1. Corporate Governance and Business Ethics
Be sure to see experienced and newer versions of the Instructor’s Manual at 
Chapter 12
Corporate Governance and Business Ethics

3. Chapter Outline 12.1 The Shared Value Framework
12.2 Corporate Governance
Agency Theory
The Board of Directors
Other Governance Mechanisms
12.3 Strategy and Business Ethics
12.4 Implications for the Strategist

4. Strategy Smart Videos
Turning around Tyco: how corporate governance saved the day
INSEAD
10:05 Minutes
Topics: Corporate Governance; Sarbanes Oxley
Instructors:
Former Tyco CEO Dennis Kozlowski and ex-CFO Mark Swartz were found guilty of larceny.

5. Strategy Smart Videos Corporate Governance Comes of Age
INSEAD
7:15 Minutes
Topics: Corporate Governance; Executive Pay; Value Creation
Instructors:
INSEAD's Solvay Chaired Professor of Technological Innovation Ludo Van Der Heyden, discusses executive pay and value creation.

6. Strategy Smart Videos Milton Friedman – Greed
An excerpt from an interview with Phil Donahue in 1979
2:24 Minutes
Topics: Corporate Governance; Capitalism; CSR
Instructors:
Milton Friedman ( ) advocated minimizing the role of government in a free market as a means of creating political and social freedom- in his book "Capitalism and Freedom" (1962).

7. Strategy Smart Videos
Can Wal-Mart Be Sustainable? Ask Patagonia Founder Yvon Chouinard
2:02 Minutes
Topics: Philanthropy; CSR
Instructors:
An interesting video clip where the founder of Patagonia explains why Walmart is his biggest and unlikeliest ally.

8. Strategy Smart Videos
[one percent] of the story – 1% for the Planet film
Network of companies that give 1% of sales to environmental causes
15:04 Minutes
Topics: Sustainability; CSR
Instructors:
The 1% of Profits Program- These are some of the stories highlighting the great non-profit groups that 1% members choose to directly support.

9. Strategy Smart Videos Interview with Yvon Chouinard
11:40 Minutes
Topics: Sustainability; CSR
Instructors:
Founder & CEO of Patagonia – shares vision for his outdoor clothing company and business much more broadly. Patagonia uses profits to support the protection of our planet. 1% of annual sales goes to environmental activists. He works as consultant for companies like Walmart to show them that ecological responsibility doesn't contradict economical success. A philosophy of a simple life consuming only what's necessary and uses all resources to protect the environment.

10. Strategy Smart Videos
Michael Porter: Why business can be good at solving social problems
TED TALK
16:28 Minutes
Topics: Social Challenges; Role of Business
Instructors:
Michael Porter admits he is biased, as a business school professor, but he advocates permitting business to try to solve massive problems like climate change and access to water.
When business solves a problem, it makes a profit -- which lets that solution grow.

11. Strategy Smart Videos
Why Does Warren Buffett Give to Charity? Bill & Melinda Gates Philanthropic Gift (2006 Donation)
C-SPAN2 News conference Coverage
43:44 Minutes
Topics: Philanthropy; Sharing Wealth; Social Responsibility
Instructors:
In June 2006, Warren Buffet announced a plan to give away his fortune to charity, with 83% of it going to the Bill & Melinda Gates Foundation.
It is likely the students have not watched very many news conferences. This one is the announcement of Warren Buffett donating most of his wealth to the Gates Foundation. Mr. Buffett, Mr Gates and Mrs Gates answer a variety of questions from the press reporters in the room.

12. HP’s Boardroom Soap Opera Continues
ChapterCase 12
©ChinaFotoPress via Getty Images
HP’s Boardroom Soap Opera Continues
$120 billion in sales
“The HP Way” – an admired corporate culture (1938)
Mark Hurd became CEO in 2005.
Good financial results – lower costs & higher sales
18-month period, HP’s market value dropped 80%
$105 billion (April ‘10) to $23 billion (November ‘12)
Leo Apotheker became CEO in Fall 2010.
Meg Whitman became CEO in Fall 2011.
Instructors:
This opening case is designed to illustrate the performance implications of ethical lapses and corporate governance missteps by the board of directors and senior executives.

