© Ram Mudambi, Temple University, 2006 Lecture 9 Governance and Business Ethics BA 950 Policy Formulation and Administration

© Ram Mudambi, Temple University, Outline  Stakeholder analysis  Corporate governance  The principal-agent problem  Business ethics

© Ram Mudambi, Temple University, Stakeholders and Corporate Performance  Stakeholders are in an exchange relationship with the company  Contributions: they supply the organization with important resources  Inducements: in exchange they expect their interests to by satisfied  Stakeholders are individuals or groups with an interest, claim, or stake in the company, what it does, and how well it performs.

© Ram Mudambi, Temple University, Stakeholders and the Enterprise Contributions Inducements A single group can occupy more than one stakeholder role, e.g., ESOPs – employees may also be stockholders

© Ram Mudambi, Temple University, Stakeholder Impact Analysis 1.Identify stakeholders 2.Identify stakeholders’ interests and concerns 3.Identify resulting claims stakeholders are likely to make 4.Identify most important stakeholders (from the organization's perspective) 5.Identify the resulting strategic challenges Usually the most important: Customers Employees Shareholders Customers Employees Shareholders

© Ram Mudambi, Temple University, The Unique Role of Shareholders  Shareholders are a company’s legal owners and the provider of risk capital, a major source of capital to operate a business.  Value of risk capital – no guaranteed payment, no guarantee of capital preservation  Maximizing long-run profitability & profit growth is the route to maximizing returns to shareholders  Also helps to satisfy the claims of most other stakeholder groups.

© Ram Mudambi, Temple University, Shareholder Claims  Shareholders receive their returns as:  Dividend payments  Capital appreciation in market value of shares  ROIC is an excellent measure of profitability.  A company generatingpositive ROIC is adding to shareholders’ equity and increasing shareholder value.  A company generating positive ROIC is adding to shareholders’ equity and increasing shareholder value.

© Ram Mudambi, Temple University, Agency Theory Principal-agent relationships arise whenever one party delegates decision-making authority or control over resources to another.  Principal : person delegating authority  Agent: person to whom authority is delegated The agency problem:  Agents and principals may have different goals.  Agents may pursue their own goals that are not in the best interests of their principals.

© Ram Mudambi, Temple University, The Corporate Governance Problem The evolution of the corporate enterprise The evolution of the corporate enterprise  Owner-managed small enterprises  Partnerships  Limited liability joint stock corporations Joint stock enterprises are characterized by Joint stock enterprises are characterized by  Separation of ownership from management  Diffused stock holding The objectives of owners (principals) and managers (agents) may diverge The objectives of owners (principals) and managers (agents) may diverge

© Ram Mudambi, Temple University, The Corporate Governance Problem On-the-job consumption  Elaborate and expensive perks for top management. Excessive pay not linked to performance  Down markets and upward spirals of executive pay. Empire building Empire building  Buying additional businesses that increase the size of the company without increasing shareholder wealth.

© Ram Mudambi, Temple University, The Tradeoff Between Profitability and Growth Rate

© Ram Mudambi, Temple University, Solving the Corporate Governance Problem  Generic solutions to the agency problem involve  Monitoring: Reducing asymmetric information between principal and agent  Incentives: Aligning the goals of the principal and the agent

© Ram Mudambi, Temple University, Corporate Governance Mechanisms - 1  Internal controls  Board of directors  Elected by stockholders  Legally accountable  Monitors corporate strategy decisions  Authority to hire, fire and compensate  Ensures accuracy of audited financial statements  Inside vs. outside directors  Auditors, SEC, GAAP  Stock-based compensation  Pay for performance  Stock options –Exercise price, exercise date Monitoring Incentives

© Ram Mudambi, Temple University, How Options Skew the Bottom Line Source: D. Henry and M. Conlin, “Too Much of a Good Incentive?” Business Week, March 4, 2002, pp. 38–39.

© Ram Mudambi, Temple University, Corporate Governance Mechanisms - 2  External controls  Corporate takeovers  Takeover-imposed constraints  Corporate raiders - LBOs  Greenmail  Internal / External controls  Leveraged buyouts - MBO  Managers offer to exchange equity for debt in a leveraged buyout (purchase of the company).

