1. Strategic Management: Concepts and Cases
Part III: Strategic Actions: Strategy Implementation
Chapter 10: Corporate Governance

2. The Strategic Management Process

3. Chapter 10: Corporate Governance (CG)
Overview: Eight content areas
Define CG and its monitor/control of managers’ decisions
Separation between ownership and management control
Agency relationship and managerial opportunism
Three internal governance mechanisms used to monitor/control management decisions
External corporate governance mechanisms:
management restraint
Executive compensation - types and effects
Use of external CG in international settings
How CG fosters ethical strategic decisions

4. CG and Its Effect on the Lives of CEOs
In 2006 record number of CEOs lost jobs
Dismissal
Retirement
Recruitment to another firm
Partly due to increasing scrutiny by
Boards
Governance activists
Increased pressure from the market for corporate control
Media
Trend: decrease in average tenure (current: mo.)
Result: CEOs looking at short-term vs. long-term

5. CG and Its Effect on the Lives of CEOs (Cont’d)
CEOs now serving on fewer external boards
CG: Double-edged sword
Can put an end to scandals
Might restrictive CEOs (i.e., they won’t take risks)

6. Chapter 10: Corporate Governance (CG)
Overview: Eight content areas
Define CG and its monitor/control of managers’ decisions
Separation between ownership and management control
Agency relationship and managerial opportunism
Three internal governance mechanisms used to monitor/control management decisions
External corporate governance mechanisms:
management restraint
Executive compensation - types and effects
Use of external CG in international settings
How CG fosters ethical strategic decisions

7. Introduction Corporate Governance (CG)
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)
Effective CG interest to nations as it reflects societal standards
Firms’ shareholders are treated as key stakeholders as they are the company’s legal owners

8. Chapter 10: Corporate Governance (CG)
Overview: Eight content areas
Define CG and its monitor/control of managers’ decisions
Separation between ownership and management control
Agency relationship and managerial opportunism
Three internal governance mechanisms used to monitor/control management decisions
External corporate governance mechanisms:
management restraint
Executive compensation - types and effects
Use of external CG in international settings
How CG fosters ethical strategic decisions

9. Separation of Ownership and Managerial Control
Introduction
Historically, firms managed by founder-owners & descendants
Separation of ownership and managerial control allow shareholders to purchase stock, entitling them to income (residual returns) – implies ‘risk’ for this group who manage their investment risk
Shareholder value reflected in price of stock

10. Separation of Ownership and Managerial Control (Cont’d)
Introduction
Small firms’ managers are high percentage owners, which implies less separation between ownership and management control
Usually implies family-owned businesses
This group faces 2 critical issues
1. As they grow, they may not have access to all needed skills to manage the growing firm and maximize its returns, so may need outsiders to improve management
2. May need to seek outside capital (whereby they give up some ownership control)

11. Separation of Ownership and Managerial Control (Cont’d)
Agency relationships
Relationships between business owners (principals) and decision-making specialists (agents) hired to manage principals' operations and maximize returns on investment (and focus of this chapter)
Other agency relationship examples: Consultants/clients; insured/insurer; manager/employee

12. Separation of Ownership and Managerial Control (Cont’d)
Agency relationships (Cont’d)
Managerial Opportunism: Seeking self-interest with guile (i.e., cunning or deceit)
Opportunism: an attitude and set of behaviors
Managers don’t know which agents will enact managerial opportunism
Principals establish governance and control mechanisms to prevent agents from acting opportunistically

13. An Agency Relationship

14. Separation of Ownership and Managerial Control (Cont’d)
Agency problems: Product diversification
Can result in 2 manager benefits shareholders “don’t enjoy”
1. Increase in firm size
2. Firm portfolio diversification which can reduce top executives’ employment risk (i.e., job loss, loss of compensation and loss of managerial reputation)
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

15. Separation of Ownership and Managerial Control (Cont’d)
Agency problems: Firm’s free cash flow
Resources remaining after the firm has invested in all projects that have positive net present values within its current businesses
Available cash flows
Managerial inclination to overdiversify can be acted upon
Shareholders may prefer distribution as dividends, so they can control how the cash is invested
Curve S depicts shareholders’ optimal level of diversification where Point A is preferred by shareholders and Point B by top executives

16. Manager and Shareholder Risk and Diversification

17. Separation of Ownership and Managerial Control (Cont’d)
Agency costs and governance mechanisms
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
Costs associated with agency relationships, and effective governance mechanisms should be employed to improve managerial decision making and strategic effectiveness
Sarbanes-Oxley Act

18. Ownership Concentration
Introduction: Key concepts
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

19. Ownership Concentration (Cont’d)
Introduction: Key concepts
Institutional Owners (Cont’d)
The growing influence of institutional owners
Provides 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

20. The Board of Directors (BOD)
Introduction
Group of shareholder-elected individuals (usually called ‘directors’) whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling the corporation’s top-level executives

