Chapter 10: Corporate Governance (CG)
 Overview:
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Define corporate governance and describe its purpose
Separation between ownership and management control
Agency relationship and managerial opportunism
Three internal governance mechanisms used to
monitor/control management decisions
The external market for corporate control
Use of external corporate governance in international
settings
How corporate governance can foster ethical strategic
decisions
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The Strategic Management Process
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Introduction
 Corporate Governance (CG): The set of mechanisms used
to manage the relationship among stakeholders and to
determine and control the strategic direction and performance
of organizations
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Concerned with identifying ways to ensure that strategic decisions
are made effectively and facilitate the achievement of strategic
competitiveness
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Primary objective: align the interests of managers and shareholders
Recent corporate scandals (Enron, Tyco, Arthur Anderson) largely
a result of poor corporate governance
Involves oversight in areas where the interests of owners,
managers, and members of the board conflict
Top-level managers are expected to make decisions that maximize
company value and owner wealth
Effective governance can lead to a competitive advantage
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Separation of Ownership and
Managerial Control
 Historically, firms were managed by founder-
owners and their descendants
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Ownership and control resided in the same persons
Over time these firms faced two critical issues
 As they grew, they did not have access to all the
skills needed to manage the growing firm and
maximize its returns, so they needed outsiders to
improve management
 They also needed to seek outside capital (whereby
they give up some ownership control)
 Firm growth lead to the separation of ownership
and control in most large corporations
 This resulted in the Modern Public Corporation
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Separation of Ownership and
Managerial Control
 The Modern Public Corporation is based on the efficient
separation of ownership and managerial control
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This separation allows shareholders to purchase stock, giving
them an ownership stake and entitling them to income (residual
returns) after expenses
This right implies a ‘risk’ for shareholders that expenses may
exceed revenues
This risk is managed through a diversified investment portfolio
Shareholder value is thus reflected in the price of the firm’s stock
 Shareholders specialize in risk bearing while managers
specialize in decision making
 The separation and specialization of ownership and
managerial control should produce the highest returns for
the firm’s owners
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Separation of Ownership and
Managerial Control
 The separation between owners and managers also
creates an agency relationship
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Separation of Ownership and
Managerial Control
 Agency Relationship – exists when one or more persons
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(principals) hire another person or persons (agents) as
decision-making specialists to perform a service
Decision making responsibility is delegated to a second party
for compensation
Agents manage principals' operations and maximize their
returns
Can lead to agency problems because
 Shareholders lack direct control
 Principals and agents have different interests and goals
 Managerial opportunism: seeking self-interest with guile (i.e.,
cunning or deceit)
 Principals don’t know which agents will act opportunistically
Principals establish governance and control mechanisms to
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prevent agents from acting opportunistically
Separation of Ownership and
Managerial Control
 Agency problems: Product diversification
 Product diversification can result in 2 managerial
benefits that shareholders do not enjoy:
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Increases in firm size is positively related to executive
compensation (firm is more complex and harder to manage)
Firm portfolio diversification 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
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Top managers prefer product diversification more than
shareholders do
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Separation of Ownership and
Managerial Control
 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
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Managerial inclination to overdiversify can be acted upon
 Self-serving and opportunistic behavior
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Shareholders may prefer distribution as dividends so they can
control how the cash is invested
Figure 10.2
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Curve S depicts the optimal level of diversification where
Point A is preferred by shareholders and Point B by top
managers
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Manager and Shareholder Risk
and Diversification
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Separation of Ownership and
Managerial Control
 Agency costs and governance mechanisms
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Agency Costs: Sum of all costs (incentive costs, monitoring costs,
enforcement costs) and individual financial losses incurred by
principals because governance mechanisms cannot guarantee
total compliance by the agent
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There are costs associated with agency relationships – principals
incur costs to control their agents’ behaviors
Effective governance mechanisms should be employed to improve
managerial decision making and strategic effectiveness
Governance mechanisms: used to control managerial behavior –
to make sure they are acting in the best interest of shareholders
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Governance mechanisms are costly
Includes internal mechanisms (ownership concentration, board of
directors, and executive compensation) and external mechanisms
(market for corporate control)
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Governance Mechanisms:
Ownership Concentration
 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 at
