1. ©2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Strategic Management: Concepts and Cases 9e Part III: Strategic Actions: Strategy Implementation Chapter 10: Corporate Governance

2. ©2011 Cengage Learning. All rights reserved. 10–2 Corporate Governance Corporate governance is:  A relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations. Primarily stockholders, not stakeholders  Concerned with identifying ways to ensure that strategic decisions are made more effectively.  Used in corporations to establish order between the firm’s owners and its top-level managers whose interests may be in conflict. Owner’s interests are often in conflict (day-traders, short-term traders, Super Fast traders, High Frequency Traders, buy-and-hold traders; dividends vs retained earnings; level of social responsibility; individual vs corporate owners)

3. ©2011 Cengage Learning. All rights reserved. 10–3 Corporate Governance Purpose: To ensure the company is run in the interest of the stockholders, not management The decision-making mechanisms you create—Either committees and review boards or written policies The assignment of decision-making authority and accountability, not the actual management decision-making Implementation Independent board members with no management responsibility Audit committee consisting of financial experts who meet regularly with both internal and external auditors Board committees composed entirely of independent directors Committee meetings are conducted IAW board approved written charters Board conducts regular, formal evaluations of the CEO Board conducts regular, formal evaluations of corporate performance Board conducts an annual ethics review Board reviews conflict of interest policies and compliance for employees and directors Independent auditors may not perform any other function for the corporation

4. ©2011 Cengage Learning. All rights reserved. 10–4 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 guiding and monitoring top- level managers’ strategic decisions

5. ©2011 Cengage Learning. All rights reserved. 10–5 Internal Governance Mechanisms Executive Compensation  The use of salary, bonuses, and long- term incentives to align managers’ interests with shareholders’ interests.  Governed by outside directors (driven by Sarbanes-Oxley Act of 2002) Market for Corporate Control  The purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness.

6. ©2011 Cengage Learning. All rights reserved. 10–6 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

7. ©2011 Cengage Learning. All rights reserved. 10–7 FIGURE 10.1 An Agency Relationship

8. ©2011 Cengage Learning. All rights reserved. 10–8 Agency Relationship Problems Principal (owners) and agent (managers) have divergent interests and goals. Shareholders lack direct control of large, publicly traded corporations. Agent makes decisions that result in the pursuit of goals that conflict with those of the principal. It is difficult or expensive for the principal to verify that the agent has behaved appropriately. Agent falls prey to managerial opportunism. (Does what is best for him rather than what is best for the organization.)

9. ©2011 Cengage Learning. All rights reserved. 10–9 Managerial Opportunism The seeking of self-interest with guile (cunning or deceit) Managerial opportunism is:  An attitude (inclination)  A set of behaviors (specific acts of self-interest) Managerial opportunism prevents the maximization of shareholder wealth (the primary goal of owner/principals).

10. ©2011 Cengage Learning. All rights reserved. 10–10 Response to Managerial Opportunism Principals do not know beforehand which agents will or will not act opportunistically. Thus, principals establish governance and control mechanisms to prevent managerial opportunism. See Satyam Case on page 304.

11. ©2011 Cengage Learning. All rights reserved. 10–11 Examples of the Agency Problem The Problem of Product Diversification  Increased size, and the relationship of size to managerial compensation  Reduction of managerial employment risk Use of Free Cash Flows  Managers prefer to invest these funds in additional product diversification (see above).  Shareholders prefer the funds as dividends so they control how the funds are invested.

12. ©2011 Cengage Learning. All rights reserved. 10–12 Agency Costs and Governance Mechanisms 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. 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. X

13. ©2011 Cengage Learning. All rights reserved. 10–13 Agency Costs and Governance Mechanisms Boards of Directors have a fiduciary duty (an obligation to act in the best interest of another party) to shareholders to monitor management.  However, Boards of Directors are often accused of being lax in performing this function.

14. ©2011 Cengage Learning. All rights reserved. 10–14 Governance Mechanisms 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. In the U.S., financial institutions are legally forbidden from directly holding board seats. Ownership Concentration (a)

15. ©2011 Cengage Learning. All rights reserved. 10–15 Governance Mechanisms The increasing influence of institutional owners (stock mutual funds and pension funds)  Have the size (proxy voting power) and incentive (demand for returns to funds) to discipline ineffective top-level managers.  Can affect the firm’s choice of strategies. Ownership Concentration (b)

16. ©2011 Cengage Learning. All rights reserved. 10–16 Governance Mechanisms Shareholder activism:  Shareholders can convene to discuss corporation’s direction.  If a consensus exists, shareholders can vote as a block to elect their candidates to the board.  Proxy fights.  There are limits on shareholder activism available to institutional owners in responding to activists’ tactics Ownership Concentration (c)

