1. Chapter 10: Corporate Governance (CG)
Overview:
Define corporate governance and describe its purpose
Separation between ownership and management control
Agency relationship and managerial opportunism
Three internal governance mechanisms used to monitor/control management decisions
The external market for corporate control
Use of external corporate governance in international settings
How corporate governance can foster ethical strategic decisions

2. The Strategic Management Process

3. Introduction
Corporate Governance (CG): The set of mechanisms used to manage the relationship among stakeholders and to determine and control the strategic direction and performance of organizations
Concerned with identifying ways to ensure that strategic decisions are made effectively and facilitate the achievement of strategic competitiveness
Primary objective: align the interests of managers and shareholders
Recent corporate scandals (Enron, Tyco, Arthur Anderson) largely a result of poor corporate governance
Involves oversight in areas where the interests of owners, managers, and members of the board conflict
Top-level managers are expected to make decisions that maximize company value and owner wealth
Effective governance can lead to a competitive advantage

4. Separation of Ownership and Managerial Control
Historically, firms were managed by founder-owners and their descendants
Ownership and control resided in the same persons
Over time these firms faced two critical issues
As they grew, they did not have access to all the skills needed to manage the growing firm and maximize its returns, so they needed outsiders to improve management
They also needed to seek outside capital (whereby they give up some ownership control)
Firm growth lead to the separation of ownership and control in most large corporations
This resulted in the Modern Public Corporation

5. Separation of Ownership and Managerial Control
The Modern Public Corporation is based on the efficient separation of ownership and managerial control
This separation allows shareholders to purchase stock, giving them an ownership stake and entitling them to income (residual returns) after expenses
This right implies a ‘risk’ for shareholders that expenses may exceed revenues
This risk is managed through a diversified investment portfolio
Shareholder value is thus reflected in the price of the firm’s stock
Shareholders specialize in risk bearing while managers specialize in decision making
The separation and specialization of ownership and managerial control should produce the highest returns for the firm’s owners

6. Separation of Ownership and Managerial Control
The separation between owners and managers also creates an agency relationship

7. Separation of Ownership and Managerial Control
Agency Relationship – exists when one or more persons (principals) hire another person or persons (agents) as decision-making specialists to perform a service
Decision making responsibility is delegated to a second party for compensation
Agents manage principals' operations and maximize their returns
Can lead to agency problems because
Shareholders lack direct control
Principals and agents have different interests and goals
Managerial opportunism: seeking self-interest with guile (i.e., cunning or deceit)
Principals don’t know which agents will act opportunistically
Principals establish governance and control mechanisms to prevent agents from acting opportunistically

8. Separation of Ownership and Managerial Control
Agency problems: Product diversification
Product diversification can result in 2 managerial benefits that shareholders do not enjoy:
Increases in firm size is positively related to executive compensation (firm is more complex and harder to manage)
Firm portfolio diversification can reduce top executives’ employment risk (i.e., job loss, loss of compensation and loss of managerial reputation)
Diversification reduces these risks because a firm and its managers are less vulnerable to the reduction in demand associated with a single or limited number of product lines or businesses
Top managers prefer product diversification more than shareholders do

9. Separation of Ownership and Managerial Control
Agency problems: Firm’s free cash flow
Resources remaining after the firm has invested in all projects that have positive net present values within its current businesses
Available cash flows
Managerial inclination to overdiversify can be acted upon
Self-serving and opportunistic behavior
Shareholders may prefer distribution as dividends so they can control how the cash is invested
Figure 10.2
Curve S depicts the optimal level of diversification where Point A is preferred by shareholders and Point B by top managers

10. Manager and Shareholder Risk and Diversification

11. Separation of Ownership and Managerial Control
Agency costs and governance mechanisms
Agency Costs: Sum of all costs (incentive costs, monitoring costs, enforcement costs) and individual financial losses incurred by principals because governance mechanisms cannot guarantee total compliance by the agent
There are costs associated with agency relationships – principals incur costs to control their agents’ behaviors
Effective governance mechanisms should be employed to improve managerial decision making and strategic effectiveness
Governance mechanisms: used to control managerial behavior – to make sure they are acting in the best interest of shareholders
Governance mechanisms are costly
Includes internal mechanisms (ownership concentration, board of directors, and executive compensation) and external mechanisms (market for corporate control)

