Chapter 11—Corporate Governance
Chapter 11—Corporate Governance
CHAPTER SUMMARY
This chapter describes the relationship between owners and managers, which provides
the foundation on which the corporation is built. The majority of this chapter is used to explain
various mechanisms owners use to govern managers and to ensure that they comply with their
responsibility to maximize shareholder value.
Three internal governance mechanisms used by modern corporations are examined, along
with the market for corporate control (an external mechanism).
The chapter’s focus then shifts to the issue of international corporate governance, briefly
describing governance approaches used in German and Japanese firms, where traditional
governance structures are being affected by global competition.
Closing the analysis of corporate governance is a consideration of the need for these
control mechanisms to encourage and support ethical behavior in organizations.
CHAPTER OUTLINE
Separation of Ownership and Managerial Control
Agency Relationships
Product Diversification as an Example of an Agency Problem
Agency Costs and Governance Mechanisms
Ownership Concentration
Institutional Owners
Shareholder Activism
Board of Directors
Board Independence
Board Effectiveness
Executive Compensation
A Complicated Governance Mechanism
The Effectiveness of Executive Compensation
Market for Corporate Control
Managerial Defense Tactics
International Corporate Governance
Corporate Governance in Germany
Corporate Governance in Japan
Global Corporate Governance
Governance Mechanisms, Stakeholder Management, and Ethical Behavior
Summary
KNOWLEDGE OBJECTIVES
1. Define corporate governance and explain why it is used to monitor and control
managers’ strategic decisions.
2. Explain how ownership came to be separated from managerial control in the modern
corporation.
3. Define an agency relationship and managerial opportunism and describe their
strategic implications.
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Chapter 11—Corporate Governance
4. Explain how three internal governance mechanisms—ownership concentration, the
board of directors, and executive compensation—are used to monitor and control
managerial decisions.
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 and Japan.
8. Describe how corporate governance fosters ethical strategic decisions and the
importance of such behaviors on the part of top-level executives.
LECTURE NOTES
See slides 1-3.
Key Terms
ƒ 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).
See Table 11.1:
Corporate
Governance
Mechanisms (slide
4).
1.
Name the internal and external mechanisms used in a wellfunctioning corporate governance and control system.
a. Internal
i. Ownership concentration
ii. Board of directors
iii. Executive compensation
b. External
i. Market for corporate control
Separation of Ownership and Managerial Control - This section describes the basis for
modern organizations, that emerged as firms began to outgrow their founders and allowed
organizations to develop beyond the limitations of their founder-owners.
See slide 5.
2.
What are the critical issues for family-controlled firms as they
grow?
a. Owner-managers may not have access to all of the skills
needed to effectively manage the growing firm and
maximize its returns for the family. Thus, they may
need outsiders to help improve management of the firm.
b. Owner-managers may need to seek outside capital and
thus give up some of the ownership control.
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Agency Relationships - This section discusses unique agency relationships between firms’
owners and top-level managers as they relate to the implementation of firm strategies. Because
the separation of ownership and control can result in divergent interests between the two parties,
the potential for managerial opportunism is also examined.
See slide 6.
Key Terms
ƒ Agency Relationship - relationships between business owners
(principals) and decision-making specialists (agents) hired to
manage the principals’ operations and maximize their returns on
investments.
ƒ Managerial Opportunism - seeking self-interest with guile (i.e.,
cunning or deceit).
See Figure 11.1: An
Agency Relationship
(slide 7).
3.
See slide 8.
See Additional Notes
Below.
4.
What are some examples of agency relationships?
a. Shareholder-Executive
b. Consultant-Client
c. Insured-Insurer
d. Manager-Employee
What types of problems can surface when ownership and
control are separated?
a. Principal and the agent having different interests and
goals.
b. Shareholders lacking direct control of large publiclytraded corporations.
c. Agent making decisions that result in the pursuit of
goals that conflict with those of the principals.
Additional Discussion Notes for Agency Relationships - These notes
include additional materials that cover diversification and innovation
without agency problems.
Owners and Managers
How to increase product diversification and how to intensify effort to
innovate without increased agency problems?
Firms undertake a variety of actions to reduce risk through
diversification, including entering diverse lines of business, joining
alliances, taking on temporary partners, and outsourcing risky projects,
including R&D. The challenge, as explained in the book, is that
shareholders do not directly benefit from risk-reducing diversification
strategies when they can replicate this diversification on their own.