13. HP’s Boardroom Soap Opera Continues
ChapterCase 12
HP’s Boardroom Soap Opera Continues
2006 First Stage – HP-initiated unethical surveillance to uncover a suspected leak.
2010 (summer) Second Stage – Jodie Fisher, a former adult-movie actress, filed a lawsuit against CEO Mark Hurd.
2010 (fall) Third Stage – (new) CEO Leo Apotheker overpaid for British software company Autonomy ($11B).
HP took nearly $9 billion write-down for this within a year!
Instructors:
Possible class discussion topic (from the IM)
The CEO of HP, Mark Hurd, resigned due to his involvement in a sex scandal with an adult movie actress, which severely
damaged the company’s image. The market value dropped roughly $10 billion, largely due to Mr. Hurd’s forced resignation.
The instructor may ask the students why a company leader’s private life is relevant to the company. The primary issue here is that Mr. Hurd used HP’s resources to pay his mistress, and this is unethical, even though Hurd is a strong leader and turned HP’s performance around. Next, ask students whether the severance package was necessary or not. Is it ethical to pay such a large severance? Also, discuss whether the decision by the board of directors to force Mr. Hurd to resign was right or wrong.

14. Exhibit The HP Way

15. Exhibit 12.2 HP Stock Performance Under CEOs Hurd, Apotheker, and Whitman

16. 12.1 The Shared Value Framework
Guidance to managers on competitive advantage
Economic imperative
Corporate social responsibility (introduced in Ch. 1)
Creates a larger pie
Benefits shareholders and other stakeholders
INSTRUCTOR: An interactive video exercise is available on this portion of the text online through McGraw-Hill’s Connect, which is available with this textbook. It covers Learning Objective 12.1.

17. Public Stock Companies and Shareholder Capitalism
Public stock companies are vital in free market economies.
Four attractive characteristics of public firms:
Limited liability for investors
Transferability of investor interest
Legal personality
Separation of ownership and control
Instructors:
You can discuss the importance of public companies and their influence on our daily life. Students need to understand the interdependent relationships between these organizations and the average citizen. For publicly held firms, in particular, it is important for management to keep in mind that it is acting as stewards for other people’s money and has public responsibilities as outlined in Exhibit 12.3.
Discuss the importance of the public companies’ stakeholders and why companies need to take good care of them. The answer is, “It is an interdependent relationship.” Only by taking care of the stakeholders can they create a win–win, with mutually beneficial results to both companies and to society.

18. Exhibit 12.3 The Public Stock Company Hierarchy of Authority

19. MILTON FRIEDMAN VS. MICHAEL PORTER
Traditional View: (Friedman)
Shareholder capitalism: shareholders – the providers of the necessary risk capital and the legal owners of public companies – have the most legitimate claim on profits.
Shared Value View: (Porter)
Corporate social responsibility (CSR): obligations extend beyond the economic responsibility and include legal, ethical, and philanthropic societal expectations
INSTRUCTOR: An Interactive video activity is available online through McGraw-Hill Connect on this section of the text. The video is a talk on Africa’s business future. It covers learning objective 12.3.
Small Group exercise 1 ties in here and may be a good option for some deeper thinking around these important topics.
Discuss in your group the contrasting perspectives of “shareholder versus stakeholder” governance. What benefits and drawbacks can you find in each view?
Students need to understand the difference between shareholders and stakeholders. Shareholders focus on self-interest and profitability, while stakeholders emphasize responsibilities and all the parties involved. They must also realize that national and cultural differences play a role when designing the governance structure.
Next, go online to find two sets of examples: (a) firms in the U.S. or Britain saving jobs by offering reduced hours to workers rather than having layoffs, and (b) large firms in Germany or Japan laying off employees or closing plants. What do the results of your search say about the impact of governance structure on corporate decisions?
German firms are more debt-financed than equity. Thus, large national banks are a major stakeholder and encourage
maintaining a high level of employment. The closure of a plant in Germany is seen as the very last resort, whereas in the UK or U.S., layoffs and plant closures are more common.

