergraduate degrees from the University of Wisconsin than from Harvard, the most represented Ivy school.” — The Wall Street Journal, Sept. 18, 2006
Primary duties of the board include:
- Selecting and overseeing the CEO, who runs the corporation with senior management on a daily basis.
- Monitoring management’s performance and adherence to corporate and ethical standards on behalf of shareholders.
Members of the board bring a wide range of knowledge and experience but do not represent any particular constituencies. Board members include:
- The chairman, who leads the board and is elected to the position by the other members of the board. w Independent directors, who are not affiliated with the corporation in any material capacity.
Board members also participate on committees with more specific duties, such as the:
- Governance and Nominating committees, which oversee effective corporate governance and identify and evaluate candidates for board positions. Nominated candidates are then voted on by the shareholders.
- Audit Committee, which supervises the corporational relationship with its auditor and oversees the corporation’s financial reporting process.
- Compensation Committee, which determines the corporation’s overall compensation structure, policies and programs.
Members of these committees are required by the New York Stock Exchange, Nasdaq and American Stock Exchange to be independent directors
The CEO and senior executives are responsible for running the day-to-day operations of the corporation and keeping the board informed of the status of these operations.
Primary duties of the CEO and senior management include:
- Performing strategic planning, including developing and implementing annual operating plans and budgets.
- Selecting qualified management and establishing an effective organizational structure.
- Identifying and managing corporate risks.
- Reporting corporate finances accurately and transparently and making timely disclosures.
- Chief executive officer (CEO). The CEO is the highest-ranking executive in the corporation. The CEO’s main responsibilities include developing and implementing high-level strategies, making major corporate decisions, managing the overall operations and resources of the corporation, and acting as the main point of communication between the board of directors and corporate operations.
- Chief financial officer (CFO). The CFO is responsible for overseeing the financial activities of the entire corporation, including certifying financial statements, monitoring cash flow and performing financial planning.
- Chief legal officer (CLO) or general counsel. The CLO is responsible for providing legal advice to senior executives and the board on issues including compliance and litigation.
- Chief operations officer (COO). The COO is responsible for managing the corporation’s day-to-day operations.
The Changing Face of CEOs
Shareholders voluntarily invest in the corporation by buying shares of its stock. Therefore, shareholders are sometimes referred to as the “owners” of the company. Shareholders provide capital, elect directors to the board and approve major transactions, but they do not have any liability for corporate actions and are not involved in day-to-day management.
Shareholder rights include:
- Voting to elect directors,
- Approving mergers and acquisitions, and
- Approving equity plans.
By the end of 2007, U.S. households combined directly owned $5.4 trillion in equities, more than any other economic sector or institution, according to the Federal Reserve. But shareholders also include mutual funds, pension funds, private equity funds, overseas investors and sovereign wealth funds. The Federal Reserve also reports that U.S. households hold about $5.1 trillion in mutual funds, the majority of which are corporate equities.
IV. Corporate Governance Reforms
The role and responsibilities of corporate boards in the United States has become a focus of attention in recent years. In response to requests from investors, corporations have taken the initiative to implement key governance improvements. Today, the debate centers on the role of the board in mitigating risk, the relationship between CEOs and boards, and the independence of corporate boards.
Relationship of the CEO and Board
Corporate scandals such as Enron and WorldCom, which caused devastating financial losses for shareholders, have resulted in today’s boards demanding more accountability from CEOs. As a result, annual CEO turnover has grown, rising 59 percent from 1995 to 2006, according to the CEO Succession White Paper 2006 by Booz Allen Hamilton. The average tenure of a Business Roundtable CEO is four years.
In principle and practice, many boards support pay for performance for senior executives. Forty percent of Business Roundtable companies reported adjusting the pay-forperformance element of senior executive compensation in 2007.
The presence of independent representatives on the board, who are capable of challenging the decisions of management, is one way to protect the interests of shareholders and other stakeholders.
