Transcript Slide 1

The Latest Research in
Corporate Governance:
Accounting
D. G. DeBoskey, Ph.D., CPA
Professor of Accountancy
SAN DIEGO STATE UNIVERSITY COLLEGE OF BUSINESS ADMINISTRATION
Top-Tier Accounting Journals
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Contemporary Accounting Research (CAR)
Journal of Accounting Research (JAR)
Review of Quantitative Finance and Accounting
(RQFA)
The Accounting Review (TAR)
Research Types
Research Types–Taxonomy
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Research Methods
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Analytical Internal Logic
Archival Primary
Empirical Case
Empirical Field
Empirical Lab
Inference Style
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Inductive
Deductive
Research Types–Taxonomy (cont.)
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Mode of Reasoning
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Descriptive Statistics
Regression
ANOVAs
Other Multivariate Techniques
Mode of Analysis
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Normative
Descriptive
Research Synthesis: 2008
Research Synthesis: 2008
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During 2008, several studies examined
corporate governance (CG) and its impact on
firm performance
Associations studied include:
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CG and Agency Conflicts (AC)
CG and Firm Performance
CG and Accounting Outcomes
CG (board independence) and CEO Turnover
CG and Disclosure
CG and Agency Conflicts (AC)
CG and Agency Conflicts (AC)
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This noteworthy study investigates whether CG
is associated with the level of agency conflicts in
firms
CG variables/measures
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22 governance variables are reduced to 7 readily
interpretable CG dimensions
Performed via a principal components analysis
(PCA), a tool used for dimensionality reduction
where a number of potentially correlated variables
are transformed into a smaller subset of uncorrelated variables called principal components
(Dey, 2008)
CG and Agency Conflicts – Proxies
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Agency conflict proxied with 7 measures: firm
size, organizational complexity, growth, risk,
ownership, leverage, and free cash flows
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A cluster analysis puts firms into homogenous
groups
A factor analysis is then performed to derive an
overall score for each firm
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Mean values within each cluster indicate the level of
agency conflict
1.12 highest mean value (HIGH AC)
-0.82 lowest mean value (LOW AC)
CG and Agency Conflicts – Findings
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Firms with High AC have better governance
mechanisms
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Particularly those related to the board, audit
committee, and the independence of the auditor
Governance mechanisms are associated with
firm performance (measured with Tobin’s Q)
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Composition and functioning of the board, auditor
independence, and equity-based compensation of
the directors, but primarily for firms with High AC
CG and Agency Conflicts – Overall
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Findings support a popular theory in the
accounting CG literature stream that CG
mechanisms are an endogenous response to
a firm’s business and economic environment
(Dey, 2008)
CG and Firm Performance
CG and Firm Performance
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This study examined whether poor governance
quality is associated with greater accounting
discretion, and whether firms with weaker
governance structures report poorer future
performance as a consequence, ceteris paribus
Much of the prior literature stops at this stage and
interprets the association between accounting
discretion and poor governance quality as
evidence that lax governance structures
encourage managerial opportunism
(Bowen et al., 2008)
CG and Firm Performance (cont.)