20. Exhibit 12.4 Global Survey of Attitudes toward Business Responsibility
Instructors:
If you have international students in your classroom, you could set up a debate on the role of firms in society by setting
students from countries on the right side of Exhibit 12.4 in opposition to students from countries on the left side of this Exhibit

21. Shared Value Framework
Reestablish the relationship between superior firm performance and societal progress
Enable firms to gain and sustain a competitive advantage
Reshape capitalism and its relationship to society
Externalities
Pollution, wasted energy, and costly accidents increase
Internal costs in lost reputation if not directly on the bottom line
Porter suggests that the two can be reconciled to create a larger pie.
Example: GE ecoimagination initiative
Generated $25B in sales in 2012
Instructors:
Discussion question 3 from the EOC is relevant here:
The shared value creation framework provides help in making connections between economic needs and social needs in a way that transforms into a business opportunity. Taking the role of consultant to Nike Inc., discuss how Nike might move beyond selling high-quality footwear and apparel and utilize its expertise to serve a social need. Give Nike some advice on actions the company could take in different geographic markets that would connect economic and social needs.
Students should start by reviewing Nike’s current social responsibility efforts. The linked site describes Nike efforts to reduce impacts on society and the environment through product design, supply chain management, and community efforts to expand access to sports. Students are likely to come up with a number of ideas of how Nike can have greater positive impact, perhaps including giving away free shoes. Challenge the students to think creatively about ways that Nike can benefit society while also benefiting firm profitability.

22. CONNECTING ECONOMIC AND SOCIETAL NEEDS
Michael Porter: Managers focus on three things here.
Expand the customer base to bring in nonconsumers .
Including those at the bottom of the pyramid
Expand traditional internal firm value chains to include more nontraditional partners.
For example, nongovernmental organizations (NGOs)
Focus on creating new regional clusters.
Chilecon Valley and Bangalore
Instructors:
Show the TED talk by Michael E. Porter “Why Business Can Be Good at Solving Social Problems” (or assign students to
watch it before class). Then, discuss these questions: In what ways can business leaders’ experience with business models and profit management add value to governments and non-profit organizations in solving social problems? How can spending corporate money for philanthropic purposes benefit shareholders?
Link to video is HERE: ing_social_problems.html
Another option from the IM is “Doing Well by Doing Good: A Leader’s Guide” (McKinsey Insights September 2013) describes an alliance of businesses, non-profit organizations, and civic leadership, known as the Itasca project, that is focused on improving the economic and social health of the Minneapolis-St. Paul region.
Link to article (which has an embedded video also) is HERE: _leaders_guide

23. 12.2 Corporate Governance AGENCY THEORY BOARD OF DIRECTORS
A theory that views the firm as a nexus of legal contracts
BOARD OF DIRECTORS
The centerpiece of corporate governance, composed of inside and outside directors who are elected by the shareholders
OTHER GOVERANCE MECHANISMS
Executive compensation
The market for corporate control
Financial statement auditors, government regulators, and industry analysis
INSTRUCTOR: An interactive exercise is available on this portion of the text online through McGraw-Hill’s Connect, which is available with this textbook. It covers Learning Objective 12.4.

24. Corporate Governance (cont’d)
Mechanisms to direct and control a firm
Ensure the pursuit of strategic goal
Address the principal−agent problem (introduced in Ch. 8)
When corporate governance fails
Accounting scandal
Global financial crisis
Information asymmetry
Insider information: Galleon Group
On-the-job consumption: Tyco & Merrill Lynch
INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. The exercise covers corporate governance and learning objective 12.4.
Insider trading is an example of information asymmetry. In October 2011, Mr. Raj Rajaratnam, a co-founder of the Galleon Group was sentenced to 11 years in U.S. jail for insider trading. This is one of the longest terms ever for this offense. (See the video What the Galleon Verdict Means, The New York Times, 5/11/11)
Link HERE: means/?_php=true&_type=blogs&_r=1