Diversification, therefore, is often seen as managers’ opportunistic
pursuit of their own self-interests at the expense of the shareholders who
can, if they so desire, diversify their individual portfolios simply by
buying shares in other companies.
While this view reflects the influence of agency theory, recently such
views have been challenged by stewardship theory (Donaldson, 1990a;
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Donaldson & Davis, 1991), a framework presuming that managers are
actually seeking to maximize organizational performance. For instance,
one reason for diversifying would be to enhance company profit and
growth prospects by reducing dependence on static or declining products,
markets, and even industries. In the parlance of the I/O model discussed in
Chapter 1, such a motive might lead companies to increase diversification
into technologies or industries where profit rates are increasing most and
to those where the competitive dynamism is relatively more stable.
Managers might also opt to diversify for earnings stability and economies
of scale. In short, diversification strategies might represent opportunism,
but they might also reflect management rational and genuine response to
financial adversity and/or the need for improved financial performance for
their company.
Product Diversification as an Example of an Agency Problem - This section discusses and
illustrates the different levels of preference for diversification that exist between owners and
managers and the potential for conflict that results.
See slide 9.
Key Terms
ƒ Free Cash Flows - resources remaining after the firm has
invested in all projects that have positive net present values
within its current businesses.
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See slides 10-11.
5.
See slide 12.
6.
See Figure 11.2:
Manager and
Shareholder Risk and
Diversification (slide
13).
7.
Why might top executives prefer more product diversification
than shareholders?
a. Increased product diversification provides an
opportunity for top executives to increase their
compensation.
i. Diversification usually increases the size of a
firm, and size is positively related to executive
compensation.
ii. Diversification increases the complexity of
managing a firm and its network of businesses
and may therefore require more pay because of
this complexity.
b. Product diversification and the resulting diversification
of the firm’s portfolio of businesses can reduce top
executives’ employment risk.
i. Managerial employment risk includes the risk
of managers losing their jobs, compensation, or
reputations.
ii. These risks are reduced with increased
diversification because a firm and its upperlevel managers are less vulnerable to the
reduction in demand associated with a single or
limited number of product lines or businesses.
How do managerial decisions to use free cash flows
demonstrate a conflict in diversification interest?
a. The managerial inclination to overdiversify can be acted
upon when free cash flows are available.
b. Shareholders may prefer that free cash flows be
distributed to them as dividends, so they can control
how the cash is invested.
Figure 11.2 illustrates the different optimal levels of
diversification held by shareholders and managers. What
factors affect the preferences of each of these parties?
a. Owners seek the level of diversification that reduces
risk of failure while increasing value through
economies. Factors that affect their preference include:
i. Firm’s primary industry
ii. Intensity of rivalry among competitors in that
industry
iii. Top management team’s experience with
implementing diversification strategies
b. Upper-level executives seek the level of diversification
that maximizes the firm’s size and their compensation
(and minimizes employment risk) while maintaining a
performance level that discourages external acquisition
of corporate control.
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Agency Costs and Governance Mechanisms - This section introduces the costs associated with
agency relationships and the impact that effective governance mechanisms have on managerial
decision making and strategic effectiveness. The Sarbanes-Oxley Act (SOX) of 2002 is
presented, along with a discussion of the costs of compliance and the impact the act has begun to
have on strategic formulation and implementation.
See slide 14.
Key Terms
ƒ 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.
Refer to Table 11.1:
Corporate
Governance
Mechanisms (slide
4).
8.
Name the internal and external mechanisms used in a wellfunctioning corporate governance and control system.
a. Internal
i. Ownership concentration
ii. Board of directors
iii. Executive compensation
b. External
c. Market for corporate control
Ownership Concentration - This section defines the governance mechanism of ownership
concentration and describes the effect that diffused ownership has on shareholder ability to
monitor managers, effectively coordinate their efforts, and ensure maximum shareholder value.
See slide 15.
Key Terms
ƒ Ownership Concentration - governance mechanism defined by
both the number of large-block shareholders and the total
percentage of shares they own.
ƒ Large Block Shareholders - shareholders owning a
concentration of at least 5 percent of a corporation’s issued
shares.
ƒ Institutional Owners - financial institutions such as stock mutual
funds and pension funds that control large-block shareholder
positions.
See slide 16.
9.