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Examples of lax structures are greater short-run
managerial compensation, balance of power tilted
in favor of managers over shareholders, chief
executive officer (CEO)-chair duality, and closer
relations between the executive team and the
board
They argue that such an interpretation is
premature unless one can show that excess
accounting discretion has negative consequences for shareholders’ wealth
CG and Firm Performance – Variables
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Surrogates are used for governance quality and
accounting discretion
Accounting discretion (dependent) variables
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They measure accounting discretion in three ways:
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Abnormal accruals use
Smoothing of earnings by means of accruals
Avoiding earnings decreases by reporting small quarterly
positive earnings surprises
These three measures are then reduced to an
overall accounting discretion index
CG and Firm Performance – Variables
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CG proxies (independent) variables
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Shareholders’ rights (Gompers et al., 2003)
Board monitoring (Dual, Onboard, Meetings and
Interlock)
Institutional ownership (% held by institutions)
Managerial ownership (% stock held by top
management)
Incentive compensation: bonus (bonus to CEO
wealth)
Incentive compensation: stock (in-the-money
exercisable stock options to CEO wealth)
CG and Firm Performance – Methods
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Two-stage least-squares regression
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Stage 1 - Association between accounting
discretion and firm economic determinants and
corporate governance proxies
Stage 2 - Association between predicted future
performance and excess accounting discretion
CG and Firm Performance – Findings
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As expected in stage 1 regression, they find
significant associations between accounting
discretion and proxies for weak governance
structures, e.g.,
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Greater short-run managerial compensation
Balance of power tilted in favor of managers over
shareholders
Chief executive officer (CEO)-chair duality
Closer relations between the executive team
and the board
CG and Firm Performance – Findings
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As expected in stage 2 regression, they do not
find a negative association between accounting
discretion due to governance and subsequent
performance
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Results do not support the claim that managers, on average,
exploit lax governance structures to exercise accounting
discretion at shareholders’ expense
They do find some evidence that discretion due to poor
governance is positively associated with future operating
cash flows and return on assets (ROA), consistent with
shareholders benefiting from earnings management, on
average (+ OCF AND ROA)
CG and Firm Performance – Overall
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This study is an improvement (in my
professional opinion), in that it clearly shows that
accounting discretion is beneficial to shareholder
wealth over a long horizon
(Bowen et al., 2008)
CG and Disclosure
CG and Disclosure
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A recent study examines the role of corporate
governance quality on voluntary disclosure of
executive compensation practices
In this study, the author examines whether
certain board and compensation committee
characteristics, as proxies for board governance
quality, are associated with the extent of board
disclosure of compensation practices
(Laksmana, 2008)
CG and Disclosure – Overall Tension
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To make effective disclosure decisions, boards
and compensation committees need to devote a
significant amount of time and resources (i.e.,
personnel and their knowledge base) to:
 Set compensation disclosure policies
 Examine potential disclosure items
 Consider the consequences of several
disclosure options
 Make the final decisions
CG and Disclosure – Overall Tension
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As a result of this tension, the researcher posits
that the time and resource commitment of
directors to perform these tasks is positively
associated with the extent of compensation
practice disclosure
CG and Disclosure – Measures
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Three proxies are used to measure the time and
resource commitment of boards:
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The proportion of busy outside directors
(measured by number of directorships)
Meeting frequency
Board (compensation committee) size
CG and Disclosure – Measures
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Self-constructed disclosure index (23 items)
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The selection of items included in his compensation disclosure checklist was guided by the SEC
rules for the Board Compensation Committee
Report (SEC 1992)
Composed of items from the following categories:
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Compensation process (3 items)
Base salary (1 item)
Pay-for-performance (3 items)
Annual incentives (8 items)
Long-term incentives (8 items)
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Firms receive 1 point for each item disclosed
CG and Disclosure – Measures
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Board governance measures are classified into five
categories:
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Board and compensation committee independence
(4 variables)
CEO power over the director nomination process
(3 variables)
Time commitment of directors (“board/compensation
committee busy status”) (4 variables)
Board and compensation committee diligence
(2 variables)
Board and compensation committee size (2 variables)
CG and Disclosure – Measures
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Board governance measures (cont.): Because
some variables are highly correlated, he uses
principal component analysis (PCA) to classify the
original variables into multiple aspects of board
governance quality and obtains factor scores that
would be used in the regression analyses
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This procedure resulted in reducing the dimensionality of the data from 15 measures to 5 discrete
factors
70.82 percent of the total variance in the original
governance variables is retained (personal
interpretation: very acceptable)
CG and Disclosure – Methods
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Ordinary least squares (OLS) regression was
performed to examine, as follows:
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Disclosure= f(Corporate Governance Factors + Control Variables)
Two proxy seasons were examined 1993 (1992
FY) and 2002 (2001 FY) (In my opinion, this
may be a major limitation, given the massive
changes in SOX and recent CD&A mandates.
Are the results generalizable?)
CG and Disclosure – Findings
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Descriptive Statistics (1992 vs. 2001)
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The average firm in 2001 has a greater proportion
of independent directors serving on its board and
compensation committee, has a smaller proportion
of outside directors appointed after the current
CEO took office, and is more likely to have a fully
independent nominating committee than that in
1992 (p<.01)
The outside directors serving on boards and
compensation committees in 2001 have a greater
number of other directorship positions than those
serving in 1992 (p<.01)
CG and Disclosure – Findings
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Descriptive Statistics (1992 vs. 2001) (cont.)