25. Exhibit 12.5 Principal-Agent Problem

26. Corporate Governance (cont’d)
Agency Theory
Views a firm as a nexus of legal contracts
Relationships among shareholders, managers, and hierarchies.
Front-line employees have an advantage over management.
Firms need to design work tasks.
Adverse Selection
Misrepresentation of a job
Beyond his/her ability to do things
Moral Hazard
Difficulty to ascertain whether the agent gives his/her best
Instructors: (from the IM)
The primary focus of agency theory is the situation where one party (the principal) seeks some outcome but requires the
assistance of an agent to carry out the necessary activities (for example, the agent may be a supervisor-subordinate). It is
assumed that both parties are motivated by self-interest, and that these interests may diverge. This also indicates the
concerns of trust. Because of the lack of trust inside the structure, a control mechanism is needed to ensure the business
functions.
Further, agents usually know more about the tasks than the principals (information asymmetry). Principals seek
to gain information (by inspection or evaluation), and develop incentive systems to ensure agent actions in the principal’s
interests. In sum, agency theory states that we need organizations to help monitor and give incentives to agents doing
coordinated, cooperative work. Cooperative situations involving complex tasks give rise to hierarchical structures. When
ownership is concentrated in one principal, then contracts are needed to define obligations and incentives, especially those in the periphery of the organization. Agency theory, recognizing the costs of monitoring systems, stresses the need to design incentive systems that will induce all participants to contribute their fair share to the common enterprise.

27. The Board of Directors Centerpiece of corporate governance
ChapterCase − problems can drain shareholder value
Different shareholder goals
Institutional investors
Individual short-term investors
Inside directors
Generally part of the company’s senior management team
Outside directors
Not employees of the firm
Senior executives from other firms or full-time professionals
Instructors:
Small Group Exercise #2 at the end of the chapter brings out the topic of under represented women and minorities on most BODs. (Below are some thoughts on these questions from the IM. )
Discuss in your group to what extent it is a problem that women are proportionally underrepresented on corporate boards. Provide the rationale for your responses.
Students will have a variety of answers since this can be a controversial issue for some. Common reasons why
underrepresentation of women IS a problem include missing top-level inputs from half the market, and a greater tendency for groupthink without diverse leadership. The reasons it is NOT a problem tend to center on selection of the most qualified people possible, even if none of them are female (or black or Latino, and so on).
Why has representation by women on U.S. boards not increased over the past 10 years? What actions could be taken by companies to increase participation? What actions could be taken by women who seek to be directors?
Part of the problem is that women continue to be under-represented in the C- Suite executive offices. This is the talent pool that firms draw upon to fill board member positions. Another underlying problem is the under-representation of women, especially in the U.S., among employees with degrees in STEM (science, technology, engineering, math) fields (see “How to attract women to the sciences,” McKinsey Insights, September 2013). Students can learn more by visiting the Catalyst site. Catalyst is a non-profit organization focused on increasing opportunities for women in business. In an 8/21/13 posting, Catalyst also provides current information on formal solutions to the problem around the globe.
Article link HERE: diversity-boards-current-index-formal-approaches

28. FUNCTIONS OF THE BOARD OF DIRECTORS
Selecting, evaluating, and compensating the CEO
Overseeing CEO succession plan
Recently problematic at both HP & Apple
Providing guidance on executives & their compensation
Reviewing, monitoring, & approving strategic initiatives
Conducting a risk assessment and mitigation
Ensuring a firm’s audited financial statements
Ensuring a firm’s compliance with laws and regulations
Instructors: (good discussion subject from the IM)
When Facebook acquired Instagram, the CEO, Mark Zuckerberg, did not even inform the board about the deal until it was done (see “In Facebook deal, board was all but out of picture,” The Wall Street Journal, 4/18/12). Working on his own was undoubtedly faster than engaging the board and seeking their advice and approval, and speed may have made the difference in gaining the target. On the other hand, how well were the shareholders served in the absence of board oversight in the negotiations process? Ask students to debate the pros and cons of Mr. Zuckerberg’s actions.
Link to article HERE: ?mod=djem_jiewr_LD_domainid

29. GE’s Board of Directors
Strategy Highlight 12.1
GE’s Board of Directors
16/17 members are independent outside directors
Comprised of business, academia, & government
Duality – Jeffrey Immelt, the one inside director, is both the CEO and chairperson of the board, a declining practice due to the conflict of interest
GE’s board has 5 committees.
Boardroom diversity (28% for GE) in backgrounds and expertise is considered an asset: More diverse boards are less likely to fall victim to groupthink.
Instructors:
The board of directors of GE is diversified so it avoids groupthink. The board of directors meets regularly to monitor the firm’s performance. Board members use different committees to oversee the company’s operations.
Ask students to review the bios of the GE board members (
and identify one unique type of experience or qualification that each member brings as a knowledge resource to the board.