What trends have improved ownership concentration and
shareholder effectiveness?
a. Increased equity ownership by institutional owners provides the size to influence strategy and an incentive
to discipline ineffective managers.
b. Increased shareholder activism supported by SEC
rulings in support of shareholder involvement and
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See slide 17.
See Additional Notes
Below.
10.
control of managerial decisions.
What types of actions to control manager behavior have active
shareholders begun to employ?
a. Threats or initiations of a proxy battle to unseat the
current board of directors.
b. Organization of press conferences.
c. Threats of a takeover bid.
d. Creation of shareholder “proposals” for the board of
directors to address at the next board meeting.
Additional Discussion Notes for Governance Mechanisms - These
notes include additional materials that cover the growing influence of
institutional owners.
The Growing Influence of Institutional Owners
The discussion on the relationship between corporate ownership and
performance was initiated as far back as the 1930s, but it remains an
issue today. Pioneering researchers in corporate governance show that
companies with separate ownership and control functions operate with
different managerial rules in investment decision-making from those in
which ownership and control are combined in a single decision-maker.
Different managerial rules are caused by the different basis on which the
stakeholders optimize the trade-off between their profit and utility
maximization and the distribution of decision-making and risk-bearing
functions. With diffused ownership and a lesser number of shares, an
individual shareholder’s control is diluted while a manager’s control
increases. This gives rise to conflict of interests resulting in less than
optimal value for the shareholders. Erosion of value also comes from
agency costs arising from ensuring that management acts in
shareholders’ interests. A manager may behave opportunistically by
choosing to exchange profits for personal benefits, such as “on-the-job”
consumption. Thus consuming away the economic goods today rather
than preserving them for the future.
It is assumed that large-block investors and institutional ownership
have both the size and the incentive to discipline ineffective managers
and thus to influence a firm’s strategic choice. The shift in governance
whereby ownership of many modern corporations is concentrated in the
hands of institutional investors might come with a high price tag vis-àvis strategic choice and long term planning. For example, institutional
investors are overly focused on current profitability, which at time might
conflict with future period earnings due to investments in risky R&D
projects, and exploration of new business models. Moreover, as
suggested in the book, even very strong institutional investors might not
avert financial disaster. For example, CalPERS, which provides
retirement and health coverage to over 1.3 million employees and is one
of the largest public employee pension funds in the United States, had
invested in Enron!
Interestingly, over the past decade the world’s leading private
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equity firms consistently have delivered internal rates of return twice as
large as the S&P 500’s. They’ve achieved this by adding value to the
underlying operations (Rogers, Holland, & Haas, 2002). For example,
private equity firms:
• Clearly define their investment thesis and its time frame to fruition
• Hire managers who act like owners
• Focus on a few measures of success that all employees understand
• Make capital work hard or otherwise re-deploy under-performing
assets quickly
• Make the center an active shareholder
Ask
Can institutional owners understand and act like managers of private
equity firms?
Board of Directors - This section introduces the Board of Directors governance mechanism and
describes some of the powers that boards possess.
See slide 18.
Key Terms
ƒ 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.
See slide 19.
11.
As stewards of an organization’s resources, how can an
effective and well-structure board of directors influence the
performance of a firm?
a. Direct the affairs of the organization
b. Punish and reward managers
c. Protect shareholders’ rights and interests
d. Protect owners from managerial opportunism
Board Independence - This section categorizes boards into three groups based on the
relationships of their members to the firms that they serve. The effectiveness of these groups is
also discussed.
See Table 11.2:
Classification of
Boards of Directors’
Members (slide 20).
12.
Describe the three types of Board of Directors.
a. Insiders - active top-level managers in the corporation
who are elected to the board because they are a source
of information about the firm’s day-to-day operations.
b. Related outsiders - board members who have some
relationship with the firm, contractual or otherwise, that
may create questions about their independence, but
these individuals are not involved with the corporation’s
day-to-day activities.
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Chapter 11—Corporate Governance
See slide 21.
See Additional Notes
Below.
13.
c. Outsiders - board members who provide independent
counsel to the firm and may hold top-level managerial
positions in other companies or may have been elected
to the board before the beginning of the current CEO’s
tenure.
What are some of the benefits and weaknesses of the trend to
elect a higher percentage of outside directors to boards?
a. Improves upon the weak managerial monitoring and
control that corresponds to inside directors.
b. Without access to daily operations and a high level of
information about managers and strategy, outside
directors tend to emphasize financial controls, to the
detriment of risk-related decisions by managers.