12. Governance Mechanisms: Ownership Concentration
Ownership Concentration: Governance mechanism defined by both the number of large-block shareholders and the total percentage of shares they own
Large Block Shareholders: Shareholders owning at least 5 percent of a corporation’s issued shares
Diffuse ownership produces weak monitoring of managers’ decisions and makes it difficult for owners to effectively coordinate their actions
Institutional Owners: Financial institutions such as stock mutual funds and pension funds that control large-block shareholder positions
Own over 50% of the stock in large U.S. corporations
Have the size and incentive to discipline ineffective managers and can influence firm’s choice of strategies and overall strategic direction

13. Governance Mechanisms: The Board of Directors (BOD)
Board of Directors: A 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 managers
An effective and well-structured board of directors can influence the performance of a firm
Boards are responsible for overseeing managers to ensure the company is operated in ways to maximize shareholder wealth
Boards have the power to:
Direct the affairs of the organization
Punish and reward managers
Protect shareholders’ rights and interests
Protect owners from managerial opportunism

14. Governance Mechanisms: The Board of Directors (BOD)
3 Groups of Directors/Board Members:
Insider
Active top-level managers in the corporation
Elected to the board because they are a source of information about the firm’s day-to-day operations
Related Outsider
Directors who have some relationships with the firm
Their independence is questionable
Not involved with the corporation’s day-to-day activities
Outsider
Directors that provide independent counsel to the firm
May hold top-level managerial positions in other companies

15. Governance Mechanisms: The Board of Directors (BOD)
Historically, BOD dominated by inside managers
Provided relatively weak monitoring and control of managerial decisions
Movement is towards greater use of independent outside directors
Becoming significant majority on boards
Chairing compensation, nomination, and audit committees
Improve weak managerial monitoring and control that corresponds to inside directors
Large number of outsiders can create problems though
Tend to emphasize financial (vs. strategic) controls
They do not have access to daily operations and a high level of information about managers and strategy
Can result in ineffective assessments of managerial decisions and initiatives.

16. Governance Mechanisms: The Board of Directors (BOD)
Enhancing BOD effectiveness (actual trends)
Increased diversity in board members’ backgrounds
Strengthening of internal management and accounting control systems
Establishment and consistent use of formal processes to evaluate the board’s performance
Creation of a “lead director” role that has strong agenda-setting and oversight powers
Modification of the compensation of directors
Require that outside directors own significant equity stakes in the company in order to keep focused on shareholder interests

17. Governance Mechanisms: Executive Compensation
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 stock awards and stock options
Critical part of compensation packages in U.S. firms
Alignment of pay and firm performance can help company avoid agency problems by linking managerial wealth with shareholder wealth

18. Governance Mechanisms: Executive Compensation (EC)
The effectiveness of executive compensation
Is complicated, especially long-term incentive compensation
The quality of complex and nonroutine strategic decisions that top-level managers make is difficult to evaluate
Decisions affect financial outcomes over an extended period
External factors can also affect a firm’s performance
Performance-based compensation plans are imperfect in their ability to monitor and control managers
Incentive-based compensation plans intended to increase firm value in line with shareholder expectations can be subject to managerial manipulation to maximize managerial interests
Many plans seemingly designed to maximize manager wealth rather than guarantee a high stock price that aligns the interests of managers and shareholders
Stock options are highly popular but can also be manipulated

19. Governance Mechanisms: Market for Corporate Control
Market for Corporate Control: external governance mechanism consisting of a set of potential owners seeking to acquire undervalued firms and earn above-average returns on their investments
Becomes active when a firm’s internal controls fail
Need (for external mechanisms) exists to
address weak internal corporate governance
correct suboptimal performance relative to competitors, and
discipline ineffective or opportunistic managers.
External mechanisms are less precise than internal governance mechanisms

20. Governance Mechanisms: Market for Corporate Control
Hostile takeovers are the major activity in the market for corporate control
Not always due to poor performance
Managerial defense tactics
Used to reduce the influence of this governance mechanism
Hostile takeover defense strategies include
Poison pill
Corporate charter amendment
Golden parachute
Litigation
Greenmail
Standstill agreement
Capital structure change

21. International Corporate Governance
Global Corporate Governance
Governance systems differ across countries
Important to understand these differences if you are competing internationally
Trend is toward relatively uniform governance structures across countries
These structures are moving closer to the U.S. corporate governance model

22. Governance Mechanisms and Ethical Behavior
It is important to serve the interests of all stakeholder groups
In the U.S., shareholders (capital market stakeholders) are the most important stakeholder group served by the board of directors
Governance mechanisms focus on control of managerial decisions to protect shareholders’ interests
Product market stakeholders (customers, suppliers and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groups
Important to maintain ethical behavior through governance mechanisms