©2004 by South-Western/Thomson Learning 1 Corporate Governance Robert E. Hoskisson Michael A. Hitt R. Duane Ireland Chapter 11

2 Chapter 2 Chapter 2 Strategic Leadership Strategic Leadership Chapter 4 Chapter 4 The Internal The Internal Organization Chapter 6 Chapter 6 Competitive Rivalry and Competitive Rivalry and Competitive Dynamics Competitive Dynamics Chapter 9 Chapter 9 International Strategy International Strategy Chapter 1 Chapter 1 Introduction to Introduction to Strategic Management Strategic Management Chapter 3 Chapter 3 The External The External Environment Chapter 5 Chapter 5 Business-Level Strategy Chapter 8 Chapter 8 Acquisition and Acquisition and Restructuring Strategies Restructuring Strategies Chapter 11 Chapter 11 Corporate Governance Corporate Governance Strategic Intent Strategic Intent Strategic Mission Strategic Mission Chapter 7 Chapter 7 Corporate-Level Strategy Corporate-Level Strategy Chapter 10 Chapter 10 Cooperative Strategy Cooperative Strategy Chapter 12 Chapter 12 Strategic Entrepreneurship Strategic Entrepreneurship Strategic Analysis Strategic Thinking Creating Competitive Advantage Monitoring And Creating Entrepreneurial Opportunities The Strategic Management Process

3 Corporate Governance Corporate governance –represents the relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations –is concerned with identifying ways to ensure that strategic decisions are made effectively –is a means to establish effective relationships between the firm’s owners and its top-level managers

4 Corporate Governance Mechanisms Ownership concentration –relative amounts of stock owned by individual shareholders and institutional investors Board of Directors –individuals responsible for representing the firm’s owners by monitoring top-level managers’ strategic decisions Internal Governance Mechanisms

5 Corporate Governance Mechanisms Executive Compensation –use of salary, bonuses, and long- term incentives to align managers’ interests with shareholders’ interests Internal Governance Mechanisms

6 Corporate Governance Mechanisms Market for Corporate Control –the purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness External Governance Mechanisms

7 Separation of Ownership and Managerial Control Basis of the modern corporation Basis of the modern corporation –shareholders purchase stock, becoming residual claimants –shareholders reduce risk by holding diversified portfolios –professional managers are contracted to provide decision-making Modern public corporation form leads to efficient specialization of tasks Modern public corporation form leads to efficient specialization of tasks –risk bearing by shareholders –strategy development and decision-making by managers

8 Firm ownersFirm owners Agency Relationship: Owners and Managers Shareholders(Principals)

9 Decision makersDecision makers Agency Relationship: Owners and Managers Managers(Agents) Shareholders(Principals) Firm ownersFirm owners

10 Risk bearing specialist (principal) pays compensation toRisk bearing specialist (principal) pays compensation to A managerial decision-making specialist (agent)A managerial decision-making specialist (agent) Agency Relationship: Owners and Managers An Agency Relationship Managers(Agents) Shareholders(Principals) Decision makersDecision makers Firm ownersFirm owners

11 Agency Theory Problem The agency problem occurs when: 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 that the agent has behaved inappropriately Solution: Solution: –principals engage in incentive-based performance contracts –monitoring mechanisms such as the board of directors –enforcement mechanisms such as the managerial labor market to mitigate the agency problem

12 Manager and Shareholder Risk and Diversification Risk Diversification DominantBusinessUnrelatedBusinessesRelatedConstrainedRelatedLinked Managerial (employment) risk profile B Shareholder (business) risk profile S A M

13 Agency Theory Conflicts Principals may engage in monitoring behavior to assess the activities and decisions of managers Principals may engage in monitoring behavior to assess the activities and decisions of managers However, dispersed shareholding makes it difficult and inefficient to monitor management’s behavior Boards of Directors have a fiduciary duty to shareholders to monitor management Boards of Directors have a fiduciary duty to shareholders to monitor management However, Boards of Directors are often accused of being lax in performing this function

14 Governance Mechanisms OwnershipConcentration Large shareholders (often institutional owners) have a strong incentive to monitor management closelyLarge shareholders (often institutional owners) have a strong incentive to monitor management closely Their large stakes make it worth their while to spend time, effort and expense to monitor closelyTheir large stakes make it worth their while to spend time, effort and expense to monitor closely They may also obtain Board seats which enhances their ability to monitor effectivelyThey may also obtain Board seats which enhances their ability to monitor effectively