21. The Board of Directors (BOD) (Cont’d)
As stewards of an organization's resources, an effective and well-structured board of directors can influence the performance of a firm
Oversee managers to ensure the company is operated in ways to maximize shareholder wealth
Direct the affairs of the organization
Punish and reward managers
Protect shareholders’ rights and interests
Protect owners from managerial opportunism
3 types: Insider, related outsider and outsider

22. The Board of Directors (BOD) (Cont’d)
Historically, BOD dominated by inside managers
Managers suspected of using their power to select and compensate directors
NYSE implemented an audit committee rule requiring outside directors to head audit committee (a response to SEC’s proposal requiring audit committees be made up of outside directors)
Sarbanes-Oxley Act passed leading to BOD changes
CG becoming more intense through BOD mechanism
BOD scandals led to trend of separating roles of CEO and Chairperson

23. The Board of Directors (BOD) (Cont’d)
Outside directors
Improve weak managerial monitoring and control that corresponds to inside directors
Tend to emphasize financial controls, to the detriment of risk-related decisions by managers, as they do not have access to daily operations and a high level of information about managers and strategy

24. The Board of Directors (BOD) (Cont’d)
Outside directors (Cont’d)
Large number of outsiders can create problems
Limited contact with the firm’s day-to-day operations and incomplete information about managers
results in ineffective assessments of managerial decisions and initiatives.
emphasizes financial, as opposed to strategic, controls to gather performance information to evaluate performance of managers & business units, which could reduce R&D investments, increase diversification, and pursue higher compensation to offset their employment risk

25. The Board of Directors (BOD) (Cont’d)
Enhancing BOD effectiveness (N=5 changes)
Increased diversity in board members’ backgrounds
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
Requires that directors own significant stakes in the company in order to keep focused on shareholder interests

26. Chapter 10: Corporate Governance (CG)
Overview: Eight content areas
Define CG and its monitor/control of managers’ decisions
Separation between ownership and management control
Agency relationship and managerial opportunism
Three internal governance mechanisms used to monitor/control management decisions
External corporate governance mechanisms:
management restraint
Executive compensation - types and effects
Use of external CG in international settings
How CG fosters ethical strategic decisions

27. Executive Compensation (EC)
Defined: 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
Thought to be excessive and out of line with performance
Alignment of pay and performance: complicated board responsibility
The effectiveness of pay plans as a governance mechanism is suspect

28. Executive Compensation (EC) (Contd’)
The effectiveness of executive compensation
Complicated, especially long-term incentive comp
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 in addition to top-level management decisions and behavior

29. Executive Compensation (EC) (Contd’)
The effectiveness of executive compensation (Cont’d)
Performance-based compensation used to motivate decisions that best serve shareholder interest are imperfect in their ability to monitor and control managers
Incentive-based compensation plans intended to increase firm value, in line with shareholder expectations, subject to managerial manipulation to maximize managerial interests
Many plans seemingly designed to maximize manager wealth rather than guarantee a high stock price that aligns the interests of managers and shareholders

30. Executive Compensation (EC) (Contd’)
The effectiveness of executive compensation (Cont’d)
Stock options are highly popular
Repricing: strike price value of options is commonly lowered from its original position
Backdating: options grant is commonly dated earlier than actually drawn up to ensure an attractive exercise price

31. Market for Corporate Control
Definition: external governance mechanism consisting of a set of potential owners seeking to acquire undervalued firms and earn above-average returns on their investments
Becomes active when a firm’s internal controls fail
Need (for external mechanisms) exists to
address weak internal corporate governance
correct suboptimal performance relative to competitors, and
discipline ineffective or opportunistic managers.
External mechanisms are less precise than internal governance mechanisms

32. Market for Corporate Control
Managerial defense tactics
Hostile takeovers are the major activity
Not always due to poor performance
Consequent to tactics are the defenses

33. Chapter 10: Corporate Governance (CG)
Overview: Eight content areas
Define CG and its monitor/control of managers’ decisions
Separation between ownership and management control
Agency relationship and managerial opportunism
Three internal governance mechanisms used to monitor/control management decisions
External corporate governance mechanisms:
management restraint
Executive compensation - types and effects
Use of external CG in international settings
How CG fosters ethical strategic decisions

34. International Corporate Governance
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

35. International Corporate Governance (Cont’d)
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

36. International Corporate Governance (Cont’d)
Global Corporate Governance
Relatively uniform governance structures are evolving
These structures are moving closer to the U.S. corporate governance model
Although implementation is slower, merging with U.S. practices is occurring even in transitional economies

37. Chapter 10: Corporate Governance (CG)
Overview: Eight content areas
Define CG and its monitor/control of managers’ decisions
Separation between ownership and management control
Agency relationship and managerial opportunism
Three internal governance mechanisms used to monitor/control management decisions
External corporate governance mechanisms:
management restraint
Executive compensation - types and effects
Use of external CG in international settings
How CG fosters ethical strategic decisions

38. Governance Mechanisms and Ethical Behavior
It is important to serve the interest of the firms’ multiple stakeholder groups
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

39. Governance Mechanisms and Ethical Behavior (Cont’d)
Product market stakeholders (customers, suppliers and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groups
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 – just remember Enron and Arthur Andersen!