Competing For Advantage Part IV – Monitoring and Creating Entrepreneurial Opportunities Chapter 11 – Corporate Governance

The Strategic Management Process

International Strategy Key Terms Corporate Governance – set of mechanisms used to manage the relationships (and conflicting interests) among stakeholders, and to determine and control the strategic direction and performance of organizations (aligning strategic decisions with company values)

Governance Mechanisms

Critical Issues for Growing Family-Controlled Firms Owner-managers may not have access to all skills needed to manage the growing firm and maximize its returns for the family They may need outsiders to help improve management of the firm Owner-managers may need to seek outside capital and thus give up some of the ownership control

Agency Relationships Key Terms Agency Relationship – relationships between business owners (principals) and decision-making specialists (agents) hired to manage principals' operations and maximize returns on investment Managerial Opportunism – seeking self- interest with guile (i.e., cunning or deceit)

An Agency Relationship

Problems with Separate Ownership and Control Principal and agent having different interests and goals Shareholders lacking direct control of large publicly traded corporations Agent makes decisions that result in the pursuit of goals that conflict with those of principal

Product Diversification as an Agency Problem Key Terms Free Cash Flows – resources remaining after the firm has invested in all projects that have positive net present values within its current businesses

Product Diversification as an Agency Problem Increased product diversification allows top executives to increase their compensation It usually increases the size of a firm, and size is positively related to executive compensation It increases the complexity of managing a firm and its network of businesses, so its leadership positions may demand more pay

Product Diversification as an Agency Problem Product diversification (and the resulting diversification of the firm’s portfolio of businesses) reduces risk for top executives Managerial employment risk includes the risk of managers losing their jobs, compensation, or reputations Diversification reduces these risks because a firm and its managers are less vulnerable to the reduction in demand associated with a single or limited number of product lines or businesses

Product Diversification as an Agency Problem Use of Free Cash Flows 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

Agency Costs Key Terms Agency Costs – 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

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 Institutional Owners – financial institutions such as stock mutual funds and pension funds that control large-block shareholder positions

Ownership Concentration – Trends Increased equity ownership by institutional owners provides the size to influence strategy and the incentive to discipline ineffective managers Increased shareholder activism supported by SEC rulings in support of shareholder involvement and control of managerial decisions

Ownership Concentration – Trends Threats or initiations of a proxy battle to unseat the current board of directors Organization of press conferences Threats of a takeover bid Creation of shareholder “proposals” to be addressed at the next board meeting

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 Directors Direct the affairs of the organization Punish and reward managers Protect shareholders’ rights and interests Protect owners from managerial opportunism

Board of Directors –Types

Outsider Directors They improve upon the weak managerial monitoring and control that corresponds to inside directors Without access to daily operations and a high level of information about managers and strategy, they tend to emphasize financial controls, to the detriment of risk- related decisions by managers

Board Effectiveness – Trends Increased diversity of the backgrounds of board members Establishment and consistent use of formal processes to evaluate the board’s performance Creation of a “lead director” role that has strong agenda-setting and oversight powers Modified compensation of directors Requirements that directors own significant stakes in the company in order to keep them focused on shareholder interests

Board Effectiveness – Trends 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 stock awards and stock options

Executive Compensation Executive compensation is thought to be excessive and out of line with performance Alignment of pay and performance is a complicated board responsibility The effectiveness of pay plans as a governance mechanism is suspect

Executive Compensation – Complications The quality of complex and nonroutine strategic decisions that top-level managers make is difficult to evaluate Decisions affect financial outcomes over an extended period, making it difficult to assess the effect of current decisions on corporation performance External factors affect a firm’s performance besides top-level managerial decisions and behavior

Executive Compensation – Complications Performance-based compensation used to motivate decisions that best serve shareholder interest are imperfect in their ability to monitor and control managers Even incentive compensation plans that are intended to increase the value of a firm in line with shareholder expectations are subject to managerial manipulation to maximize managerial interests

Executive Compensation Plans – A Question of Stock Issues Effectiveness Many plans seem to be designed to maximize manager wealth rather than guarantee a high stock price that aligns the interests of managers and shareholders Repricing – strike price value of options is commonly lowered from its original position Backdating – options grant is commonly dated earlier than it was actually drawn up to ensure an attractive exercise price

Market for Corporate Control Key Terms Market for Corporate Control – external governance mechanism consisting of a set of potential owners who are seeking to acquire undervalued firms and earn above-average returns on their investments, a process which becomes active when a firm’s internal controls fail

Market for Corporate Control Addresses weak internal corporate governance Corrects suboptimal performance relative to competitors Disciplines ineffective or opportunistic managers

Corporate Governance – 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 – 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 Trends Relatively uniform governance structures are evolving 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 the most important stakeholder group served by the board of directors Governance mechanisms focus on control of managerial decisions to protect shareholders’ interests It is important to serve the interests of the firm’s multiple stakeholder groups Capital Market Stakeholders

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 Market Stakeholders

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 example of Enron and Arthur Andersen. Product Market Stakeholders OrganizationalStakeholders Capital Market Stakeholders

Ethical Questions 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 Questions What are the ethical implications associated with owners assuming that managers will act in their own self-interest?

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

Ethical Questions 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 Questions What ethical issues, if any, do top executives face when asking their firms to provide them with golden parachutes?

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