Chapter 11
Corporate Governance
Robert E. Hoskisson
Michael A. Hitt
R. Duane Ireland
©2004 by South-Western/Thomson Learning
1
The Strategic Management Process
Strategic
Thinking
Chapter 1
Introduction to
Strategic Management
Chapter 2
Strategic Leadership
Strategic
Analysis
Chapter 3
The External
Environment
Chapter 4
The Internal
Organization
Strategic Intent
Strategic Mission
Chapter 5
Business-Level
Strategy
Chapter 6
Competitive Rivalry and
Competitive Dynamics
Chapter 7
Corporate-Level Strategy
Chapter 8
Acquisition and
Restructuring Strategies
Chapter 9
International Strategy
Chapter 10
Cooperative Strategy
Creating
Competitive
Advantage
Monitoring
And Creating
Entrepreneurial
Opportunities
Chapter 11
Corporate Governance
Chapter 12
Strategic Entrepreneurship
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Corporate Governance

Corporate governance
– represents the relationship among stakeholders
that is used to determine and control the
strategic direction and performance of
organizations
– is concerned with identifying ways to ensure
that strategic decisions are made effectively
– is a means to establish effective relationships
between the firm’s owners and its top-level
managers
3
Corporate Governance
Mechanisms
Internal Governance Mechanisms
Ownership concentration
– relative amounts of stock owned
by individual shareholders and
institutional investors
Board of Directors
– individuals responsible for
representing the firm’s owners by
monitoring top-level managers’
strategic decisions
4
Corporate Governance
Mechanisms
Internal Governance Mechanisms
Executive Compensation
– use of salary, bonuses, and longterm incentives to align managers’
interests with shareholders’
interests
5
Corporate Governance
Mechanisms
External Governance Mechanisms
Market for Corporate Control
– the purchase of a firm that is
underperforming relative to
industry rivals in order to improve
its strategic competitiveness
6
Separation of Ownership and
Managerial Control

Basis of the modern corporation
– shareholders purchase stock, becoming
residual claimants
– shareholders reduce risk by holding
diversified portfolios
– professional managers are contracted to
provide decision-making

Modern public corporation form leads to
efficient specialization of tasks
– risk bearing by shareholders
– strategy development and decision-making by
managers
7
Agency Relationship: Owners and
Managers
Shareholders
(Principals)
• Firm owners
8
Agency Relationship: Owners and
Managers
Shareholders
(Principals)
• Firm owners
• Decision makers
Managers
(Agents)
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Agency Relationship: Owners and
Managers
Shareholders
(Principals)
• Firm owners
• Decision makers
Managers
(Agents)
• Risk bearing specialist (principal)
pays compensation to
• A managerial decision-making
specialist (agent)
An Agency
Relationship
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Agency Theory Problem

The agency problem occurs when:
– the desires or goals of the principal and agent
conflict and it is difficult or expensive for the
principal to verify that the agent has behaved
inappropriately

Solution:
– principals engage in incentive-based
performance contracts
– monitoring mechanisms such as the board of
directors
– enforcement mechanisms such as the
managerial labor market to mitigate the agency
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problem
Risk
Manager and Shareholder Risk
and Diversification
Shareholder
(business)
S risk profile
Managerial
(employment)
risk profile M
A
Dominant
Related
Business Constrained
Related
Linked
Diversification
B
Unrelated
Businesses
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Agency Theory Conflicts