30. Other Governance Mechanisms
Executive Compensation
The Market for Corporate Control
Financial statement auditors, government regulators, and industry analysis

31. EXECUTIVE COMPENSATION
Salary, bonus, and stock options (long-term incentives)
CEO pay - two issues:
CEO pay compared to average employee pay
U.S. ratio 2012: 300 to 1, 1980: 40 to 1
Average CEO pay in Fortune 500 firm: $11 million
Firm performance and CEO pay
McKesson high salary but also high performance
Home Depot, HP….NOT
Instructors:
A brief video by Professor Dan Ariely discusses executive pay and his experiments on the most effective compensation
range for physical and mental labors. (Link is HERE:
Ethical/ Social question 2 asks the students to look into CEO pay issues.
What are the potentially negative effects of this increasing disparity in CEO pay? Do you believe that
current executive pay packages are justified? Why or why not?
The majority of compensation for CEOs comes from stock options, which allows the CEO to purchase shares in company
stock at a set price that can be significantly lower than market value. The ability to buy stock at a lower price and sell when stock prices are higher may motivate the CEO to find ways to exaggerate the value of company shares. This temptation can motivate CEOs to direct subordinates to report false profit statements and undertake unethical accounting methods, creating a false impression of corporate profitability.
When the CEO pay is 300 times the average worker pay, it presents an unfair situation to the entire society. It does NOT
seem justified, but it would take coordination across shareholders and boards to reverse the trend. CEO positions are subject to the same supply and demand conditions of major sports figures and actors, where it is viewed to be a position not many people can successfully perform. The salaries go up chasing the talent deemed to be ready for the post.

32. Other Governance Mechanisms (cont’d)
The market for corporate control
External governance mechanism
Hostile takeover
Corporate raiders and hedge funds
2013 − Dell’s LBO was a target of Carl Icahn.
Auditors, government regulators, and industry analysts
SEC- GAAP as reported publicly via EDGAR
The Wall Street Journal, Bloomberg BusinessWeek, Forbes…
GovernanceMetrics International (GMI Ratings)

33. 12.3 Strategy and Business Ethics
Agreed-upon explicit code of conduct in business
Legal conduct vs. Ethical conduct
Legal (min acceptable standard), but may not be ethical
Mortgage brokers selling “option ARMs”
Ethical, but may not be legal
Pharmaceutical firms discussing pricing to increase affordability
When facing ethical dilemma:
Do the actions fall into acceptable norms of professional behavior?
Does it feel comfortable explaining and defending the decision in public?
INSTRUCTOR: An interactive video exercise is available on this portion of the text online through McGraw-Hill’s Connect, which is available with this textbook. It covers Learning Objective 12.6.
Ethical/ Social Question 1 from the end of chapter:
Assume you work in the accounting department of a large software company. Toward the end of December, your
supervisor tells you to change the dates on several executive stock option grants from March 15 to July 30. Why
would she ask for this change? What should you do?
This seems like illegal and unethical tax evasive actions are being demanded by the supervisor. Unless there is some
legitimate error in the stock option dating, the employee has every right to refuse to make these changes because of the
liability issues. Further, if this request is condoned in the organization, it may be time to quit the job or contact the IRS to
report the issue.