17. ©2011 Cengage Learning. All rights reserved. 10–17 Governance Mechanisms Board of directors  Group of elected individuals that acts in the owners’ interests to formally monitor and control the firm’s top-level executives Board has the power to:  Direct the affairs of the organization  Punish and reward managers  Protect owners from managerial opportunism OwnershipConcentration Board of Directors (a)

18. ©2011 Cengage Learning. All rights reserved. 10–18 Governance Mechanisms Composition of Boards:  Insiders: the firm’s CEO and other top- level managers  Related Outsiders: individuals uninvolved with day-to-day operations, but who have a relationship with the firm  Outsiders: individuals who are independent of the firm’s day-to-day operations and other relationships OwnershipConcentration Board of Directors (b)

19. ©2011 Cengage Learning. All rights reserved. 10–19 Governance Mechanisms Criticisms of Boards of Directors include:  Too readily approve managers’ self- serving initiatives  Are exploited by managers with personal ties to board members  Are not vigilant enough in hiring and monitoring CEO behavior  Lack of agreement about the number of and most appropriate role of outside directors. OwnershipConcentration Board of Directors (c)

20. ©2011 Cengage Learning. All rights reserved. 10–20 Governance Mechanisms Enhancing the effectiveness of boards and directors:  More diversity in the backgrounds of board members  Stronger internal management and accounting control systems  More formal processes to evaluate the board’s performance  Adopting a “lead director” role.  Changes in compensation of directors. OwnershipConcentration Board of Directors (d)

21. ©2011 Cengage Learning. All rights reserved. 10–21 Governance Mechanisms Forms of compensation:  Salaries, bonuses, long-term performance incentives, stock awards, stock options Factors complicating executive compensation:  Strategic decisions by top-level managers are complex, non-routine and affect the firm over an extended period. Won’t know for a long time the effectiveness of a decision.  Other variables affecting the firm’s performance over time. Which gets credit or blame? OwnershipConcentration Executive Compensation (a) Board of Directors

22. ©2011 Cengage Learning. All rights reserved. 10–22 Governance Mechanisms Limits on the effectiveness of executive compensation:  Unintended consequences of stock options  Firm performance not as important than firm size  Balance sheet not showing executive wealth  Options not expensed at the time they are awarded OwnershipConcentration Board of Directors Executive Compensation (b)

23. ©2011 Cengage Learning. All rights reserved. 10–23 Governance Mechanisms Individuals and firms buy or take over undervalued corporations.  Ineffective managers are usually replaced in such takeovers. Threat of takeover may lead firm to operate more efficiently. Changes in regulations have made hostile takeovers difficult. OwnershipConcentration Market for Corporate Control (a) Board of Directors ExecutiveCompensation

24. ©2011 Cengage Learning. All rights reserved. 10–24 Governance Mechanisms Managerial defense tactics increase the costs of mounting a takeover Defense tactics may require:  Asset restructuring  Changes in the financial structure of the firm  Shareholder approval Market for corporate control lacks the precision of internal governance mechanisms. OwnershipConcentration ExecutiveCompensation Market for Corporate Control (b) Board of Directors X

25. ©2011 Cengage Learning. All rights reserved. 10–25 TABLE 10.2 Hostile Takeover Defense Strategies Poison pill—Preferred stock in the merged firm offered cheaply Corporate charter amendment—Staggered board elections to prevent wholesale changes Golden parachute—Large lump sum payments to senior executives of acquired firm Litigation—Lawsuits for antitrust, fraud, inadequate disclosure, etc. Greenmail—Repurchase of shares of pursuer at high value in exchange for leaving the company alone Standstill agreement—Target firm pays pursuer not to buy more shares for a specified time to give target firm time to do something Capital structure change—Dilution of stock such as increased ESOPs, recapitalization, new debt, new stock sales, etc to increase cost to buy the target firm Source: J. A. Pearce II & R. B. Robinson, Jr., 2004, Hostile takeover defenses that maximize shareholder wealth, Business Horizons, 47(5): 15–24.

26. ©2011 Cengage Learning. All rights reserved. 10–26 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.

27. ©2011 Cengage Learning. All rights reserved. 10–27 International Corporate Governance Japan  Important governance factors: Obligation “Family” Consensus  Keiretsus: strongly interrelated groups of firms tied together by cross- shareholdings.  Banks (especially “main bank”) are highly influential with firm’s managers

28. ©2011 Cengage Learning. All rights reserved. 10–28 International Corporate Governance Japan (cont’d)  Other governance 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

29. International Corporate Governance China  The state dominates strategies employed by most firms through direct or indirect controls State Owned Enterprises (SOE) Shareholder profit may not be most important factor Executives don’t seek to maximize shareholder returns Inhibits international M&A and contracting  HOWEVER, that is slowly but steadily changing as more private companies emerge, the equity market takes a more prominent role, and stock trading becomes more fairly managed  More Chinese executives are being compensated based on firm financial performance ©2011 Cengage Learning. All rights reserved. 10–29

