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Competing for

ADVANTAGE

PART IV
MONITORING AND CREATING
ENTREPRENEURIAL OPPORTUNITIES
Chapter 11
Corporate Governance

The Strategic Management


Process

Corporate Governance

Key Terms

Corporate governance
Set of mechanisms used to manage
the relationships among stakeholders
and to determine and control the
strategic direction and performance of
organizations

Governance Mechanisms

Separation of Ownership
and Managerial Control
Ownership

Management

Founder-Owners
Family-Owned Firms
Modern Public Corporations
Shareholders

Professional Managers

Agency Relationships

Key Terms
Agency

relationship

Relationship which exists when one or


more people (principals) hire another
person or people (agents) as decisionmaking specialists to perform a service
Managerial

opportunism

Seeking self-interest with guile (i.e.,


cunning or deceit)

An Agency Relationship

The Agency Problem

The agency problem occurs when


the desires or goals of the
principal and agent conflict and it
is difficult or expensive for the
principal to verify whether the
agent has behaved
inappropriately.

Problems with Separate


Ownership and Control

Principal and the agent having


different interests and goals

Shareholders lacking direct control


in large publicly traded
corporations

Agent making decisions which


result in actions that conflict with
interests of the principal

Product Diversification
as an Agency Problem

Interests of Top Executives


Increased
Reduced

compensation

employment risk

Interests of Shareholders
Increased
Reduced

value of firm

risk of firm failure

Use of Free Cash Flows


Free cash flows are resources
remaining after the firm has
invested in all projects that have
positive net present values within
its current businesses.

The managerial inclination to overdiversify


can be acted upon when free cash flows are
available.

Shareholders may prefer that free cash


flows be distributed to them as dividends, so
they can control how the cash is invested.

Manager and Shareholder


Risk and Diversification

Agency Costs and


Governance Mechanisms

Key Terms
Agency

costs

The sum of incentive costs, monitoring


costs, enforcement costs, and individual
financial losses incurred by principals,
because governance mechanisms
cannot guarantee total compliance by
the agent

Regulatory Oversight of
Corporate Governance

2002 Sarbanes-Oxley (SOX)


Act

2010 Dodd-Frank Wall Street


Reform and Consumer
Protection Act (Dodd-Frank)

Dodd-Frank Provisions

Creates a Financial Stability Oversight


Council headed by the Treasury Secretary
Establishes a new system for liquidation of
certain financial companies
Provides for a new framework to regulate
derivatives
Establishes new corporate governance
requirements
Regulates credit rating agencies and
securitizations
Establishes a new consumer protection
bureau, providing for extensive consumer
protection in financial services

Ownership Concentration

Key Terms
Ownership

concentration

Governance mechanism defined by both the


number of large-block shareholders and the
total percentage of shares they own
Large

block shareholders

Shareholders owning a concentration of at


least 5 percent of a corporations issued
shares

Effects of Ownership
Concentration

Diffuse ownership produces weak monitoring


of managers decisions.

Ownership concentration is associated with


lower levels of firm product diversification.

High degrees of ownership concentration


improve the probability that managers
strategic decisions will increase shareholder
value.

In general, ownership concentrations influence


on strategies and firm performance is positive.

Influence of
Institutional Owners

Key Terms
Institutional

owners

Financial institutions such as stock


mutual funds and pension funds that
control large-block shareholder positions

Influence of
Institutional Owners

Becoming more active in efforts to


influence the corporations strategic
decisions

Initially focused on CEO performance


and accountability

Now targeting ineffective boards of


directors and executive compensation
policies

Growing efforts to expand


shareholders decision rights

Board of Directors

Key Terms
Board

of directors

Group of shareholder-elected individuals


whose primary responsibility is to act in
the owners interests by formally
monitoring and controlling the
corporations top-level executives

Board of Director
Responsibilities

Direct the affairs of the


organization

Punish and reward managers

Protect shareholders rights and


interests

Protect owners from managerial


opportunism

Classifications of Boards of
Directors Members

Outsider Directors

Enhance managerial monitoring

Contribute to strategic direction

Provide valuable links to external


stakeholders

Promoted by regulatory agencies

Do not guarantee high


performance

Problems with
Outsider-Dominated Boards

Limited access to daily operations and


critical information

May lack insights required to fully and


perhaps effectively evaluate manager
decisions and initiatives

Tendency to emphasize financial


controls
Shifts
Can

risk to top-level managers

increase detrimental managerial

Trends Among Boards

Background diversity

Formal processes to evaluate board


performance

Lead director role with strong agendasetting and oversight powers

Changes in compensation packages

Ownership stake requirements

Demand for greater accountability and


improved performance

Social networks with external stakeholders

Board Effectiveness

Become engaged in the firm,


without trying to micromanage it

Challenge the reasoning behind


decisions, but be supportive of
decisions that are made

Provide an independent
perspective on important
decisions

Executive Compensation

Key Terms
Executive

compensation

Governance mechanism that seeks to


align the interests of top managers and
owners through salaries, bonuses, and
long-term incentive compensation, such
as restricted stock awards and stock
options

Executive Compensation
Issues

High visibility and controversy


surrounding CEO pay

Downward pressure from


shareholders and activists

Relationship to performance

Long-term incentive plans

Effective governance mechanism


for firms implementing
international strategies

Executive Compensation for


International Strategies

Pay levels vary by regions of the world.