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However, the percentages of busy boards and
compensation committees (with more than 50
percent of outside members serving on three or
more other boards) are not significantly different
between the two time periods
The frequency of board and compensation
committee meetings remains the same between
the two periods
A typical board and compensation committee held
about seven and four meetings, respectively
CG and Disclosure – Findings
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Descriptive Statistics (1992 vs. 2001) (cont.)
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Despite increased board and compensation
committee independence, the average number of
directors serving on a board decreased between
1992 and 2001 (p<.05)
In both periods, however, the average number of
compensation committee members remains
constant
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A typical compensation committee has about four
members
CG and Disclosure – Findings
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1993 OLS Regression Results (Disclosure on CG +
Controls)
Board independence is positively related to
disclosure
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Suggesting that independent-dominated boards
report more details on compensation practices than
management-dominated boards (p<.05, one-tailed)
Greater CEO power in the director nomination
process is associated with a smaller number of
disclosed items (p<.01, one tailed)
Implying that dominant CEOs are more likely to limit
compensation disclosures
CG and Disclosure – Findings
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2002 OLS Regression Results (Disclosure on
CG + Controls)
Overall, the 2002 results are weaker than the
1993 results
DILIGENCE/SIZE is the only governance
variable significantly associated with SCORE
(p<.05, two-tailed)
CG and Disclosure – Findings
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2002 OLS Regression Results (Disclosure on CG +
Controls)
Unlike 1993, INDEPENDENCE and CEOPOWER
are insignificantly associated with DISCLOSURE.
Why? (author speculates)
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First, firms have responded to pressure on governance
reform by increasing the number of independent directors serving on boards and compensation committees
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Overall Board Independence 67 percent in 1992
to 79 percent in 2001
Overall Compensation Committee Independence
87 percent in 1993 to 97 percent in 2002)
CG and Disclosure – Findings
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Unlike 1993, INDEPENDENCE and CEOPOWER
are insignificantly associated with DISCLOSURE.
Why? (author speculates) (cont.)
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Second, with the pressure from shareholders for better
board governance in recent years, independent
outside directors whose careers are more closely tied
to their reputations as good monitors of management
are more sensitive to this shareholder pressure
CG and Disclosure – Overall
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The study shows some evidence that effective
board and committee characteristics are
associated with greater communication about
board practices to shareholders
Particularly, the study complements prior
research by providing evidence that board
(compensation committee) meeting frequency
and board (committee) size are positively
associated with the transparency of board
disclosure practices
(Laksmana, 2008)
Global Trends
Global Trends – Emerging Markets
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Brazil
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October 2007: Code of “Best Practice” issued
by Organization for Economic Cooperation and
Development (OECD)
Significant improvement and uptake is noted
The 2000 launch of the Novo Mercado by the
Bovespa stock exchange, with its focus on
transparency, was one of many factors that
drove uptake
A new edition of the Code is expected to be
released in 2009
Global Trends – Emerging Markets
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China/Hong Kong (China)
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Both China and Hong Kong (China), have adopted
the “comply or explain” corporate governance model
practiced in the United Kingdom, which calls for
abiding by CG guidelines or describing the
reasoning behind deviations.
The latest Hong Kong (China) Code, released in
January 2005, requires publication of a corporate
governance report containing “comply or explain”
disclosures; failure to issue such a report constitutes
a breach of the listing
Global Trends – Emerging Markets
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China/Hong Kong (China) (cont.)
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China Securities Regulation Commission (CSRC)
issued guidelines entitled,“Regulations on
Information Disclosure of Listed Companies,” in
December 2006
A RiskMetrics report comparing CG between
China and Hong Kong (China), determines that
the CSRC regulations are not as developed
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RiskMetrics report argues that enforcement of these rules
faces challenges in both China and Hong Kong (China)
The report gives Hong Kong (China) an aggregate score of 67
on a 100-point scale, while China scores 45, against an
average of 52 for all countries in the ACGA study
Global Trends – Emerging Markets
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India
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With an aggregate score of 83.6 percent, India tops a
January 2008 corporate governance study
(Florida International University, 2008)
While India places in the “observed” category on almost
all CG elements, including “Access to Information,” the
country places in the lower category of “largely
observed” for “Disclosure Standards”
In February 2008, the IFC Global Corporate Governance Forum initiated a research project surveying
500 publicly traded companies in India to identify
opportunities to improve corporate governance practice.