least 5 percent of a corporation’s issued shares
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Diffuse ownership produces weak monitoring of managers’
decisions and makes it difficult for owners to effectively
coordinate their actions
Institutional Owners: Financial institutions such as
stock mutual funds and pension funds that control
large-block shareholder positions
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Own over 50% of the stock in large U.S. corporations
Have the size and incentive to discipline ineffective managers
and can influence firm’s choice of strategies and overall
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strategic direction
Governance Mechanisms:
The Board of Directors (BOD)
 Board of Directors: A 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 managers
 An effective and well-structured board of directors can influence
the performance of a firm
 Boards are responsible for overseeing managers to ensure the
company is operated in ways to maximize shareholder wealth
 Boards have the power to:
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Direct the affairs of the organization
Punish and reward managers
Protect shareholders’ rights and interests
Protect owners from managerial opportunism
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Governance Mechanisms:
The Board of Directors (BOD)
 3 Groups of Directors/Board Members:
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Insider
 Active top-level managers in the corporation
 Elected to the board because they are a source of
information about the firm’s day-to-day operations
Related Outsider
 Directors who have some relationships with the firm
 Their independence is questionable
 Not involved with the corporation’s day-to-day activities
Outsider
 Directors that provide independent counsel to the firm
 May hold top-level managerial positions in other
companies
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Governance Mechanisms:
The Board of Directors (BOD)
 Historically, BOD dominated by inside managers
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Provided relatively weak monitoring and control of managerial
decisions
 Movement is towards greater use of independent outside
directors
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Becoming significant majority on boards
Chairing compensation, nomination, and audit committees
Improve weak managerial monitoring and control that corresponds
to inside directors
Large number of outsiders can create problems though
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Tend to emphasize financial (vs. strategic) controls
They do not have access to daily operations and a high level of
information about managers and strategy
 Can result in ineffective assessments of managerial decisions
and initiatives.
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Governance Mechanisms:
The Board of Directors (BOD)
 Enhancing BOD effectiveness (actual trends)
 Increased diversity in board members’ backgrounds
 Strengthening of internal management and accounting
control systems
 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
 Modification of the compensation of directors
 Require that outside directors own significant equity
stakes in the company in order to keep focused on
shareholder interests
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Governance Mechanisms:
Executive Compensation
 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
 Critical part of compensation packages in U.S. firms
 Alignment of pay and firm performance can help
company avoid agency problems by linking managerial
wealth with shareholder wealth
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Governance Mechanisms:
Executive Compensation (EC)
 The effectiveness of executive compensation
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Is complicated, especially long-term incentive compensation
 The quality of complex and nonroutine strategic decisions that toplevel managers make is difficult to evaluate
 Decisions affect financial outcomes over an extended period
 External factors can also affect a firm’s performance
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Performance-based compensation plans are imperfect in their
ability to monitor and control managers
Incentive-based compensation plans intended to increase firm
value in line with shareholder expectations can be 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
Stock options are highly popular but can also be manipulated
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Governance Mechanisms:
Market for Corporate Control
 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
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Need (for external mechanisms) exists to
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Becomes active when a firm’s internal controls fail
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
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Governance Mechanisms:
Market for Corporate Control
 Hostile takeovers are the major activity in the market for
corporate control
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Not always due to poor performance
 Managerial defense tactics
 Used to reduce the influence of this governance mechanism
 Hostile takeover defense strategies include
 Poison pill
 Corporate charter amendment
 Golden parachute
 Litigation
 Greenmail
 Standstill agreement
 Capital structure change
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International Corporate Governance
 Global Corporate Governance
 Governance systems differ across countries
 Important to understand these differences if you
are competing internationally
 Trend is toward relatively uniform governance
structures across countries
 These structures are moving closer to the U.S.
corporate governance model
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Governance Mechanisms and
Ethical Behavior
 It is important to serve the interests of all stakeholder
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groups
In the U.S., shareholders (capital market stakeholders) are
the most important stakeholder group served by the board
of directors
Governance mechanisms focus on control of managerial
decisions to protect shareholders’ interests
Product market stakeholders (customers, suppliers and
host communities) and organizational stakeholders
(managerial and non-managerial employees) are also
important stakeholder groups
Important to maintain ethical behavior through governance
mechanisms
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