Strategic Management:
Concepts and Cases
Part III: Strategic Actions: Strategy Implementation
Chapter 10: Corporate Governance
1
The Strategic Management Process
2
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
3
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: 18-24 mo.)
 Result: CEOs looking at short-term vs. long-term
4
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)
5
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
6
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
7
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
8
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
9
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)
10
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
11
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
12
An Agency Relationship
13
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
14
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
15
Manager and Shareholder Risk
and Diversification
16
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
17
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
18
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
19
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
20
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
21
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
22
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
23
The Board of Directors (BOD)
 Outside directors

(Cont’d)
(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
24
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
25
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
26
Executive Compensation (EC)
 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
27
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
28
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

29
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
30
Market for Corporate Control
 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
31
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
32
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
33
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
34
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
35
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
36
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
37
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
38
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!
39