Global Trends – Emerging Markets
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The Middle East and North Africa
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Dialogue on corporate governance in the
region is moving from more general CG issues
to specific issues related to the composition
and the role of the board in implementing
transparency and disclosure
(Dr. Mahmoud Mohieldin, Minister of Investment for the
Arab Republic of Egypt, 2008)
Global Trends – Emerging Markets
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Russian Federation
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Dramatic improvement in standards of CG since
the 2002 introduction of a voluntary CG code
Much more responsive to investor requests and
disclose more information than they used to
Still lacking a sufficient number of independent
directors on company boards
(Aneta McCoy, RiskMetrics, 2008)
Global Trends – Developed Markets
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European Union
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Since September 2008, listed companies must
have complied with Fourth and Seventh
Accounting Directives
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By publishing a discrete corporate governance
statement, either in the annual report or separately
Global Trends – Developed Markets
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Japan
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2008 Japanese proxy season pitted shareholder
activists against companies for the second
straight year
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Companies are using every weapon in their arsenal to fight
back
Most notable weapon in managements’ arsenals is all-out
effort to attract management-friendly shareholders from
among the ranks of companies’ lenders and business partners
(Mark Goldstein, RiskMetrics, 2008)
Cross-shareholding rates rose in 2007/2008
Cross-shareholding resulted in a drop of latent profits
amounting to several hundred billion yen
Global Trends – Developed Markets
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United States
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Anomalies in reporting loss contingencies
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For example, on page 39 of Merck’s Third Quarter 2007
10-Q, filed on November 1, 2008, the company noted
that it “cannot reasonably estimate the possible loss or
range of loss with respect to the Vioxx Lawsuits…the
company has not established any reserves for any
potential liability relating to the Vioxx lawsuits…”
(emphasis added)
A week later, the company announced a $4.85 billion
settlement of the lawsuits
New FASB Exposure Draft “Disclosure of Certain Loss
Contingencies” comment period ended August 2008
Global Trends – Developed Markets
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United States (cont.)
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New Compensation Discussion & Analysis
(CD&A) assessment by the SEC
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350 first-year CD&A’s analysis
CD&A statements ran over 6,000 words
“Where’s the Analysis?”
Global Trends – Developed Markets
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United States (CD&A cont.)
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Great amount of detail, but lacking sufficient
discussion of how philosophies and processes
resulted in the numbers the company presented
in tabular disclosure
Too much jargon and legalese obfuscate the key
analysis of executive compensation philosophies
and practices
Global Trends – Developed Markets
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United States (CD&A cont.)
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ISS recently reported that “say on pay” policies received
an average level of shareholder support of 41.7 percent
at 41 meetings in the first half of 2007 and received a
majority vote at seven (7) companies
In 2008, that number rose to 10 companies
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Both Verizon and Aflac have announced that they will hold
shareholder advisory votes on executive compensation at
their 2009 annual meetings. Also, Pfizer and several other
large companies are starting internal campaigns to invoke
similar policies
As a final note, in April 2008, “say on pay” legislation
received the approval of the U.S. House of Representatives, and a companion bill was promptly introduced in
the Senate
Issues Facing Boards in 2009
Issues Facing Boards in 2009
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Shareholder proposals
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Executive compensation
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To implement or not implement, that is the question
Shareholder activism—friend or foe?
How do we juggle short-term performance and
long-term success?
Issues Facing Boards in 2009 (cont.)
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Director elections
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New SEC rule allowing Internet distribution of
proxy statements
“Withhold-the-vote” campaigns
Majority voting for director elections promoted
by shareholder activists
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See for example, that Intel, FedEx, Cisco and many
others have amended their bylaws to implement a
majority voting standard for uncontested elections
The Latest Research in
Corporate Governance:
Accounting
D. G. DeBoskey, Ph.D., CPA
Professor of Accountancy
SAN DIEGO STATE UNIVERSITY COLLEGE OF BUSINESS ADMINISTRATION