To comply with the Sarbanes-Oxley Act and enhance accountability, S&P 500 corporations have increased the percentages of independent directors on their boards.
A 2007 Business Roundtable CEO survey showed that U.S. corporations continue to increase the percentage of their independent board members and independent board leadership positions.
- Ninety percent of Business Roundtable corporations reported that 80 percent of their board members were outside directors.
- Nine out of 10 companies had an independent chairman, lead director or presiding director.
- The percentage of corporations with an independent chairman has continued to increase, growing by 120 percent between 2006 and 2008.
- The percentage of companies that have adopted majority voting for directors leapt to 82 percent between 2006 and 2007.
In addition, fewer CEOs are serving on other boards, given the enhanced time commitment of serving on a board of directors. Three-quarters of Business Roundtable CEOs serve on no more than one other public company board.
V. Governance Challenges for Maintaining U.S. Competitiveness
As the United States seeks ways to maintain its competitive edge in the global marketplace and generate prosperity for individuals and the economy, a series of challenges must be addressed.
Unlevel Playing Field with Foreign Markets Foreign companies increasingly are delisting shares from U.S. exchanges, according to a survey by McKinsey Financial Services.
- The number of delisted foreign companies rose from 12 a decade ago to 30 in 2006 and a record 56 from January to October 2007.
- In 1996, eight of the 20 largest global initial public offerings (IPOs) of stock from private companies were listed on a U.S. exchange. That plunged to one in 2006, and for the first 10 months of 2007, not one of the top 20 were listed in the United States.
Competition from Private Equity
Hedge funds and private equity firms can build a substantial stake in a corporation and therefore may have disproportionate power in the boardroom. Often, they have hostile intentions, such as elimination of jobs, sale of assets or a focus on short-term gains at the expense of long-term shareholder value.
Abuse of the Resolution Process
Shareholder resolutions have historically been limited to a handful of proposals. In recent years, there has been an explosion of proposals promoting social issues or political agendas that are not necessarily in the best interests of all shareholders. Currently, more than 1,000 resolutions are filed each year with S&P 500 companies.
Companies are forced to spend significant time and shareholder resources responding to these proposals, including review by counsel, correspondence with the SEC and possible inclusion on the company proxy.
While some proposals address governance issues, many are not relevant to the business of the corporation. These issues are appropriate for public policy debates but not a company proxy statement. Increasing time and resources spent on this process adversely affects profitability, shareholder returns and competitiveness in a global economy.
Growth of Sovereign Wealth Funds
Sovereign wealth funds, which may not be subject to the same rules and/or have the same governance structure as U.S. funds, increasingly are investing in U.S. companies.
As of Dec. 1, 2007, The Wall Street Journal reported that:
- Singapore’s Temasek Holdings was the most active buyer in 2007, spending $8.5 billion on 18 deals.
- Abu Dhabi Investment Authority spent $7.5 billion, and Dubai International Capital spent $5.7 billion.
- China’s state-owned China Investment Corp. paid $3 billion for a 9.3 percent share of private-equity group The Blackstone Group L.P.
- Middle Eastern firms and funds spent $82.4 billion, compared with $30.8 billion in 2006 and $4.5 billion in 2004, according to Dealogic.
- The United States was the biggest recipient of sovereign wealth funds in 2007, receiving $11.8 billion.
“Most [sovereign wealth funds] are not transparent or publicly accountable, and we know little about their governance structures or fiduciary controls. So the bottom line is that we don’t know if their decisions are made exclusively on an economic basis.” — U.S. Sen. Charles Schumer, D-NY
The U.S. corporate structure has helped make America the greatest driver of wealth creation in the world. We must safeguard and preserve this structure. Boards, elected by and working in the interests of shareholders, should continue to direct management, strategy and decisions. Changing this governance model may make the U.S. market and corporations less competitive in a global economy; diminish productivity; and make corporations more vulnerable to pressure from private equity firms, hedge funds, sovereign wealth funds, politics and special interests.