Michael A. Hitt R. Duane Ireland Robert E. Hoskisson Chapter 10 Corporate Governance Michael A. Hitt R. Duane Ireland Robert E. Hoskisson ©2003 Southwestern Publishing Company

Strategy Implementation The Strategic Management Process Chapter 2 The External Environment Strategic Intent Strategic Mission Strategic Inputs Chapter 3 The Internal Environment Strategy Formulation Strategy Implementation Chapter 4 Business-Level Strategy Chapter 5 Competitive Rivalry and Competitive Dynamics Chapter 6 Corporate- Level Strategy Chapter 10 Corporate Governance Strategic Actions Chapter 7 Acquisition and Restructuring Strategies Chapter 8 International Strategy Chapter 9 Cooperative Strategy Strategic Competitiveness Above-Average Returns Strategic Outcomes Feedback

Corporate Governance Corporate governance is a relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations concerned with identifying ways to ensure that strategic decisions are made effectively used in corporations to establish order between the firm’s owners and its top-level managers

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 The Firm

Corporate Governance Mechanisms Internal Governance Mechanisms Executive Compensation use of salary, bonuses, and long-term incentives to align managers’ interests with shareholders’ interests Monitoring by top-level managers they may obtain Board seats (not in financial institutions) they may elect Board representatives The Firm

Corporate Governance Mechanisms External Governance Mechanisms The Firm The Firm Market for Corporate Control the purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness

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

Agency Relationship: Owners and Managers Shareholders (Principals) Firm owners

Agency Relationship: Owners and Managers Shareholders (Principals) Firm owners Managers (Agents) Decision makers

Agency Relationship: Owners and Managers Shareholders (Principals) Firm owners Managers (Agents) Decision makers Risk bearing specialist (principal) pays compensation to A managerial decision-making specialist (agent) An Agency Relationships

Agency Theory Problem The agency problem occurs when: Solution: 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 appropriately 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 problem

Manager and Shareholder Risk and Diversification Shareholder (business) risk profile Managerial (employment) risk profile S M Risk A B Dominant Business Related Constrained Related Linked Unrelated Businesses Diversification

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

Governance Mechanisms Ownership Concentration Large block shareholders 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 (although financial institutions are legally forbidden from directly holding board seats)

Governance Mechanisms Ownership Concentration Insiders The firm’s CEO and other top-level managers Related Outsiders Individuals not involved with day-to-day operations, but who have a relationship with the company Outsiders Individuals who are independent of the firm’s day-to-day operations and other relationships Boards of Directors

Governance Mechanisms Ownership Concentration 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 Boards of Directors

Governance Mechanisms Ownership Concentration 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 Boards of Directors Executive Compensation

Governance Mechanisms Ownership Concentration 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 Boards of Directors Executive Compensation

Governance Mechanisms Ownership Concentration 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 Changes in regulations have made hostile takeovers difficult Acts as an important source of discipline over managerial incompetence and waste Boards of Directors Executive Compensation Market for Corporate Control

International Corporate Governance: Germany Owner and manager are often the same in private firms Public firms often have a dominant shareholder, frequently a bank Frequently there is less emphasis on shareholder value than in U.S. firms, although this may be changing

International Corporate Governance: Germany Medium to large firms have a two-tiered board vorstand monitors and controls managerial decisions aufsichtsrat selects the Vorstand employees, union members and shareholders appoint members to the Aufsichtsrat

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 cross-shareholdings

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

Corporate Governance and Ethical Behavior The Firm It is important to serve the interests of the firm’s multiple stakeholder groups! 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 Capital Market Stakeholders

Corporate Governance and Ethical Behavior The Firm It is important to serve the interests of the firm’s multiple stakeholder groups! Product market stakeholders (customers, suppliers and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groups Capital Market Stakeholders Product Market Stakeholders

Corporate Governance and Ethical Behavior The Firm It is important to serve the interests of the firm’s multiple stakeholder groups! 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 Capital Market Stakeholders Product Market Stakeholders Organizational Stakeholders