PART IV
MONITORING AND CREATING
ENTREPRENEURIAL OPPORTUNITIES
Chapter 11
Corporate Governance
1
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Key Terms
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Corporate governance
Set of mechanisms used to manage the
relationships among stakeholders and to
determine and control the strategic direction
and performance of organizations
Ownership
Management
Founder-Owners
Family-Owned Firms
Modern Public Corporations
Shareholders
Professional Managers
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Key Terms
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Agency relationship
Relationship which exists when one or more
people (principals) hire another person or
people (agents) as decision-making specialists
to perform a service
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Managerial opportunism
Seeking self-interest with guile (i.e., cunning
or deceit)
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 whether the agent
has behaved inappropriately.
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Principal and the agent having different
interests and goals
Shareholders lacking direct control in
large publicly traded corporations
Agent making decisions which result in
actions that conflict with interests of the
principal
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Interests of Top Executives
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Increased compensation

Reduced employment risk
Interests of Shareholders
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Increased value of firm
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Reduced risk of firm failure
Free cash flows are resources remaining
after the firm has invested in all projects
that have positive net present values
within its current businesses.
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The managerial inclination to overdiversify
can be acted upon when free cash flows are
available.
Shareholders may prefer that free cash flows
be distributed to them as dividends, so they
can control how the cash is invested.
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Key Terms

Agency costs
The 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
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2002 Sarbanes-Oxley (SOX) Act
2010 Dodd-Frank Wall Street
Reform and Consumer
Protection Act (Dodd-Frank)
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Creates a Financial Stability Oversight Council
headed by the Treasury Secretary
Establishes a new system for liquidation of certain
financial companies
Provides for a new framework to regulate
derivatives
Establishes new corporate governance
requirements
Regulates credit rating agencies and securitizations
Establishes a new consumer protection bureau,
providing for extensive consumer protection in
financial services
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Key Terms
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Ownership concentration
Governance mechanism defined by both the
number of large-block shareholders and the total
percentage of shares they own
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Large block shareholders
Shareholders owning a concentration of at least 5
percent of a corporation’s issued shares
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Diffuse ownership produces weak monitoring
of managers’ decisions.
Ownership concentration is associated with
lower levels of firm product diversification.
High degrees of ownership concentration
improve the probability that managers’
strategic decisions will increase shareholder
value.
In general, ownership concentration’s influence
on strategies and firm performance is positive.
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Key Terms
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Institutional owners
Financial institutions such as stock mutual
funds and pension funds that control largeblock shareholder positions
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Becoming more active in efforts to influence
the corporation’s strategic decisions
Initially focused on CEO performance and
accountability
Now targeting ineffective boards of directors
and executive compensation policies
Growing efforts to expand shareholders’
decision rights
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Key Terms
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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
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Direct the affairs of the organization
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Punish and reward managers
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Protect shareholders’ rights and
interests
Protect owners from managerial
opportunism
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Enhance managerial monitoring
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Contribute to strategic direction
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Provide valuable links to external
stakeholders
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Promoted by regulatory agencies
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Do not guarantee high performance
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Limited access to daily operations and
critical information
May lack insights required to fully and
perhaps effectively evaluate manager
decisions and initiatives
Tendency to emphasize financial controls
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Shifts risk to top-level managers
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Can increase detrimental managerial actions
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Background diversity
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Formal processes to evaluate board performance
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“Lead director” role with strong agenda-setting
and oversight powers
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Changes in compensation packages
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Ownership stake requirements
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Demand for greater accountability and
improved performance
Social networks with external stakeholders
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Become engaged in the firm, without
trying to micromanage it
Challenge the reasoning behind
decisions, but be supportive of
decisions that are made
Provide an independent perspective
on important decisions
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Key Terms
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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 restricted stock awards
and stock options
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High visibility and controversy
surrounding CEO pay
Downward pressure from
shareholders and activists
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Relationship to performance
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Long-term incentive plans
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Effective governance mechanism
for firms implementing
international strategies
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Pay levels vary by regions of the world.
Owners of multinational corporations may be
best served with less uniformity across the
firm’s foreign subsidiaries.
Multiple compensation plans increase the need
for monitoring and other related agency costs.
Complexity and potential dissatisfaction
increase as corporations acquire firms in other
countries.
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Address potential agency problems
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Viewed positively by the stock market
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Reduce pressure for changes in the
board
Reduce pressure for outside directors
Assumed to effectively link executive
pay with firm performance
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It is difficult to evaluate complex and
nonroutine strategic decisions made by toplevel managers.
It is difficult to assess the long-term strategic
effect of current decisions which affect
financial performance outcomes over an
extended period.
Multiple external factors affect a firm’s
performance other than top-level managerial
decisions and behavior.
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Performance-based (incentive)
compensation plans are imperfect in their
ability to monitor and control managers.
Conflicting short-term and long-term
objectives have a complex effect on
managerial decisions and behaviors.
Excessive compensations correlate with
weak corporate governance.
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Manager wealth v. high stock prices
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Earnings manipulations
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Risk taking
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Repricing
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Backdating
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Key Terms
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Market for corporate control
An external governance mechanism which is
composed of individuals and firms that buy
ownership positions in or take over potentially
undervalued corporations so they can form new
divisions in established diversified companies
or merge two previously separate firms
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Addresses weak internal corporate
governance
Corrects suboptimal performance
relative to competitors
Disciplines ineffective or
opportunistic managers
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May not be entirely efficient
Lacks the precision of internal
governance mechanisms
Can be an effective constraint on
questionable manager motives
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Similarities among governance structures in
industrialized nations are increasing.
Firms using an international strategy must
understand the dissimilarities in order to
operate effectively in different international
markets.
Traditional governance structures in foreign
nations, like Germany and Japan, are being
affected by global competition.
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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.
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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.
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Relatively uniform governance structures
are evolving in developed countries.
These structures are moving closer to the
U.S. model of corporate governance.
Although implementation is slower, this
merging with U.S. practices is occurring
even in transitional economies.
Capital Market
Stakeholders
• In the U.S., shareholders (in the
capital market stakeholder group) are
viewed as the most important
stakeholder group 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.
It is important to serve the
interests of the firm’s multiple
stakeholder groups.
Product Market
Stakeholders
Organizational
Stakeholders
• Product market stakeholders
(customers, suppliers, and host
communities) and organizational
stakeholders (managerial and nonmanagerial employees) are also
important stakeholder groups.
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 examples of
recent corporate scandals.
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Design CEO pay structure with long-term focus
Actively set boundaries for ethical behavior
Actively define organization’s values
Clearly communicate expectations to all
stakeholders
Foster an ethical culture of accountability
Promote CEOs as positive role models
Monitor ethical behavior of top executives
Do not stifle manager flexibility and
entrepreneurship
45
Do managers have an ethical responsibility
to push aside their own values with regard
to how certain stakeholders are treated (i.e.,
special interest groups) in order to
maximize shareholder returns?
What are the ethical implications
associated with owners assuming that
managers will act in their own self-interest?
What ethical issues surround executive
compensation? How can we determine
whether top executives are paid too much?
Is it ethical for firms involved in the
market for corporate control to target
companies performing at levels
exceeding the industry average?
Why or why not?
What ethical issues, if any, do top
executives face when asking their firm to
provide them with a golden parachute?
How can governance mechanisms be
designed to ensure against managerial
opportunism, ineffectiveness, and
unethical behaviors?