1 Chapter 11 Corporate Governance PART IV MONITORING AND CREATING ENTREPRENEURIAL OPPORTUNITIES.

Competing for ADVANTAGE

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Chapter 11 Corporate Governance

PART IVMONITORING AND CREATING ENTREPRENEURIAL OPPORTUNITIES

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

Shareholders Professional ManagersModern Public Corporations

Agency Relationships

Key Terms

Agency relationship

Relationship which exists when one or more people (principals) hire another person or people (agents) as decision-making 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 ExecutivesIncreased compensation

Reduced employment risk

Interests of ShareholdersIncreased value of firm

Reduced risk of firm failure

Use of Free Cash Flows

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.

Free cash flows are resources remaining after the firm has

invested in all projects that have positive net present values within

its current businesses.

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 corporation’s 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 concentration’s 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 corporation’s 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 corporation’s 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 risk to top-level managers Can increase detrimental managerial

actions

Trends Among Boards

Background diversity Formal processes to evaluate board

performance “Lead director” role with strong agenda-

setting 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 firm’s 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

executive pay with firm performance

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 firm’s 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 economies.

Corporate Governance and Ethical Behavior

• 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.

Capital MarketStakeholders

It is important to serve the interests of the firm’s multiple stakeholder groups.

Corporate Governance and Ethical Behavior

• Product market stakeholders (customers, suppliers, and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groups.

Product MarketStakeholders

OrganizationalStakeholders

It is important to serve the interests of the firm’s multiple stakeholder groups.

Corporate Governance and Ethical Behavior

• 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.

Product MarketStakeholders

OrganizationalStakeholders

Capital MarketStakeholders

Corporate Governance and Ethical Behavior

Design CEO pay structure with long-term focus

Actively set boundaries for ethical behavior Actively define organization’s 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

entrepreneurship45

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 self-interest?

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?