34. Did Goldman Sachs and the “Fabulous Fab” Commit Securities Fraud?
Strategy Highlight 12.2
Did Goldman Sachs and the “Fabulous Fab” Commit Securities Fraud?
The SEC alleged that Goldman violated its fiduciary responsibility and defrauded its clients.
Collateralized Debt Obligation (CDO) such as Abacus
Roll-up of risky investments into a AAA-rated CDO
Rating agencies falsely viewed these as safe investments!
Goldman Sachs settled by paying a $550 million
Did not admit any wrongdoing
Mr. Tourre convicted of securities fraud in Aug. 2013
Instructors:
This is a clear example of a firm and individuals within a firm capitalizing on information asymmetry. It is clear that if they had disclosed accurately what they knew about the investment instrument, it would not have sold very well. One might also ask what responsibility the ratings organizations hold in such matters. Even if the firm was unclear whether or not their actions were illegal, they certainly should have known that the majority of society would probably view them as unethical.

35. ORGANIZATIONAL CONTEXT
Is unethical behavior just a few “bad apples”?
Research – some organizations have unethical climate
Ethical decision making depends on the organization
Enron−creating an inflated share price at any cost
Employees observed and followed the behavior set by leaders.
Ethical leadership is critical.
CEOs at large public firms face increasing scrutiny.
Mark Hurd fired at HP without proof of illegal behavior
Formal and informal cultures
Must be aligned with executive behavior

36. Exhibit The MBA Oath

37. 12.4 Implications for the Strategist
Effective corporate governance and business ethics
Critical to gaining and sustaining competitive advantage
Strategic leaders need to take actions with integrity.
IBM emphasizes its values across the globe.
Example of an employee falling ill at a training session
An expectation among IBMers−a “lived” value
Glaring ethical lapses in the last 10 years call for:
Ethical values and code of conduct
Professionalization of management
Instructors:
Harvard Business Review published “The Best Performing CEOs in the World” in January/February Ask students to
choose one leader from this list and investigate the firm’s activities in social responsibility and the strength of the firm’s
board of directors. Then, discuss in class whether the CEO’s strong performance results are related to help from a strong
board and/or corporate social responsibility. (Link is HERE:
Your students may not have access to copies of this article, but you could assign them each a name from the list.

38. ChapterCase 12 Consider This…
©ChinaFotoPress via Getty Images
Consider This…
HP featured in the bestseller Built to Last (1994)
Much has changed since Mr. Hewlett’s death in 2001.
HP board’s decisions destroyed $82 billion in shareholder value.
Exhibited groupthink in rallying around Mr. Apotheker as CEO
Full board never met him before hiring him.
Flawed due diligence process in the Autonomy acquisition
Lack of an open search to appoint Meg Whitman as CEO
Instructors:
Below are some thoughts from the IM on the questions at the end of Consider This….
Who is to blame for HP’s shareholder value destruction—the CEO, the board of directors, or both? What recourse, if any, do shareholders have?
Refer to Exhibit 12.2 to see a visual depiction of the value destruction.
It seems Mr. Hurd acted inappropriately and should be held accountable for his actions and behavior as HP CEO. The board needs to take ownership for the transition of CEOs, as Mr. Apotheker cannot be held accountable for the departure of Mr. Hurd, nor the decline in stock value before his arrival. That said, Mr. Apotheker is responsible for a weak strategic vision for the firm that was poorly communicated to shareholders and customers throughout his tenure. Moreover, he and the board share responsibility for the disastrous Autonomy acquisition. Meg Whitman asserts that the firm’s turnaround efforts are being slowed by long term under-investment in new product development. Both the board and past CEOs should be held accountable for that.
Shareholders can (and have) sued HP; however, the best course for HP is to get itself back on track and improve its performance in the marketplace. Shareholders can continue to “vote with their feet” and sell their positions or refuse to purchase HP shares going forward.
You are brought in as (a) a corporate governance consultant or (b) a business ethics consultant by HP’s CEO. What recommendations would you give the new CEO, Meg Whitman? How would you go about implementing them? Be
specific.
In the area of business ethics, the HP Way (see Exhibit 12.1) provides a good historical foundation for the firm’s values going forward, but the culture needs to be reformed to value compliance with the value system. Perhaps part of the
problem was the extensive acquisition efforts of the firm—Compaq, Tandy, Digital Equipment, and Autonomy, to name but a few. These serial major horizontal acquisitions and the accompanying process of continuous layoffs and
reorganizations may have sapped the coherence of the culture. It could be reinvigorated with new artifacts and stronger norms through a socialization process.
You might want to bring the class discussion back to topics covered in Chapter 2. Ms. Whitman entered a company in crisis with demoralized employees and a seeming loss of strategic focus. She should prioritize the internally oriented roles
of strategic leadership, such as leader, monitor, disseminator, and resource allocator. Using these roles to gather the pertinent background from key employees, she can use Level-4 and Level-5 leadership, focusing on key strategies and driving their implementation forward.

