1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

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

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

10. 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

11. 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

12. 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

13. 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

14. 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)

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

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 cross-shareholdings

23. 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

24. 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

25. 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

26. 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