Principals may engage in monitoring behavior to
assess the activities and decisions of managers
However, dispersed shareholding makes it
difficult and inefficient to monitor management’s
behavior
Boards of Directors have a fiduciary duty to
shareholders to monitor management
However, Boards of Directors are often accused
of being lax in performing this function
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Governance Mechanisms
Ownership
Concentration
• Large shareholders (often
institutional owners) have a strong
incentive to monitor management
closely
• Their large stakes make it worth
their while to spend time, effort and
expense to monitor closely
• They may also obtain Board seats
which enhances their ability to
monitor effectively
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Governance Mechanisms
Ownership
Concentration
Board of
Directors
Insiders
• The firm’s CEO and other top-level
managers
Related Outsiders (Affiliated)
• Individuals not involved with dayto-day operations, but who have a
relationship with the company
Outsiders (Independent)
• Individuals who are independent of
the firm’s day-to-day operations
and other relationships
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Governance Mechanisms
Ownership
Concentration
Board of
Directors
Recommendations for more effective
Board Governance:
• Increase diversity of board
members’ backgrounds
• Strengthen internal management
and accounting control systems
• Establish formal processes for
evaluation of the board’s
performance
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Governance Mechanisms
Ownership
Concentration
Board of
Directors
Executive
Compensation
• Salary, bonuses, long term incentive
compensation
• Executive decisions are complex and
non-routine
• Many factors intervene making it
difficult to establish how managerial
decisions are directly responsible for
outcomes
17
Governance Mechanisms
Ownership
Concentration
Board of
Directors
Executive
Compensation
• Stock ownership (long-term
incentive compensation) makes
managers more susceptible to
market changes which are partially
beyond their control
• Incentive systems do not guarantee
that managers make the “right”
decisions, but do increase the
likelihood that managers will do the
things for which they are rewarded
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Governance Mechanisms
Ownership
Concentration
Board of
Directors
Executive
Compensation
Market for
Corporate Control
• Firms face the risk of takeover
when they are operated inefficiently
• Many firms begin to operate more
efficiently as a result of the “threat”
of takeover, even though the actual
incidence of hostile takeovers is
relatively small
• Acts as an important source of
discipline over managerial
incompetence and waste
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Managerial Defense Tactics

Designed to fend off a hostile takeover
attempt
 Increase the costs of making a hostile
acquisition
 Causes incumbent management to
become entrenched while reducing the
chances of introducing a new
management team
 Institutional investors oppose the use of
defense tactics
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International Corporate
Governance: Germany

Owner and manager are often the same in
private firms
 Public firms often have a dominant
shareholder, frequently a bank
 Less emphasis on shareholder value than
in U.S. firms, although this may be
changing
21
International Corporate
Governance: Germany

Medium to large firms have a two-tiered
board
– Aufsichtsrat (the supervisory board) monitors
and controls managerial decisions of the
Vorstand (the management board)
– Aufsichtsrat selects the Vorstand
– Employees, union members and shareholders
appoint members to the Aufsichtsrat
22
International Corporate
Governance: Japan
Obligation, “family” and consensus are
important factors
 Banks (especially “main bank”) are highly
influential with firm’s managers
 Keiretsus are strongly interrelated groups
of firms tied together by crossshareholdings

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International Corporate
Governance: Japan

Other characteristics:
– powerful government intervention
– close relationships between firms and
government sectors
– passive and stable shareholders who exert
little control
– virtual absence of external market for
corporate control
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Corporate Governance and
Ethical Behavior
It is important to serve the interests
of the firm’s multiple stakeholder
groups!
Capital Market
Stakeholders
• In the U.S., shareholders (in the capital
market stakeholder group) are viewed as
the most important stakeholder group
• which are served by the board of
directors
• Hence, the focus of governance
mechanisms is on the control of
managerial decisions to ensure that
shareholders’ interests will be served
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Corporate Governance and
Ethical Behavior
It is important to serve the interests
of the firm’s multiple stakeholder
groups!
Capital Market
Stakeholders
Product Market
Stakeholders
• Product market stakeholders (customers,
suppliers and host communities) and
organizational stakeholders (managerial
and non-managerial employees) are also
important stakeholder groups
Organizational
Stakeholders
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Corporate Governance and
Ethical Behavior
It is important to serve the interests
of the firm’s multiple stakeholder
groups!
Capital Market
Stakeholders
Product Market
Stakeholders
Organizational
Stakeholders
• 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
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