39. Describe the framework and its relationship to competitive advantage.
Take-Away Concepts
Value Creation
By focusing on financial performance, many companies have defined value creation too narrowly.
Shared Value
Companies should instead focus on creating shared value, a concept that includes value creation for both shareholders and society.
Competitive Advantage
The shared value creation framework seeks to identify connections between economic and social needs, and then leverage them into competitive advantage.
LO 12-1
Describe the framework and its relationship to competitive advantage.

40. Explain the role of corporate governance.
Take-Away Concepts
Corporate Governance
Corporate governance involves mechanisms used to direct and control an enterprise in order to ensure that it pursues its strategic goals successfully and legally.
Principal Agent Problems
Corporate governance attempts to address the principal–agent problem, which describes any situation in which an agent performs activities on behalf of a principal.
LO 12-2
Explain the role of corporate governance.

41. Take-Away Concepts LO 12-3
Apply agency theory to explain why and how companies use governance mechanisms to align interests of principals and agents.
Agency theory views the firm as a nexus of legal contracts.
The principal–agent problem concerns the relationship between owners (shareholders) and managers and also cascades down the organizational hierarchy.
The risk of opportunism on behalf of agents is exacerbated by information asymmetry: Agents are generally better informed than the principals.
Governance mechanisms are used to align incentives between principals and agents.
Governance mechanisms need to be designed in such a fashion as to overcome two specific agency problems: adverse selection and moral hazard.

42. Take-Away Concepts LO 12-4
The shareholders are the legal owners of a publicly traded company and appoint a board of directors to represent their interests.
The day-to-day business operations of a publicly traded stock company are conducted by its managers and employees, under the direction of the chief executive officer (CEO) and the oversight of the board of directors. The board of directors is composed of inside and outside directors, who are elected by the shareholders.
Inside directors are generally part of the company’s senior management team, such as the chief financial officer (CFO) and the chief operating officer (COO).
Outside directors are not employees of the firm. They frequently are senior executives from other firms or full-time professionals who are appointed to a board and who serve on several boards simultaneously.
LO 12-4
Evaluate the board of directors as the central governance mechanism for public stock companies.

43. Evaluate other governance mechanisms.
Take-Away Concepts
Other important corporate mechanisms are executive compensation, the market for corporate control, and financial statement auditors, government regulators, and industry analysts.
Executive compensation has attracted significant attention in recent years. Two issues are at the forefront: (1) the absolute size of the CEO pay package compared with the pay of the average employee and (2) the relationship between firm performance and CEO pay.
The board of directors and executive compensation are internal corporate-governance mechanisms. The market for corporate control is an important external corporate-governance mechanism. It consists of activist investors who seek to gain control of an underperforming corporation by buying shares of its stock in the open market.
All public companies listed on the U.S. stock exchanges must file a number of financial statements with the Securities and Exchange Commission (SEC), a federal regulatory agency whose task it is to oversee stock trading and enforce federal securities laws. Auditors and industry analysts study these public financial statements carefully for clues of a firm’s future valuations, financial irregularities, and strategy.
LO 12-5
Evaluate other governance mechanisms.

44. Explain the relationship between strategy and business ethics.
Take-Away Concepts
LO 12-6
Explain the relationship between strategy and business ethics.
The ethical pursuit of competitive advantage lays the foundation for long-term superior performance.
Law and ethics are not synonymous; obeying the law is the minimum that society expects of a corporation and its managers.
A manager’s actions can be completely legal, but ethically questionable.
Some argue that management needs an accepted code of conduct that holds members to a high professional standard and imposes consequences for misconduct.