15 Governance Mechanisms OwnershipConcentration Board of Directors Insiders The firm’s CEO and other top-level managersThe firm’s CEO and other top-level managers Related Outsiders (Affiliated) Individuals not involved with day- to-day operations, but who have a relationship with the companyIndividuals not involved with day- to-day operations, but who have a relationship with the company Outsiders (Independent) Individuals who are independent of the firm’s day-to-day operations and other relationshipsIndividuals who are independent of the firm’s day-to-day operations and other relationships

16 Governance Mechanisms OwnershipConcentration Recommendations for more effective Board Governance: Increase diversity of board members’ backgroundsIncrease diversity of board members’ backgrounds Strengthen internal management and accounting control systemsStrengthen internal management and accounting control systems Establish formal processes for evaluation of the board’s performanceEstablish formal processes for evaluation of the board’s performance Board of Directors

17 Governance Mechanisms OwnershipConcentration ExecutiveCompensation Salary, bonuses, long term incentive compensationSalary, bonuses, long term incentive compensation Executive decisions are complex and non-routineExecutive decisions are complex and non-routine Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomesMany factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes Board of Directors

18 Governance Mechanisms OwnershipConcentration ExecutiveCompensation Stock ownership (long-term incentive compensation) makes managers more susceptible to market changes which are partially beyond their controlStock ownership (long-term incentive compensation) makes managers more susceptible to market changes which are partially beyond their control Incentive systems do not guarantee that managers make the “right” decisions, but do increase the likelihood that managers will do the things for which they are rewardedIncentive systems do not guarantee that managers make the “right” decisions, but do increase the likelihood that managers will do the things for which they are rewarded Board of Directors

19 Governance Mechanisms OwnershipConcentration ExecutiveCompensation Market for Corporate Control Firms face the risk of takeover when they are operated inefficientlyFirms face the risk of takeover when they are operated inefficiently Many firms begin to operate more efficiently as a result of the “threat” of takeover, even though the actual incidence of hostile takeovers is relatively smallMany firms begin to operate more efficiently as a result of the “threat” of takeover, even though the actual incidence of hostile takeovers is relatively small Acts as an important source of discipline over managerial incompetence and wasteActs as an important source of discipline over managerial incompetence and waste Board of Directors

20 Managerial Defense Tactics Designed to fend off a hostile takeover attempt Increase the costs of making a hostile acquisition Causes incumbent management to become entrenched while reducing the chances of introducing a new management team Institutional investors oppose the use of defense tactics

21 International Corporate Governance: Owner and manager are often the same in private firms Owner and manager are often the same in private firms Public firms often have a dominant shareholder, frequently a bank Public firms often have a dominant shareholder, frequently a bank Less emphasis on shareholder value than in U.S. firms, although this may be changing Less emphasis on shareholder value than in U.S. firms, although this may be changing Germany

22 International Corporate Governance: Medium to large firms have a two-tiered board Medium to large firms have a two-tiered board –Aufsichtsrat (the supervisory board) monitors and controls managerial decisions of the Vorstand (the management board) –Aufsichtsrat selects the Vorstand –Employees, union members and shareholders appoint members to the Aufsichtsrat Germany

23 International Corporate Governance: Obligation, “family” and consensus are important factors Obligation, “family” and consensus are important factors Banks (especially “main bank”) are highly influential with firm’s managers Banks (especially “main bank”) are highly influential with firm’s managers Keiretsus are strongly interrelated groups of firms tied together by cross- shareholdings Keiretsus are strongly interrelated groups of firms tied together by cross- shareholdings Japan

24 International Corporate Governance: Other characteristics: Other characteristics: –powerful government intervention –close relationships between firms and government sectors –passive and stable shareholders who exert little control –virtual absence of external market for corporate control Japan

25 Corporate Governance and Ethical Behavior In the U.S., shareholders (in the capital market stakeholder group) are viewed as the most important stakeholder groupIn the U.S., shareholders (in the capital market stakeholder group) are viewed as the most important stakeholder group which are served by the board of directorswhich are 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 servedHence, the focus of governance mechanisms is on the control of managerial decisions to ensure that shareholders’ interests will be served It is important to serve the interests of the firm’s multiple stakeholder groups! Capital Market Stakeholders

26 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 groupsProduct market stakeholders (customers, suppliers and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groups Product Market Stakeholders OrganizationalStakeholders Capital Market Stakeholders

27 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’ interestsAlthough 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 example of Enron and Arthur AndersenImportance of maintaining ethical behavior through governance mechanisms is seen in the example of Enron and Arthur Andersen Product Market Stakeholders OrganizationalStakeholders Capital Market Stakeholders