Additional Discussion Notes for Governance Mechanisms - These
notes include additional materials that cover the risks associated with
boards dominated by outside members.
Board of Directors
Much of the governance literature advocates boards dominated by
outsiders. What might be some of the risks associated with boards
dominated by outsiders?
As discussed in the book, a large number of outsiders can create
several problems. First, outsiders have limited contact with the firm’s
day-to-day operations and incomplete information about managers.
This, in turn, leads to ineffective assessments of managerial decisions
and initiatives. Second, in the absence of full information, outsiderdominated boards emphasize the use of financial, as opposed to
strategic, controls to gather performance information to evaluate
managers’ and business units’ performances. Strong reliance on
financial evaluations shifts risk to managers, who, in turn, may reduce
R&D investments, increase diversification, and pursue higher
compensation to offset their employment risk.
Recently, Phan and his colleagues (2002) explained the
relationships between corporate governance and innovation (R&D
expenditures, patents, and new products) in 86 publicly listed
pharmaceutical firms. Consistent with agency theory, they found that the
presence of large block private and institutional shareholders—
controlling for firm size and performance—positively influenced
innovation. They demonstrated that CEO duality was positively related
to R&D expenditures, and that boards with more insiders were
positively associated with the number of new products. In short, in the
highly turbulent pharmaceutical industry, where risky decisions have to
be made under substantial uncertainty, active ownership, unitary
command structures, and strategically involved boards provide superior
explanatory power for the governance-innovation link.
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Chapter 11—Corporate Governance
Board Effectiveness - This section discusses trends among boards that respond to demands for
greater accountability and improved performance. The board’s role in creating social networks to
link external stakeholders and the power of collaborative, diverse boards to effectively advise
managers are also discussed.
See slide 22.
See slide 23.
14.
15.
Describe the trends among boards to monitor managerial
behavior.
a. Increases in the diversity of the backgrounds of board
members (for example, a greater number of directors
from public service, academic, and scientific settings; a
greater percentage on boards of ethnic minorities and
women; and members from different countries on
boards of U.S. firms).
b. The establishment and consistent use of formal
processes to evaluate the board’s performance.
c. The creation of a “lead director” role that has strong
powers with regard to the setting of the board’s agenda
and oversight of the activities of nonmanagement board
members.
d. Modifications of the compensation of directors,
especially reducing or eliminating stock options as a
part of the package.
e. Requirements that directors own significant stakes in
the company in order to keep them focused on
shareholder interests.
What types of behavior should newly-appointed, non-executive
directors use to increase their effectiveness?
a. Become engaged in the firm, without trying to
micromanage it.
b. Challenge the reasoning behind decisions, but be
supportive of decisions that are made.
c. Provide an independent perspective on important
decisions.
Executive Compensation - This section presents a discussion of executive compensation,
emphasizing the complications and effectiveness of this governance mechanism. The challenge
of implementing executive compensations in firms with international strategies is covered.
See slide 24.
Key Terms
ƒ 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.
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Chapter 11—Corporate Governance
See slide 25.
16.
See slides 26-27.
17.
See slide 28.
18.
Why is the topic of executive compensation of interest and
controversial?
a. Executive compensation is thought to be excessive and
out of line with performance.
b. Alignment of pay and performance is a complicated
board responsibility.
c. The effectiveness of compensation plans as a
governance mechanism is suspect.
What are some of the complications of using executive
compensation to govern corporations?
a. The strategic decisions that top-level managers make
are typically complex and nonroutine, so it is difficult to
evaluate the quality of those decisions.
b. An executive’s decision often affects a firm’s financial
outcomes over an extended period, making it difficult to
assess the effect of current decisions on the
corporation’s performance.
c. A number of other factors affect a firm’s performance
besides top-level managerial decisions and behavior,
such as unpredictable economic, social, or legal changes
(see Chapter 3), making it difficult to discern the effects
of strategic decisions.
d. Although performance-based compensation may
provide incentives to top management teams to make
decisions that best serve shareholders’ interests, such
compensation plans alone are imperfect in their ability
to monitor and control managers.
e. 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.
What are some of the practices that make the effectiveness of
compensating with stock issues questionable?
a. 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.
b. Repricing - strike price value of options is lowered from
its original position—is common.
c. Backdating - options grant is dated earlier than it was
actually drawn up to ensure an attractive exercise
price—is common.
