11-1© 2006 by Nelson, a division of Thomson Canada Limited. Corporate Governance Chapter Eleven

11-2© 2006 by Nelson, a division of Thomson Canada Limited. The Strategic. Management. Process The Strategic Management Process Chapter 5 Bus. - Level Strategy Chapter 6 Competitive Dynamics Chapter 9 International Strategy Chapter 10 Cooperative Strategies Chapter 8 Acquisitions & Restructuring Strategic Inputs Strategic Actions Strategic Outcomes Chapter 4 Internal Environment Chapter 3 External Environment Strat. Intent Strat. Mission Strategy Formulation Strategic Competitiveness Chapter 1 Above Average Returns Chapter 2 Strategic Competitiveness Chapter 1 Chapter 7 Corp. - Level Strategy Chapter 5 Bus. - Level Strategy Chapter 11 Corporate Governance Chapter 12 Structure & Control Chapter 13 Strategic Leadership Chapter 14 Entrepreneurship & Innovation Strategy Implementation Feedback Chapter 11 Corporate Governance

11-3© 2006 by Nelson, a division of Thomson Canada Limited. Corporate Governance Knowledge objectives: 1.Define corporate governance & explain why it is used to monitor & control managers’ strategic decisions. 2.Explain how ownership came to be separated from managerial control in the modern corporation. 3.Define an agency relationship & managerial opportunism & describe their strategic implications. 4.Explain how three internal governance mechanisms – ownership concentration, the board of directors and executive compensation – are used to monitor & control managerial decisions.

11-4© 2006 by Nelson, a division of Thomson Canada Limited. Corporate Governance Knowledge objectives cont’d… 5. Discuss trends among the three types of compensation executives receive and their effects on strategic decisions. 6. Describe how the external corporate governance mechanism – the market for corporate control - acts as a restraint on top level managers strategic decisions. 7. Discuss the use of corporate governance in international settings, in particular in Germany & Japan. 8. Describe how corporate governance fosters ethical strategic decisions & the importance of such behaviours on the part of top-level executives.

11-5© 2006 by Nelson, a division of Thomson Canada Limited. Corporate Governance is a relationship among stakeholders that is used to determine and control the strategic direction & performance of organizations. Concerned with identifying ways to ensure that strategic decisions are made effectively. Used in corporations to establish order between the firm’s owners and its top-level managers. Corporate Governance

11-6© 2006 by Nelson, a division of Thomson Canada Limited. Ten most admired & respected corporations in Canada

11-7© 2006 by Nelson, a division of Thomson Canada Limited. Internal Governance Mechanisms

11-8© 2006 by Nelson, a division of Thomson Canada Limited. Separation of Ownership & Managerial Control Basis of the modern corporation Shareholders purchase stock, becoming Residual Claimants Professional managers contract to provide decision-making. Modern public corporation form leads to efficient specialization of tasks. Shareholders reduce risk efficiently by holding diversified portfolios. Risk bearing by shareholders. Strategy development and decision-making by managers.

11-9© 2006 by Nelson, a division of Thomson Canada Limited. Agency Relationship Risk Bearing Specialist (Principal) Managers (Agents) Decision Makers which creates Managerial Decision- Making Specialist (Agent) Hire An agency relationship exists when: Shareholder s (Principals) Firm Owners Agency Theory

11-10© 2006 by Nelson, a division of Thomson Canada Limited. The Agency problem occurs when: The desires or goals of the principal & agent conflict and it is difficult or expensive for the principal to verify that the agent has behaved appropriately. Example: Over - diversification: Greater product diversification leads to lower management employment risk & greater compensation. Solution: Principals engage in incentive-based performance contracts, monitoring mechanisms like the board of directors & enforcement mechanisms like managerial labour market to mitigate agency problems. Agency Theory

11-11© 2006 by Nelson, a division of Thomson Canada Limited. Product Diversification as an example of an Agency Problem Diversification usually increases the size of the firm – therefore complexity and an opportunity for top executives to increase their compensation. Diversification usually reduces top executives’ employment risk. Top executives have control over free cash flow and may invest in in products not associated with the firm’s current lines of business.

11-12© 2006 by Nelson, a division of Thomson Canada Limited. Risk Level of Diversification Dominant Business Unrelated Businesses Related Constrained Related Linked Managerial (Employment) Risk Profile M B Shareholder (Business) Risk Profile S A Manager & Shareholder Risk & Diversification

11-13© 2006 by Nelson, a division of Thomson Canada Limited. Agency Costs & Governance Mechanisms Managerial interests may prevail when governance mechanisms are weak. If the board of directors control managerial autonomy, the firm’s strategies should better reflect the interests of the shareholders.

11-14© 2006 by Nelson, a division of Thomson Canada Limited. Governance Mechanisms Ownership Concentration - Large block shareholders have a strong incentive to monitor management closely. In Canada such shareholders account for 65% to 70% of publicly traded stocks (59% in the U.S.) - Their large stakes make it worth their while to spend time, effort & expense to monitor closely. - Institutional owners are financial institutions such as stock mutual funds and pension funds that control large- block shareholder positions.

11-15© 2006 by Nelson, a division of Thomson Canada Limited. Insiders Outsiders Boards of Directors - Set compensation of CEO & decide when to replace the CEO. - Formally monitor & control the firm’s top- level executives. - May lack contact with day to day operations. A firm’s CEO & other top-level managers Related Outsiders Individuals not involved with a firm’s day-to- day operations, but who have a relationship with the company Individuals independent of a firm’s day-to- day operations and other relationships Governance Mechanisms

11-16© 2006 by Nelson, a division of Thomson Canada Limited. Accountability of Board Members Increased diversity amongst board members. The strengthening of internal management & accounting control systems. The establishment & consistent use of formal processes to evaluate board’s performance. Directors are being required to own significant equity stakes as a prerequisite to holding a board seat.

11-17© 2006 by Nelson, a division of Thomson Canada Limited. Executive Compensation Executive compensation: A governance mechanism aligning the interests of managers & owners through salaries, bonuses and long term incentives such as stock options. Stock options: A mechanism which links the executive’s performance to the performance of the company.

11-18© 2006 by Nelson, a division of Thomson Canada Limited. Table 11.4

11-19© 2006 by Nelson, a division of Thomson Canada Limited. Table 11.5

11-20© 2006 by Nelson, a division of Thomson Canada Limited. Market for Corporate Control An external governance mechanism that becomes active when a firms internal controls fail which is triggered by a firm’s poor performance, relative to industry competition.

11-21© 2006 by Nelson, a division of Thomson Canada Limited. A Basic List of Management Defence Tactics Increase the costs of mounting a takeover and can entrench current management. Greenmail Where company money is used to repurchase stock from a corporate raider to avoid takeover. Golden Parachute Raises the cost of making changes at a take-over target due to the need to pay fired executives large severance packages. Poison Pill When the takeover target does something to make itself unpalatable to the suitor (e.g. assume a large amount of debt and then issue dividends with the money).

11-22© 2006 by Nelson, a division of Thomson Canada Limited. Governance Mechanism & Ethical Behaviour Shareholders are recognized as a company’s most significant stakeholders. The minimum interests or needs of all stakeholders must be recognized through the firms actions. A firm’s strategic competitiveness is enhanced when its governance mechanisms take into consideration the interests of all stakeholders. Only when the proper corporate governance is exercised can strategies be formulated & implemented that will help the firm achieve strategic competitiveness & earn above average returns.