30. Chinese Executive Compensation 9/6/11 China's highest paid executive in 2010 was Yang Yuanqing, CEO of Lenovo Group. 78.72M RMB ($12.2 million) The highest paid CEO at an SOE is Han Junliang. He was paid 8.58M RMB by Sinovel Wind Group Co Ltd in 2010.  China policy limits salaries in 2009 to 2.8 million yuan for executives of SOEs, but the policy isn’t enforced The highest paid CEO in the A-share market was Ma Mingzhe, CEO of private company Ping An Insurance (Group) Company of China Ltd, who received 9.87 million yuan. According to the list, there are 232 A-share market CEOs whose annual salary exceeds 1 million yuan. A total of 121 of them are from SOEs and the other 111 are from private companies. 10–30

31. A report released in 2010 by the All-China Federation of Trade Unions showed that SOE executives earned on average 18 times the salary of their average employees. About 20 percent of these employees' salaries have not risen in the past two years. The question is not about whether CEOs are getting too much. It is about whether the individual investors are getting too little from these companies' good performances. In the US, individual investors can share the profits with the executives. In China, the main purpose of companies going public is for financing. Some companies have not distributed dividends for five years although they are expanding their businesses fast. SOE executives are not recruited from the market but assigned by the government. Many huge SOEs have important social functions to provide welfare to society, such as energy and transportation Paying too much will also affect the feelings of civil servants who do a similar job to the SOE executives." Suggestions made to impose regulations on the salary of SOE executives based on the salaries of civil servants at an equivalent level. 10–31

32. The Boards Of Directors Of SOEs Are Expected To Be Given The Right To Hire Or Dismiss Executives According to a draft report on SOE reform (9/5/11) The right to appoint SOE leaders is currently held by the State-Owned Assets Supervision and Administration Commission (SASAC) Currently half of the Board of Directors have to be selected from outside the company by SASAC from retired executives of SOEs in a different business sector  Better diversification to include outside investors would change management and supervision—maybe later 10–32

33. © 2010 South-Western, a part of Cengage Learning. All rights reserved. 10–33

34. ©2011 Cengage Learning. All rights reserved. 10–34 International Corporate Governance Global Corporate Governance  Organizations worldwide are adopting a relatively uniform governance structure. Boards of directors are becoming smaller, with more independent and outside members. Investors are becoming more active. In rapidly developing market economies, minority shareholder rights are not protected by adequate governance controls.

35. ©2011 Cengage Learning. All rights reserved. 10–35 OrganizationalStakeholders Product Market Stakeholders Governance Mechanisms and Ethical Behavior It is important to serve the interests of the firm’s multiple stakeholder groups! Shareholders (in the capital market stakeholder group) are viewed as the most important stakeholder group. The focus of governance mechanisms is on the control of managerial decisions to assure shareholder interests. Interests of shareholders is served by the Board of Directors. Capital Market Stakeholders

36. ©2011 Cengage Learning. All rights reserved. 10–36 OrganizationalStakeholders Product Market Stakeholders Capital Market Stakeholders Governance Mechanisms and Ethical Behavior Product market stakeholders (customers, suppliers and host communities) and organizational stakeholders may withdraw their support of the firm if their needs are not met, at least minimally. It is important to serve the interests of the firm’s multiple stakeholder groups!

37. ©2011 Cengage Learning. All rights reserved. 10–37 Product Market Stakeholders OrganizationalStakeholders Capital Market Stakeholders Governance Mechanisms and Ethical Behavior It is important to serve the interests of the firm’s multiple stakeholder groups! Some observers believe that ethically responsible companies design and use governance mechanisms that serve all stakeholders’ interests. Importance of maintaining ethical behavior is seen in the examples of Enron, WorldCom, HealthSouth and Tyco.

38. ©2011 Cengage Learning. All rights reserved. 10–38 CEO Turnover in the U.S. (12 Oct 2006, ADG) 152 chief executives left their jobs in Sep 2006  Roughly 7.6 departures every business day — surpasses the previous monthly record of 148 set in May 2006 Number of CEO departures thru Sep 2006 more than 1,000. Several high-profile cases of top executives entangled in scandals.  Hewlett-Packard executives are under heavy scrutiny for trying to plug a corporate leak.  Former WorldCom CEO Bernie Ebbers started a 25-year prison sentence at the end of September. Many of the executives are leaving jobs after relatively short tenures  About 28 percent of the executives had been on the job less than three years  Another 13 percent had been on the job under a year, the average tenure of those being shorter than six months. Computer giant CompUSA named its second CEO in four months. Computer maker Gateway has had five CEOs in six years.