Market for Corporate Control - This section explains the need for external mechanisms to
address weak internal corporate governance, correct suboptimal performance relative to
competitors, and discipline ineffective or opportunistic managers. Although it is less precise than
internal governance mechanisms, this market has been active over the past few decades, and
current takeover practices demonstrate its role in promoting responsible managerial behavior.
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Chapter 11—Corporate Governance
See slides 29-30.
Key Terms
ƒ Market for Corporate Control - external governance mechanism
consisting of a set of potential owners, seeking to acquire
undervalued firms and earn above-average returns on their
investments, that becomes active when a firm’s internal controls
fail.
Managerial Defense Tactics - This section discusses the increased risk to managers posed by
external corporate governance mechanisms and the tactics used by managers to discourage
takeover activity. The controversial nature and inconclusive results of these tactics are also
mentioned.
See Table 11.3:
Example of a Hostile
Takeover Defense
Tactics (slide 31).
19.
Discuss some of the defense tactics used by managers (and their
effectiveness) to reduce the risk of external influence on their
firms.
a. Preventative
i. Poison pill (High)
ii. Corporate charter amendment (Very low)
iii. Golden parachute (Low)
b. Reactive
i. Litigation (Low)
ii. Greenmail (Medium)
iii. Standstill agreement (Low)
iv. Capital structure change (Medium)
International Corporate Governance - This section introduces the importance of studying the
similarities and differences among governance structures across nations to effectively implement
an international strategy, highlighting essential features found in Germany and Japan and global
implications.
See slide 32.
20.
See slide 33.
21.
Describe some of the corporate governance features seen in
Germany.
a. Concentration of ownership is strong.
b. Banks exercise significant power as a source of
financing for firms.
c. Two-tiered board structures, required for larger
employers, place responsibility for monitoring and
controlling managerial decisions and actions with
separate groups.
d. Power sharing includes representation from the
community as well as unions.
Describe some of the corporate governance features seen in
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Chapter 11—Corporate Governance
See slide 34.
22.
Japan.
a. Cultural concepts of obligation, family and consensus
affect attitudes toward governance.
b. Close relationships between stakeholders and a
company are manifested in cross-shareholding and can
negatively impact efficiencies.
c. Banks play an important role in financing and
monitoring large public firms.
d. Despite the counter-cultural nature of corporate
takeovers, changes in corporate governance have
introduced this practice.
What are some global corporate governance trends?
a. Relatively uniform governance structures are evolving.
b. These structures are moving closer to the U.S. model of
corporate governance.
c. Although implementation is slower, this merging with
U.S. practices is occurring even in transitional
economies.
Governance Mechanisms, Stakeholder Management, and Ethical Behavior - This closing
section is a reminder of the importance of market and organizational stakeholders (in addition to
investors). The likelihood of ethical actions in companies that design and use governance
mechanisms to address the interests of all stakeholders is emphasized. The deterrent nature of
board decisions and actions is also noted. (See slides 35-37 and Additional Notes Below.)
Additional Discussion Notes for Corporate Governance and Ethical
Behavior - These notes include additional materials that cover statistics
on the separation of chairperson and CEO.
Corporate Governance and Ethical Behavior
To improve corporate governance, watchdog groups advocate separating
the chairperson and the chief executive positions and creating corporate
boards that are dominated by outsiders. Here is where the S&P 500
currently stands in relation to this issue:
ƒ Fifteen instances where Chairperson is not CEO and is an
Independent Director, 16 instances where Chairperson is not
CEO and is an Outside Related Director, 65 instances where
Chairperson is Former CEO, three instances where Chairperson is
not CEO and is An Executive, six instances where Chairperson is
not CEO and is A Former Executive, 392 instances (78%) where
Chairperson is ALSO the CEO (CEO duality).
Source: The Corporate Library. 2003. Exclusive special report on CEO/Chairman splits in the S&P
500: How Many and How Independent? (http://www.thecorporatelibrary.
com/spotlight/boardsanddirectors/SplitChairs.html)
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Chapter 11—Corporate Governance
Ethical Questions - Recognizing the need for firms to effectively interact with stakeholders
during the strategic management process, all strategic management topics have an ethical
dimension. A list of ethical questions appears after the Summary section of each chapter in the
textbook. The topic of ethics is best covered throughout the course to emphasize its prevalence
and importance. We recommend posing at least one of these questions during your class time to
stimulate discussion of ethical issues relevant to the chapter material that you are covering (See
slides 38-43).
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