Owners of multinational corporations may


be best served with less uniformity across
the firms foreign subsidiaries.

Multiple compensation plans increase the


need for monitoring and other related
agency costs.

Complexity and potential dissatisfaction


increase as corporations acquire firms in
other countries.

Long-Term Incentive Plans

Address potential agency problems

Viewed positively by the stock


market

Reduce pressure for changes in the


board

Reduce pressure for outside


directors

Assumed to effectively link

The Effectiveness of
Executive Compensation

It is difficult to evaluate complex and


nonroutine strategic decisions made by
top-level managers.

It is difficult to assess the long-term


strategic effect of current decisions which
affect financial performance outcomes
over an extended period.

Multiple external factors affect a firms


performance other than top-level
managerial decisions and behavior.

The Effectiveness of
Executive Compensation

Performance-based (incentive)
compensation plans are imperfect in
their ability to monitor and control
managers.

Conflicting short-term and long-term


objectives have a complex effect on
managerial decisions and behaviors.

Excessive compensations correlate


with weak corporate governance.

Executive Compensation A
Question of Stock Issue
Effectiveness

Manager wealth v. high stock


prices

Earnings manipulations

Risk taking

Repricing

Backdating

Market for Corporate


Control

Key Terms
Market

for corporate control

An external governance mechanism which


is composed of individuals and firms that
buy ownership positions in or take over
potentially undervalued corporations so
they can form new divisions in established
diversified companies or merge two
previously separate firms

Market for Corporate


Control

Addresses weak internal


corporate governance

Corrects suboptimal
performance relative to
competitors

Disciplines ineffective or
opportunistic managers

Hostile Takeover
Defense Strategies

Market for Corporate


Control

May not be entirely efficient

Lacks the precision of internal


governance mechanisms

Can be an effective constraint


on questionable manager
motives

International
Corporate Governance

Similarities among governance structures


in industrialized nations are increasing.

Firms using an international strategy


must understand the dissimilarities in
order to operate effectively in different
international markets.

Traditional governance structures in


foreign nations, like Germany and Japan,
are being affected by global competition.

Corporate Governance
in Germany

Concentration of ownership is strong.

Banks exercise significant power as a


source of financing for firms.

Two-tiered board structures, required


for larger employers, place
responsibility for monitoring and
controlling managerial decisions and
actions with separate groups.

Power sharing includes representation


from the community as well as unions.

Corporate Governance
in Japan

Cultural concepts of obligation, family, and


consensus affect attitudes toward governance.

Close relationships between stakeholders and a


company are manifested in cross-shareholding
and can negatively impact efficiencies.

Banks play an important role in financing and


monitoring large public firms.

Despite the counter-cultural nature of


corporate takeovers, changes in corporate
governance have introduced this practice.

Global Corporate Governance

Relatively uniform governance


structures are evolving in developed
countries.

These structures are moving closer


to the U.S. model of corporate
governance.

Although implementation is slower,


this merging with U.S. practices is
occurring even in transitional

Corporate Governance and


Ethical Behavior

The Firm
Capital Market
Stakeholders

In the U.S., shareholders (in the


capital market stakeholder group) are
viewed as the most important
stakeholder group served by the board
of directors.
Hence, the focus of governance
mechanisms is on the control of
managerial decisions to ensure that
shareholders interests will be served.

Corporate Governance and


Ethical Behavior

The Firm
Product Market
Stakeholders
Organizational
Stakeholders

It is important to serve the


interests of the firms multiple
stakeholder groups.
Product market stakeholders
(customers, suppliers, and host
communities) and organizational
stakeholders (managerial and nonmanagerial employees) are also
important stakeholder groups.

Corporate Governance and


Ethical Behavior

The Firm
Capital Market
Stakeholders
Product Market
Stakeholders
Organizational
Stakeholders

It is important to serve the


interests of the firms multiple
stakeholder groups.
Although the idea is subject to debate,
some believe that ethically responsible
companies design and use governance
mechanisms that serve all
stakeholders interests.
Importance of maintaining ethical
behavior through governance
mechanisms is seen in the examples of
recent corporate scandals.

Corporate Governance
and Ethical Behavior

Design CEO pay structure with long-term


focus
Actively set boundaries for ethical behavior
Actively define organizations values
Clearly communicate expectations to all
stakeholders
Foster an ethical culture of accountability
Promote CEOs as positive role models
Monitor ethical behavior of top executives
Do not stifle manager flexibility and
entrepreneurship
45

ETHICAL QUESTION
Do managers have an ethical
responsibility to push aside their own
values with regard to how certain
stakeholders are treated (i.e., special
interest groups) in order to maximize
shareholder returns?

ETHICAL QUESTION
What are the ethical implications
associated with owners assuming that
managers will act in their own selfinterest?

ETHICAL QUESTION
What ethical issues surround
executive compensation? How can
we determine whether top executives
are paid too much?

ETHICAL QUESTION
Is it ethical for firms involved in the
market for corporate control to
target companies performing at
levels exceeding the industry
average?
Why or why not?

ETHICAL QUESTION
What ethical issues, if any, do top
executives face when asking their
firm to provide them with a golden
parachute?

ETHICAL QUESTION
How can governance mechanisms be
designed to ensure against
managerial opportunism,
ineffectiveness, and unethical
behaviors?

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