© Ram Mudambi, Temple University, Cascading agency relationships Board of directors Represents stockholders Top management Senior executives Middle managers Corporate governance Employees Strategic control systems

© Ram Mudambi, Temple University, Strategic Control Systems  To establish standards against which performance can be measured  To create systems for measuring and monitoring performance  To compare actual performance against target  To evaluate results and take corrective actions  Employee incentives  Employee stock options and stock ownership plans  Compensation tied to attainment of superior efficiency, quality, innovation, and responsiveness to customers  Up-or-out systems  Balanced Scorecard model approach is used to drive future performance

© Ram Mudambi, Temple University, The Balanced Scorecard Approach

© Ram Mudambi, Temple University, Ethics and Strategy – 1  Business ethics examines ethical rules and principles within a commercial context  The accepted principles of right or wrong governing the conduct of businesspeople  Ethical dilemmas occur when:  There is no agreement over what the accepted principles are  None of the available alternatives seem ethically acceptable

© Ram Mudambi, Temple University, Ethics and Strategy – 2 An ethical strategy is one that does not violate the accepted principles. Many accepted principles are codified into laws:  Tort laws – governing product liability  Contract law – contracts and breaches of contracts  Intellectual property law – protection of intellectual property  Antitrust law – governing competitive behavior  Securities law - issuing and selling securities Behaving ethically goes beyond staying Behaving ethically goes beyond staying within the law

© Ram Mudambi, Temple University, Ethical Issues in Strategy Ethical issues are due to a potential conflict between the goals of the enterprise, the goals of the individual managers, and the rights of important stakeholders: Self-dealing Self-dealing Managers feather their nests with corporate monies Managers feather their nests with corporate monies Information manipulation Information manipulation Distort or hide information to enhance competitive or personal situation Distort or hide information to enhance competitive or personal situation Anti-competitive behavior Anti-competitive behavior Actions aimed at harming actual or potential competitors Actions aimed at harming actual or potential competitors Opportunistic exploitation Opportunistic exploitation Of other players in the value chain in which the firm is embedded Of other players in the value chain in which the firm is embedded Substandard working conditions Substandard working conditions Underinvest in working conditions or pay below market wages Underinvest in working conditions or pay below market wages Environmental degradation Environmental degradation Directly or indirectly take actions that result in environmental harm Directly or indirectly take actions that result in environmental harm Corruption Corruption Companies pay bribes to gain access to lucrative business contracts. Companies pay bribes to gain access to lucrative business contracts. Are these ethical dilemmas?

© Ram Mudambi, Temple University, The Roots of Unethical Behavior Why do some managers behave unethically? Why do some managers behave unethically? No simple answers, but some generalizations:  Mission: Do not realize they are behaving unethically by failing to ask the right questions  Mentor: Leadership promotes an organization culture that de-emphasizes ethics and considers primarily economic consequences  Unrealistic performance goals: encouraging and legitimizing unethical behavior  Mirror: Personal ethics code

© Ram Mudambi, Temple University, The Friedman Doctrine The only social responsibility of business is to increase profits, as long as the company stays within the law and the rules of the game without deception or fraud. The only social responsibility of business is to increase profits, as long as the company stays within the law and the rules of the game without deception or fraud. Utilitarian and Kantian Ethics The moral worth of actions is determined by its consequences – leading to the best possible balance of good versus bad consequences. Committed to the maximization of good and the minimization of harm. The moral worth of actions is determined by its consequences – leading to the best possible balance of good versus bad consequences. Committed to the maximization of good and the minimization of harm. Philosophical Approaches to Ethics - 1

© Ram Mudambi, Temple University, Rights Theories Recognizes that human beings have fundamental rights and privileges. Rights establish a minimum level of morally acceptable behavior. Recognizes that human beings have fundamental rights and privileges. Rights establish a minimum level of morally acceptable behavior. Justice Theories Focus on the attainment of a just (fair and equitable) distribution of economic goods and services. Focus on the attainment of a just (fair and equitable) distribution of economic goods and services. Philosophical Approaches to Ethics - 2

© Ram Mudambi, Temple University, Thinking Through Ethical Problems A model of ethical decision making

© Ram Mudambi, Temple University, Summary  Stakeholder analysis  Why look beyond shareholders?  Corporate governance  The agency problem  Strategy and ethics  Morality and business